In part 2 of my series on financial success, I dig into how I think about personal finance concepts.  Not only do I need to know myself, but I need to know how property, money, time, and energy interact to improve my wealth and well-being. Of course, wealth is only a means to an end – my happiness. Wealth of course isn’t a guarantee of happiness, far from it, but it can provide additional opportunities to live a happy, enriching life.

Focus on Essentials

Let me begin with the foundation of financial accounting – the big 4 – assets, liabilities, income, and expenses.  Generally speaking, assets produce income and liabilities produce expenses.  That’s not always true, but I don’t want to complicate things at this point.

Now, thinking about all 4 of these things is essential for businesses, but in personal finance, it can become overwhelming.  While developing my new personal financial system, I wanted to simplify.  So, I started by focusing on just two of these four – assets and expenses.  When investing in an asset, I generally care what income it creates.  But not always.  Some assets produce little to no income (like gold), yet I choose to invest in them for other reasons.  It puts my focus on increasing valuable assets that produce long-term value, not so much on near term income.  I did not place the same focus on types of income, because as far as I’m concerned, once money gets into my hands, it really doesn’t matter how it got there.

For a similar reason, I don’t focus on liabilities in my financial system because my mind shuts down when I realize that I owe nearly a half million on two mortgages.  That doesn’t help me manage the debt, which I can do far more effectively by focusing on the expenses and lowering them as appropriate. There are also other parts to living that require expenses (like food and kids), which aren’t liabilities.

So where is how I break down my assets and expenses.

Investing in Assets

An asset is an economic resources, either tangible or intangible, that produces value.  Assets can range from land, to buildings, to cash, to copyrights, to trademarks, to knowledge, to networks of professional associates.  Tangible assets are the ultimate for living, because we are tangible – flesh and blood – in the real world.  If you can’t convert an intangible asset into something tangible, then it really isn’t an asset.

In my system, I define three buckets for assets – one for security, one for income production, and one for speculation.

The security bucket contains assets such as cash, precious metals, CDs, and even my own home (especially if it’s completely paid off). The idea behind the security bucket is that these cores assets will help in case of emergencies.  If you lose your job, having 6 months’ worth of living expenses in the bank can help tide you over until you find a new income source.  Owning your own home, mortgage free, is a massive boon for your financial security because it makes living through extreme emergencies far more tenable.

You can also invest in knowledge security.  Whether basic home maintenance or Armageddon preparedness, that knowledge asset can help you when changing careers or surviving a depression.

The next bucket is income production – what I like to call the cash cow investments.  For many of us, those assets take the form of knowledge of a specific trade.  The salary we earn enables us to cash in on that knowledge.  It is extremely time intensive and not very tax friendly, but still lucrative and generally easy to find. I know this categorization completely contradicts a lot of the personal finance literature on how to get wealthy, but it is a mistake to treat this income as anything other than what it is. Other cash cow assets include book/music/movie royalties, rental property, REIT, pensions, dividends, and ownership of a profitable business.

Keep in mind the three-way interaction between assets, income, and time.  While ROI (return on investment) takes these three into consideration, time should also include your personal time to make an asset produce an income.  For example, my rental property produces an income of approximately $1000 per year.  Small, I know.  Of course, I’m not including the principle I’m paying off, nor appreciation because neither of those have been realized.  However, it requires approximately 5 hours of my time per year depositing checks, hiring maintenance workers, and communicating with the tenant (netting me about $200/hr).  The investment in my education has produced an asset that nets me over $100k per year in salary from ECU. Because of a graduate assistantship, I paid less than $5000 for that PhD.  It would seem to be a great ROI. However, it requires over 2000 hours of work per year (roughly $50/hr).  The time required to maintain my salary restricts the time I have available to increase my income by other means.  On an hour by hour basis, the rental property makes me more money.

The last asset bucket is for speculation.  Investment in these assets generally are done in hopes the asset can be sold at a higher price than purchased, not necessarily because of the cash flow.  These include investments in stocks, mutual funds, or derivatives.  Although, I also include new ventures that may become income producing cash cows, but the newness of the venture warrants a speculative mind-set until the asset prove itself.  It may include starting a new business, writing a book, or getting a college degree or certification.

The key to these buckets is that you want to fill the security bucket first, up to a pre-established amount.  Once that’s filled, start filling the second bucket – cash cows.  And while I do include job related salaries as cash cows, keep in mind that the salary will end at some point (retirement), so a variety of assets in this category makes for a more secure future.  Lastly, fill the speculation bucket.

Tracking Expenses

For expenses in personal finance, I want three buckets as well – living expenses, assets, and fun.

The first, living expenses, is for everyday living – rent/mortgage, food, tuition, insurance, car payments, clothes, utilities, books, etc. Generally speaking, the living expenses should be paid first, because, you know, you want to stay alive.  Problem is, this bucket tends to rapidly expand consuming any additional income as it becomes available.  Buying that bigger house, which means more taxes, more insurance, higher utilities, more furniture, and on and on. That’s why Kiyosaki in Rich Dad, Poor Dad, recommended paying into the second bucket first.  Yes, pay for the things in the first bucket to stay alive, but if you pay for things in the second bucket first, you will quickly develop the income to cover the expenses from the first bucket while simultaneously developing the skills to continue to build that asset column.

The second is for asset building – adding to security, income producing, and speculation buckets respectively. I cover those above, so I won’t rehash them here.  But they should be treated as a necessary expense.  If you don’t then inevitably everything will wind up in the first and third buckets and you’ll have no assets when it comes time to retire.

The last bucket is for fun.  Fun small things like going out to dinner, buying a gift, or catching a play at the theater. And big fun things like going on a cruise, shopping at Quent Cordair fine art gallery, buying a boat, touring through Scotland, or hiring your very own butler. Only after the first two buckets have been filled will any money go towards fun money.

And that last bucket is extremely important.  While it’s understandable when you are first starting out to minimize the fun bucket, the point of living is to have those unique experiences that come from spending money now and then on fun things.  So work hard enough to acquire the assets to enjoy the fun stuff.

Real Life Assets and Expenses

All this talk of buckets and money being used for one bucket before another sounds all simple and easy.  In reality, it’s not.  For example, part of my problem is that the expenses being funneled into the asset building bucket, through my 401k, is primarily invested in speculative investments (mutual funds). Although it’s good they are paid first, I would prefer to direct that money into income producing assets, not speculative investments.  What’s worse is that I don’t see the money, so I don’t think about it.  And while it has worked well-enough in the short-term, I run the risk of wasting those gains if the stock market slides.

I also struggle with finding income producing assets with small down payments, good returns, and little time investment.  I suppose that’s a problem with everyone.  Still I would like to make it easier.

I also need to find a way to make myself accountable so that the flow of money from one bucket to another occurs regularly without a lot of angst or worry.