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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.   

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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.

 

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Water Works – Managing Personal Cash Flow

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Analogy is one of the most effective teaching tools.  By showing similar relationships in the familiar and concrete to the new and abstract, it becomes much easier to illustrate the relationships to the inexperienced.  One of the most concrete analogies I have seen to explain abstract concepts is in plumbing.  I have seen plumbing used to explain such diverse fields as electricity to organizational systemic behavior.  Plumbing also is a great way to illustrate the flow of money.

In every household, there is income which consists of the water source and a set of expenses that serve as a drain.  Most people have a drain that is large enough to drain the bathtub nearly as fast as the water flows into it.  Not only is one required to keep filling the tub by working hard, but also should something disrupt the flow of water, such as a bout of unemployment, the tub quickly drains and fundamental needs of food and shelter become difficult to have.

I started working when I was 13 years old.  I have always worked and worked hard.  One of the best things that can be instilled in a young person is a work ethic, but a work ethic without an ability to manage personal cash flow only serves to help make everyone else more well off.  When I started working, I earned some money and I was able to buy a few nice things, but one of the lessons I learned far too late is that when you buy something that doesn’t pay you back, that purchase only serves to make the seller richer and you poorer.  Diligent efforts must be made to make some portion of your earnings work for you over time and that only happens with a combination of saving and investing.

I will be discussing more about how to manage cash flow in the weeks to come.  But it is fact that one will never get ahead financially unless one learns to reduce expenses sufficiently to divert some income into savings and investments.

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