So you have read the books, and you are convinced that building your asset base is the right thing to do. It builds security in your life and helps on the step to building out toward your financial goals, financial independence and financial freedom. Unfortunately, the language used in the financial sector can be confusing, and the path to building wealth can often be unclear. The background to understanding this can often be noisy, and internet searches can often feel like people shouting at each other in a room, with the person shouting loudest winning the race.
The other key issue is that often people will argue the importance of assets and asset building wealth from their perspective. Either because they have their own bias (usually because it has done well for them) or they are trying to sell you one of the specific asset classes (e.g. dividend-paying stocks, index funds, exchange-traded funds, real estate investment trusts, other assets, owning property).
Understanding the difference between asset classes and how to build them all comes down to financial education. Understanding when to use them and how to use them depends on many factors (life stage, living expenses, existing assets, your ability to earn money etc.).
Before we delve into the details here, we need to understand some basic finances. First, we need to understand an asset and a basic overview of asset classes. So often, people are influenced by others suggesting they will make more money or earn passive income-producing assets by taking a single course of action.
It would be best if you weren't either passive or under-educated in this when meeting someone who is trying to influence you. If you feel like this, it is not an inherent fault, but the fact you were never taught this at school, university or by friends or family (who often have not had financial education either).
We need to first start by understanding the difference between an asset and a liability.
What Is An Asset?
The Cambridge English Dictionary describes an asset as:
Something valuable belonging to a person or organisation that can be used for the payment of debts
At first glance, this seems quite simple and could include many forms, such as cash, savings, commodities, an income-producing asset, individual stocks, or treasury bonds.
The problem with this definition is it does not say how that value is derived (e.g. income vs capital growth) or over what time frame the debt needs to be paid.
An asset can be used to pay debts (or produce income) either from the capital growth of the asset(i.e. how much it goes up in value) or income. For example, let's use the value of your own home and assume that you own this with a mortgage. The asset's value (usually) goes up over time, but there will be no income unless you rent out a room. So, going back to the original definition, you need to sell your house to repay debt or produce income. Alternatively, if you rent a second home, you will gain capital growth and generate income from the rent.
Whether your own home is an asset or not has been a cause of controversy in the financial sector and brought to the fore by Robert Kiyosaki in the book Rich Dad Poor Dad. His definition of an asset is:
An asset puts money in your pocket
This definition concentrates on income-producing assets and cash flow, not capital growth. Using this perspective, by investing in the best income-producing assets, you can generate income which will pay for your life regardless of capital growth.
Going back to the idea of your house owned with a mortgage, it produces no income and has considerable expenses and a mortgage. The cash flow here is almost always negative with no income-generating potential and, therefore, a liability. A second home rented out, providing the income is more than expenses, would be an asset and produce positive cash flow (and hopefully capital growth).
So which definition should we use? Purists can argue about this all day, but I prefer the most empowering definition. In this case, that is Robert Kiyosaki's Rich Dad approach.
How Do I Acquire Assets?
Very simply, there are two ways of acquiring assets. You can either buy them or create them. One requires money, and the second time and creativity. Both require some level of education, where the Building Out blog comes in.
Going back to the idea of real estate as an asset, you can look on the open market and buy a house (usually by lending money for a mortgage), or if you have the technical skills, you could build the house yourself, which costs less in monetary terms but clearly requires your time and experience. So real estate investing to help achieve financial freedom can be done very differently depending on the time and money available.
Other examples of buying assets to produce a great income-producing asset would be to own a business either by building a traditional business or online business or buying a portion of an existing business, usually through the stock market.
The best asset classes depend on multiple different things, such as your life stage, tolerance for risk, and financial background. The ultimate aim is to produce multiple income streams to achieve financial independence and then financial freedom. All the while building your net worth. In future blogs, we will discuss which asset class in more detail.
What Is A Liability?
The dictionary definition of a liability is:
The responsibility of a person, business, or organisation to pay or give up something of value
Good examples of this would be a mortgage or personal loan. Again this definition is very broad, and it is easy to assume all liabilities are bad from a financial perspective. For example, an equity loan against your house would be a liability but could be used to start a business that brings in more income-producing assets.
Rich Dad's Robert Kiyosaki argues again that the definition of liability is related to cash flow:
A liability takes money out of your pocket
With his approach using debt to produce income-producing assets (income after expenses) is an asset rather than a liability. Again this is a far more empowering definition of what a liability is.
How Do I Reduce Liabilities?
Reducing liabilities can be difficult. Often as people go through the school system into employed work, their income increases, and the trap of acquiring liabilities has a powerful pull. In addition, society's expectation of a great car, a big house, regular holidays, and other status symbols draws us in. They give a feeling of doing well and psychological safety of being able to afford a comfortable lifestyle. If you feel like this is you, you are not alone.
SO what are we to do? The first thing is to be aware of this and not increase these liabilities further. When your car needs changing, what do you do? Look to get a better one or something that is just functional. The 'keeping up with the Jones' is a real phenomenon and deep-rooted in social comparison and acceptance by others.
Identifying your liabilities and which can be reduced is a really important step to building your assets. There will shortly be another post on this and the exact specifics of how to approach reviewing your liabilities.
If you want to deep dive into this topic, I recommend you get a copy of the Rich Dad Poor Dad book.
I hope you found this useful, and I would love to hear from you and where you are on your journey. The next blog post is on the type of asset classes.
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Good luck on your journey!
Diarmaid
