I find it interesting that wisdom is often clearly laid out before everyone in a book or a lecture, and few truly understand it. It’s just as Napoleon Hill wrote in “Think and Grow Rich” when he hinted that one needs to re-read the book several times; and even then, the wisdom can only be captured when a person is ready to hear it.
The wisdom that I have in mind as I write this article is the treasure that can be found in the children’s fable “The Goose and The Golden Egg.”
The idea was further developed in popular wealth literature such as George Clason’s “The Richest Man in Babylon,” which was echoed in Kiyosaki’s “Rich Dad, Poor Dad” and also supported by Warren Buffet’s 1st and 2nd rules of investing.
Pay Yourself First
The simple, but powerful concept is generally known as “pay yourself first”.
Most of you that read this article will be familiar with the principle, but my guess is that few truly understand it; and fewer still practice the concept.
The concept is so simple, yet possibly the most powerful wealth building principle available to the average person.
What Does “Pay Yourself First Mean?”
In “The Richest Man in Babylon,” Clason describes a technique that includes putting aside 10% of your income to “pay yourself first.” The idea is simple, yet profound in it’s implications.
I find that there is widespread misunderstanding about what “pay yourself first” means. The definition is subtle, but important to understand if you plan on using it to create wealth.
Let’s start out with what it’s not.
Some people think that “pay yourself first” means to treat yourself to something nice when you get your paycheck. For example: someone might get their paycheck on Friday and decide to go out to eat with the first dollars of the check before they pay their bills.
It’s important to realize that this scenario does not pay you first, but instead, pays the restaurant first. Do you see the subtle difference? If you were paying yourself first, you would still have the money.
Buying a House to Live In
Many people think that they are “paying themselves first” by putting aside money to purchase a home. While this isn’t the worst thing you could do with your money, a home doesn’t qualify as a cashflowing asset. Robert Kiyosaki describes in “Rich Dad, Poor Dad” that your home is actually a liability because it takes money out of your pocket each month.
Automatic Distributions to a 401k
Many people arrange for their employer to automatically deposit 10% of their paycheck into a 401k. While this is in line with the spirit of pay yourself first, it doesn’t completely qualify under Warren Buffet’s rules of investing.
The problem with a 401k is that people tend to invested it in stocks or assets that might lose value. To make matters worse, people tend to tap into their 401k early by borrowing against it or taking a premature distribution.
Worst of all, the majority of retirees have to draw down their 401k principle, which is effectively “killing the goose.”
The Real Definition
Based on my understanding of the works of Warren Buffet, Napoleon Hill, George Clason, and Robert Kiyosaki; I have have come up with a definition of what “pay yourself first” really means.
The simplest comparison I can make is the goose from “The Goose and the Golden Egg.”
Wealth is created by consistently feeding the goose that provides you with golden eggs. In order to continue to grow in wealth, it is important to always feed the goose and never destroy it.
The Equity Goose
I like to call it the Equity Goose: an asset or group of assets you own and contribute to on a regular basis that rewards you with passive cashflow.
Your equity goose is not your net worth. The two concepts are loosely related, but not the same thing. Many of the assets you might own that contribute to your net worth will not qualify as your equity goose.
In order to qualify as an equity goose, your asset has to meet 3 requirements:
1. It Can Not Be Tapped Into
It is of the utmost importance that your equity goose always grows and never gets smaller. This automatically disqualifies your “rainy day fund” because you might potentially tap into it (when it rains).
It disqualifies your checking account, because you use it to pay your bills. Remember, the equity goose can never get smaller.
It disqualifies the equity in your home if you ever take out a home equity line of credit.
Basically, your equity goose needs to have a firewall around it. It needs to be hard as possible to tap into.
For example: the simplest form of an equity goose is a money market account. Money market accounts limit your ability to access the asset for this exact reason. I even suggest getting a money market account at a different bank than the one you use to pay your bills. The temptation to make an online transfer from one account to another might kill the goose.
