If you want to become wealthy, you need to manage money like wealthy people do. As Robert Kiyosaki explains in his book, Rich Dad, Poor Dad, people who are poor or middle class have money come into their pockets through work and then right out again for expenses. Rich people use some of their money to acquire assets – things that make money for them. These assets keep paying them their whole lives, allowing them to increase their income little-by-little. This is having your cake and eating it too. When you have a cash flow plan where the income from assets is used to buy more assets, you really have the recipe for building wealthy.
In Chapter 6 of The SmallIvy Book of Investing, Book 1, I go through the process of creating a cash flow plan. A cash flow plan shows how money comes into your life and where it goes once it gets there. This starts with a budget, where income is allocated to expenses, but then goes beyond this to allocating money to investments, both what I call “required investments,” which are things like investing for retirement and for college, and other investments in just standard, taxable accounts that allow you to supplement your monthly income. A good cash flow plan will have both of these elements. The required investing will ensure you have the money you need for retirement, college tuition, and another expenses that will occur. The other investments will allow you to add to your income and eventually get to the point where you don’t need to work to support yourself.
The gory details of preparing a cash flow plan are presented in the book, but the basic elements are shown in the figure below. In fact, if you wanted you could print off the figure below and use it as a template in preparing your own cash flow plan.
Your cash flow starts with your income, shown in Box a) above. This flows into your bank account or your pocket and becomes your “cash on hand” in Box b). For most people, this money then flows into:
c) Obligated Expenses, like rent, car insurance, and student loans,
d) Necessary Expenses, like food, utilities, and clothing, and
e) Optional Expenses, like cell phones, vacations, and cable TV
and then the cash flow diagram stops. Every dollars that comes in goes out to expenses, and optional expenses are added until that equilibrium is reached. One issue with that sort of cash flow diagram is that no money is saved and invested, meaning that even though you earn a lot of money, you never gain any wealth. You are as poor as you started when the month ends despite all of your hard work. The bigger issue is that you have no savings to take care of things that don’t occur every month but are very expensive, like car repairs and medical bills. When these things happen, you end up taking out another loan or putting the bill on a credit card and adding to your obligated expenses.
A final issue with this sort of cash flow plan – the typical cash flow plan for a middle class family – is that no money is put into Box f) Required Investments. This means that when college or retirement rolls around, there is no money to pay for these things. How sad is it that families that go through millions of dollars in their working lifetimes plead poverty when it comes to paying for college or a nursing home! It is even sadder that publications like Money magazine provide advice on how middle class and even wealthy families can qualify for college financial aid and free nursing homes by how they use their money. Can’t anyone just pay for things anymore? But I digress….
In the very least, every family should be putting money into Box f) Required Investments. You should be putting 15% of your paycheck away in a 401K or other retirement account so that you’ll be able to retire with dignity. You should also be saving for your children’s college through an educational IRA or a 529 Plan, putting money away for medical co-pays and deductibles, and saving money for car repairs, home repairs, and vacations. Note on the cash flow plan, however, that there is no arrow coming back from Box f) to Box b) Cash on Hand, meaning that those investments do not contribute to your income, at least not until you retire.
If you want to increase your income and become financially independent of your job while you’re still young, you need to increase your free cash flow, shown in the upper right corner. This is your income minus your f) Required Investments, c) Obligated Expanses, and d) Necessary Expenses. This will allow you to direct income into Box g) Saving and Investing, where your optional investments reside. In this box are investments in things like mutual funds and individual stocks outside of retirement accounts. These assets create investment income, which flows into Box a) Income. You can spend some of this additional income, but if you keep your cash flowing from Box a) to Box b) to Box g)and back to Box a) again, you can buy more assets and increase your income. This increases the size of Box a) and thereby increases your free cash flow.
It starts slowly at first and takes time, but just as feedback through a microphone produces a deafening screech as sound is circulated through the microphone, to the speakers, and back through the microphone again, set up a circular path in your family’s cash flow and you’ll have a massive free cash flow that will overwhelm the amount of money you’re bringing in through work by the time you reach the middle of your career. If you want to be wealthy, manage your cash flow like a wealthy person does.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.