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Earn and acquire assets like the rich, spend like the poor

3 February 2015 in Investing Insights

There are three main classes in most societies: the poor, the middle class, and the rich. In a recent survey, approximately 40% identify themselves as poor, about 44% label themselves as middle-class, and only about 15% consider themselves to be upper-class or rich. While some lack the necessary resources to become rich, many have the ability, but simply do not purchase assets that have the potential to appreciate in order to eventually make them rich. Instead, money is often spent as soon as it is earned for immediate need or gratification.

The average person might think the rich were born into their money, but studies have shown only 30% of billionaires actually inherited their wealth. Instead, many rich citizens have stemmed from humble middle-class families, and have simply learned what it takes to acquire wealth.

THE DIFFERENCE BETWEEN GOOD ASSETS AND BAD ASSETS

When one learns basic accounting in college, professors explain that a balance sheet is made up of assets, liabilities, and equity. But, hardly ever is the student taught that there is a dramatic difference between good assets and bad assets, especially in the context of earning money.

In their most basic form, good assets earn a positive cash flow while bad assets end up costing you money (or at the very least constricting your cash flow). As an example, a car, based on accounting principles, is typically a bad asset. Once you buy a car, it tends to start depreciating in value, not to mention it also costs you money in insurance, gas, and maintenance. More importantly, it is unlikely to generate any cash flow, unless you rent it out in one of today’s many car-sharing businesses.

A rental property, however, can be a good asset because if rented to a responsible tenant, it will repeatedly put money in your pocket each month. Other possible examples of good assets are dividend paying stocks, bonds, and businesses because these assets have the potential to earn positive cash flow during the duration of ownership.

WHAT ASSETS DOES EACH CLASS TYPICALLY OWN?

Although the ability to earn money and create wealth is not the same for everybody due to circumstance, America provides one of the greatest platforms for people to move forward. We’ve got a stable government, a working legal system, strong employee rights, and public infrastructure that enables people with enough determination to get ahead.

By their very definition, the poor have a limited ability to purchase assets due to most of their income going toward basic necessities.  The difficulty of having to survive on a low income may tempt some to uproot themselves from poverty through get-rich actions like gambling or purchasing lottery tickets. Very few come out ahead this way and a great majority of those already in poverty may unfortunately stay in poverty. It can be a very vicious cycle that requires a confluence of education and time.

The middle-class tend to have jobs that are consistent and pay well from week to week or month to month, which gives them the ability to purchase assets. However, simply having an ability to purchase assets may not result in a sensible investment, especially if buyers spend beyond their means. Examples of waste include buying McMansions, expensive cars on payment plans, and boats. Unfortunately for such spenders, these types of assets aren’t going to earn them money. Instead, these items are likely eating away at their cash flow each month, especially if they are purchased on unfavorable credit terms. Without a healthy cash flow, it is difficult to acquire good assets, which can contribute to keeping the middle-class in their respective societal position for life.

The rich have an entirely different story. Instead of buying bad assets that generate no revenue, the rich have the opportunity to delay gratification and purchase assets that produce income or a higher principal value down the road, perhaps on more favorable terms. This process is repeated again and again, which, in an opportunistic situation can result in their asset income exceeding their work income. The rich may continue to get richer, and it may be  because they are making timely investments in the proper assets.

ASSET ALLOCATION VARIANCES BY WEALTH

It is interesting to look at how asset composition varies amongst wealth classes. Notice how large the principal residence weighting is for the Middle 60% compared to the weighting for the Top 1% in the chart below. When the housing downturn hit in 2008-2010, the middle class got crushed in part because they lacked the diversification of income from good assets to be able to compensate for their short-term expenses.

