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Income Diversity is Essential to Financial (and Moral) Success

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At one time or another most children are asked what it is they want to do when they grow up.  Consensus is building that the answer to that question is not a single answer anymore. 

Financial planners consistently tell us that we should have diversity in our investment portfolios.  Diversity, they say, provides a hedge against the risk of a single investment failing.  I am a strong supporter of diversity in income sources.  Multiple streams of income can provide a hedge against an interruption of a one income stream.  It is a reality of the global economy that almost everyone is vulnerable to a layoff.  If your current job is your only source of income, a layoff is potentially devastating to your family’s financial health. If you are a business owner and one sales market suffers a setback, your business can quickly fall apart.  Multiple income sources protect you and your family from financial catastrophe.

But there are other advantages to having multiple income streams.  First, not all income sources require significant active management.  Many of them are passive or semi-active, meaning that you can create them and they enrich you without significant effort.  Among all the types of income, earning from working a job is the most time consuming and often the lowest paid.  Passive income sources, such as investing in dividend producing stocks, or semi active sources, such as rental real estate or options trading, can be very lucrative with only a few hours of your time a month.  Even the most motivated person cannot work more than 2 or 3 jobs, but one can manage dozens of passive and semi-active income sources with proper care and investment.  Over time, by the mathematic force of multiplication, it is possible to eclipse your active income sources with the passive and semi-active sources.  This is the dream of the investor–becoming one who can safely afford to retire from work life with no sacrifice in lifestyle.  Indeed, with the increase in free time, you will be free to realize ever larger increases in income because you will be able to devote yourself entirely to building new income sources. 

More importantly, there is a huge difference in the type of person you can be when you have multiple sources of income.  In times of financial stress or insecurity, people often find themselves in ethical dilemmas.  Your employer may ask you to cut corners to increase the company bottom line.  You may find yourself having to choose between eating and falsifying your tax return.  You may even be tempted to steal from those closest to you.  Financial stress may drive you to do things that you would never have considered doing if you didn’t feel the stress.  Actions that you resort to in times of great stress may haunt you for the rest of your life, either physically in the case of imprisonment or psychologically with regret and shame. 

Multiple income streams, therefore, help you build a firewall to protect your moral and ethical self.  They allow you to always do things on your terms and empower you to say “No!” when your conscience tells you to do so.

 Income Diversity is Essential to Financial (and Moral) Success
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Check Your Financial Idle – Keep Committed Expenses Low

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In my last article, I introduced the concept of the financial speedometer to provide a simple framework on how to evaluate the extent of spending in your household.  To extend the analogy, so long as a car engine is running, a car will consume some power and fuel even when the car is not moving.  Some big and typically highly inefficient engines burn fuel at high rates even when idling.  This makes sense for a complicated machine like a semi tractor which is geared for towing and hauling very heavy loads up and down mountains.  For a semi, high power comes at a cost of lower efficiency, but it is a fair tradeoff, because that additional power can be brought to bear to pull the load in times of need. 

A high idle, however, is much less appropriate for a small economy car.  Unfortunately, too many households have the financial engine of an economy car that idles in the red.  When I say that a household budget is idling in the red, I mean that many families have arranged their financial affairs so that their committed expenses every month almost equal their entire income.  Through the choices they have made and circumstances they have endured, they have eroded almost all the financial operating room they have.  Unlike the semi which can draw upon additional power when needed, households idling red are unable to use their budget or discipline to change their financial situation. 

Many people overspend on clothes, entertainment and food.  In most cases, instilling fiscal discipline and refusing to spend opens up financial capacity that can very quickly help a family improve its position.  But a family that has overcommitted to rent/housing expenses, insurance, taxes, utilities, gym memberships, contractual obligations and most of all debt cannot simply choose to stop spending.  These expenses are commitments and breaking commitments carries much larger repercussions in practical, philosophical and often moral terms.   

371562914 704db0ad3b m Check Your Financial Idle   Keep Committed Expenses Low
Image by Brajeshwar via Flickr

I, therefore, advise people to carefully monitor what percentage of their spending is composed of committed expenses.  The percentage of income that is spent on committed expenses is called your financial idle.  I urge people to never allow your idle to exceed more than 55 to 60 percent of your take home pay, (45 to 50 percent if you have irregular income).   If, at any time, your financial idle exceeds 80 percent of your income, you are more likely than not, bankrupt.   Even if you can somehow stave off bankruptcy in the current arrangement, you will end up endlessly treading water with no hope of improving your situation.  To escape this exhausting physical and mental grind, you have only 2 options: upgrade your financial engine by seeking either more lucrative work or additional work, or you will need to make draconian cuts in your lifestyle when you do have opportunities to exit some expenses.  By draconian, I recall advising someone to move within a couple of blocks of work, sell the car and give up driving altogether.  Some folks have moved a family of four from a 3 bedroom house to a 2 bedroom apartment. 

Keep in mind the concept of financial idle.  It is one of the key concepts that will help you avoid ending up in a situation where the only escape is via the path of pain.  It’s best not to walk that road at all.

 

 Check Your Financial Idle   Keep Committed Expenses Low
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Managing Cash Flow

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I have always been interested in entrepreneurship.  In college, I took several courses that dealt with starting and running a business.  Though none of the material was exceptionally difficult, I was intimidated by assembling financial statements.  One would normally think that being an engineer and otherwise being very proficient in mathematics, this wouldn’t be difficult.  However, there is a world of difference between using math to solve an interesting problem and using math to keep a business solvent, feeding your family and keeping people employed. 

Like many people I was intimidated by assembling income statements and balance sheets and left the creation of these documents by other folks who were in traditional finance fields.  Looking back this is amazing since both income statements and balance sheets consist of nothing more than simple addition and subtraction.  The most difficult parts of preparing financial statements usually comes in the initial setup when you do not have a history that will guide you in making predictions moving forward.  Even in these instances, there are numerous ways one can estimate costs and incomes if one thinks things through.    I would have given myself a tremendous advantage earlier on had I chosen to apply myself more in facing my lack of confidence and learn it. 

Speaking plainly, you will never move forward financially until you learn to track your financials and make reasonable financial projections.  You need to learn to track your income and outflow so you can effectively manage the challenges of spending today and projections are needed to manage the challenges of spending in the future.

 Managing Cash Flow
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