On the way to financial freedom, we first need some basic knowledge. It’s similar to learning a new language at school: at first, we get to know a few new words. Without them, it won’t work. But don’t worry, we limit this to two terms in total. Very manageable. If you understand these two and the difference between them, you have won half the battle. It’s about spendings and investments.
In short, when I spend money, I buy something that will be worn out or used up afterwards. The item does not bring in any more money. On the other hand, when I want to invest some money, I hand it out with the intention of making more. On the way to financial freedom, we essentially want to make investments and avoid spendings.
About Spendings, Luxury and Knick-knack
Let’s make a few examples: classic spendings are if you buy some food (will get consumed) or clothing (will get frayed). This unfortunately applies also for womankind: the beautiful, new, shiny pair of shoes is an emotional investment at best. But as soon as it disappears in the closet among the other hundreds of pairs, it has to be written down as a spending. Further examples of spendings are new furniture, a new car or owner-occupied properties.
“But Markus, I need those things to stay alive. Without food I’ll starve to death and without a car I can’t get to work. Then I can’t earn the money that I need to become financially free.”
That’s right! So there are two classes of spendings. Let’s call them necessary expenses and knick-knack. The food that I need to avoid starvation or the clothes that I need to do my job are necessary. If spendings allow me to live more comfortably and, by that, gain more motivation to earn money, then a fancy car or a nicer apartment can also be necessary expenses. However, this needs to be carefully questioned. We’ll find out how this works in a moment.
First we need to know a little more about the second class of spendings: By knick-knack I mean expenses which go beyond what’s necessary. Things that “only” offer emotional added value. If I use my car only for driving to work and for necessary daily shopping, then in theory I could restrain myself to a small used car which costs a few thousand dollars. A Porsche on the other hand would clearly be knick-knack, especially for this purpose — or even impractical because the second beer crate won’t fit in the trunk. And putting it on my lap while driving the car could be a little bit dangerous.
Please don’t get me wrong. I don’t want to deny anyone an adequate deal of luxury. It can help if certain nice gadgets, carefully dosed, provide better motivation to achieve your own goals. You just shouldn’t spend too much money that could be put into investments otherwise. When buying luxury goods, I always weigh up: do I really need this piece now? Or can it wait until I have enough passive income and the purchase no longer costs working hours directly? Because later on, such a purchase is practically for free. It no longer eats up the foundation I’m building up right now. And I most probably have way more time to enjoy it.
I can make an example from my own life: until now, I never owned a car. I know, one day I’ll buy a really fancy luxury sports car. I already have a certain brand in mind. But right now, I would not enjoy it that much, because it would burn too much investment potential. I’ve realized, in a big city with a fair coverage of public transport, I don’t need a car. I was usually able to choose the location of my apartments, so that I could go to work by subway or bike. And cycling in particular has always provided me with a large part of my daily sports dose. For the party shopping at the weekend, there was car sharing. OK, the apartments usually were a bit more expensive because they were closer to the city center. But i liked this proximity even more than owning a car because everything was really close when I wanted to go out in the evening. The luxury of a nicer apartment gave me more motivation to reach my goals than a fancy car.
The example may sound a little bit extreme to some of you. But not everyone has to do it that way. The important thing is, that you question your expenses and check if they are necessary. If you’ve never done this before, you’ll be amazed what amounts of money you can save. You don’t have to optimize everything towards this “one big goal”. There should also be left some room for fun, so that you know what you live for. There’s one thing in peculiar about the path to financial freedom: it’s often longer than you think. But especially for people who are a bit cash-strapped here and there or who want to excavate even more potential for their investments, it can be worthwhile to critically question one’s expenses for a while and optimize your own lifestyle. If you think about the various options for a while, sooner or later you will find a reasonable compromise.
About Investments and Hourly Wage
So much for the expenses. Investments on the other hand are made with the intention of bringing in more money than they originally cost. In the best case, this goes with less time invested than in your current job. It’s important that the time invested pays off. You should be able to make more money per hour than you do with your current work, at least medium to long term. Otherwise the investment would be useless. It would be less passive than your actual work.
There is one exception, though: an investment can often yield less than your work in the beginning. Sometimes it takes time to master certain learnings and make the necessary progress to get things going. But i the longterm, I want my investments to be more profitable than my current work.
And how do I know how profitable my work is? You can calculate that instantly. Simply divide your monthly net salary by the number of hours you work per month and you know your wage rate per hour. This will not only give you a good benchmark of the worth of your work, you also get to know the value of each single hour of your lifetime.
Let’s make an example: with a net salary of $4,000 per month and the classic 40-hour work week, I get an hourly wage of $25 ($4,000 per month divided by 40 hours per week divided by 4 weeks per month). Suppose, I spend around three to four hours a month with maintaining a well-running stock portfolio. In there, I have twenty thousand dollars and this money grows with a return of, let’s say, five to ten percent per year, then the invested time pays off. Especially in the long term. In the first year I’d make round about $1,000-$2,000 (an “hourly wage” between just below $21 and around $55). In the second year it would be $22 to $61 per hour – assumed I don’t cash out anything. And in the tenth year, I’ve reached $32 to $130 per hour. You can get a glimpse here of the power of compound interest.
However, if I’d invest even a single hour for researching the best possible interest rate for a savings account for the same twenty thousand, it would take at least a year to pay off. If I even consider inflation, this “investment” will remain permanently in the red. I could spend that time better working overtime in my current job – especially if I enjoy my work in general.
