Once you have Golden Rule #1 – Spend Less Than You Earn under control, your focus should shift to making your money work for you.
Step 1 – Emergency Fund
For myself, before I started investing, I created an emergency fund in a savings account consisting of 1 year’s worth of expenses. Some people choose to follow my strategy. Some people save about six month’s worth of expenses, some even longer than a year – it is a personal preference. Another option is not to have an emergency fund in a savings account but rather to use a line of credit in the event of an emergency. I feel uncomfortable with this strategy and have never pursued it since it can leave you at the mercy of your bank.
The emergency fund is important as it helps in the event the following happens:
- You lose your job.
- You have a slow down in your business.
- You have a large unexpected expense such as a car breakdown, a medical emergency, or issues with your home or apartment (major renovations).
- You can’t stand your job or business anymore and want to quit. An emergency fund allows you to pay your expenses with ease of mind while you look for another job.
29% of Canadians say their savings will only last one month. 66 million Americans have no emergency savings. These people will be hard pressed during a recession. Some of this is because of a lack of discipline by these people. But with that said some of these people face unfortunate circumstances that don’t allow them to build an emergency fund.
I know coming up with an emergency fund can take time and is a pain but reaching financial freedom is not easy. It takes hard work. Once I filled my emergency fund, it was a great feeling and gave me peace of mind. I could then shift my focus to investing.
Step 2 – Investing
My parents always told me to save. Those people around me who were fiscally responsible always said save, save, save. However, I realized that this was all wrong when I read the book: Rich Dad, Poor Dad. In his book, Robert T. Kiyosaki points out that the rich have their money really work for them. A savings account pays you interest but that is peanuts in today’s low interest world. You need to generate returns greater than the 1% a savings account will pay you. If you have money in a savings account generating 1%, you are losing 1% per year because inflation is running at about 2% per year.
One needs to focus on assets that pay you more. Note that an asset is something that pays you. If you buy a house, it doesn’t pay you. Rather you pay the bank if you have a mortgage. This is one of the key things I keep in mind. Never get over-extended on a mortgage and never purchase too much house. My rule of thumb is to never have a mortgage greater than 2.5x my after-tax household income. This may seem low but it leaves me with plenty of disposable income to invest. I don’t even count the equity in my house in my net worth because my house doesn’t pay me. I need to live somewhere so if I sold my house I’d have to buy something else with the same money or I’d have to rent.
So what investments options are there. I like the following:
- Rental real estate
- Human Capital
Rental real estate can be a great investment, either residential or commercial. However, it comes with significant risks. Due to the capital commitment required to purchase a rental property, careful research is needed before purchasing:
- You need to find the right neighborhood to buy in. This is extremely important. I personally prefer buying in the city I live in or somewhere within driving distance. The reason for this is because I can see the property and manage it personally – so I don’t have to rely on a management company. I find it hard to manage a property outside of the city that I live in.
- The capitalization (“cap”) rate is an important metric when buying a rental property. It is calculated as the net income from a property divided by cost. This is where you can see the power of leverage. For example, if you earn $10,000 of net income from a property and put $100,000 down on a $500,000 rental property, your cap rate is 10%. I like to use the equity I put up for the property as the cost in the cap rate formula. I usually like to see a cap rate in the 7.5% to 15% range although this is becoming tougher and tougher to get as property prices keep increasing. This is pretty much impossible if you live in Vancouver, Toronto, San Francisco, or Seattle.
- You need to account for potential vacancy as an expense. I also like to have a maintenance reserve in the event of unexpected repairs.
- One thing to watch out for is over-leveraging yourself. For example, if you put 5% down, you can have great leveraged returns but if your property value falls and it is time for you to renew your mortgage, you could be underwater and could have to make up the difference.
- Be conservative in your calculations when estimating your net income and cap rate. I always strive to have my rental revenue cover all costs including the principal and interest portion of the mortgage. You want cash flow positive rental properties.
- You can get a “snowball” started after your first rental property purchase. You can continue to buy cash flow positive properties by using the cash flow surplus from one property to buy another.
If you aren’t comfortable buying individual real estate, another option is purchase REITs which own a broad spectrum of properties. The Vanguard REIT ETF tracks the performance of the MSCI US REIT Index which is a gauge of US real estate stocks. iShares S&P/TSX Capped REIT Index ETF tracks the performance of the S&P/TSX Capped REIT Index which consists of Canada’s largest REITs on the TSX. You can also consider buying individual REITs which own real estate such as W.P. Carey Inc. REIT and Simon Property Group.
Value investing is the process of buying stocks that trade at a price that is less than their intrinsic value. Intrinsic value is what a company is worth and is a subjective term. I took to this approach of investing as it intuitively made sense to me. I read Warren Buffet’s work as well including all of his shareholder letters dating back to 1977. Warren Buffett took Benjamin Graham’s philosophy one-step further and focused on companies that had competitive advantages which he termed “moats”. Moats can be created by various things such as brand names, patents, trademarks, and other intellectual property.
Investing in stocks is my favorite way of accumulating wealth as I love performing analysis on companies and I love the fact that once you buy shares in a great company, you can just sit back and watch the company grow and dividends roll in. You don’t have any ongoing costs like a rental property.
I’m a fan of dividend growth investing which involves investing in great companies that increase their dividends over time. I find that the key to identifying these companies is looking for companies that have a reasonable chance to increase their earnings over time – these include the Johnson & Johnson, Coca-Cola, Nike, and Exxon Mobil’s of the world. Focus on earnings growth because without it, you won’t get any dividend growth. I also love the fact that you can walk into a Nike store and watch people buying pairs of Nike runners knowing that a fraction (albeit a tiny fraction) of the earnings are yours.
My top investment holding, Berkshire Hathaway, doesn’t pay a dividend. I don’t mind this though since I’m deferring income taxes until I sell the shares (which will probably be never) or until they finally pay a dividend. Berkshire is one of the greatest and most shareholder friendly companies in the world – the legacy of Warren Buffett.
Human capital is often an over looked type of investment.
The first type is investing in yourself through education and job experience. This can greatly increase your future income. You can then use this increased income to invest in real estate, stocks, and technology.
The human capital that I’m primarily referring to however is you delegating your work to your employees or junior staff while you focus on more important work. You can do this if you’re an employee or if you have your own business. For example, if you’re in a management position, you’re human capital to someone else but you can also delegate work to junior staff. If you have your own business, well then, you can delegate to anyone unless you’re a one man/woman shop.
There is nothing shady about using human capital. The people working for you are getting paid. It is how the economy works. By using human capital, you can gain extreme leverage. For example, if you have an accounting or law firm, you can use associates to do tedious and time-consuming work while you focus on reviewing work and client relationships. You pay your associates but you charge a mark up on the work done by your associates. You can make a lot more money this way compared to doing all the work yourself.
Investing in technology can also be important. For example, think about this blog and your blog if you have one. They are powered by a hosting site and you’re using a computer to make your posts. You paid for these things and they are helping you generate work and hopefully some money. Therefore, these are investments helping you generate a return. You may consider buying a better computer or upgrade your hosting site – this is the use of technology to generate a better return.
Using technology in business is key as well. Look at Amazon’s use of robots in their warehouses. Car manufacturers use automation. Soon, self-driving Uber cars and long-haul trucks will be hitting the road. Technology makes the world more efficient and helps us move forward. With this said, it does have sociopolitical implications because people are displaced from work. I believe there should be programs in place to help educate displaced people and move them into other meaningful work – this is a topic for another day though.