Before you turn over your down payment on an investment property or write a
check for $2,000 in stocks, it's a good idea to know what exactly you're
investing for. It surprises me how many people, many of whom have already
purchased investments, don't understand this one basic concept of investing. If
you learn this single fundamental, you'll be ahead of the game.
Two Things Count
With any investment, there are generally two things you invest for: capital
gains or cash flow.
Capital gains is the profit you make on the sale of an investment. For
example, you buy a house for $100,000. You put a little money into fixing up the
property. You then sell the property for $150,000. Your profit on that sale is
called capital gains. The same applies to stocks. You purchase shares of a stock
at $25 per share. The stock price goes to $35 per share. Your profit when you
sell is your capital gains. A capital gain is only realized when you actually
sell the investment. Of course, if you sell the investment and lose money, you
have a capital loss.
Cash flow is money that comes in on a regular basis from an investment
you hold on to. Let's go back to that $100,000 house. Instead of fixing it up
and selling it, you fix it up and rent it out for $1,000 per month. Each month
you collect your rent and pay the expenses, such as repairs, taxes and
insurance, and the mortgage. If you've managed the property well, at the end of
each month you'll have a profit--or positive cash flow--that goes into your
pocket. Some stocks deliver cash flow in the form of dividends. Or maybe you've
invested in a friend's startup and she agrees to pay you 12 percent per year on
the money you invested with her. That's also cash flow.
A simple way to remember the two concepts and the difference between them is
a gain is a one-time event or sale; cash flow is continual, or flowing.
Which Strategy Is Best?
Why is knowing the difference important? It depends on what your investment
goals and interests are. One strategy isn't better than the other, just
different.
In 1989 when I bought my first rental property, my husband, Robert, and I had
a goal: to be financially free. Our definition of financial freedom was having
more money coming in every month from our investments than was going out each
month for living expenses. Not rocket science. Yet by defining that goal, our
focus went immediately to cash flow.
To have money flow in every month, our plan was to buy, hold and rent our
properties. We accomplished our goal of financial freedom in 1994. We had
$10,000 coming in each month from our apartment buildings and a few
single-family homes. The beauty of this formula was that our living expenses
were only $3,000 per month. At that point, we were free. We no longer had to
work for money because our money was working for us. That, to me, is the beauty
of cash flow: It's not about the amount of money you accumulate, it's about the
freedom it brings you.
That certainly doesn't mean that investing for capital gains doesn't have
merit. It's just not my primary strategy. Ideally, I look for investments that
have cash flow and future capital gains, also known as appreciation. I want
every investment I make to appreciate over time. The difference is I don't
invest with just one strategy, hoping and praying that the property appreciates
quickly so I can sell it and make a profit.
"The Rich Woman in You" is about attaining financial independence. Only you
can decide how best to do that. If stock trading is your thing, then go for it
full-tilt. If you enjoy buying and selling properties, then have at it. Just be
clear on what your financial goal is.
A Difference to Consider
The main difference for me between the two strategies is this: If I only focus
on buying and selling investments, which is the capital gains approach to
investing, then I have to keep doing it again and again to amass millions of
dollars to cover my living expenses if my goal is to be financially free and
independent. I don't have money coming in each month on a steady basis. Once I
sell an investment, I need to buy and sell another to amass more money. To me,
it's a much longer and more time-consuming process.
A Money Rule for Life
And that thought brings up an important rule that I live by. Any dollar that
goes into my investment or asset column stays in that column. In other words,
let's say I put $100,000 as a down payment on a $1 million property. Each month
that property gives me a cash flow of $1,000, or 10 percent. I can use that cash
flow from my property any way I want, but if I sell that property, the original
$100,000 goes into another investment. I don't spend it because I want my
investment portfolio to keep growing.
Similarly, if I buy 100 ounces of silver--and I do buy a good amount of
1-ounce silver coins or larger bars--it would cost me about $1,500 today. Then,
if I sell that silver at a later date, I'll move the original $1,500 into a new
investment. My profit or capital gain is mine to do with as I choose.
What I see happening repeatedly is that a person buys the $1,500 worth of
silver and when an unexpected expense pops up, such as needing to buy new tires
for her car, she cashes in her silver and buys the new tires. Now she's back at
square one without any investments.
Once you've committed a dollar for an investment, that dollar should never go
toward anything other than investments. If that investment is the first place
you turn to when a financial emergency arises, your investment portfolio will
never grow, and you'll find yourself back at square one time and time again.
Is It One or the Other?
Do I ever invest for capital gains? Absolutely. It's not my primary
focus, but I do have capital gains investments. Next month, I'll tell you how I
used both capital gains and cash flow in one real estate deal to accomplish my
goal. I'll also discuss some other properties I've purchased and why I bought
them.