This week we thought we would change tack a little. As we all continue in a version of lock down and with Easter now behind us, most schools have reverted to home learning. So, we thought we would provide a little lesson in basic financial management ourselves. If you or someone you know is home-schooling a young person, you might like to use this as a lesson. If not, you can always enjoy the lesson for yourself. It might seem basic, but sometimes the basic things are worth reiterating. And remember, it is never too late to start.
People get their money from ‘the economy.’ The economy is essentially a place of exchange. When people contribute something to the economy they receive something back in exchange. That ‘something back’ is usually money and people receive it when they contribute some combination of the following: their labour, their land and/or their capital. Labour, land and capital are known as the ‘factors of production’ because they are used in the economy to make things.
People who contribute labour typically receive a salary or wages in return (self-employed sole traders receive drawings or net profits, but these are very similar to wages and salary). The basic idea is that you contribute your skills for a period of time and, in most cases, you are reimbursed for that time. That is why wages are generally expressed ‘per hour’ and salaries are generally expressed ‘per year.’
Sometimes, labour can be paid for by the task. A tradesperson, for example, might quote a specific fee to complete a job. That fee is what their client will pay regardless of how long the job takes. But, in most cases, even this task-based payment is based on an estimate of the time the task will take, especially in markets where there is competition for the work. So, most labour income is related, at least indirectly, to time spent.
Some people call labour income active income because you need to be active to receive it. Active income has its advantages and disadvantages compared to other kinds of income. The main advantage is that a relatively larger number of people can make labour available to the economy. Not all labour is paid the same, of course. Some labour is skilled (think of a surgeon or a lawyer); some is unskilled (think people working in supermarkets, etc). More highly skilled labour generally gets a better return, especially if there is high demand for that labour and the supply is relatively small (again, think of surgeons). Specialised labour usually requires people to spend time acquiring the ability to provide that kind of labour – such as an apprenticeship for a tradesperson or University for a doctor.
The main limitation for labour is that it is generally related to time. If a person cannot contribute time to the economy (for example, if they are disabled or they need to provide care for someone else, such as their children), then they will be unable to be paid for their labour. Another limitation is that a labourer needs to find an employer who wants to pay for their labour. As we are seeing at the moment, such an employer is not always available.
Another way to contribute to the economy is to own land that is used for some economic activity. This can range from owning a home that you rent out to others (maybe even a single spare room on AirBnB) to owning something like a farm on which alpacas are agisted. There are two main types of payment you can receive for land: the first is rent, which you receive while you continue to own the land. The second is a capital return, which you receive when you sell the land. To generate a positive capital return – to make money – you need to sell the land for more than you paid for it.
There is a third type of return for land if you live on or use your land yourself: you save on rent that you would have to pay if you were using land owned by someone else. A tradesman who owns his or her own factory, for example, generates a type of benefit from that factory by avoiding having to rent a space to perform his or her trade.
The third way to contribute to the economy is to own capital – which is basically any assets other than land. Capital can either be money that you lend to other people (which is what actually happens when you put money in the bank), or other types of asset that you use to generate a return. These other types of asset can be real things (tangible assets such as a truck owned by a delivery driver) or abstract things (intangible assets such as shares in a company that performs some profitable work. The company might be a large public one, whose shares are traded on the ASX, or a smaller, privately-owned one).
Owning either or both of land and capital is a form of investment. The main benefit of owning an investment is that land and capital tend not to have the same limits as labour. Land and capital can often generate returns 168 hours per week, for example, whereas labourers typically cannot work more than 40-50 hours per week. Provided they are properly maintained, land and capital do not need holidays, do not get sick or injured, do not get bored or need to take time off to do things like go to parent-teacher appointments.
This is why income from investments is often known as passive income: it is not usually linked with being active like labour income is.
Another major benefit of investments is that they are not limited in size. You can generally only have one or two ‘jobs’ which use your labour, but you can own many investments.
Passive income is generally ‘better’ than active income, because passive income is not linked to your time or your general health. You can earn passive income when you are asleep, or sick, or on holiday. Some people continue to earn passive income even after they die – although those benefits tend to go to their beneficiaries, not themselves. You really can’t take it with you!
Land and capital (investment) assets typically require a relatively large purchase price. Many people therefore commence their ‘economic life’ providing labour alone to the economy. They save a portion of this labour income and they use that portion to buy land or capital items. Fewer, more fortunate people inherit or maybe even win land or capital.
Largely because of the cost of acquisition, relatively few people live off passive income alone. Most people earn pretty much all their income from labour. Some sensible people complement their active income with passive income. Over time, as they save to buy more assets, or as the value of their land or capital grows, most investors find that passive income provides a growing proportion of overall income.
This is a still further benefit of passive income: it tends to grow over time as the value of the land or capital assets rise, where labour income can reduce as you get older.
When most people think of having wealth, they usually mean investment assets. In fact, some people define ‘being wealthy’ as generating all the income you need from investments. So, ‘being wealthy’ depends on two things: how much income your assets provide – and how much income you need to enjoy the lifestyle you want.
That is why there is no specific definition of ‘being wealthy.’ It all depends on how much you need to spend for the lifestyle you want.
“Retirement” refers to the time when a person stops generating labour income.
While the official ‘retirement age’ is in your 60s, this is actually just the minimum age at which the Government will pay you an aged pension if you cannot create sufficient income for yourself. You can retire at any age you like – provided you have enough passive income to fund your lifestyle. Deciding how ‘early’ you can retire therefore generally depends on two things: how many investment assets you have managed to acquire; and how much money you want to spend after you retire.
The hardest thing about acquiring investments is often simply ‘getting started.’ Unfortunately, many people either do not know about passive income or they do not know how to go about acquiring the investment assets needed to create passive income. Sadly, this can mean that they either do not invest at all, or that they start investing later in life than need be.
Don’t let that be you. Take the time to understand that your labour is only one way to generate income. Learn about the other two and get started on creating passive income as soon as you can. If this is the only thing you learn in the Coronavirus lockdown, your time will have been very well-spent.
