Life

Intro

I’m by no means an expert in finance. And what follows is by no means a comprehensive guide on how to get rich or anything similar.

It is simply my attempt to organize the high-level concepts involved in achieving financial freedom within one lifetime. A guide that I could give to my son when he starts his first part-time job to help him understand the game he’s beginning to play.

The game of money as being defined here, is played starting from zero with the end goal of achieving true financial freedom.

We have true financial freedom when our yearly passive (near-risk free) income from investments is greater than the cost of our family’s acceptable lifestyle + inflation.

You’ve Won the Game of Money when:

Yearly Passive Income from (near risk free) Investments – Tax Costs – Inflation Costs > Family Yearly Expenses

For most of us, that means achieving a net worth of 300 to 400 times our average monthly expenses.

Before getting into strategies for achieving financial freedom, let’s first talk about money.

Money

What is Money?

Money is a human invention that solves the problem of how to transport value across space and time and among an unlimited number of people. Money is an IOU that we’ve all agreed to transact with. Without money only the smallest and simplest of economies can function. I catch fish, I give you some fish, you build me a hut, we’re even. With money we can trade our time/expertise now, store the value we traded as money, and reinvest that money building wealth to be accessed at any future time for any purpose we want.

Why would I want money?

People invent all kinds of reasons for wanting money. Status, power, comfort, and convenience are chief among them. However, I would argue the primary reason to play the money game and attempt to reach financial freedom is optionality. Playing the game of money well will not solve our health, relationship, or mental problems. But it will solve the problem of never having to be in a place, doing a thing we don’t want to do just to get paid. Playing the money game well frees us up to work on things that interest us rather than being forced to work on things we’re obligated to.

What inputs can be used to produce money as an output?

There are 3 resources we can use as inputs to make money with. Time, valuable skill and money. There are also forms of leverage we can use to increase the return on our time, skill and money but we’ll talk more about those in the next section.

Linear Money

When we’re young we need to trade time for money because we have no real skills or money to work with. This would be something like stocking shelves at a local grocer, cleaning cars, flipping burgers.
In this sense money is earned linearly with time and at a relatively low rate.

Money = Time * Low Skill (linear)

If we can acquire some valuable skill through experience or training we can increase the money we make by combining that skill with our time. Doctors, software engineers, executives all still trade time for money, however their return is multiplied by their skill level.

Money = Time * High Skill (linear)

Obviously, there are factors other than skill that go into our hourly rate for labor such as geographic location, physical danger, night shift vs day shift, desirability of working conditions, etc. I’m ignoring these here for simplification. But if a low-skilled worker wants to increase his hourly rate immediately these other factors can be very useful to understand.

Linear money is often earned in the form of a job, but it can also be earned through freelancing, consulting or operating a stable cash flow business. The advantage of linear money is that it’s often predictable and low or no risk. If we screw up in our job and lose the firm a bunch of money we only get fired, we don’t have to come up with the lost funds. The disadvantage is that it’s severely limited in its potential growth, and if we stop working it stops being produced.


Linear money is always a direct tradeoff of time for money.

Exponential Money

If we can make more linear money than we spend on living expenses we’ll start to save some cash. This is generally when we can start to make money with money. (Another option would be to use debt rather than saving ourselves). We can grow money passively or actively through debt and/or equity investments. The returns here are exponential instead of linear and for passive investments typically fall into the 5-10% annually range over time depending on how much risk we’re willing to accept in our investments.

Passive investing could be lending our money (debt) or buying stocks or REITs (equity).

Money = Money * Passive ROI (exponential)

Active investing would be combining our money with our own skill and time to attempt to multiply it faster in an area where we have a unique edge. Perhaps we understand home renovations quite well. We could buy an old house, fix it up and sell it and get a substantial return. In this scenario we might be able to return 20% on our money every 6 months or over 40% per year. However, the difference in the return isn’t free because it costs us skill + time as well.

Active investing and owning a business are very similar. Our goal with both is to grow equity and/or cash flow through the application of our knowledge/time.

Active ROI = Passive ROI + Additional ROI based on time + skill used

Money = Money * Active ROI (exponential)

Linear Money vs Exponential Money

We always need to be calculating where our time is best used. Is it better to spend more time making linear money through a job and passively investing our savings? Or should we spend more time actively investing to increase the ROI of our money?

Typically, but not always, in the beginning of life our time is better spent making linear money (whether through a job or as a freelancer). In doing so we earn risk free money to pay our bills, start saving some cash, as well as acquire skills and a network. As we save more it typically makes sense to transition to active investing or business ownership as we’ll have more money to grow and thus the ROI on our time for growing our money will likely surpass the ROI on our time for working a job. Although, during the transition we may want to keep working part-time to have a guaranteed cash flow to at least cover our basic expenses.  These tradeoffs need to be calculated at all times along the way.

