All Income Is Not Equal

Today I want to talk about one of the most common misperceptions that people have about jobs and income. I remember a couple of years ago, Mary and I were eating out with a friend, and we mentioned that Mary’s gluten free recipes website was starting to generate some cash flow. The friend asked us how much it had made, and we replied that it was around $100 for the last three or four months.

We were pretty proud of cash flow that we had created, but our friend was clearly surprised that the amount was so low. Why be excited about something that makes you only $20 or $30 a month? The answer lies in the difference between earned and passive income. Let’s take a look at that difference, and see why even small amounts of passive income can be so great.

Income

Let’s say I got a job that paid me $1,000 a month. Is that a good or bad job? Most of you probably said it’s a bad job. However, the astute (and amazingly polite) among you said “I need more information before I can answer that question, please, sir.” And you’re right, you do need more information before you can answer.

As it happens, the job I just got pays me $1,000 a month in exchange for 40 hours of work each week. It’s a typical full time job. So is it a good job or a bad job? Well, it’s not too good. Work a full time job for an annual salary of $12,000? No, thanks.

But now let’s say that the job only requires 20 hours per week. The income has stayed the same, but now the job is a bit better. I could get two of these jobs, work 40 hours a week, and double my yearly income to $24,000. Things are looking up a bit, right?

Now let’s say that the job only requires 8 hours of work each week, and your time will be spent testing the comfort levels of various hammocks while on a beach in the Caribbean. Now, that’s a job! You could get 5 of those gigs, spend all your time on the beach, and make $60,000 a year. Not too shabby.

But as good as all of this sounds, there’s still one problem with each of these jobs. They all require you to trade your time for money. Your earnings potential is capped at the amount of time you have available to spend on the job. If you want to take some time off, if you want to scale back your hours to spend more time with your family, or if you leave for a new job, your income is going to decline. Ultimately, if you quit working altogether, your income will stop completely. I’ve yet to hear of a job where they’ll pay you to *not* work.

Talking about income and work in this way probably sounds a bit silly to most people. Of course you have to work to get paid! It’s as basic a fact as saying that the sky is blue or that sticking your finger in a light socket is bad. But the truth of the matter is, this is not the only way to make money. In fact, this is not even the best way to make money. To be perfectly honest, it’s just about the worst way to make money!

Passive Income

Just about anyone who has access to CNBC or the financial section of a newspaper has probably heard about passive income. But let’s take a minute to discuss exactly what it is.

Passive income (and I’m using a practical, working definition of it; not the official accounting definition) is simply income that you earn while you are not working. Or, to be more specific, it’s income from a system or project that is earned even when you are not working directly on that system or project. It is differentiated from earned income, which requires you to be working directly to generate money.

I’m not going to delve too deeply into passive income systems today, but I do want to talk about why passive income is so great. Remember the website up above? Let’s say that it makes $25 each month, with little to no attention from Mary. That means her website is earning her money when she’s watching TV, asleep, feeding the baby or whatever else she wants to do. It also means – and this is the important point – that her website will continue to plug along and make money even when Mary decides to start up a new website. And in a few months, that new website is making $25 a month. And so she starts up another one, and another one, and another one. Before long she’s got a couple hundred coming in each month (or more) and it’s all passive income.

Do you see why we were excited about making $20 from her website now? We’ve since gone on to start several new websites, and her gluten free site is still plugging along for us. That’s the power of creating passive income systems. Instead of being limited by the amount of time you want to spend actively working, you’re only limited by the number of systems you want to create. Right now, my goal is 20 different systems. When I hit that goal, I’ll probably shoot for 50. Why just have one job?

If all of this is too much to digest at once (or if it totally blows your mind), don’t worry. It’s a big paradigm shift, and it can take some time to sink in fully. In some future posts we’ll explore passive income and the systems that produce it more fully, but for now, just give some thought to the strength of passive income and what it could mean to you.

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This is Part One in my series on passive income. Check out the other parts below.

1) All Income Is Not Equal
2) Using Passive Income Systems To Make Money

How to Think About Assets

John mentioned in his Rich Dad, Poor Dad review that wealthy people think about money differently than poor/middle class people. We have certainly found this to be true and are actively working to change our beliefs about money so that we can make wiser decisions.  Those new thoughts have directly impacted the path that we have chosen for our life, and we’ll be writing a lot about that in the future. But let’s start by talking about assets.

What is an asset?

I started writing this post several days ago and came up with a great definition of an asset. Then I tried to explain my definition to John he completely shot it down – not because it was inaccurate but because it was too complicated. So I’m going to use John’s definition: an asset is something that puts cash into your pocket.

