There is a vital difference between an asset and a liability. A liability will only cost you money whereas you can reach financial independence by investing in assets. Let’s take a look at the types of assets that are worth purchasing.
One of the most important lessons in the pursuit of Financial freedom, or FIRE (Financial Independence Retire Early), is to understand the difference between an Asset and a Liability. Put simply, an Asset is something you control that produces you money, and a Liability is something that costs you money.
Think that brand new SUV is an asset or a liability? 90% of people would call it an asset and list it as so on a home loan application, but the reality is that 99.9% of cars are a big, fat, liability! They cost you money every week, whilst also depreciating at an average rate of over 20%!
So what about a Yacht? Well to me this is just a type of Boat (clearly an acronym for ‘Better Outlay Another Thousand’…). You would have to be an absolute spanner to not realise this is a GIGANTIC liability. The bigger the boat, the bigger the liability (and the longer it will take to achieve financial independence).
On the other hand assets, sometimes called productive Assets (because of the virtue of them producing gains or returns for their owners) come in several classes. The defining feature of income-generating assets is that they can put money back in your pocket. For example, the following are the main asset classes that come to mind when I think of assets:
- Gold, and other precious metals and gems
- Real estate
- Collectables: Artwork, Wine, Cars, Stamps
Investors may take their savings and invest it into the economy, such as buying a stake in a business, called a stock or stock of that business. This enables capital raising for business ventures by an IPO (initial public offering) sometimes referred to as Floating or Going public. The concept of stocks, and specifically buying of stocks through low-fee index fund ETFs is explained in my articles on Index funds and Investing In Shares In Australia For Beginners.
Inside the world of the stock market and stocks, are a multitude of financial products and ways to own them. All you really need to know is that by owning a stock you are owning a slice in a productive (and hopefully profitable) business. A low cost, stock market index fund ETF is easily the best way to take advantage of the benefits of the stock market if you are serious about becoming financially independent, and potential early retirement.
Modern ETF funds like Vanguards VTS, VAS and VEU funds have Rock bottom Management expenses. VTS has a management fee of something like .04% or $4 annually for every $10,000 you have invested. An investment this size should on average produce you $1000 of passive income in returns each year – meaning your fee is only .4% of your total profit.
If you hear the word ‘mutual fund’ or ‘mutual stocks’ that someone is trying to sell you, you should probably start running, since their fees can be as much as 4% (or more) per year! A Mutual fund or actively managed investment is where a fund manager actively tries to pick stocks for you – which is basically like throwing darts at a dartboard whilst blindfolded! When it comes to investing I am a smart investor and take my advice from the best – Mr Warren Buffet himself. And what Does Warren Buffet say?
When investing in stocks (or anything for that matter) you really need to consider the fees and charges involved. Consider that a mutual fund charging 4% is 100 times as expensive as the Vanguard ETF. Vanguard takes only .4% of your profit compared to the mutual fund which takes 40% of your profit. 40% was the average fee to return percentage paid by private investors calculated by Stockspot.com across the entire financial industry in 2019.
Bonds (fixed interest)
Some investors even invest in the nation directly, buying government-backed treasury bonds – these are essentially an IOU from the government and a form of ‘bank free’ savings account. When a government sells you a bond (IOU) they can then use this money upfront for infrastructure projects or to pay off foreign debts. They promise to pay you back the amount of the bond (called the principle) at the end of the agreement term (called the maturity date). For your efforts, you are given a fixed rate of interest called a ‘bond coupon’ or the ‘coupon rate’, which is agreed upon when you purchase the bond. This is often referred to as fixed interest in a portfolio.
You can buy bonds from companies too, which is another avenue for them to raise money without having to generate shares and give investors all the associated rights that a shareholder would have over the company. The basic concept is the same: you buy a bond and hand over the principle, and then receive the coupon rate until maturity, where you get your money back. As an example, if you purchased a $100K bond with a 5-year maturity with a 6% coupon, you would theoretically receive $6,000 every year for five years, and then your $100K back at the end of the fifth year. You can see why fixed interest is such an attractive option for retirees then, who want a known source of income to live on.
So what happens when it goes wrong? This is where it all gets a little tricky. Companies can fail, or default on their debts if it all goes to shit. This might include not paying you your bond coupon rate or even worse not paying back your principle! If this happens, they can go into administration and liquidators could seize a company’s assets to pay off their debts. It’s a complicated process but usually secured creditors such as banks that lend directly against assets will get paid first (or they take control of assets and then sell them), then will governments, bond owners, and lastly the shareholders.
Companies that are at a higher risk of defaulting will need to pay a higher coupon rate to attract customers to buy their bonds. That’s why treasury bonds from AAA rated nations (such as treasury bills), or other premium bonds normally pay bugger all and have a low coupon rate (such as a low treasury bill rate). More risky bonds, often called Junk bonds – such as CCC rated risky borrowers like start-ups, ‘sub-prime’ mortgage tranches or collateralised debt obligations have a much higher coupon rate. Peer to Peer lending is an interesting subset of Junk Bonds, such as RateSetter which takes your bond money and offers personal loans to people. Several members of the FI community have posted about RateSetter recently. If you’re keen on learning more about bonds as a financial instrument, plus seeing Margot Robbie in a bubble bath, do yourself a favour and Netflix the movie ‘The Big Short.’
