I’m a visual leaner so when information can be presented in a picture, then I absorb it a lot faster. That’s why I was so damned impressed when I came across the following link on one of my travels through the Internet: Cash Flow Diagrams. In all honesty, this is one of the best links I have ever found! In a few simple diagrams, Jacob Lund Fisker of Early Retirement Extreme succinctly illuminates the basic underlying principles behind the following concepts:
– paying yourself first;
– acquiring assets;
– creating passive income; and
– benefiting from compound interest.
Much ink has been spilled and many trees felled to write numerous books to explain these four foundational concepts. Mr. Fisker has accomplished the same goal with a few hand-drawn diagrams that are not overly complicated nor difficult to grasp. Please, please, please take the time to read Cash Flow Diagrams and figure out if your current cash flow is helping you to get to where you want to be or whether it’s holding you back from achieving your personal dreams.
The first diagram is a representation of the cash flow in the lives of those of you who live from paycheque to paycheque without going into debt. You are working hard for your money. When you get your money, you pay for your life and you have no money left over. You have to go back to work to make more money. This is called living at your means. In other words, your means are equal to your money and you spend all of your money between each paycheque. There is no room for investing because you spend every cent you make. This is not a good way to live! There is no breathing room – there is no cushion – there is nothing set aside for the day when you can no longer work. If you’re in this situation, I implore you to find a way to get out of it. Get a part-time job and use the money from that part-time job – or side hustle as it is now called – to get yourself into the position of being able to buy assets as displayed in diagram 3.
The second of Mr. Fisker’s diagrams applies to those of you who live from paycheque to paycheque and go into debt. You’re in an even worse situation than the people in the first diagram because you’re using credit to fund your life. Using credit means that you are going into debt. This is a very bad cash flow situation because it means that your money is not enough to pay for your life so you’re relying on credit to make ends meet. You are living above your means, and this is a very bad state of affairs. The reason why it is so undesirable is that you’re paying interest on the credit that you’ve borrowed. If your paycheque is not enough money to pay for your life already, then it’s an absolute certainty that your money is not enough to cover both your life and the interest owing on your debt. (Again, as soon as you use credit it become a debt!) If you’re in this situation, I would suggest that you do whatever you can to get out of it sooner rather than later. Compounding interest is working against you and keeping you from achieving what you really want from life!
If you have disposable income after buying whatever stuff you need to keep body and soul together, also known as: the necessities, then your cash flow is reflected in the third diagram. Disposable income is just a fancy way of saying leftover money. If you, my friend, are fortunate enough to have leftover money, then you are in the enviable position of being able to acquire some assets.
What’s an asset? An asset is anything that puts money in your pocket by producing an income payable to you. If you are living below your means, then you have leftover money for investing. And when that leftover money is put to good use through purchasing assets, you are well on your way to creating a stream of passive income. This is a very good thing! Ideally, everyone can get themselves to this point, namely having some amount of passive income even though, at first, that passive income isn’t enough to fund your entire life. Passive income will grow if it is diligently reinvested and left to compound over time. You still have to work, but that’s okay because working means that you’re generating more money to buy more assets that will increase your passive income. Eventually, your passive income will exceed the size of your paycheque. The faster you acquire income-producing assets, the faster your passive income will increase.
Once you make it to the fourth diagram, you’re laughing. At this point, the reality of your cash flow is that your assets are throwing off enough passive income to pay for your stuff. In other words, you are not required to work. You don’t have to quit your job if you don’t want to – it’s just that working for a salary is now completely optional. This is a wonderful achievement! You can do what you want with your time because your passive income has replaced your wage as the source of money to fund your life. If you’ve reached this stage, then my hat is off to you – congratulations!
The fifth diagram represents retirement. As in the fourth diagram, the cash flow from your assets is sufficient to fund your life and you’ve simply chosen not to work for wages anymore. At this stage, your passive income has replaced your paycheque. Hooray!
When I found this article online, I was already living the life depicted in the third diagram. Thankfully, I had no debt and my take-home pay was enough to pay for my living expenses – there was money leftover every payday. My student loans were gone. My mortgage was paid off. I no longer had a car loan. At that point in my life, I knew that I had to absolutely, positively invest my money after maxing out my registered retirement savings plan (RRSP) and my tax free savings account (TFSA), but I didn’t know where or how or what to do. I didn’t trust financial advisors, so I decided to buy units in dividend-paying mutual funds. (At the time, I didn’t know that mutual funds were vastly more expensive than index funds or exchange-traded funds [ETFs] – now that I know better, I do better!)
I set up an automatic bi-weekly transfer of money from my chequing account to my investment account so that I could invest monthly and take advantage of the benefits of dollar-cost averaging. Automating my savings meant that I didn’t have to decide whether to set aside my leftover money. Relying on automation to fund my investment account was an exceptionally smart move on my part because I’m sure that I would’ve been tempted to buy something other than investments if I had to think about saving vs. spending every time I got paid.
Did I pick the perfect investment? I doubt it. I’m not that lucky nor am I that smart. Also, my accumulating years have taught me that there is no one perfect investment. I invested in a product that I understood – dividend funds – and set up a dividend reinvestment plan (DRIP) so that my dividend payments were automatically reinvested. I had no idea whether this plan would work perfectly. All I knew at the time was that dividends were a form of passive income. I knew I didn’t have the skills or inclination to read company reports and to follow the stock market. I knew that I wanted an investment portfolio that would supplement my other retirement income when I decided to leave work. Dividend mutual funds – and, later, dividend ETFs – satisfied my list of what I wanted for my portfolio so I picked one and started investing.
Dividend payments are my preferred form of passive income so I invest my money in dividend-producing assets. As a Singleton, I don’t have the benefits that come with having another person’s income contributing to my household. Having a reliable stream of dividend income soothes some of the risk of living in a single-income household. My goal is for my passive income to cover my monthly necessities. Once I’ve met that goal, then I’ll know that I can survive on my own even if my salary goes away.
As a result of my choices to automate my money and to invest it regularly, I’m now in the position of comfortably earning four figures of dividend income every month. My passive income stream is not yet enough for me to live on, so I still have several years of working in my future. However, my passive income is compounding every single month as it’s added to the new investment purchases that I make with the money that is automatically transferred to my investment account when I get paid. I’m comfortably investing the equivalent of one paycheque every month. I like to think of my dividend income as my side hustle income, even though I don’t have to do anything other than breathe to earn the dividends.
Where are you now? And where do you want to be in five, ten, twenty years? How much passive income do you want in order to live the life of your dreams? What steps are you taking to put yourself in the cash flow position that you want for your future?