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A Formula for building wealth

Too often we hear about people who 'got rich from stocks' or 'became wealthy because an investment paid off' or 'because they inherited wealth'- and I say 'too often' because really, there's always more to it than just that one thing. Making money alone will not make you wealthy unless other conditions are met as well. We've all met people with high income, but who live paycheck to paycheck. We've seen people who've received lumps of money but squandered it and are scrambling to pay bills and service enormous debt. We've heard about paper millionaires who lost it all in the market and are struggling to pay the bills for their expensive cars and other bad debt- these people all had one or more of the keys to becoming wealthy, but none of them are now wealthy- and that's unfortunate... but it's also, in large part, predictable.

In his book 'SpeedWealth', T. Harv Ecker describes what he refers to as one's financial thermostat- it's the number, in terms of income and wealth, that you regard as 'normal', and which you manage to maintain. It's your financial comfort zone- if your wealth goes below there you'll find a way to make more and become comfortable again- and at the same time, if your wealth goes above your emotional comfort zone, you'll find ways to correct that, too.

It's not as simple, however, as picking a number and choosing to be that wealthy- if that were the case, I'd be a godzillionaire and so would you. Rather, your number is created by the little things that you do, from balancing your checkbook every week to starting your own business- and it's the net effect of these little things that determines how much money you make and how much of it you keep. Further, it is your basic day-to-day attitudes about money that govern how you make those little choices, which in turn influences your bottom line.

Ecker's premise is that by taking an empowered look at your personal money mythology, your beliefs about money and to what money represents for you, it's not just easy to change your financial thermostat, it's inevitable that if you change your relationship to money that you'll create a way to expand your financial comfort zone, and to fill it.

In their book 'The Millionaire Next Door', Stanley and Danko point out that wealthy people come in all shapes and sizes and personalities- and that the one thing they really all have in common is not high incomes, but rather, they manage their money well.

Between Ecker, Stanley, and Danko, there's some very common and uncommon sense- Ecker points out that wealth is a consequence of the little decisions that come from your belief system, and Stanley and Danko point out that the bottom line is a function of proper, sensible money management. I believe they're both right.

In this article we'll discuss 5 key ingredients to your financial health, after which we'll go over a method for managing money that incorporates both sensible financial principles and helps you deal with the challenges your personality and attitude can throw into the works.

Five Keys to building Wealth

There are 5 keys to building wealth- without all five going on, the process will be much less reliable. They are:

Working income- We're all familiar with this one- this is the money we go work for. It's likely to be your largest income stream, but the problem with it is that it doesn't have any residual value- once you've done the work, you've got to go in the next day and do it all over again. Your goal in generating working income is definitely to make as much as your work is worth- so your challenge is to find ways to make your working time more valuable. Over the long term, however, you want to be positioned so that you don't have to work- you want to retire one day, right? You may still choose to work when you're retired, but it's only a choice if you can afford not to.
Passive income- Passive income is money coming in that is not the direct result of your own labor- rather, it is income derived from leveraged investments of your time, money, property, or effort. If you own a business that generates income for you, that is passive (unless you did the work that created the income yourself.) If you wrote a book or music or software or other intellectual property that generates royalties or residuals, those constitute passive income. If you own investment properties, such as apartment buildings- even if you work to maintain them, that's passive income. If you're involved in network marketing, commissions based on your downline's sales volume are passive income. Many people are challenged by the notion of receiving money for which they didn't work- essentially, they're too proud to make money in this fashion- but in all honesty, there is work and risk involved- passive income is well-earned, and it's vital in this process. Your goal is to reach a point where your passive income covers your expenses- at that point, you can retire without worrying about running out of money.
Savings- Pretty straightforward- if you don't save, you'll never have any- and that's going to hurt down the road. Your goal is to use your savings to take care of the big things that come up in life- putting up a down payment on a house, buying cars, taking care of the big-ticket items.
Investments- Savings alone won't do the job. If you save $100 today, in 30 years it'll be worth $10 if you're lucky. If your money isn't working for you, you're the only one who is- and inflation is working against you. With your investments growing your money for you, over time your investments will generate their own residual income that will exceed your working income. Your goal with your investments is to stay ahead of inflation and to eventually provide you with a sustained income stream when you retire. In the short term, your investment goals could simply be to acquire assets that provide you with passive income.
Simplification- To grow your wealth, you need to live below your means, period. The more you simplify your expenses, the more efficiently you'll progress toward financial freedom. I know of someone who, after receiving an inheritance of $300k, simplified her lifestyle to the point where the income from her investments on that money covered all of her expenses- she was financially free at the age of 29 because she simplified.

If you hit on all 5 of these points, you'll probably become financially free more than twice as quickly as if you only hit on four.

