The Four Pillars of Personal Finance

When it comes to personal finance, the basics are so important.

 

We live in a day and age where more and more people are finding their net worth in the negatives and that just shouldn’t be happening.

 

I really believe that it is within the grasp of almost everyone to become a millionaire if they dedicate the time and discipline that it takes. There’s really four key areas that you have to master to have a solid foundation and to be ahead of 99% of people.

 

Here are my four core pillars of personal finance:

 

1) Spend Less than you Earn

 

This is the most obvious one and the one that people touch on the most.

 

My take on it is slightly different.

 

Most personal finance writers, even the ones who I most respect, spend the vast majority of their time focusing on the first part of the equation, spending less.

 

As I have written about before, my position is that you should only focus on spending less long enough to grab the low-hanging fruit, and then aggressively switch your mindset to increasing the second part of the equation, how much you earn.

 

If you spend $30,000 a year the, amount of money you can save is capped at $30,000. The amount you can earn is practically unlimited.

 

One of the corollaries of this principle of spending less than you earn is to avoid debt. More specifically, my position is that you should only borrow to build.

 

In other words, borrowing money to consume more stuff and inflate your lifestyle is a huge no-no. Borrowing that can be leveraged into a better financial position down the road is okay.

 

Examples of acceptable borrowing include a mortgage to buy a house, student loans for a college degree, and a loan to start a small business.

 

Even then, just because you are doing one of those things doesn’t automatically make borrowing a smart decision. With the house you should be absolutely certain that you are buying something within your price range and that the mortgage payments won’t get you into trouble. With the degree you should make sure you are pursuing a major that will make you employable, and even then you should be careful to keep the costs down.  Taking out $100,000 in loans to get a gender studies degree does not count as smart borrowing. With a business you should only borrow after having carefully thinking through why borrowing is better in your situation than bootstrapping. And, in general, I would recommend some level of bootstrapping before you borrow so that you have a proof of concept. Borrowing before you have any sales is inherently more risky than borrowing after you’ve made even a single sale.

 

Overall, you should think about how you can live within your means and pay for things with what you have. The bottom line is that the gap between what you spend and what you earn is the amount that will grow into your fortune. Take care to preserve and increase the gap.

 

2) Build Assets Instead of Accumulating Liabilities

 

For our purposes, an asset is defined as either cash, something readily converted to cash, or something that makes you more cash.

 

A liability on the other hand is something that costs you money.

 

To be perfectly clear, I’m not saying that assets are good and liabilities are bad. Food is technically a liability and I’m pretty pro-food. What I am saying is that to build wealth you need to develop a strong preference for amassing assets over accumulating liabilities.

 

It’s worth noting here that not everything fits neatly into one category or the other. A house is an asset in the sense that you could sell it for cash or rent it out to earn cash, but it’s also a liability in the form of taxes, insurance, and maintenance (and a mortgage if you don’t own the house outright).

 

Similarly, a car is both an asset and a liability for roughly the same reasons.

 

In general though, when I say you should focus on assets over liabilities, a house belongs in the former category and a car belongs in the latter. There are a few key reasons for this.

 

The first is that there is a strong tendency for houses to appreciate in value, especially over the long term. Conversely, there is a strong tendency for cars (especially new cars) to depreciate in value from the second you drive them off the lot.

 

Secondly, while the potential for earning extra revenue with your car has increased in recent years with the advent of Uber, it still doesn’t come close to beating the passive, scalable income that can be earned by renting out your house.

 

Finally, there’s the fact that unless you choose to be travelling nomad you’re pretty much always going to have a house payment, making the mortgage and maintenance costs of a home a reasonable tradeoff for rent. On the other hand, there are way more people who can get by without a car than there are people who can get by without a place to live.

 

If you really like cars, you are certainly welcome to buy yourself a car. But to amass great wealth you need to focus on assets not liabilities and cars are a big, shiny distraction. Buy a car when and if you need one and keep the costs down as much as possible.

