Chapter Two - LESSON 2

WHY TEACH FINANCIAL LITERACY?
 

It’s not how much money you make.

It’s how much money you keep.

In 1990, Mike took over his father’s empire and is, in fact, doing a better job than his dad did. We see each other once or twice a year on the golf course. He and his wife are wealthier than you could imagine. Rich dad’s empire is in great hands, and Mike is now grooming his son to take his place, as his dad had groomed us. 

In 1994, I retired at the age of 47, and my wife Kim was 37. Retirement does not mean notworking. For us, it means that, barring unforeseen cataclysmic changes, we can work or notwork, and our wealth grows automatically, staying ahead of inflation. Our assets are largeenough to grow by themselves. It’s like planting a tree. You water it for years, and then oneday it doesn’t need you anymore. Its roots are implanted deep enough. Then the tree providesshade for your enjoyment.

Mike chose to run the empire, and I chose to retire.

Whenever I speak to groups of people, they often ask what I would recommend that they do. “How do I get started?” “Is there a book you would recommend?” “What should I do toprepare my children?” “What is your secret to success?” “How do I make millions?”

Whenever I hear one of these questions, I’m reminded of the following story:

The Richest Businessmen

In 1923 a group of our greatest leaders and richest businessmen held a meeting at the Edgewater Beach hotel in Chicago. Among them were Charles Schwab, head of thelargest independent steel company; Samuel Insull, president of the world’s largestutility; Howard Hopson, head of the largest gas company; Ivar Kreuger, president of International Match Co., one of the world’s largest companies at that time; Leon Frazier, president of the Bank of International Settlements; Richard Whitney,president of the New York Stock Exchange; Arthur Cotton and Jesse Livermore, twoof the biggest stock speculators; and Albert Fall, a member of President Harding’scabinet. Twenty-five years later, nine of these titans ended their lives as follows: Schwab died penniless after living for five years on borrowed money. Insull diedbroke in a foreign land, and Kreuger and Cotton also died broke. Hopson wentinsane. Whitney and Albert Fall were released from prison, and Fraser and Livermore committed suicide.

I doubt if anyone can say what really happened to these men. If you look at the date, 1923, itwas just before the 1929 market crash and the Great Depression, which I suspect had a greatimpact on these men and their lives. The point is this: Today we live in times of greater andfaster change than these men did. I suspect there will be many booms and busts in the comingyears that will parallel the ups and downs these men faced. I am concerned that too many people are too focused on money and not on their greatest wealth, their education. If people are prepared to be flexible, keep an open mind and learn, they will grow richer and richer despite tough changes. If they think money will solve problems, they will have a rough ride. Intelligence solves problems and produces money. Money without financial intelligence is money soon gone.

Most people fail to realize that in life, it’s not how much money you make. It’s how muchmoney you keep. We’ve all heard stories of lottery winners who are poor, then suddenlyrich, and then poor again.

They win millions, yet are soon back where they started. Or stories of professional athletes,who at the age of 24 are earning millions, but are sleeping under a bridge 10 years later.

I remember a story of a young basketball player who a year ago had millions. Today, at just 29, he claims his friends, attorney, and accountant took his money, and he was forced towork at a car wash for minimum wage. He was fired from the car wash because he refusedto take off his championship ring as he was wiping off the cars. His story made nationalnews and he is appealing his termination, claiming hardship and discrimination. He claimsthat the ring is all he has left and if it was stripped away, he’ll crumble.

I know so many people who became instant millionaires. And while I am glad some peoplehave become richer and richer, I caution them that in the long run, it’s not how much moneyyou make. It’s how much you keep, and how many generations you keep it.

So when people ask, “Where do I get started?” or “Tell me how to get rich quick,” theyoften are greatly disappointed with my answer. I simply say to them what my rich dad said tome when I was a little kid. “If you want to be rich, you need to be financially literate.”

That idea was drummed into my head every time we were together. As I said, my educateddad stressed the importance of reading books, while my rich dad stressed the need to masterfinancial literacy.