The Accounting System:

I use this system. It's accelerated my movement towards my short and long-term financial goals significantly- it's helped me to understand in detail where my money is going, what it's doing, to define goals for it, and to control how I spend it. To do this, you'll need 6 containers (I use plastic jars), 6 accounts of varying types, and a credit card. The idea is that every time you are paid, pass your income through this accounting process in order to divide your income into different accounts for different purposes.

The accounts, and what they are for:

Retirement / Financial Freedom - This is the big cheese account, this is the one that will make you financially free. The purpose of this account is to grow and grow until it can make enough money by itself to cover your expenses. The goal for this account is to provide for your retirement, but it is NOT meant to be spent during your retirement! It's purpose is to provide you with an income stream when you retire, rather than principle to spend. If your plan is to spend your principle during your retirement, you risk running out of money, and that's unacceptable. You will never spend money from this account, with two exceptions: 1) You can use funds in this account to purchase assets- that is, properties that will provide you with an income stream, and 2) once this fund is capable of generating sustained income equal to your expenses on it's own, then you can spend that income, but not the principle. The faster you make this happen, the faster retirement becomes an available option to you. This account can probably better be described as a portfolio- it can contain your 401(k) and IRA, it can own income-producing real-estate or businesses or annuities or other income-producing investment vehicles like businesses, but it's important that all income from this fund be passive- if you own the business, make sure it doesn't need you there all the time, this fund is so you can retire! Diversification is a good idea in this fund- I recommend a bit of each, and I also recommend that you invest in educating yourself on how to manage all of the above.
Savings - This account is there to help you manage big-ticket items like a down payment on a house or a car, and can also be used to service debt on big-ticket items. This account's revenue stream can be divided up among items that you want- say, for example that I want to buy a hot tub ($2k) and put a down payment on a truck ($3k) and the monthly revenue stream going into this account is $500. If I go 50-50 on that, my hot tub fund gets $250 and my truck fund gets $250 each month. In 8 months I can pay cash for the hot tub, after which the truck fund gets the full $500- so in 10 months I'll have my down payment for the truck. Alternately, I could buy the hot tub today using credit and have it paid off probably in a year while still saving up for the truck down payment- and during this timeframe I know that my big-ticket purchase budget is full. *one very important use for this account is that it serves as your emergency fund*. When starting this account, make sure that part of it's stream goes toward saving up 3 months' worth of income for use in emergencies like unemployment. As the name implies, this should be a savings account.
Play!- This account is incredibly important, simply because it's the most fun... and remember, enjoying yourself now and later is the purpose of this exercise. The money that goes into this account must be spent every month, on something you value very much. This is not frivolous money, this is indulgent money- this is money you spend to make yourself feel *good*. As you use this account, you'll become more discriminating about how to get the most fun value out of your play dollar- and that's the point. For those of us who have a hard time enjoying our money, this account exists to take the guilt out of enjoying it- after all, you're saving twice as much as you're playing with, relax already. For those of us who don't have this problem, this account puts limits on what you can spend, requires you to be more picky about how you spend it. The goal for this account is to help you become better at enjoying yourself more and more with a finite amount of money- and this provides enormous benefits not only to your monthly budget, but to your relationship with yourself, your money, and your life. Nurturing yourself is a vital, vital part of being happy- and at the same time, it's a value that is under-stressed in our culture. This part of your budget is devoted expressly toward the purpose of this goal. This account should be a checking account.
Education- By far the most important asset you have is your brain- and like any other part of you, if you don't use it, it will become flabby. I use this account to buy books and pay for classes on any subject that interests me- computer programming, martial arts, finance, the subject isn't important. What is important is making learning constantly into a habit- if you do this, you'll make solving problems, all of your problems, into a habit. In other words, you'll make success into a habit. Your goal with this account is to foster your love of learning- so pick things that interest you and explore them! If something is boring, put it aside, your purpose is to find something that excites and engages you. You can use this fund to invest in your financial education, as well- even if you don't have money to invest now, you will soon- being up to speed on how investing works is a good thing, and you'd be amazed at how having money in the bank makes investing more interesting. :-) When you're excited or engaged, you're exciting and engaging- you're at your most effective as a person- and you almost can't help but be happy in the process. (checking account)
Give- This account is one of the most important ones, in my opinion. This account is your giving budget- gifts to loved ones, donations to charity. This account requires you to think about how your money can do the most good in your life and in the lives of others. If money is *really* tight and giving money distresses you, give of your time or your energy or your skills- the important part of this is to become more comfortable with generosity and to make generosity a balanced part of your life. Another intensely important purpose this account serves is to get you thinking about what other people want or need- once you make a habit of taking an interest in what people need, all manner of opportunities will present themselves, the world will become a fuller and more abundant place. Becoming good at perceiving the needs of others will make you into a better person, and it will open many doors for you... and it'll also train you to become much richer, much more quickly. Of all my accounts, I'm growing to like this one more and more. (checking account)
Necessities- (checking) This account's purpose is to cover the essentials, stuff you can't live without- food, clothes, a place to live, insurance, a vehicle if you need it to get to work, that sort of thing. Your goal, in terms of reaching financial freedom as quickly as possible, is to reduce the percentage of your income that this account represents by as much as possible. The simpler you live, the faster you will become financially free, for two reasons: 1) you'll be able to put more in your investments faster, and 2) your investments will only need to be able to generate enough income to meet your expenses. In a strategic sense, once you're out of the rat race, you've won the game- so it makes sense to win the game first, and *then* add on the luxuries. Remember, your goal is to win the game, to become free.

Ratios:

The following table expresses how to divide your income, and sets goals for you to reach if you're not already there with it's initial percentages number. These are guidelines only- they're meant to provide you with goals to reach and to eventually exceed. Explained simply, the first four accounts should receive equal percentages of your after-tax income, your give account should get half as much as any of the first 4, and the Necessities account should take as little as you can give it. When I began using this system, my 'necessities' budget was over 55% of my income- I found ways to reduce that number... in part by starting a side business to increase my income, partly by simplifying. At the same time, my Education spending was under 10%, as was my spendable savings.

Account name Initial parts Ratios

Retirement / Financial Freedom 1 Equal to SS, Play, Edu

Savings 1 Equal to FF, Play, Edu

Play 1 Equal to FF, SS, Edu

Education 1 Equal to FF, SS, Play

Give .5 Half the amount of any one of the above

Necessities 10 As low as possible.

Implementing this system

There are 3 procedures you'll do when using this system- setting it up, divvying up your income into your accounts, and paying your bills.

Getting started- This is the part that took me the longest. I went through my current finances, last month's bank statement, and divvied up all the charges and checks into the categories they fell into- mortgage and utilities and food and such to necessities, kayaking stuff in the play category, etc... After this I went down to my bank and opened up a few more accounts to allow me to have accounts for each jar. I wrote checks from my main account to each of the new accounts as seed money, and I was done. The process required me to take the first steps toward money management- align each expense with a goal, and to see if my spending was balanced with my goals. (it wasn't then, but is now.)
Divvying up- This is the easy part for me- I have a direct deposit arrangement with my work, I just added the new accounts to my direct deposit rule, and it's done. Whenever I make money directly I divvy it up immediately using my jars- if I'm paid in cash, it goes into the jars until the next time I go to the bank. If it's a check, I'll put the check in one jar and write checks to each of the other jars in order to do the divvying up. Then, the next time I go to the bank, I hand them a bundle of checks and they get to sort out the transferring. (I've also found it to be *very* easy to manage multiple accounts online- that way you can just deposit one check and do the balance transfers at home.)
Paying your bills- For day-to-day expenses, use your credit card- there's no need to carry around several checkbooks. Then, at the end of the month, go through your statement and break down the charges into categories that correspond to each of your jars- and pay your credit card in full with checks written from each of the accounts, for the correct amounts. That makes balancing your checkbooks pretty simple- one check per month. For bills that you must write checks for, write them directly from the account. Using a credit card in this manner, provided you stay within each of your budgets and pay off the balance each month, is good news for your credit and if the card has other benefits (like airline miles, fraud protection, car rental discounts, travel insurance, etc) those are plain bonuses.

Principles and benefits of the system:

Regard your income as streams

When considering how much money you can spend on a certain expense, whether it's buying a big-ticket item or a lot of little things, it can be easy to think in terms of lump sums, and in terms of whether you can or can't afford a certain thing or things. When regarded in terms of streams, it's easier to be disciplined with regard to what you should or not spend on a given purpose in a given month... and it also simplifies the process of understanding when you'll be able to cover the expense. Also, if you regard a portion of your income as a stream, it's easier to be responsible about using credit- rather than waiting to save money to purchase a big-ticket item, that part of your income could go to servicing a loan, for example- so you'll know how much you have per month to spend on, say, a car payment.