How can the Middle 60% try to reduce their principal residence exposure to get more inline with the Next 19% and Top 1%? One possibility is purchasing smaller, more affordable homes to free up more funds for investing in financial securities. Another significantly lower weighted asset class for the Middle 60% is business equity and other real estate. This is likely a challenging category for the Middle 60% to expand due to greater difficulties obtaining loans to launch a company, buy a rental property, and come up with cash necessary to invest in private equity. Paying down debt to improve their debt to income ratio can help with their ability to be flexible with taking advantage of opportunities that arise, such as qualifying for a loan to acquire a rental property or new business endeavor.

asset-mix-of-rich

Source: http://www.wsj.com/articles/BL-REB-29827

THE PROCESS OF BECOMING RICH

Discipline is a key word in becoming rich. There are countless examples of people making millions of dollars and ending up broke due to a lack of discipline. The temptation to spend is ubiquitous to the point of complete exhaustion. In order to start down the road to riches, consider some common examples from those who have already met their goal:

  • Maxing out your 401k and IRA.
  • Saving an additional 20% or more of your after-retirement, after-tax income.
  • Invest your additional savings in a portfolio of stocks and bonds appropriate to your risk tolerance and financial objectives.
  • Accumulate real assets, such as real estate property, to further diversify your net worth
  • Track your net worth so you know where your money is going.
  • Do not let your spending increase faster than the rate of your income growth.

Motif Investing offers flexible investment products and services to prepare you for retirement and help you build your wealth. Select motifs that suit your investment needs and let Motif Investing help you achieve your financial goals.

  1. theYellowDart
    4 Feb at 4:24 pm

    Maxing out your 401K is NOT the path to becoming rich. Maxing out your 401k only makes sense if you are planning to retire poor. A 401k eliminates your control over the assets, only allows you to invest in mutual funds that are expensive and gets taxed heavily, and if your planning on retiring rich, you will actually be in a higher tax bracket when you retire because your loose your mortgage deductions and dependents (Hopefully).

    I do put into my 401k for my employers match, but beyond that I put the rest of my money into assets that the government pays me (in the form of tax credits and tax incentives) to obtain.

    Reply
    • Nick Bear
      4 Feb at 6:17 pm

      Thank you for the comment. I am an Registered employee of Motif.

      It is fair to say there are many ways people can reach this goal, so if you feel your strategy is better, perfect!

      The one thing I will clarify is you comment around investment choices within a 401k plan. Each company has a different plan, and has different options offered to their employees. I have seen plans that only allow mutual funds to plans that allow stocks, ETFs and funds. Plan options are up to the employer and how robust of a 401k they want to offer their employees.

      Thanks!

      Reply
      • Jay
        25 Feb at 5:01 pm

        Nick, can you list here or email me a 401k plan that allows stocks? I am starting one for my employees and this is a goal, but I am striking out in finding one – only found those that allow investment in mutual funds, as if the owner of the retirement account isn’t knowledgeable or responsible enough to chart his own destiny with stocks. Thanks.

        Reply
        • BruiserB
          2 Mar at 9:03 pm

          My company’s 401k is administered by Hewitt. As an option we can transfer funds to a “PCRA” (Personal Choice Retirement Account) at Schwab where we can buy pretty much anything Schwab offers. The PCRA is just another fund in the Hewitt choices that we can transfer to or from. If you Google “Schwab PCRA” you can find info on this option.

          Reply
        • John Kissane
          29 Mar at 5:24 am

          I rolled my 401K to Vanguard and they allow stocks.

          Reply
    • Mohamed zaman
      3 Apr at 9:04 am

      Which funds gets you incentives in tax from government?

      Reply
    • Uncle Scrooge
      7 Aug at 5:52 am

      100% Correct.

      Reply
  2. Jack
    4 Feb at 5:04 pm

    Interesting on the high percent of business equity and other real estate in the top 1%. I can see how having assets like rental properties and ownership in one or more businesses can really benefit over time. Takes risk and being disciplined not to throw money away into wasteful things.

    Reply
    • MikeM
      4 Feb at 11:17 pm

      Yes. Very interesting. I believe that business equity and non-home RE are illiquid assets and are non-correlated with public markets. Being difficult to get into and out of rapidly protects the holders from speculators. What is available to the non-1%s? Being a landlord is very difficult and buying into a business can be to expensive and risky. What public assets behave the most like business equity and RE. Berkshire Hathaway?