The hourly wage is a powerful tool. Even if it’s just a virtual number, as is often the case when you are an employee and not self-employed. With this number, I can make things comparable that would be difficult to compare otherwise. Most freelancers calculate an (internal) hourly wage for their projects, even if they work at fixed prices only. With that, you can compare projects with e. g. a different duration. In addition, when you are self-employed, you often have to spend lots of hours for acquisition and marketing. Those are working hours that a client usually doesn’t pay. If I add them to the working hours of my projects, I get an hourly wage that makes the work of freelancers comparable to employees. And very important for us: it’s also comparable with the labor costs of our investments. When calculating the hourly wage of an investment, it’s important to think long term and don’t consider the initial buildup that much. I’d like to know how much time the investment will cost me once it works. Only then I can judge how passive it really is. But more about passiveness in the corresponding article. What counts right now is to do a first step to get started. If you don’t know it already, I want you to take a short break from reading and calculate your current hourly wage.
About Compund Interest and Scaling
What else should you pay attention to when making investments? One of the most important things is compound interest – and that it works for me. Interest is one of the most powerful tools to generate passive income and to let wealth grow.
Why? Let’s make an example. If your assets grow with a return of 5% per year and you have invested a total of 10,000 dollars, then you earn $500 in one year. That’s not bad, but it’s also just enough to go out to dinner for a few times. If you have a million in the depot instead, the income at the end of the year is a whopping $50,000. You can keep afloat with that if you don’t have too many demands. Even after you paid your taxes.
If you don’t consume the money right away and continue to invest at the same rate of return instead, you’ll get interest on the interest and then things will really take off. There are more than enough examples on the Internet that explain this nice and clear, so I don’t want to go too deep into the details here. However, it cannot be emphasized enough how incredibly important it is for an investment to have an annual return. And not just in a single year, but in the long term. The annual return is one of the most important parameters for assessing and comparing investments.
Another important point is: the annual return on employment is zero! In white-collar occupation, I get the same salary every year. It won’t rise on its own unless I manage to negotiate a raise or get promoted. And that’s why we should engage in investing. With an employment contract I can buy some food, pay my rent, and support the family. With a lot of effort, I can afford building a house to live in. But as an employee I will never (!!!) manage to escape the rat race. And in old age, I can only hope that there’s enough money in my 401K or in the pension fund of the company I worked for. Otherwise, I’m in trouble. If you think, that’s too risky, you have no choice but to take charge of your own destiny and look for suitable investments.
But what are good investments? There are the classic examples like equity trading, buy a house and rent it, or building up your own business model. But also a hobby can become an investment if you are able to make money with it. The best example is collecting and trading rare or valuable items. But there are also more fanciful options like sweepstakes. When I was a student, I used to take part in all kinds of competitions. Not only to make money. It was fun and I wanted to know what cool stuff I would win. I even got to a point where I automated the “business”. I found providers who registered me for new competitions, just for a small fee. The stuff I won I sold on eBay.
That was fun for a while. What was missing in the end was scalability, which is another important quality of investments. It should be upgradable. At some point, the investment must yield a multiple of what I earn as an employee. With the sweepstakes, the income per hour was capped at a certain level.
With stocks or real estate you can start with a relatively small stake and keep increasing it, up to the millions or even billions. The return depends mainly on the money invested and not so much on the time you put in. And that usually applies to all types of investments that have an annual return.
About “Vitamin B”
And there is one more important aspect that can help immensely when scaling an investment: connections. By communicating with other people, I can get an idea what is important to those people and what they may need. If I happen to have something that someone else needs and this someone is also willing to pay me more than I originally paid for, then we have a classic win-win situation. A very common example is trading goods for money. But there’s also the possibility that a fellow competitor in your business passes a job on to you when he’s temporarily too busy. Most likely because he hopes that you’ll return the favor in time.
With the notorious Vitamin B, you can reach new magnitudes of scaling. It’s a shame that so many people talk badly about this kind of business opportunity. They often say: “He only made it because he has connections.” I think, people who talk that way either don’t have good connections and are jealous of others who do. Or they have not yet understood the principle behind and do not know how to apply it properly.
I definitely don’t want to offend anyone here. But especially if you feel piqued by these lines, then you should check if you are a lone warrior. How does collaboration with colleagues at work look like? How often do you do teamwork? Is this teamwork fun for you? I write those lines because I myself have been a lone warrior for a big part of my life. For me, the downsides of cooperation often were more exhausting than I gained from the benefits. When you deal with others, there may be some friction. Or you have to protect yourself against losses and fraudsters. Over time, I have learned how I can turn the downside of cooperating with others from an uncomfortable mammoth task into a necessary routine, so that those collaborations work better and better.
And that brings us to the flip side of the coin: sometimes you should be careful when dealing with connections. There are also people who do not have the noblest of intentions. Contracts can help to protect. Fortunately, in this day and age, if you make a wrong encounter in the financial sector, you no longer have to worry that you find yourself in the gutter with a knife in your back. But the money invested — it is not gone. The owner just has changed. I personally met some people who didn’t have the best intentions, have done business with them and lost a lot of money in the process. Of course, I didn’t know beforehand that they weren’t going to play fair. What helped me here was the first Golden Rule of investing: never put all eggs in one basket. Whenever I engage in something new, I generally under-invest. An amount of money where the loss doesn’t hurt. And if the cooperation with those new partners improves or the investment grows over time, then I restock piece after piece.
Conclusion
On the path to financial freedom, we want avoid expenses, i.e. purchases that consume money. This goes especially for unnecessary luxury (knick-knack). We want to invest: to purchase something that brings in more money than it costs. The goal is to generate passive income by increasing our hourly wage through suitable investments and through scaling those investments. The most important element of those investments is the rate of return. We also gain more if we build up more knowledge about the investments. A good network of connections can also work in our favor. Such a network needs to be built up and maintained.
The next article from the “Basics” series continues here:
