Risk reduction. Insurance companies do it every time they underwrite a new policy by estimating probable outcomes based on past behavior and other factors. So do restaurants and coffee shops when they hedge their costs on items such as coffee beans, wheat, and dairy products. Holding companies strive for it when they acquire businesses in fields that have nothing to do with the core enterprise. How about you and your family?
The same techniques that are often used by some of the best corporations in America and the world can do a lot of good for you whether you're a white-shoed banker on Park Avenue or a construction worker in the Rust Belt. It's unlikely you were ever taught to think this way in high school or even college, but it's time to start looking at your own life, assets, and earnings stream as a business in order to protect yourself from the dangers lurking in every day life.
Some of this material has been drawn from my older articles and updated because it offered useful information on the topic of risk reduction. Where vague, I've tried to expand on the concepts so I think even long-term readers of the site will find it useful.
1. Keep your fixed payments as low as possible relative to cash flow
I've made this statement before and I want you to think about it: It's not debt per se that puts someone into bankruptcy, it's their inability to make a payment. That's why I wrote Why Building Equity at the Sake of Liquidity Can Lead to Bankruptcy and A Lesson From September 11th - The Importance of Liquidity.
Put simply, you need a healthy amount of net working capital just as a corporate does. That is the money left over when you take all of your current assets and subtract out your current liabilities. In order to do that, you want to design a system that allows you to make fewer payments when your cash flow is low and higher payments when it is good. That's why fixed payments, such as those on a car loan, real estate leases, et cetera can be so bad. The people you owe the money to don't care that sales were down or you were laid off from work.
Any time you think about adding an additional fixed payment liability to your balance sheet, think long and hard. To some degree, you're adding handcuffs to yourself and reducing your fiscal flexibility.
2. Only use your cash to buy income producing assets.
The poor and the middle class buy things that go down in value, take out loans, and then pay interest (which is essentially the cost of "renting" money). Think about new cars off the lot, or brand new furniture at full price. For the past few decades, this type of interest expense has not been tax-deductible.
The rich, on the other hand, typically take on debt to buy assets that actually generate cash! They may borrow money to build or acquire car washes, or storage units, or open a local McDonald's franchise. Not only should those assets increase in value if managed well, but the interest cost is actually tax-deductible, meaning it costs them less to borrow! A few years of this disparity, and the reason some people get richer and some get poorer becomes all too evident. It's the compounding effect of small advantages over time.
Think about the same purchase - a notebook computer - one bought for a college student to go to work and another bought to handle accounting needs at a corporation. Our college student and accountant both buy the same system and it costs them $2,000. The student puts it on a credit card and ends up paying $500 in interest before wiping the balance out, for a total cost of $2,500. After factoring in payroll and income taxes, they may need to earn around $3,400 pre-tax to afford that. If they get $8 per hour working off campus in a retail store, that will require 425 hours of labor, or a bit more than 21 part-time weeks.
The accountant, on the other hand, writes a check against the company line of credit. She, too, pays the same $500 in interest for a total cost of $2,500. However, the computer is depreciated down and the interest expense written off, reducing her tax bill by $750, making the net cost of the machine $1,750 ($2,500 - $750 = $1,750). It costs nearly 50% less for the same machine, with identical features, and identical interest rates due to the nature of the tax code. Not to mention that if the accountant grows his or her business, they will be generating far more profit and creating jobs, making them even richer. This is why some business men and women are able to enjoy far nicer lifestyles during the growing phase of their business because they don't really appreciate just how much things would cost if they had to buy them personally. An older executive is a perfect example because the business may provide a lifestyle, such as showing up to a mahogany paneled office and traveling to France on the company jet in order to meet a client, that would require a $20+ million net worth.