Most of us start with a job where we earn a salary. We spend part of the salary taking care of our expenses including taxes, and invest the balance amount, if there is any.

Over time:

calculator– Our salary typically increases, though that is not a certainty

– Our investments sometimes go up and sometimes go down, again with no certainty.

– Our living expenses on the other hand go up with absolute certainty. They often need to be funded by sources outside our salary….could be investment returns or more often debt.

The lifestyle upgrades

After all we are quite adept at enhancing and locking our lifestyles, every time there is a remote visibility of a raise or a bonus. With everybody watching, the life style enhancements become so darn important, that funding it with debt becomes the accepted norm. Of course the fifth bedroom, the faster car, all possible upgrades, the spring collection, the coveted memberships, the Michelin stars – everything becomes a necessity. What if we get caught red-handed without one of them.

Looking at it as a business

However, a more evolved and smarter way of looking at this cycle is to treat it like a business. Each of us is running our own little business. A business where each of us is investing our human capital and financial capital to generate an earnings stream. Our human capital is a combination of our capabilities and our time. Our profession is where we invest our human capital, to earn a return in the form of a salary or professional fees. Unless we are also investors in our own companies, our financial capital is invested outside our profession to generate investment returns.

Just like any good business would focus on it’s profitability rather than trying to take pride in what it is spending on, we can do the same. A well-run business would ensure that it’s expenses are in lines with it’s revenue expectations so that the business is profitable. Expenses do not get incurred just because the funds (capital) are available. Otherwise the business would be on the road to bankruptcy. If the business is making capital expenditures, it is investing with the objective of earning larger future profits. Wouldn’t it be smarter for us to do the same in our day to day lives? This line of thinking is the best way to get out of the ‘life-style trap’. I am not trying to advocate against enhancing life-styles. By all means we should aspire to lead a better life-style. However that life-style should be income funded rather than capital (often debt) funded.

People who are smart about money, use their own capital and debt to boost future earnings. Part of the earnings is in turn used to boost their life-styles within reason. They don’t dip into their capital to fund current expenses, compromising future earnings stream. There are however certain expenses which I would categorize as investments that will benefit us in future e.g. gym membership, education etc. I don’t think there is any problem in using capital for funding these.

Investing in cashflow

Once the investment earnings outside a person’s salary income become large enough to fund all the expenses, that is the time to make the all important choice. Whether to continue with one’s profession purely for the love of the profession (which would also mean the person is really good at what he/she does) or whether to pursue other interests. Please refer to our earlier post on this topic. This takes time, as initially the financial capital is limited and is not enough to generate adequate cash-flows to cover all expenses. However some discipline, risk management and compounding of the returns (refer to earlier post) over time can make this a reality. There is absolutely no requirement for hitting multi-baggers with the financial investments as long as one is being sensible about costs.

Some people would be super smart or lucky to invest their human capital in creating a Whatsapp, and selling it for 19 billion. Such people can do without thinking ‘cashflows’. However that is more of a statistical aberration. Each of us should of course aim for such lofty goals in our own chosen fields….but while we are at it, it will not harm to plan for future cash-flows, just in case the 19 billion doesn’t hit out account soon. That way, even if we do not end up being phenomenally lucky or smart, we can still continue to enjoy our freedom of choice, while paying for our ever growing expenses. Not only does investing in cash-flows help us to achieve freedom, it also gives us the staying power in our financial investments.

Part 2 will be a continuation on  this topic, and we will take a closer look at the term ‘financial well-being’ and outline what it takes to achieve financial well-being.

In the part 3, we will use specific examples to distinguish between the two types of investing – investing for cashflow and investing for capital gains. We will look at the advantage and disadvantage of each of them and discuss how these can be combined effectively to take us closer to our financial goals.