 

Besides a home, some good assets to think about would include a solid emergency fund that will help keep you out of debt should you even need it, a retirement account or other brokerage account where you can invest money in the stock market and have it grow, and a small business which can both earn you money and even potentially be sold one day.

 

3) Invest Your Time (and Money) into Creating Something You Can Sell Besides Time

 

Let’s get one thing straight form the beginning: the only way to make money is by selling something. If you aren’t sure what it is that you are selling, you’re probably selling your time. If you are selling it by the hour you call it a wage and if you are selling it by the year we call it a salary.

 

You are selling time for money.

 

In one sense, this isn’t an unreasonable strategy. The main resources that can be leveraged into money are time an money, and since we all start with time and want money, why not trade time for money?

 

The answer is because time is more valuable than money, and eventually you’re going to want your time back as well.

 

As long as you keep trading time for money, you’re stuck. You can’t stop working because you’ll stop getting paid.

 

The best solution is to start investing the time (and money) that you have into creating something that you can sell besides your time.

 

One way of doing this is to create a small business. That idea has come up a lot in this post so far, because it pretty much checks all the boxes. It’s a great way to increase how much you earn, it is an asset, and it has the potential to keep earning you money even if you aren’t working on it.

 

Now, starting a small business isn’t by any means easy, but it’s easier than it has ever been. If you are willing to invest the time and hard work up front, you can create something that will make money for you while you sleep.

 

Even making the jump from getting paid based on time to being paid based on results helps here. My wife is a stay at home mom, but she also has a side hustle selling books. Selling is great because she gets paid based on how many people she helps, not how many hours she puts in. When you’re in sales there’s always the potential to sell more in the same amount of time.

 

Once you do have a bit of money, you can also invest money to make money. The easiest way to do this is to invest in a low cost index fund. The stock market is technically a risky investment in the sense that there is always risk, but in practice it is one of the safer investments out there over the long term.

 

You only have so much time. Better invest it wisely.

 

4) Diversify

 

At the end of the last point I mentioned risk. You can never fully escape risk, but you have a very potent weapon that you can used against it called diversification.

 

The old adage of not putting all your eggs into one basket is still good advice.

 

In some cases, diversification is pretty easy. In the example that I mentioned above, a low-cost index fund has diversification baked right in. Essentially an index fund is a collection of stocks that are picked according to some set of rules. So if you buy an index that tracks the S&P 500, the rules are for the fund to buy stocks from the 500 largest companies, buying more of the largest and less of the 500th largest.

 

This would mean that if any one company does poorly, it won’t affect you. As long as the largest companies keep providing value to their customers (and chances are as a whole, they will), their stock value will keep going up and your investment will grow.

 

Of course, just like you don’t want to put all your eggs in just one stock, you probably don’t want them all in the stock market either. Sometimes the economy as a whole takes a bit of a downturn and while this isn’t a problem in the long run, the timing could bite you (there were lots of people looking to retire in 2008 that experienced what was for them a very poorly timed crash).

 

In my opinion, outside of the stock market the best places to invest your money are in real estate or a small business (look at that, small business popped up in all four core pillars of personal finance. That’s not a coincidence).

 

Even if the financial sector is shaky, people generally still want a place to live.

 

Also, even when the economy is hurting, those who run their business well usually still do fine.

 

Even in the rare instances where the economy tanks, in reality most of it keeps humming along just fine.

 

For me those are the big three. The stock market, real estate, and a starting a business. I’ve written before that those are the three realistic ways an average person can become a millionaire and I believe it.

 

Final Thoughts

 

Understanding these four principles is easy. Implementing them is tough, but well worth it.

 

The first pace to start is by making sure you are spending less than you earn. Grab the low-hanging fruit when it comes to lowering your expenses (i.e. cut any spending you don’t think you would miss) and then focus resolutely on making more money.

 

As you are making money, develop a strong preference for acquiring assets instead of liabilities.

 

Invest your time into creating something you can sell besides time.

 

Finally, diversify your wealth and money-making vehicles.

 

This all takes a lot of effort to pull off, but is as solid of a financial blueprint as you can dream up.