Rich Dad, Poor Dad Part 5

"Don't worry right now," said rich dad. "Just let the idea sink in. If you can comprehend the simplicity, your life will have a plan and be financially easy. It is simple; that is why the idea is missed."

"You mean all we need to know is what an a.s.set is, acquire them and we'll be rich?" I asked.

Rich dad nodded his head. "It's that simple."

"If it's that simple, how come everyone is not rich?" I asked.

Rich dad smiled. "Because people do not know the difference between an a.s.set and a liability."

I remember asking, "How could adults be so silly. If it is that simple, if it is that important, why would everyone not want to find out?"

It took our rich dad only a few minutes to explain what a.s.sets and liabilities were.

As an adult, I have difficulty explaining it to other adults. Why? Because adults are smarter. In most cases, the simplicity of the idea escapes most adults because they have been educated differently. They have been educated by other educated professionals, such as bankers, accountants, real estate agents, financial planners, and so forth. The difficulty comes in asking adults to unlearn, or become children again. An intelligent adult often feels it is demeaning to pay attention to simplistic definitions.

Rich dad believed in the KISS principle-"Keep It Simple Stupid"-so he kept it simple for two young boys, and that made the financial foundation strong.

So what causes the confusion? Or how could something so simple be so screwed up? Why would someone buy an a.s.set that was really a liability. The answer is found in basic education.

We focus on the word "literacy" and not "financial literacy." What defines something to be an a.s.set, or something to be a liability are not words. In fact, if you really want to be confused, look up the words "a.s.set" and "liability" in the dictionary. I know the definition may sound good to a trained accountant, but for the average person it makes no sense. But we adults are often too proud to admit that something does not make sense.

As young boys, rich dad said, "What defines an a.s.set is not words but numbers. And if you cannot read the numbers, you cannot tell an a.s.set from a hole in the ground."

"In accounting," rich dad would say, "it's not the numbers, but what the numbers are telling you. It's just like words. It's not the words, but the story the words are telling you.

Many people read, but do not understand much. It's called reading comprehension. And we all have different abilities when it comes to reading comprehension. For example, I recently bought a new VCR. It came with an instruction book that explained how to program the VCR. All I wanted to do was record my favorite TV show on Friday night. I nearly went crazy trying to read the manual. Nothing in my world is more complex than learning how to program my VCR. I could read the words, but I understood nothing. I get an "A" for recognizing the words. I get an "F" for comprehension. And so it is with financial statements for most people.

"If you want to be rich, you've got to read and understand numbers." If I heard that once, I heard it a thousand times from my rich dad. And I also heard, "The rich acquire a.s.sets and the poor and middle cla.s.s acquire liabilities."

Here is how to tell the difference between an a.s.set and a liability. Most accountants and financial professionals do net agree with the definitions, but these simple drawings were the start of strong financial foundations for two young boys.

To teach pre?teen boys, rich dad kept everything simple, using as many pictures as possible, as few words as possible, and no numbers for years.

"This is the Cash Flow pattern of an a.s.set."

---------------> Income -------------------------.

Expense +------------------------+.

a.s.sets Liabilities .

_________ ____________ .

The above box is an Income Statement, often called a Profit and Loss Statement. It measures income and expenses. Money in and money out. The bottom diagram is the Balance Sheet. It is called that because it is supposed to balance a.s.sets against liabilities. Many financial novices don't know the relations.h.i.+p between the Income Statement and the Balance Sheet. That relations.h.i.+p is vital to understand.

The primary cause of financial struggle is simply not knowing the difference between an a.s.set and a liability. The cause of the confusion is found in the definition of the two words. If you want a lesson in confusion, simply look up the words "a.s.set" and "liability" in the dictionary.

Now it may make sense to trained accountants, but to the average person, it may as well be written in Mandarin. You read the words in the definition, but true comprehension is difficult.

So as I said earlier, my rich dad simply told two young boys that "a.s.sets put money in your pocket." Nice, simple and usable.

"This is Cash Flow pattern of a liability."

Income -------------------------.

Expense +----- -------------------+.

a.s.sets Liabilities .

_________ ____________ .

Now that a.s.sets and liabilities have been defined through pictures, it may be easier to understand my definitions in words.

An a.s.set is something that puts money in my pocket.

A liability is something that takes money out of my pocket.

This is really all you need to know. If you want to be rich, simply spend your life buying a.s.sets. If you want to be poor or middle cla.s.s, spend your life buying liabilities. It's not knowing the difference that causes most of the financial struggle in the real world.