As a rule of thumb, if our net worth multiplied by the difference in return between full-time active investing / business ownership and passive investing is greater than our yearly linear earnings we should focus mainly on exponential money.

For example, assume we have $500,000 in the bank and we expect a yearly passive return of 5%, or a yearly active return of 20%, and our salary is $70,000 a year.

$500,000 * (20 – 5) % = $75,000 > $70,000

We would be better off spending our time growing our money rather than working a linear job. Both for the short-term and definitely for the long term.

In summary, our goal in the game of money is to maximize the hourly return on our time until reaching financial freedom. For most people this means making linear money early in life, transitioning to exponential money as we accumulate skills, contacts, and savings, and finally once we’ve reached financial freedom, parking our net worth in low-risk passive investments and living off the interest.

Now that we’ve understood the overall framework of the game let’s talk about another important factor, leverage.

Leverage

What is Leverage and how is it used?

Up until now we haven’t talked about leverage. Leverage is when we borrow time or money and use it to amplify our results. It has a cost. For that reason, leverage can be positive or negative. Meaning we can lose time/money with leverage if it’s miscalculated. However, if used properly leverage can vastly increase our returns on our own time, skill and money. Leverage adds risk to most business activities, but to reach financial freedom in a single lifetime it’s a necessary part of the strategy.

Here are some examples of leverage.

Time and Skill leverage

Hiring an employee or contractor – when we have tasks that need to be done that can be hired out for a lower hourly rate than what we’re paid for other tasks we have to do it makes sense to pay someone else to do them.

Using reproducible media to make copies of our work – anyone who’s ever tried to sell a pdf ebook, a video course, or anything else online has tried using this form of leverage. It costs time to make the initial product but if copies can be made for free or very cheaply and distributed in mass the returns can be significant.

Building a trusted network – when we’ve built trust with contractors and partners we can get to work much faster with far less bureaucracy and risk. When we know the right people we can leverage their expertise with a quick phone call. Network and reputation are massive forms of leverage that take time to build but payoff with gains in efficiency and otherwise unreachable opportunities.

Systems, procedures, checklists – once we’ve gained unique knowledge in an area in order to leverage it we can build systems based on our knowledge that either run automatically with computer code, or are simple enough for a contractor to follow and execute.

All of these time and skill leverage devices cost us time and/or money to put in place. Therefore, they need to pay us back at least as much as they cost. This is a calculation we need to try to make. How much time/money will this new hire or system or reproducible product make/save me? It’s not always easy to get an exact answer but that’s part of the game.

Financial leverage

Financial leverage occurs when we use other people’s money to grow our wealth or do a project we otherwise couldn’t have. It can be either debt or equity based. However, for the purpose of this article I’ll use a debt example as it clearly highlights the dangers of negative leverage.

If I have a project that will return me 10% on my capital and I can borrow money at 5% to do the project my overall return will be higher than 10% (positive leverage). If it costs me 15% to borrow the money and the project returns 10% then I’ll lose money taking this leverage (negative leverage).

Below is an example where I’m investing $100,000 of my own money and borrowing another $100,000 to do a project. It shows how the cost of borrowed money affects the projects leveraged return. For financial leverage to be positive the cost of borrowed money must be less than the projects unleveraged return.

In the positive leverage example, I invest $100,000 and get $115,000 back. With neutral leverage I get $110,000 back (the same as if I hadn’t borrowed any money). And with negative leverage I get $105,000 back (a terrible use of borrowed funds).

Needless to say we always want to use positive financial leverage or none at all.

Even though financial leverage is easy to understand it can be hard to obtain. In order for someone to give us their money they usually need to have a high level of trust in us which comes from a track record of success, and a strong project plan.

Finally, let’s discuss a few potential strategies for playing the game of money.

Strategies for Playing the Money Game

There are any number of ways to play the money game.

We can play full-out from the beginning and try to hit financial freedom as young as possible. We can play part time and enjoy other aspects of life while being conscious of the game and our progress in it. Or we can decide not to play at all and just spend the money in our account each month as we feel like it.

We could take a more traditional approach like getting a salaried job, saving up for 15 years, then transitioning to business ownership. Or a more modern approach like starting work in a small growth company, getting equity, and swinging for the fences.

This decision, how to play the game of money, is a reflection of our personal values, the clarity of our priorities, and the constraints of our unique life situation and age. As such, it’s very difficult to advise one strategy over another.

The approach that I’ve settled on at least for this phase of life is to divide up how I spend my time into certain categories based on my priorities and allocate a specific number of hours per week to the game of money. Then play the game as well as I can, earning a mixture of linear and exponential money for that number of hours, and forget about it outside those hours.

In the end I think it’s a game worth playing. Or at least, worth understanding, and choosing whether to play or not.

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