      Reply
      • ryan
        4 Apr at 2:51 pm

        Look into REITS.

        Reply
  3. Jacob
    4 Feb at 5:55 pm

    I’ve built a lot of my wealth through real estate. It’s the easiest asset class to own and it inflates with inflation. Stocks are a mixed bag. I’ve had good luck, and bad luck. I like how you can build a 30 stock motif inexpensively, instead of having to put my eggs in one or two stocks.

    Reply
    • Nick Bear
      4 Feb at 6:17 pm

      Thanks Jacob for the comment!

      Reply
  4. Eric
    3 Apr at 10:36 am

    This article is so true. In 2002, I invested in my first rental property and while still working full-time, I accumulated 9 investment properties including multiple apartment buildings. While working my regular job, I also maxed out my 401K / ROTH. In addition, in 2009, I took a risk and bought stocks when the DOW was around 6500. One of the stocks included a bank stock that was $1.48/share when I first bought it and it is now around $19/share. In 2012, I quit my job and now live on my investments (real estate / stocks). Since than, I have paid off my house (worth around $255k) to increase my monthly cash flow. With having two 1998 vehicles, I have managed to keep my monthly expenses to around $1300 (car/home insurance, health care, property taxes, utilities, etc.). I am by no means a billionaire and make around what my previous salary was when I worked full-time, but my quality of life has increased 10-fold and the workload has drastically been reduced. I did start off on the right foot by going to college and got a decent job in the IT field, but I used that as a stepping stone to have the financial freedom that I now have today.

    Reply
    • Mike
      28 Oct at 12:09 pm

      Hi Eric,

      I’m hoping to get into investments just like you mentioned here. Could you give me a little more info on how you got into your first rental property investment? Did you get a second loan (apart from your primary residence loan) to purchase a new property to rent out? Or did you invest in REITs? I’m a very new first-time homebuyer and it doesn’t seems to me that I’d be able to get a decent second loan to purchase a property. Thanks for any info!

      Reply
    • Zohib
      28 Jan at 6:37 am

      Hi Eric – I’m very interested in your path to becoming financial independent. As for me, I’m a very frugal individual when it comes to saving and spending. One of the best book i have read is “Millionaire Next Door”. I highly encourage everyone to read this book. Please let me know how i can follow your foot steps? Thanks Zohib

      Reply
    • hy
      28 Jan at 7:23 am

      I am inspired by you

      Reply
    • Mauro castro
      31 Jan at 3:06 pm

      I love your story. Is great that everything work out your way. Personally I think is good to take the risks and be financially free. You don’t mind telling me what kind of stocks/ shares did you bought? I want to start buying stocks but I’m not sure where to start, so it will be great to get a good recomendetion from a person who did good at it. Thank you!

      Reply
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  6. Tom Psillas
    27 May at 3:17 pm

    If you really want to become a millionaire, while working for someone else, consider angel investing, up to 10% of your net worth.
    If the company becomes a $20 Billion venture in 3-5 years and you buy 5% of the company, you would become a Billionaire.

    Reply
    • Alfred o. Garcia
      26 Feb at 9:32 pm

      What is angel investing?

      Reply
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  8. David
    24 Nov at 7:47 pm

    I have a question and I know it is a little too late from the date this article was published. From reading the article and studying the asset mix diagram, the top 1% has about 27% of their wealth dedicated to financial securities. What types of accounts would support that?

    Reply
  9. Carl
    23 Feb at 7:58 am

    Fascinating chart on the asset mix by net worth. I should start diversifying more.

    Reply
  10. gee
    10 Jun at 12:02 am

    Good article

    Reply
  11. amy
    25 Jun at 7:32 am

    At this point in the market, telling you how I bought stocks in 2011 that are up 200% helps no one. Today, I would learn FAST how to trade options, but SPY puts, and sell calls, both naked and covered.

    Reply
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