Don’t trust in your own will power to protect the goose. Humans have weak moments. The smart thing to do is to keep it away from yourself.
2. It Can Not Lose Value
Warren Buffet’s 1st and 2nd rules of investing are: 1) Don’t lose money, and 2) Don’t forget rule #1.
I’ve known these rules for many years, but only recently did I understand what he was trying to tell us.
Warren Buffet is telling us not to invest in anything that has the possibility of going down in value. This immediately eliminates stocks. Ironic as it may seem, Buffet is telling you not to invest in stocks because they have the possibility of losing value.
The only way to protect your asset from losing value is to buy it at wholesale. Warren Buffet buys $1 Million companies for $500k. 50 cents on the dollar.
To keep your goose healthy, you need to buy assets at 50-70 cents on the dollar. The most practical asset class to accomplish this rule is real estate investing.
By either buying a house at 70 cents on the dollar or becoming a private lender who loans no more than 70% loan-to-value; you are protecting yourself from losses.
3. It Must Cashflow
The masters have been trying to tell us for hundreds of years to buy assets that produce realized cash on a monthly or quarterly basis. So why do people buy stocks with no dividends? Somewhere along the way, we have been sold on the concept that we don’t need cashflow; but we do.
Sources of cashflow include: interest on savings and money market accounts, dividends on stocks (not capital appreciation), and cashflow from real estate.
A money market account is the most secure form of cashflow, because it is guaranteed by the FDIC. These accounts only yield 1-2%, but they fit all the requirements of the equity goose.
Rental real estate is my favorite form of cashflow, and provies a higher rate of return, anywhere from 10 – 20%. If you buy your rental real estate a at wholesale with cashflow, you are protected from downturns and it meets all the requirements of the equity goose.
The First Step
The first step is to figure out how big your equity goose is. Given the strict guidelines laid out above, many people will not have many assets that qualify.
It’s okay if your number is not impressive, the key is to know where you stand so that you can plot a course.
Everyone Has 2 Numbers
To really take advantage of the wisdom of “pay yourself first”; every person should know 2 numbers: 1) Their equity goose, and 2) the cashflow, or “golden egg” that their goose provides.
It’s kind of like knowing your weight, or your GPA in school. Each person should know where they stand; but few do.
If Your Number is Zero
If your equity goose is nil, your first action should be to scrounge up enough money (even if it’s just a few hundred bucks), to open a money market account that you will never allow yourself to tap into except to purchase cashflowing assets. Remember to choose a different bank from the one you already use for you monthly bills.
You will feel a tremendous amount of accomplishment by taking this simple step. The sum of your whole life up to that point was a zero equity goose, but now you have planted the seed that will soon make you wealthy!
Every month from this point on, it’s important to put something in the account. Even if you can’t afford the entire 10% of your salary, at least you are feeding something to your equity goose.
Your First Acquisition
Before long, you will have enough in your equity goose to purchase a cashflowing asset; but don’t rush it… your money market account fits all the requirements until you find another qualified asset to move it to.
It’s more important to keep your money in a low-performing asset that fits all the criteria than it is to risk your goose on a higher-performing asset that doesn’t fit.
When you find an asset selling at a wholesale price that cashflows, do your due diligence and if it qualifies, purchase the asset.
It might be a single-family home selling for less than it’s worth.
It might be a bulk-candy vending business that you can buy for pennies on the dollar.
It might be a private loan that you make to a real estate investor at 70% loan to value.
As long as you follow the rules, you can take comfort in the fact that your goose will always get bigger and your cashflow will grow along with it.
Ultimately, your goal will be to live on the cashflow without ever touching your goose.
In real estate, you can reasonably expect to make 10% cashflow on your investment. That makes it easy to determine how big your goose needs to be to support you.
If you need $50,000 a year to live on, you need an equity goose of $500,000. If you need $100,000, you need $1 million.
Make a plan to grow your goose until it’s big enough for you to live on.