Good Thinking

Ideas that influence the way we think.

The Best Financial Advice I Ever Got

These three simple rules can put an end to living paycheck to paycheck.

After graduating from college with a Batchelors degree in Psychology, I did not go straight on to graduate school. Instead, I decided to capitalize on my business minor by venturing into the finance world where I worked as an analyst for several years. This was long before the financial meltdowns, back when banks held onto the commercial and mortgage loans they made—meaning that they wanted to know whether the business or family that was applying for the loan was actually credit-worthy. And so I spent a good deal of time analyzing balance sheets (statements of assets and liabilities) and income statements (income and expenses) in order to make recommendations concerning a firm's creditworthiness. I also took courses and read a good deal about personal finance strategies.

In this blog, I want to share with you three pieces of advice that made a difference in the way I thought about, earned, spent, and invested money.

1. Understand the difference between an asset and a liability.

You probably think you already know the difference—that an asset is what you own and a liability is what you owe. But re-casting your definition of asset to mean "something that puts money in my pocket" and liability to mean "something that takes money out of my pocket", as Rich Dad, Poor Dad author Robert Kiyosaki recommends, will change the way you think about money.

Kiyosaki points out that the rich buy assets, the poor get mired in liabilities and expenses, and the middle class buys liabilities on credit while thinking think are assets. Using Kiyosaki's definition, your college degree is an asset if it allows you to get a job that puts money in your pocket on a regular basis. A boat, a Coach bag, a Rolex watch—these are all liabilities: They took money out of your pocket. If you bought them on credit, they continue to take money out of your pocket. To give you another example, a camera that you buy on credit just for fun is a liability that keeps taking money out of your pocket. A camera that you buy with cash and use to take photos that you sell on iStock.com or Flicker is an asset because it directs a flow of money into your pocket. If you bought it on credit, it is still an asset if they money you earn from selling the photos exceeds your payments.

2. Watch the cash flow program running in your head.

Most people have a cash flow program that looks like this: Earn money from your job, pay expenses, buy stuff, and then, if there is anything left over, put some money aside. That is the surest way to remain trapped on the financial treadmill.

Most importantly, make sure you have set aside at least an amount equivalent to 6-8 months expenses in case you lose your job, as Suze Orman recommends. Otherwise, you may find yourself forever behind the curve when it comes to financial solvency, watching your dreams of financial security remain forever beyond your grasp.

Equally important is that you have a plan for "paying yourself first", that is, investing some of your income in assets that put money back into your pocket. The more you do that, the more money you will have coming in, and the less dependent you will be on your paycheck to make ends meet. Typical examples are on-line businesses, or royalties from books or music you've written. The trick is to make sure that your alternative sources of income don't turn into second or third jobs. And that usually means investing your money wisely so that your money works for you and not the other way around.

3. Be careful where you put your money.

What are the best ways to make your money work for you? A recent Gallup poll asked Americans to choose the best option for long-term investments: real estate, stocks and mutual funds, gold, savings accounts and CDs, or bonds. The winners were real estate (30%), stocks and mutual funds (24%), and gold (24%). Only 14% of Americans believe savings accounts constitute good investments, and even fewer believe bonds are a good bet (6%).

Americans are being rational when they take such a dim view of savings accounts, CDs, and bonds. Why? Because, sorry to say, these time-honored safe investment vehicles are no longer viable investments for growing wealth. Savings accounts used to pay between 5 and 5 ½ percent. Certificates of deposit earned around 7%. U.S. Bonds paid 4%. Today, savings accounts pay less than 1%, CDs pay between 1-2%, and US bonds pay less than 2 ½ percent (depending on the maturity date). Given that prices inevitably rise over time, holding your money in these investment vehicles essentially means that they will lose buying power over time. Unless legislation is passed requiring banks to pay better interest rates on personal savings accounts and CD's, you will have to look elsewhere to grow your money.

Americans tend to trust the real estate market more than the stock market, despite the subprime mortgage crisis that brought about the 2008 global economic downturn. This because the average American tends to have more experience with real estate than with the stock market, usually through home ownership. According to the Gallup poll, upper-income Americans are most likely to say they own their home, at 87%, followed by middle (66%) and lower-income Americans (36%). Homeowners (33%) are also more likely than renters (24%) to say real estate is the best choice for long-term investments.

The problem is that your residence puts ready money in your pocket only by allowing you to claim mortgage interest as a deduction on your income taxes. The wealth you acquire by owning a home is equal to what you can sell your home for, minus what you owe on your home—which is called home equity. But you have to sell your home (or obtain a reverse mortgage) to touch that money. You can borrow against that equity via a home equity loan, but that still counts as borrowed money. And living on borrowed money is a disastrous strategy that has taken many an American into bankruptcy.

To make real estate an asset in Kiyasaki's terms, it needs to put money in your pocket on a regular basis. There are two ways that upper middle class Americans achieve this goal. First, they buy a property and rent it to others to live in or to conduct business in. The renters pay them monthly. If the rent the owner is charging exceeds the amount the owner is paying for mortgage interest, property taxes, insurance, and repairs, then the property is indeed an asset—it provides positive cash flow. The second way Americans invest in real estate is to purchase a "fixer-upper", renovate it, and sell it at a higher price. This is called "flipping" property.

And that brings us to the stock market. Perhaps, like many Americans, your find the idea of investing in the stock market daunting. Well, rest assured, you are already there. Have a pension or 401k at work? Well, that money is undoubtedly invested in the stock market. According the Gallup poll, upper-income Americans are the most likely to own stocks (82%), followed by middle-(57%) and lower-income Americans (16%).

The safest way to invest in stocks is through index funds. These are mutual funds that are designed to track a particular market index, such as the S&P 500.

Another way is to buy "bed-rock stocks", sometimes also referred to as "widows and orphans" stocks because they are considered safe investments, such as General Electric or Johnson & Johnson.

What you should not do—unless you have fully trained in the "sport"—is engage in day trading or other short term stock trading. Nor should you automatically place complete trust in your bank or brokerage firm, assuming that they operate with their customers' best financial interests in mind. In my next blog, we'll take a closer look at how honest investors can fall prey to savvy traders.

Copyright Dr. Denise Cummins May 23, 2014

Dr. Cummins is a research psychologist, a Fellow of the Association for Psychological Science, and the author of Good Thinking: Seven Powerful Ideas That Influence the Way We Think.

More information about me can be found on my homepage.

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Denise Dellarosa Cummins, Ph.D., is the author Good Thinking, The Historical Foundations of Cognitive Science, and Evolution of Mind.

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