For example, if I own a website that generates $1,000 of advertising revenue a month, that website is an asset. If I own a stock that pays me dividends every quarter, that is an asset.

A business can also be an asset. If the entire business entity has more cash inflows than outflows it is an asset. In fact, a common measure of a business’ value is  its positive cashflow times some industry-specific multiple. If the business is not generating a positive cash flow, it’s not an asset and it’s not worth anything.

What is not an asset?

Things that takes cash out of your pocket are not assets. Most of the things that you buy for yourself are not assets – your car, your house, your dog. While all of these things have the potential to make your life happier, they aren’t assets.

A lot of people think of their house as assets. I recently heard a coworker say that she and her husband wanted to invest in a house while prices and interest rates are low.  What she really meant is that she and her husband were about to pay several thousand dollars to commit themselves to a large monthly payment that they couldn’t afford.

The idea of a personal residence as an investment is one of the greatest fallacies of our times.  The house that you live in has one primary purpose: to shelter you. You can choose to pay for that shelter by paying a monthly rent or by paying one lump sum upfront (purchase price of home).  The home that you buy might appreciate, but that appreciation is completely worthless to you until you sell the house. At which time, you will more than likely use the money to buy another house. The appreciation is stuck in the house – which means that it’s not putting cash in your pocket – which means that your house is not an asset.

Why is this important?

The definition of an asset is important only in that it helps you start thinking about assets. In order to change your financial situation you need to internalize the following two rules:

1. Every stream of cash that flows into your pocket is created by an asset.

Where do you get most of your cash?  Think back through the last month and identify the source of all of the deposits to your checking account.  Rule #1 states that each of these cash flows was created by an asset.

Here’s an example from our lives.  During the past month, we deposited 2 payroll checks and one bonus check. We also had direct deposits for interest income and a commission payment from Amazon. Given this you should be able to deduce that we have the following assets: cash, internet properties, and ourselves.

The average American gets an semi-monthly infusion of cash from there employer. If every stream of cash is created by an asset, then what is the asset that creates your salary? That’s right. It’s you.

Think about this for just a second. The main asset (and maybe the only asset) in your life is you – your body, your mind, your talents. YOU! Hold that thought and let’s move on to the second rule for a second.

2. Every stream of cash that flows out of your pocket has to be paid for with cash created by an asset.

If you buy a piece of land and do nothing with it, you’ve just purchased something that is going to cause cash to flow out of your pocket in the form of property taxes.  If you took out a loan to purchase the land, more money will flow out of your pocket to pay for interest and to pay back the principal of the loan. The land that you thought was an asset is not really an asset. In fact, it’s making your poorer every single month.

And where does the cash come from to pay for this land that’s making you poorer and poorer and poorer. Oh yeah, back to rule one now. It has to come from one of your other assets. And if you don’t have asset other than yourself to produce the cash, you’re having to work harder and harder to pay for this supposed asset that is actually draining money from your wallet.

What do I do now?

For now, just mull these things over. Figure out what assets you have in your life. Make a conscious decision that you are happy with the assets that you have, or make a conscious decision that you would like to change the assets in your life.

If you only have one or two assets that are creating all of the cash in your pocket, consider what would happen if one of those assets disappeared. Could you do without the cash from that asset?  Do you have insurance that would help make up the difference?

Consider whether your life viewed as a whole is an asset? Does the cash that you earn from working exceed the expenses that you incur to sustain your life?  If you life as a whole is an asset, then you will have cash leftover each month.

And finally, imagine what your life like you want it to be. Then imagine opening up your mailbox and pulling out your monthly bank statement. Open it as you walk back to your house (the house that you want to be living in) and look at the deposit section. Where are the deposits coming from? How big are they? How have you chosen to make money?

Rich Dad, Poor Dad Review

Rich Dad, Poor Dad, by Robert Kiyosaki, was one of the first books I read years ago when I first started thinking about ways to become more effective and make money more easily. It’s also probably one of the most well known books in the entrepreneur/business genre. Opinions on it, though, are definitely split. Some people love Kiyosaki (and the book), while others say that he is a phony hack and that the book is pretty much a waste of time.

Let’s take a look at what he has to say in the book and see which side is right.

Rich Dad, Poor Dad

The idea behind the Rich Dad, Poor Dad title is that Kiyosaki says when he was growing up in Hawaii, he essentially had two dads: his biological father (Poor Dad) and the father of his best friend (Rich Dad). Poor Dad was a superintendent in the Hawaii school system, and followed a very traditional career path: work at the same company for many years, and slowly work your way up the ladder. He wasn’t poor exactly – his family lived comfortably – but he was definitely a wage slave who did not like to take much risk.