Illiteracy, both in words and numbers, is the foundation of financial struggle. If people are having difficulties financially, there is something that they cannot read, either in numbers or words. Something is misunderstood. The rich are rich because they are more literate in different areas than people who struggle financially. So if you want to be rich and maintain your wealth, it's important to be financially literate, in words as well as numbers.

The arrows in the diagrams represent the flow of cash, or "cash flow." Numbers alone really mean little. Just as words alone mean little. It's the story that counts. In financial reporting, reading numbers is looking for the plot, the story. The story of where the cash is flowing. In 80 percent of most families, the financial story is a story of working hard in an effort to get ahead. Not because they don't make money. But because they spend their lives buying liabilities instead of a.s.sets.

For instance, this is the cash flow pattern of a poor person, or a young person still at home: Job (provides income)-> Expenses(Taxes Food Rent Clothes Fun Transportation) a.s.set (none) Liability (none) This is the cash flow pattern of a person in the middle cla.s.s: Job (provides income)-> Expenses(Taxes Food Mortgage Clothes Fun Transportation) a.s.set (none) Liability (Mortgage Consumer loans Credit Cards) This is the cash flow pattern of a wealthy person: a.s.sets(stocks bonds notes real estate intellectual property)->income (dividends interest rental income royalties) Liabilities (none) All of these diagrams were obviously oversimplified. Everyone has living expenses, the need for food, shelter and clothing.

The diagrams show the flow of cash through a poor, middle cla.s.s or wealthy person's life. It is the cash flow that tells the story. It is the story of how a person handles their money, what they do after they get the money in their hand.

The reason I started with the story of the richest men in America is to ill.u.s.trate the flaw in the thinking of so many people. The flaw is that money will solve all problems. That is why I cringe whenever 1 hear people ask me how to get rich quicker. Or where do they start? I often hear, "I'm in debt so I need lo make more money."

But more money will often not solve the problem; in fact, it may actually accelerate the problem. Money often makes obvious our tragic human flaws. Money often puts a spotlight on what we do not know. That is why, all too often, a person who comes into a sudden windfall of cash-let's say an inheritance, a pay raise or lottery winnings-soon returns to the same financial mess, if not worse than the mess they were in before they received the money. Money only accentuates the cash flow pattern running in your head. If your pattern is to spend everything you get, most likely an increase in cash will just result in an increase in spending. Thus, the saying, "A fool and his money is one big party," I have said many times that we go to school to gain scholastic skills and professional skills, both important. We learn to make money with our professional skills. In the 1960s, when I was in high school, if someone did well in school academically, almost immediately people a.s.sumed this bright student would go on to be a medical doctor. Often no one asked the child if they wanted to be a doctor. It was a.s.sumed. It was the profession with the promise of the greatest financial reward.

Today, doctors are facing financial challenges I would not wish on my worst enemy; insurance companies taking control of the business, managed health care, government intervention, and malpractice suits, to name a few. Today, kids want to be basketball stars, golfers like Tiger Woods, computer nerds, movie stare, rock stars, beauty queens, or traders on Wall Street. Simply because that is where the fame, money and prestige is. That is the reason it is so hard to motivate kids in school today. They know that professional success is no longer solely linked to academic success, as it once was.

Because students leave school without financial skills, millions of educated people pursue their profession successfully, but later find themselves struggling financially. They work harder, but don't get ahead. What is missing from their education is not how to make money, but how to spend money-what to do after you make it. It's called financial apt.i.tude-what you do with the money once you make it, how to keep people from taking it from you, how long you keep it, and how hard that money works for you. Most people cannot tell why they struggle financially because they don't understand cash flow. A person can be highly educated, professionally successful and financially illiterate. These people often work harder than they need to because they learned how to work hard, but not how to have their money work for them.

The story of bow the quest for a Financial Dream turns into a financial nightmare. The moving-picture show of hard-working people has a set pattern. Recently married, the happy, highly educated young couple move in together, in one of their cramped rented apartments. Immediately, they realize that they are saving money because two can live as cheaply as one.

The problem is, the apartment is cramped. They decide to save money to buy their dream home so they can have kids. They now have two incomes, and they begin to focus on their careers.

Their incomes begin to increase.

As their incomes go up...their expenses go up as well.

The No. 1 expense for most people is taxes. Many people think it's income tax, but for most Americans their highest tax is Social Security. As an employee, it appears as if the Social Security tax combined with the Medicare tax rate is roughly 7.5 percent, but it's really 15 percent since the employer must match the Social Security amount. In essence, it is money the employer cannot pay you. On top of that, you still have to pay income tax on the amount deducted from your wages for Social Security tax, income you never receive because it went directly to Social Security through withholding. Then, their liabilities go up.

This is best demonstrated by going back to the young couple. As a result of their incomes going up, they decide to go out and buy the house of their dreams. Once in their house, they have a new tax, called property tax. Then, they buy a new car, new furniture and new appliances to match [heir new house. Ail of a sudden, they wake up and their liabilities column is full of mortgage debt and credit-card debt.

They're now trapped in the rat race. A child comes along. They work harder. The process repeats itself. More money and higher taxes, also called bracket creep, A credit card comes in the mail. They use it. It maxes out. A loan company calls and says their greatest "a.s.set," their home, has appreciated in value. The company offers a "bill consolidation" loan, because their credit is so good, and tells them the intelligent thing to do is clear off the high-interest consumer debt by paying off their credit card. And besides, interest on their home is a tax deduction. They go for it, and pay off those high-interest credit cards. They breathe a sigh of relief. Their credit cards are paid off. They've now folded their consumer debt into their home mortgage. Their payments go down because they extend their debt over 30 years. It is the smart thing to do.

Their neighbor calls to invite them to go shopping-the Memorial Day sale is on. A chance to save some money. They say to themselves, "I won't buy anything. I'll just go look." But just in case they find something, they tuck that clean credit card inside their wallet.

I run into this young couple all the time. Their names change, but their financial dilemma is the same. They come to one of my talks to hear what I have to say. They ask me, "Can you tell us how to make more money?" Their spending habits have caused them to seek more income.

They don't even know that the trouble is really how they choose to spend the money they do have, and that is the real cause of their financial struggle. It is caused by financial illiteracy and not understanding the difference between an a.s.set and a liability.

More money seldom solves someone's money problems. Intelligence solves problems, There is a saying a friend of mine says over and over to people in debt.

"If you find you have dug yourself into a hole... stop digging."

As a child, my dad often told us that the j.a.panese were aware of three powers; "The power of the sword, the jewel and the mirror."

The sword symbolizes the power of weapons. America has spent trillions of dollars on weapons and, because of this, is the supreme military presence in the world.

The jewel symbolizes the power of money. There is some degree of truth to the saying, "Remember the golden rule. He who has the gold makes the rules."

The mirror symbolizes the power of self-knowledge. This self-knowledge, according to j.a.panese legend, was the most treasured of the three.

The poor and middle cla.s.s all loo often allow the power of money to control them. By simply getting up and working harder, failing to ask themselves if what they do makes sense, they shoot themselves in the foot as they leave for work every morning. By not fully understanding nioney, the vast majority of people allow the awesome power of money to control them. The power of money is used against them.

If they used the power of the mirror, they would have asked themselves, "Does this make sense?" All too often, instead of trusting their inner wisdom, that genius inside of them, most people go along with the crowd. They do things because everybody else does it. They conform rather than question. Often, they mindlessly repeat what they have been told. Ideas such as "diversify" or "your home is an a.s.set." "Your home is your biggest investment." "You get a tax break for going into greater debt." "Get a safe job." "Don't make mistakes." "Don't take risks."

It is said that the fear of public speaking is a fear greater than death for most people. According to psychiatrists, the fear of public speaking is caused by the fear of ostracism, the fear of standing out, the fear of criticism, the fear of ridicule, the fear of being an outcast. The fear of being different prevents most people from seeking new ways to solve their problems.

That is why my educated dad said the j.a.panese valued the power of the mirror the most, for it is only when we as humans look into the mirror do we find truth. And the main reason that most people say "Play it safe1' is out of fear. That goes for anything, be it sports, relations.h.i.+ps, career, money.

It is that same fear, the fear of ostracism that causes people to conform and not question commonly accepted opinions or popular trends. "Your home is an a.s.set." "Get a bill consolidation loan and get out of debt." "Work harder." "It's a promotion." "Someday I'll be a vice president." "Save money." "When ! get a raise, I'll buy us a bigger house." "Mutual funds are safe." "Tickle Me Elmo dolls are out of stock, but I just happen to have one in back that another customer has not come by for yet."

Many great financial problems are caused by going along with the crowd and trying to keep up with the Joneses. Occasionally, we all need to look in the mirror and be true to our inner wisdom rather than our fears.

By the time Mike and I were 16 years old, we began to have problems in school. We were not bad kids. We just began to separate from the crowd. We worked for Mike's dad after school and on the weekends. Mike and I often spent hours after work just sitting at a table with his dad while he held meetings with his bankers, attorneys, accountants, brokers, investors, managers and employees. Here was a man who had left school at the age of 13, now directing, instructing, ordering and asking questions of educated people. They came at his beck and call, and cringed when he did not approve of them.

Here was a man who had not gone along with the crowd. He was a man who did his own thinking and detested the words, "We have to do it this way because that's the way everyone else does it." He also hated the word "can't." If you wanted him to do something, just say, "I don't think you can do it."

Mike and I learned more sitting at his meetings than we did in all our years of school, college included. Mike's dad was not school educated, but he was financially educated and successful as a result. He use to tell us over and over again. "An intelligent person hires people who are more intelligent than they are." So Mike and I had the benefit of spending hours listening to and, in the process, learning From intelligent people.

But because of this, both Mike and I just could not go along with the standard dogma that our teachers preached, And that caused the problems. Whenever the teacher said, "If you don't get good grades, you won't do well in the real world," Mike and I just raised our eyebrows. When we were told to follow set procedures and not deviate from the rules, we could see how this schooling process actually discouraged creativity. We started to understand why our rich dad told us that schools were designed to produce good employees instead of employers.

Occasionally Mike or I would ask our teachers how what we studied was applicable, or we asked why we never studied money and how it worked. To the later question, we often got the answer that money was not important, that if we excelled in our education, the money would follow.

The more we knew about the power of money, the more distant we grew from the teachers and our cla.s.smates.

My highly educated dad never pressured me about my grades. I often wondered why. But we did begin to argue about money. By the time I was 16, I probably had a far better foundation with money than both my mom and dad. I could keep books, I listened to tax accountants, corporate attorneys, bankers, real estate brokers, investors and so forth. My dad talked to teachers.

One day, my dad was telling me why our home was his greatest investment. A not-too-pleasant argument took place when I showed him why I thought a house was not a good investment.

The following diagram ill.u.s.trates the difference in perception between my rich dad and my poor dad when it came to their homes. One dad thought his house was an a.s.set, and the other dad thought it was a liability.

I remember when I drew a diagram for my dad showing him the direction of cash flow. I also showed him the ancillary expenses that went along with owning the home. A bigger home meant bigger expenses, and the cash flow kept going out through the expense column.

Today, I am still challenged on the idea of a house not being an a.s.set. And 1 know that for many people, it is their dream as well as their largest investment. And owning your own home is better than nothing. I simply offer an alternate way of looking at this popular dogma. If my wife and I were to buy a bigger, more flashy house we realize it would not be an a.s.set, it would be a liability, since it would take money out of our pocket.

So here is the argument I put forth. I really do not expect most people to agree with it because a nice home is an emotional thing. And when it comes to money, high emotions tend to lower financial intelligence. 1 know from personal experience that money has a way of making every decision emotional.

1. When it comes to houses, I point out that most people work all their lives paying for a home they never own. In other words, most people buy a new house every so many years, each time incurring a new 30-year loan to pay off the previous one.

2. Even though people receive a tax deduction for interest on mortgage payments, they pay for all their other expenses with after-tax dollars. Even after they pay off their mortgage.

3. Property taxes. My wife's parents were shocked when the property taxes on their home went to $1,000 a month. This was after they had retired, so the increase put a strain on their retirement budget, and they felt forced to move.

4 Houses do not always go up in value. In 1997, I still have friends who owe a million dollars for a home that will today sell for only $700,000.

5. The greatest losses of all are those from missed opportunities. If all your money is tied up in your house, you may be forced to work harder because your money continues blowing out of the expense column, instead of adding to the a.s.set column, the cla.s.sic middle cla.s.s cash flow pattern. If a young couple would put more money into their a.s.set column early on, their later years would get easier, especially as they prepared to send their children to college. Their a.s.sets would have grown and would be available to help cover expenses. All too often, a house only serves as a vehicle for incurring a home-equity loan to pay for mounting expenses. In summary, the end result in making a decision to own a house that is too expensive in lieu of starting an investment portfolio early on impacts an individual in at least the following three ways: 1. Loss of time, during which other a.s.sets could have grown in value.

2. Loss of additional capital, which could have been invested instead of paying for high-maintenance expenses related directly to the home.

3. Loss of education. Too often, people count their house, savings and retirement plan as all they have in their a.s.set column. Because they have no money to invest, they simply do not invest. This costs them investment experience. Most never become what the investment world calls a "sophisticated investor." And the best investments are usually first sold to "sophisticated investors," who then turn around and sell them to the people playing it safe. I am not saying don't buy a house. I am saying, understand the difference between an a.s.set and a liability. When I want a bigger house, I first buy a.s.sets that will generate the cash flow to pay for the house.

My educated dad's personal financial statement best demonstrates the life of someone in the rat race. His expenses seem to always keep up with his income, never allowing him to invest in a.s.sets. As a result, his liabilities, such as his mortgage and credit card debts are larger than his a.s.sets. The following picture is worth a thousand words: Educated Dad's Financial Statement Income=Expense a.s.set < liability="" my="" rich="" dad's="" personal="" financial="" statement,="" on="" the="" other="" hand,="" reflects="" the="" results="" of="" a="" life="" dedicated="" to="" investing="" and="" minimizing="" liabilities:="" rich="" dad's="" financial="" statement="" income=""> Expense a.s.set > Liability A review of my rich dad's financial statement is why the rich get richer. The a.s.set column generates more than enough income to cover expenses, with the balance reinvested into the a.s.set column. The a.s.set column continues to grow and, therefore, the income it produces grows with it.

The result being: The rich get richer!

Why the Rich Get Richer Income -> a.s.sets -> More Income Expenses are low, Liabilities are low The middle cla.s.s finds itself in a constant state of financial struggle. Their primary- income is through wages, and as their wages increase, so do their taxes. Their expenses tend to increase in equal increments as their wages increase; hence the phrase "the rat race." They treat their home as their primary a.s.set, instead on investing in income-producing a.s.sets.

Why the Middle Cla.s.s Struggle Income goes up, Expenses go up a.s.sets do not increase, Liabilities do increase This pattern of treating your home as an investment and the philosophy that a pay raise means you can buy a larger home or spend more is the foundation of today's debt-ridden society. This process of increased spending throws families into greater debt and into more financial uncertainty, even though they may be advancing in their jobs and receiving pay raises on a regular basis. This is high risk living caused by weak financial education.

The ma.s.sive loss of jobs in the 1990s-the downsizing of businesses-has brought to light how shaky the middle cla.s.s really is financially. Suddenly, company pension plans are being replaced by 401k plans. Social Security is obviously in trouble and cannot be looked at as a source for retirement. Panic has sei in for the middle cla.s.s. The good thing today is that many of these people have recognized these issues and have begun buying mutual funds. This increase in investing is largely responsible for the huge rally we have seen in the stock market. Today, there are more and more mutual funds being created to answer the demand by the middle cla.s.s.

Mutual funds are popular because they represent safety. Average mutual fund buyers are too busy working to pay taxes and mortgages, save for their children's college and pay off credit cards. They do not have time to study to learn how to invest, so they rely on the expertise of the manager of a mutual fund. Also, because the mutual fund includes many different types of investments, they feel their money is safer because ii is "diversified."

This group of educated middle cla.s.s subscribes to the "diversify" dogma put out by mutual fund brokers and financial planners. Play it safe. Avoid risk.

The real tragedy is that the lack of early financial education is what creates the risk faced by average middle cla.s.s people. The reason they have to play it safe is because their financial positions are tenuous at best. Their balance sheets are not balanced. They are loaded with liabilities, with no real a.s.sets that generate income. Typically, their only source of income is their paycheck. Their livelihood becomes entirely dependent on their employer.

So when genuine "deals of a lifetime" come along, those same people cannot take advantage of the opportunity. They must play it safe, simply because they are working so hard, are taxed to the max, and are loaded with debt.

As I said at the start of this section, the most important rule is to know the difference between an a.s.set and a liability. Once you understand the difference, concentrate your efforts on only buying income-generating a.s.sets. That's the best way to get started on a path to becoming rich. Keep doing that, and your a.s.set column will grow. Focus on keeping liabilities and expenses down. This will make more money available to continue pouring into the a.s.set column. Soon, the a.s.set base will be so deep that you can afford to look at more speculative investments. Investments that may have returns of 100 percent to infinity. Investments that for $5,000 are soon turned into $1 million or more. Investments that the middle cla.s.s calls "too risky." The investment is not risky. It's the lack of simple financial intelligence, beginning with financial literacy, that causes the individual to be "too risky,"