Gold, precious metals (and gems)
Gold does not produce a dividend, but it has been used for thousands of years as a defensive asset and store of wealth. Many people like to own this tangible asset as it is liquid (you can sell it) and offers diversification. There are many places you can buy physical gold, or you can also buy gold stocks on the stock exchange.
Some people may try and time the market and flip gold; by buying gold and hoping for a stock market crash, they think that gold will go up in value and they will then be able to sell it and buy good quality stocks at a discount. Gold has historically increased in price roughly in line with inflation, so it has been a ‘store’ of wealth when compared to holding cash (fiat currency). Some people go so far as to delineate between money (gold) and currency (fiat dollars).
It doesn’t seem to perform as well as other asset classes though.
You can try micro-investing in gold and silver through apps such as Bamboo. I have tried out Bamboo for micro-investing in crypto as well as precious metals. You can check out my review of Bamboo HERE.
Real estate or property is a huge asset class globally. Everybody needs a place to live, right? and everybody needs a place to work? Real estate can range from something as simple as a small detached (freestanding) house on a block of land to a towering 100-floor apartment complex, all the way to a giant mega-factory used to produce Boeing Airliner Jets (like in Seattle, USA!)
If you don’t have the appetite for bonds, buying shares or being locked into using a ‘high’ interest savings account and losing purchasing power over time you could get higher returns using your existing loan. If you have a mortgage, you could put your savings into an offset account to lower the amount of interest payable on the loan – you could be saving 3.5% which is the average homeowner mortgage interest rate.
That’s better than the rate you’d be getting on a savings account, but also has a hidden bonus. Saving money on your loan is not a form of income; the loan is debt – which means any money you save yourself is tax-free. So that 3.5% whilst it doesn’t sound like much, should then be ‘grossed’ up by your marginal tax rate to give the representational return that other taxable investments would make. The average worker being charged a 30c in the dollar income tax rate would therefore be getting a grossed up savings of 4.55% – much higher than the savings rate any bank is offering now, and significantly higher than most AAA rated bond instruments.
Collectables are a name I give to a variety of items that might be worth investing in as they are known to appreciate over time faster than inflation. In general though, these collectables do nothing productive but instead, take up space and gather dust as you wait for someone to pay more for them than you did (the greater fool principle). Some collectables like famous artwork can be worth hundreds of millions of dollars and represent an amazing investment from a cultural standpoint, but may incur a serious cost of ownership. A few types of collectable assets are;
- Classic Cars
- Certain types of memorabilia
- First edition books or papers
For example, a particularly well vintage wine such as Penfolds Grange might sell on release for upwards of $700 a bottle these days, however ten or twenty years later that same bottle (if kept under strict cellar conditions) might be worth substantially more. For example, Penfolds first commercial release of Grange in 1952 was sold at $1 a bottle (a very high price by 1952 standards). Today, nearly 70 years later that same bottle sells for over $16,000 – representing a rate of return of over 15%.
Of course, there are costs and risks associated with storing such items (the wine might spoil, your beanie baby collection could get stolen etc etc) so it’s not all beer and skittles, and personally, I prefer to keep this asset class to a minimum. I think most of those on the path to financial independence are interested to some degree in minimalism and so might be against owning ‘stuff’ like this.
So there is a quick rundown about assets and liabilities, and some asset classes which you might consider investing in on your path to Financial Independence.
Some Financial Advisers tell people to buy a ‘portfolio’ that includes bonds (sometimes called fixed interest) to even out volatility. Personally, I am not a financial adviser, but I smell bullshit. Bonds return bugger all over the long run (especially in the economic climate of today and ultra low-interest rates) and if you are worried about volatility and have a weak stomach then maybe you need to learn more about how the stock market works. Short-term volatility is part of the market and over time, its effects are nullified.
I think when I am closer to retirement planning, I might be more interested in some kind of fixed return or annuity and a bond might be more attractive. I think a smart investor could just stay completely exposed to stocks and keep a healthy savings buffer of cash to get them by in any economic downturn (which on average are incredibly short-lived). By any measure, someone chasing financial freedom should be throwing as much as possible into growth assets such as stock ETF and good quality real estate as much as possible rather than defensive plays such as Cash, gold or fixed interest.
Personally, I prefer to invest in good quality and low-fee stock market index fund ETF, real estate like a rental property and websites, over say Gold or collectables. I prefer to have my money invested in productive assets which are making the world a better place, and which have very low overheads or cost of ownership. I also value portability which is a major advantage an ETF has over something like a wine collection (plus I’d probably just drink the wine!).
The FIRE movement is becoming increasingly popular but just remember, financial independence means different things to different people. You need to consider your income level and your living expenses, whether you have a safe emergency fund saved (3-6 months of expenses), your risk tolerance for investing and your personal financial goals.
Make sure you always seek professional advice based on your own personal circumstances, because personal finance is just that – personal to you.
So if you care to share, what’s your FIRE plan and what Assets do you own?
Captain FI is a Retired Pilot who lives in Adelaide, South Australia. He is passionate about Financial Independence and writes about Personal Finance and his journey to reach FI at 29, allowing him to retire at 30.