Kiyosaki’s Rich Dad, on the other hand, was an entrepreneur and business owner. Among other things, he owned several mini-marts in Hawaii as well as a good bit of rental property. He encouraged people (including his son and a young Kiyosaki) to question their beliefs about money and see if there was a better way to go about generating income.

Kiyosaki lays out the differences in his two dads in this way:

One dad recommended, “Study hard so you can find a good company to work for.” The other recommended, “Study hard so you can find a good company to buy.”

One dad said, “The reason I’m not rich is because I have you kids.” The other said, “The reason I must be rich is because I have you kids.”

One encouraged talking about money and business at the dinner table. The other forbade the subject of money to be discussed over a meal.

One said, “When it comes to money, play it safe, don’t take risks.” The other said, “Learn to manage risk.”

Kiyosaki says that he took a job from his Rich Dad when he was 9 years old, and his Rich Dad began to teach him important financial principles and the “rich mindset”.

Rich Mindset

Kiyosaki said says the most important difference between his two dads (and between the rich and poor/middle class) is how they think about money. The poor, he says, spend all of their money on expenses and liabilities. The middle class spend their money on things they think are assets, but are really liabilities. The rich, on the other hand, know the difference between assets and liabilities, and spend their money on assets. These assets then generate enough cash flow to pay for their liabilities.

The second thing that Rich Dad taught was the need for financial literacy. Too many people, especially among the poor and middle class, have very little idea how money, business, investing or real estate actually work. Think about all of the “experts” out there who want to help you with those very things. Then think about this: Have you ever met a poor stockbroker? How bout a poor real estate agent? I bet you haven’t, and a large part of that is because those people know how money actually works.

The responsibility for teaching financial literacy, Kiyosaki says, lies largely with parents, as it is generally not taught in schools. If parents can ensure that their children have a solid financial knowledge base before they leave the house, then they will be way ahead of the game, and will hopefully avoid the traps that so many young adults fall into.

Another point that Kiyosaki makes is the importance of knowing exactly what business you’re in. He shares a humorous story of being interviewed by a writer for a newspaper who complained to him that her career didn’t seem to be going anywhere. Kiyosaki suggested that she attend a class his friend taught on how to sell. She got offended, saying that she had a Masters in literature and didn’t need to know how to sell. As she began to pack up her bags, ending the interview, Kiyosaki pointed at her notes where she had written “Robert Kiyosaki – best selling author.” He pointed out to her that being a best writing author doesn’t guarantee anything, but if you can manage to become a best selling author, success is much more likely.

What To Expect from Rich Dad, Poor Dad

As I mentioned above, there is a bit of controversy surrounding Kiyosaki and his books. Excluding the ad hominem attacks and complaints that Kiyosaki’s Rich Dad may not have actually existed, much of the criticism of Rich Dad, Poor Dad centers around the fact that Kiyosaki doesn’t provide much specific detail in this book. For example, he tells you to start up a business, but doesn’t provide any specific business ideas. He suggests investing in stocks, but doesn’t say which specific stocks are good investments and which ones you should avoid.

While I agree with this criticism – the book does indeed lack specific, detail-level advice – I don’t think that this is necessarily a strike against the book. Rich Dad, Poor Dad is not meant to be a detailed guide to starting your own business or investing in the stock market. Instead, it is a big-picture overview of the things you need to know in order to become rich. If you don’t have the big picture, then knowing the little details is only going to be of so much benefit. So much of  making money is identifying the beliefs that you have about money that have brought you to where you are, and then choosing which beliefs you need to change (and which ones you can keep) in order to get to where you want to go.

For example, if you don’t understand why having a job is ultimately a bad thing – and it is – then why would you need to start your own business? If you think that buying a house is the best investment you can make, then you’ll never see the benefit in investing in something smaller that will actually put money in your pocket. So much of what we think we know about money and becoming wealthy is actually wrong, but unless you get the big picture first, you’ll never learn why changing the way you think is so important.

Overall, Rich Dad, Poor Dad is a great book. It’s possible that if you are already highly financially literate, then you won’t find too much value in this book, but the chances of that are small. The vast majority of people will find tremendous value in this book and the knowledge gained from it will be well worth your time. If you are stuck in a job that you don’t like, or if you are tired of working each month just to barely be able to pay your bills, or if you are simply considering ways to make more money, this book will certainly help you meet your goals. Highly recommended.