Keys to success #5: Be sure you understand the differences between a liability and an asset.

I can waffle on for hours on this topic, and my opinions will differ from most other people - especially those that have not built substantial wealth.

For this discussion, I will set the definitions of what an asset and liability really are.

In short, an ASSET is anything that puts money into your pocket.

A LIABILITY is something that takes money out of your pocket.

Simple, right?!

Let's look at assets. Things that I believe fall into this category are profitable businesses, the right kind of investment properties, dividend yielding equities (stocks, ETF's, bonds etc) and sometimes (but not always) cash.

If you purchase an investment property, and it is cash flow positive, it is an asset as it puts money in your pocket and appreciates in value over time (hopefully). It should generate income for you that you can then take out and reinvest or use to pay down debt.

A business, if run correctly and grows, will put money in your pocket and will increase in value over time. It too, will generate more income for you to then take and reinvest.

Equities (shares, bonds, ETF's) should also generate dividends to put money in your pocket and hopefully the capital invested will grow over time, generate dividends which can be reinvested.

We can also throw commodities (such as gold, silver etc) in this mix, but these are more a "store of value" than a true asset as it is not something that puts money in your pocket. However, long term, these have historically increased in value relative to cash.

Speaking of cash, if you have cash invested and you are earning an interest rate on it, that beats inflation, then cash is also an asset. However, as I write this in 2021, the interest rate on cash is less than 1%. The government stated Inflation Rate (we talk about this more later) is closer to 2%. As such, cash is losing value as I write. When it comes to cash investments, it's about knowing what is happening in the economy and markets at that particular point in time as to whether cash is a liability or an asset.

Let's now look at liabilities. Boats, cars, furniture, holidays, home renovations and anything you can think of that cannot meet BOTH of the following two criteria are likely to be liabilities.

Criteria #1: Does the item put money in your pocket or create an income enough to pay for itself AND put money in your pocket? If the answer is no, then it is a liability.

Criteria #2: Is it likely that the item will be worth more in the future or less. If the answer is less, then it is likely to be a liability.

As always, there are exceptions to every rule and one needs to analyse the whole picture.

If, for example, you own a boat which we know loses value over time, but you use the boat for charters and have paying customers, then based on the above, the boat may be losing value over time but if it generates money for you that not only pays for the cost of the boat, the running of the boat, plus puts money in your pocket, then the boat is an asset.

If however the boat is a personal pleasure craft that loses value over time, costs you money to run and maintain and does not generate any income, then it is definitely a liability because it COSTS you money.

Cars would fall under the same exceptions. If you have a vehicle that is used as (for example) a taxi, this vehicle will lose value over time BUT it also generates an income that covers the cost, maintenance and running of the taxi PLUS puts money in your pocket, then it would be an asset. However, the moment the vehicle became a private and personal mode of transport, it becomes a liability because it COSTS you money.

You will see advertisements that state that "for many people, their car is their second biggest investment" - it may be so, but it is a losing "investment"! I hate those sorts of misleading claims.

Now let's look at a controversial topic.... negatively geared investment properties.

This is touted as a great investment by people thet don't understand assets and liabilities OR by people trying make money from you by selling you a property or a loan.

In reality, a negatively geared property is called such because it creates NEGATIVE cash flow for the owners. That means you are LOSING money every month in order to fund the mortgage. The LOSS or "NEGATIVE GEARING" is then used to offset some of the personal taxes paid by the owner.

Let's say you own a negatively geared property and you rent it out to tenants. Your tenants then pay you (say) $600 per week rental. Your property may have cost you (say) $750,000.

Let's say you had a 10% deposit of $75,000. That means you have borrowed $675,000 at (again, let's say) 2.8% interest for 25 years. Your weekly repayment would be $780 per week. You are now already losing $180 per week from your pocket. On top of that, you also have all the maintenance costs, water rates, council rates, building insurance, landlord insurance etc which would bump that up approximately $100 per week to a total loss of $280 per week. Of course, you can claim that loss against tax that you have paid and get back somewhere between 30% and 45% depending on what tax bracket in are in. BUT the reality is that this property is LOSING you money each week whether you get tax back or not! Of course, people will justify this loss by assuming that the property will have capital growth sometime in the future. While you wait for the capital growth, you are losing $10,000 per year (even after getting some of your tax back).

I fell into this trap in my early days of investing and that's why I KNOW it's not a winning formula. When the average person gets 3-4 of these "investments", they find that they are "bleeding" so much cash and it will quickly make them cash strapped and send them to the poverty line!

If we instead look at positively geared property (which is now what I ALWAYS do), I make sure the rent being paid covers the mortgage and ALL costs of the investment. It is POSITIVELY geared and makes a profit. This is money that I put in my pocket after ALL costs, and if I have to pay (say) 30% tax on my profits, I don't care because I am MAKING money instead of LOSING money.

In other words, I would rather make 70 cents out of every dollar that my positively geared investment property earns, than lose money year after year on a negatively geared property.

Remember this fact.... When you invest, the Government will tax you when you make money and give you a tax break when you lose money Knowing this is true, and knowing that negative gearing gets you tax breaks from the government, then that in its self is evidence that negative gearing is a money losing game.

Assets put money in your pocket. Liabilities take money out of your pocket. It's a simple concept. My car, my boat, my holidays, my retirement etc are all liabilities that cost money. However, they are all funded by PASSIVE income generated from my assets (property, business, equities etc). These liabilities are NOT funded by me having to work for an income, they are funded by people/businesses that rent my properties, and businesses that pay me dividends.

Now, let's look at an even more controversial "investment"........ your home.

Is it a liability or an investment for you??? That is easy to work out by asking whether your home puts money in your pocket or takes money out of your pocket?

The answer is the latter - Your home is a liability. It costs you money to run and to keep.

It is also an asset, but only when you sell it and realise any capital gains. If you do not sell, then it remains your liability and your kids asset! The vast majority of people cannot see that their home is a liability. However, if one TRULY understands the differences between assets and liabilities, then they will understand what their home actually is. It is no different than your car or your boat as far as cash flow goes - ALL of them take money OUT f your pocket!

Your challenge as an investor is to pick assets that put money in your pocket and NOT drain your cash flow. When assets put money in your pocket, that gives you more money to invest - it is using the power of compounding to increase wealth. The longer you can compound your returns, the more your wealth grows.

The vast majority of people pay for their liabilities by working for an income to purchase them. You must learn to purchase income producing assets instead of liabilities.

Once you have passive income from your assets, then you can use that (rather than the sweat of your brow) to fund your liabilities such as boats, fancy cars, holidays, big house etc.

I don't pay for my liabilities, the income from my investments pay for my liabilities via the rent and dividends I receive. I do not want, or need to work to pay for my lifestyle, because I made the sacrifices in the early years to set myself up.

Lessons:

1. Make sure you understand the differences between assets and liabilities. The easy determining factor is the question "does the investment put money into my pocket or take money out of my pocket?"

2. Invest in assets that will increase in value AND provide you an income/dividends that you can reinvest.

3. We all want our "toys" such as boats, fancy cars etc, but don't work to pay for them, instead, fund these liabilities from passive investment income. Let someone else pay for them.