If you are going to build the Empire State Building, the first thing you need to do is dig adeep hole and pour a strong foundation. If you are going to build a home in the suburbs, allyou need to do is pour a six-inch slab of concrete. Most people, in their drive to get rich, aretrying to build an Empire State Building on a six-inch slab.

Our school system, created in the Agrarian Age, still believes in homes with no foundation. Dirt floors are still the rage. So kids graduate from school with virtually no financialfoundation. One day, sleepless and deep in debt in suburbia, living the American Dream,they decide that the answer to their financial problems is to find a way to get rich quick.

Construction on the skyscraper begins. It goes up quickly, and soon, instead of the Empire State Building, we have the Leaning Tower of Suburbia. The sleepless nights return.

As for Mike and me in our adult years, both of our choices were possible because we weretaught to pour a strong financial foundation when we were just kids.

Accounting is possibly the most confusing, boring subject in the world, but if you want to berich long-term, it could be the most important subject. For rich dad, the question was how totake a boring and confusing subject and teach it to kids. The answer he found was to make itsimple by teaching it in pictures.

My rich dad poured a strong financial foundation for Mike and me. Since we were just kids,he created a simple way to teach us. For years he only drew pictures and used few words. Mike and I understood the simple drawings, the jargon, the movement of money, and then inlater years, rich dad began adding numbers. Today, Mike has gone on to master much morecomplex and sophisticated accounting analysis because he had to in order to run his empire. I am not as sophisticated because my empire is smaller, yet we come from the same simplefoundation. Over the following pages, I offer to you the same simple line drawings Mike’sdad created for us. Though basic, those drawings helped guide two little boys in buildinggreat sums of wealth on a solid and deep foundation.

Rule #1: You must know the difference between an asset and a liability, andbuy assets.

If you want to be rich, this is all you need to know. It is rule number one. It is the only rule. This may sound absurdly simple, but most people have no idea how profound this rule is. Most people struggle financially because they do not know the difference between an assetand a liability.

“Rich people acquire assets. The poor and middle class acquire liabilities that they think are assets, “ said rich dad.

When rich dad explained this to Mike and me, we thought he was kidding. Here we were,nearly teenagers and waiting for the secret to getting rich, and this was his answer. It was sosimple that we stopped for a long time to think about it.

“What is an asset?” asked Mike.

“Don’t worry right now,” said rich dad. “Just let the idea sink in. If you can comprehend the simplicity, your life will have a plan and be financially easy. It is simple. That is why the idea is missed.”

“You mean all we need to know is what an asset is, acquire them, and we’ll be rich?” I asked.

Rich dad nodded his head. “It’s that simple.”

“If it’s that simple, how come everyone is not rich?” I asked.

Rich dad smiled. “Because people do not know the difference between an asset and aliability.”

I remember asking, “How could adults be so misguided? If it is that simple, if it is thatimportant, why would everyone not want to find out?”

It took rich dad only a few minutes to explain what assets and liabilities were.

As an adult, I have difficulty explaining it to other adults. The simplicity of the idea escapesthem because they have been educated differently. They were taught by other educatedprofessionals, such as bankers, accountants, real estate agents, financial planners, and soforth. The difficulty comes in asking adults to unlearn, or become children again. Anintelligent adult often feels it is demeaning to pay attention to simplistic definitions.

Rich dad believed in the KISS principle—Keep It Simple, Stupid (or Keep It Super Simple)

—so he kept it simple for us, and that made our financial foundation strong.

So what causes the confusion? How could something so simple be so screwed up? Whywould someone buy an asset that was really a liability? The answer is found in basiceducation.

We focus on the word “literacy” and not “financial literacy.”

What defines something to be an asset or a liability are not words. In fact, if you really wantto be confused, look up the words “asset” and “liability” in the dictionary. I know thedefinition may sound good to a trained accountant, but for the average person, it makes nosense. But we adults are often too proud to admit that something does not make sense.

To us young boys, rich dad said, “What defines an asset are not words, but numbers. And ifyou can’t read the numbers, you can’t tell an asset from a hole in the ground.”

“In accounting,” rich dad would say, “it’s not the numbers, but what the numbers are telling you. It’s just like words. It’s not the words, but the story the words are telling you.” “If you want to be rich, you’ve got to read and understand numbers.” If I heard that once, I heard it a thousand times from my rich dad. And I also heard, “The rich acquire assets, and the poor and middle class acquire liabilities.”

