Financial freedom eludes so many people these days who by all logical conclusions and observations should have obtained it. It’s commonly cited as one of the most important and sought after goals in life and yet is rarely attained. This article does not attempt to give you a magic formula for success but I do share with you the choices that made a difference to me and can, if you choose put you well on the path to freedom.
You can choose to spend some or all of your money on “consumption” items. These include food, entertainment, holidays, housing, motor cars, hobbies, and so on. These are things we need to live on a day-to-day basis. They also consist of items that service the things we want and so improve lifestyle.
You can choose to spend some or all of your money on investment items such as revenue producing real estate, shares, interest bearing deposits, businesses that produce revenue, etc.
Consumption or investment
Two important factors need to be understood about the simple concepts of consumption and investment.
The first factor is that spending on “consumption” items results in reducing the total value of your assets (net worth). Spending on investment items aims to increase your net worth. The second factor is that you have choice. You can choose between spending on consumption or investment items.
Of course, the best spending patterns are those that aim to attain a balance between spending on consumption and investment items.
Choosing consumption or investment
You now know the difference between consumption and investment spending and that you can choose between the two.
All you need to do is to think before you spend. Consumption spending can contribute to your lifestyle (driving a new car is fun, even if it was bought on credit and has created a liability of three to five years of payments). Investment spending provides income and wealth.
Shades of Grey
There is, of course, some spending that is not clearly defined as consumption or investment. Buying your own home is considered by many to be an investment. It isn’t! The purchase usually is financed and the repayments are a liability. The upkeep of a house costs money. There are rates and taxes payable on it. You do not get any revenue from it. If you plan to sell it in a few years to make a profit on its increased value, then it may be an investment. However if you have to buy another house to live in are you really any better off?
Investment spending is necessary for building wealth
In order to build wealth, some investment spending is necessary. The more that goes into investment spending, the bigger and quicker your wealth will grow. However, if too much goes into investment spending, and not enough into consumption, then lifestyle can become meagre. But you can choose.
Accumulation over time
Most people are not born rich. Certainly, some inherit wealth, but consequently may not appreciate it. A few win wealth in lotteries, but ironically, perhaps because they have not worked for it, or are not used to it, could end up squandering the temporary riches.
Everyone, however, has one thing in common. The same amount of time goes past for each of us, and at the same rate. How you employ that time is significant.
Imagine that at the age of 21, you invested $1,000 at an average annual rate of return of 10%, and then by the time you reach 65, you would have accumulated over $70,000 without doing anything else.
If at the age of 21, you invested $1,000 at an average annual rate of return of 10%, and each month invested an additional $100, then by the time you reach 65, you would be a millionaire, without doing anything else.
If you did neither of these things, then the same time would pass, and you would not have accumulated any wealth.
These examples of investment, quite deliberately, use amounts of money that are affordable by most, and if spent on investment, rather than consumption, would probably not be missed.
In terms of investing, time is on your side. Of course, you may not be 21 any more and you may wish to accumulate wealth at a faster rate. This is possible by increasing the amount invested, and the annual rate of return. It is not possible to systematically accumulate significant wealth (millions) without looking at a timeframe of several years (say 5 to 10). If you are trying to make more money in less time, then your objectives may not be realistic. Perhaps a lottery ticket, crossed fingers and large amount of luck could produce your desired result, but don’t hold your breath waiting.
The power of compounding
In the above examples there is an additional factor at work. The entire return was reinvested and participated in earning the same rate of return as the original investment. None of the investment return was withdrawn and spent on consumption items.