Having a lot of stuff does not make a person wealthy. It is true that to be wealthy you need to own lots of assets, but these assets must be of a certain type. Cars and clothes won’t build your wealth, but stocks and investment properties will.
To make your money work for you so that you can end up living a comfortable life, you have to know the difference between good and bad assets.
You can distinguish between the two types by answering two questions:
1. Does the value of this thing increase or decrease over time?
2. Does this thing generate a positive or a negative cash flow?
Let us take a house as example. When you buy the biggest and most expensive house you can afford, you could easily end up in a cash-flow crunch. Between servicing your home loan and maintaining the house and garden, you might not have money left for much else. (You will certainly not have money to acquire other wealth-creating assets!)
In this example, the asset you have bought only passes the first test (increasing in value). It doesn’t pass the cash-flow test.
When you look at an asset based on the two questions, you can place it into one of three categories:
- Best: Assets that BOTH increase in value AND generate positive cash flow
- 2nd best: Assets that EITHER increase in value OR generate positive cash flow
- Worst: Assets the NEITHER increase in value NOR generate positive cash flow
Usually, the house in which you live (also called your primary residence) falls into the “2nd best” asset category. However, if you don’t live in your house alone but rent out parts of it – maybe a room or a garden cottage – it has the potential to grow in value and generate a positive cash flow (but only if the monthly rental income is greater than the monthly mortgage, insurance, property tax and maintenance expenses). A rental property is therefore an example of a “Best” asset type.
How about “Worst” assets? Examples of these include clothes, cars, boats, furniture and household goods. They lose value and they don’t generate positive cash flow. While you obviously need a car and furniture, your financial wellness is best served by limiting the amount of money you spend on these bad assets.
Bad assets take money out of your pocket in three main ways:
1. They cost you money to buy.
2. They usually cost you money to maintain.
3. They have an opportunity cost.
This means they prevent you from doing something else with your money – something that could have resulted in a “Best” asset.Simply put, when an asset is not making money for you and you put more money into it than you can get out of it, it is a bad asset.
Good assets, in contrast, put money in your bank account. They are things like stocks, bonds, mutual funds, commodities, investment property, futures, options, hedge funds, and so on. All these assets are commonly called investments.
Many of us believe that as an ordinary salary earner we cannot have investments. That is not true. Your pension fund, for instance, is an investment, which is why you should think very carefully before cashing out your pension when you change jobs.
The best way to get your money to work, is to invest in good assets and steer clear of the bad ones. Understanding the difference between them, is the key to spending less on things that make you poorer and more on investing in the future.