Here is how to tell the difference between an asset and a liability. Most accountants andfinancial professionals do not agree with the definitions, but these simple drawings were thestart of strong financial foundations for two young boys.

This is the cash-flow pattern of an asset:

The top part of the diagram is an Income Statement, often called a Profit-and-Loss Statement. It measures income and expenses: money in and money out. The lower part of the diagram isa Balance Sheet. It’s called that because it’s supposed to balance assets against liabilities. Many financial novices do not know the relationship between the Income Statement and the Balance Sheet, and it is vital to understand that relationship.

So as I said earlier, my rich dad simply told two young boys that “assets put money in yourpocket.” Nice, simple, and usable.

This is the cash-flow pattern of a liability:

Now that assets and liabilities have been defined through pictures, it may be easier tounderstand my definitions in words. An asset is something that puts money in my pocket. Aliability is something that takes money out of my pocket. This is really all you need to know.

If you want to be rich, simply spend your life buying assets. If you want to be poor or middleclass, spend your life buying liabilities.

Illiteracy, both in words and numbers, is the foundation of financial struggle. If people arehaving difficulties financially, there is something that they don’t understand, either in wordsor numbers. The rich are rich because they are more literate in different areas than peoplewho struggle financially. So if you want to be rich and maintain your wealth, it’s importantto be financially literate, in words as well as numbers.

The arrows in the diagrams represent the flow of cash, or “cash flow.” Numbers alone meanlittle, just as words out of context mean little. It’s the story that counts. In financial reporting,reading numbers is looking for the plot, the story of where the cash is flowing. In 80 percentof most families, the financial story paints a picture of hard work to get ahead. However,this effort is for naught because they spend their lives buying liabilities instead of assets.

This is the cash-flow pattern of a poor person:

This is the cash-flow pattern of a person in the middle class:

This is the cash-flow pattern of a wealthy person:

All of these diagrams are obviously oversimplified. Everyone has living expenses, the need for food, shelter, and clothing. The diagrams show the flow of cash through a poor, middleclass, and wealthy person’s life. It is the cash flow that tells the story of how a person handles their money.

The reason I started with the story of the richest men in America is to illustrate the flaw inbelieving that money will solve all problems. That is why I cringe whenever I hear peopleask me how to get rich quicker, or where they should start. I often hear, “I’m in debt, so Ineed to make more money.”

But more money will often not solve the problem. In fact, it may compound the problem. Money often makes obvious our tragic human flaws, putting a spotlight on what we don’tknow. That is why, all too often, a person who comes into a sudden windfall of cash—let’ssay an inheritance, a pay raise, or lottery winnings—soon returns to the same financial mess,if not worse, than the mess they were in before. Money only accentuates the cash-flowpattern running in your head. If your pattern is to spend everything you get, most likely anincrease in cash will just result in an increase in spending. Thus, the saying, “A fool and hismoney is one big party.”

I have said many times that we go to school to gain scholastic and professional skills, bothof which are important. We learn to make money with our professional skills. In the 1960swhen I was in high school, if someone did well academically, people assumed this brightstudent would go on to be a medical doctor because it was the profession with the promiseof the greatest financial reward.

Today, doctors face financial challenges I wouldn’t wish on my worst enemy: insurancecompanies taking control of the business, managed health care, government intervention, andmalpractice suits. Today, kids want to be famous athletes, movie stars, rock stars, beautyqueens, or CEOs because that is where the fame, money, and prestige are. That is the reasonit is so hard to motivate kids in school today. They know that professional success is nolonger solely linked to academic success, as it once was.

Because students leave school without financial skills, millions of educated people pursuetheir profession successfully, but later find themselves struggling financially. They workharder but don’t get ahead. What is missing from their education is not how to make money, but how to manage money. It’s called financial aptitude—what you do with the money once you make it, how to keep people from taking it from you, how to keep it longer, and how to make that money work hard for you. Most people don’t understand why they struggle financially because they don’t understand cash flow. A person can be highly educated, professionally successful, and financially illiterate. These people often work harder than they need to because they learned how to work hard, but not how to have their money work hard for them.