Separate streams serve separate goals

If you limit your expenditures in every category to the percentages you've allocated to them, you'll always have everything covered- and you'll have better control over when and how you'll be able to afford short and long-term goals. Moreover, if you're strict about not borrowing from one fund to pay for what you want out of another, instead of borrowing from Peter to pay Paul you'll be motivated to find ways to change the big picture, rather than the smaller ones- that is, you'll find ways to cut down your 'necessities' expenses or expand your income, rather than borrowing from your retirement fund and never paying it back. Remember, borrowing from one account to pay out another one isn't doing you any favors- all it's doing is hurting the whole picture by short-changing you in that area of your financial game. You wouldn't coach your kid's soccer team to send all players, including the goalie, to charge after the ball, because to do so would open up a serious hole in their game- one pass and the other team would score. Each player has a different job to do, a different part of the field to cover, and this is just as true in your finances. Remember, the goal is to become financially free and each of these accounts serves that goal first.

Don't cross the streams.

It's tempting to borrow from one account and rationalize that it's okay for whatever reason- but that defeats the purpose of this system. The purpose of this system is to take your rationalizations out of the picture and to balance your financial expenditures in a way that will guarantee you to be responsible about your money while at the same time requiring you to nurture yourself, feed your brain, and have fun with it. It's designed to motivate you to simplify your expenses and increase your income when you want more money for a specific purpose, rather than borrowing from some other place in your budget. The idea is that if your lifestyle demands a certain amount of spending to maintain, this system will push you to make the numbers meet in a balanced way, rather than cannibalizing your budget in other places. If you cut your expenses or increase your income, you can do more fun things with your fun account, while assuring you that you're saving as much as you play with, and you're investing as much in your education as you are in your long-term spending account. The purpose is to keep you balanced and on track, and to make being balanced and on track into a habit, to make it feel 'normal' if it doesn't already. Simple and steady is the name of this game, and it works.

Use the jars as a physical reminder

The jars are there to help you keep stuff separate. Cash that drops into a jar with a name on it has a purpose- cash that drops into an unmarked drawer doesn't- and this cash will fall prey to your old habits. The accounts are separate for the same reason- money that goes into an un-dedicated account is subject to appropriation by whatever whims may seize you in the moment.

Trust the Formula to take your personality out of the picture

The reason most people have financial problems is that their perspectives and motivations around their money lead them to an imbalanced way of budgeting- that is, their financial personality is working against them and either they spend too much and don't save enough, or they hoard too much and get sick of it or they avoid the subject entirely and end up on the business end of a collection agency. The main purpose of this system is to provide a balanced financial structure that takes your personality and your old habits out of the mix. Taking your personality out of the picture will help you balance better... and it can also let you relax about money- if you're using this system or one like it, you don't need to worry about it, it's taking care of itself- and this can be great not only for your peace of mind, but for your relationships.

I know a couple who recently started using this system- she was a spender and he was an avoider- he got his money under control and she started having money in her savings. He stopped being afraid of having to bear the responsibility for both of their retirements, she stopped resenting his worrying. Both cut back on their frivolous spending, and both have more fun now with their money... and both have more.

...and a final word- if you're like me, you'll resist. You'll take one look at the system and you'll say 'it's stupid!'. You may get angry or frustrated or intensely bored- this is normal. The part of you that's saying this is your Financial Personality, it's the inner control freak we all have who doesn't want to change or be changed, freaking out. When this comes up, (and it will, most likely) you have a choice to make. You can use the system to help you control your money, or you can yield control of your money to your own financial personality- with the understanding that you've already seen the results it will generate. If it's track record is good, go with it, you're rare and blessed. Otherwise, thank the part of you that resists for it's contribution, but go ahead and stick with the plan.

Making it Work for Couples

This system can be modified to work for two people quite easily- and all it requires is that both of you agree to use it. Some possible variations:

Each partner can follow this plan separately, using their own jars and accounts
Each partner can follow this plan separately, but pool specific accounts (like necessities or FFA) and manage them jointly
You could begin by pooling your income and distributing equally from there, or contribute to each account by percentage of your personal income (requires agreement, obviously)

Looking at the purposes of each account, it seems to me that some lend themselves easily to joint management while some, depending on your wants and needs, might not- I like to have my own education account, for example, because it's purpose is to feed my brain and what interests me might not interest my sweetie... and it feels easier for me if I know that my choice to get a book on how stock options work doesn't take away from her- and that's why she's got her own EDU account... to make me feel comfortable with using that money for it's intended purpose: my brain.

Your thinking and implementation on this will vary, because this is ultimately a personal accounting system- it exists to serve your needs, guide you toward balance, to take your personalities out of the mix, and to help give you control over your money together.

Summary

This is not the only method, there are others that work too. This is the best one I've found for me in terms of balance and ease of use. You don't need anything more than basic accounting to balance a checkbook, bank accounts are free if you use the right banks, and a set of jars cost me $12. They've paid for themselves many times over.

I can't guarantee you of riches- only you can do that. I can tell you that starting to use this accounting system has been an important step in managing my money. If you have questions, concerns, or problems, I welcome your input.