The Story of How the Quest for a Financial Dream Turns into a Financial Nightmare

The classic story of hardworking people has a set pattern. Recently married, the happy,highly educated young couple moves into one of their cramped rented apartments.

Immediately, they realize that they are saving money because two can live as cheaply as one.

The problem is the apartment is cramped. They decide to save money to buy their dreamhome so they can have kids. They now have two incomes, and they begin to focus on theircareers. Their incomes begin to increase.

As their incomes go up, their expenses go up as well.

The number-one expense for most people is taxes. Many people think it’s income tax, but for most Americans, their highest tax is Social Security. As an employee, it appears as if the Social Security tax combined with the Medicare tax rate is roughly 7.5 percent, but it’s really 15 percent since the employer must match the Social Security amount. In essence, it is money the employer can’t pay you. On top of that, you still have to pay income tax on the amount deducted from your wages for Social Security tax, income you never received because it went directly to Social Security through withholding.

Going back to the young couple, as a result of their incomes increasing, they decide to buythe house of their dreams. Once in their house, they have a new tax, called property tax. Thenthey buy a new car, new furniture, and new appliances to match their new house. All of asudden, they wake up and their liabilities column is full of mortgage and credit-card debt. Their liabilities go up.

They’re now trapped in the Rat Race. Pretty soon a baby comes along and they work harder.

The process repeats itself: Higher incomes cause higher taxes, also called “bracket creep.” A credit card comes in the mail. They use it. It maxes out. A loan company calls and saystheir greatest “asset,” their home, has appreciated in value. Because their credit is so good,the company offers a bill-consolidation loan and tells them the intelligent thing to do is clearoff the high-interest consumer debt by paying off their credit card. And besides, interest ontheir home is a tax deduction. They go for it, and pay off those high-interest credit cards. They breathe a sigh of relief. Their credit cards are paid off. They’ve now folded theirconsumer debt into their home mortgage. Their payments go down because they extend theirdebt over 30 years. It is the smart thing to do.

Their neighbor calls to invite them to go shopping. The Memorial Day sale is on. Theypromise themselves they’ll just window shop, but they take a credit card, just in case.

I run into this young couple all the time. Their names change, but their financial dilemma isthe same. They come to one of my talks to hear what I have to say. They ask me, “Can youtell us how to make more money?”

They don’t understand that their trouble is really how they choose to spend the money theydo have. It is caused by financial illiteracy and not understanding the difference between anasset and a liability.

More money seldom solves someone’s money problems. Intelligence solves problems. There is a saying a friend of mine says over and over to people in debt: “If you find you have dug yourself into a hole... stop digging.”

As a child, my dad often told us that the Japanese were aware of three powers: the power ofthe sword, the jewel, and the mirror.

The sword symbolizes the power of weapons. America has spent trillions of dollars onweapons and, because of this, is a powerful military presence in the world.

The jewel symbolizes the power of money. There is some degree of truth to the saying, “Remember the golden rule. He who has the gold makes the rules.” The mirror symbolizes the power of self-knowledge. This self-knowledge, according to Japanese legend, was the most treasured of the three.

All too often, the poor and middle class allow the power of money to control them. Bysimply getting up and working harder, failing to ask themselves if what they do makes sense,they shoot themselves in the foot as they leave for work every morning. By not fullyunderstanding money, the vast majority of people allow its awesome power to control them.

If they used the power of the mirror, they would have asked themselves, “Does this makesense?” All too often, instead of trusting their inner wisdom, that genius inside, most peoplefollow the crowd. They do things because everybody else does them. They conform, ratherthan question. Often, they mindlessly repeat what they have been told: “Diversify.” “Your home is an asset.” “Your home is your biggest investment.” “You get a tax break for going into greater debt.” “Get a safe job.” “Don’t make mistakes.” “Don’t take risks.”

It is said that the fear of public speaking is a fear greater than death for most people. According to psychiatrists, the fear of public speaking is caused by the fear of ostracism, thefear of standing out, the fear of criticism, the fear of ridicule, and the fear of being anoutcast. The fear of being different prevents most people from seeking new ways to solvetheir problems.

That is why my educated dad said the Japanese valued the power of the mirror the most, forit is only when we look into it that we find truth. Fear is the main reason that people say, “Play it safe.” That goes for anything, be it sports, relationships, careers, or money.

It is that same fear, the fear of ostracism, that causes people to conform to, and not question,commonly accepted opinions or popular trends: “Your home is an asset.” “Get a bill-consolidation loan, and get out of debt.” “Work harder.” “It’s a promotion.” “Someday I’llbe a vice president.” “Save money.” “When I get a raise, I’ll buy us a bigger house.” “Mutual funds are safe.”

Many financial problems are caused by trying to keep up with the Joneses. Occasionally, weall need to look in the mirror and be true to our inner wisdom rather than our fears.

By the time Mike and I were 16 years old, we began to have problems in school. We werenot bad kids. We just began to separate from the crowd. We worked for Mike’s dad afterschool and on weekends. Mike and I often spent hours after work just sitting at a table withhis dad while he held meetings with his bankers, attorneys, accountants, brokers, investors,managers, and employees. Here was a man who had left school at 13 who was nowdirecting, instructing, ordering, and asking questions of educated people. They came at hisbeck and call, and cringed when he didn’t approve of them.

Here was a man who had not gone along with the crowd. He was a man who did his ownthinking and detested the words, “We have to do it this way because that’s the way everyoneelse does it.” He also hated the word “can’t.” If you wanted him to do something, just say, “Idon’t think you can do it.”

Mike and I learned more sitting in on his meetings than we did in all our years of school,college included. Mike’s dad was not book-smart, but he was financially educated andsuccessful as a result. He told us over and over again, “An intelligent person hires peoplewho are more intelligent than he is.” So Mike and I had the benefit of spending hourslistening to and learning from intelligent people.

But because of this, Mike and I couldn’t go along with the standard dogma our teacherspreached, and that caused problems. Whenever the teacher said, “If you don’t get goodgrades, you won’t do well in the real world,” Mike and I just raised our eyebrows. Whenwe were told to follow set procedures and not deviate from the rules, we could see howschool discouraged creativity. We started to understand why our rich dad told us thatschools were designed to produce good employees, instead of employers. Occasionally, Mike or I would ask our teachers how what we studied was applicable in the real world, orwhy we never studied money and how it worked. To the latter question, we often got theanswer that money was not important, that if we excelled in our education, the money wouldfollow. The more we knew about the power of money, the more distant we grew from theteachers and our classmates.

My highly educated dad never pressured me about my grades, but we did begin to argueabout money. By the time I was 16, I probably had a far better foundation with money thanboth my parents. I could keep books, I listened to tax accountants, corporate attorneys,bankers, real estate brokers, investors, and so forth. By contrast, my dad talked to otherteachers.

One day my dad told me that our home was his greatest investment. A not-too-pleasantargument took place when I showed him why I thought a house was not a good investment.

The above diagram illustrates the difference in perception between my rich dad and my poordad when it came to their homes. One dad thought his house was an asset, and the other dadthought it was a liability.

I remember when I drew the following diagram for my dad showing him the direction ofcash flow. I also showed him the ancillary expenses that went along with owning the home. A bigger home meant bigger expenses, and the cash flow kept going out through the expensecolumn.

Today, people still challenge me on the idea of a house not being an asset. I know that for many people, it is their dream as well as their largest investment. And owning your own home is better than nothing. I simply offer an alternate way of looking at this popular dogma. If my wife and I were to buy a bigger, flashier house, we realize it wouldn’t be an asset. It would be a liability since it would take money out of our pocket.

So here is the argument I put forth. I really don’t expect most people to agree with it becauseyour home is an emotional thing and when it comes to money, high emotions tend to lowerfinancial intelligence. I know from personal experience that money has a way of makingevery decision emotional.

1. When it comes to houses, most people work all their lives paying for a home they never own. In other words, most people buy a new house every few years, each time incurring a new 30-year loan to pay off the previous one.

2. Even though people receive a tax deduction for interest on mortgage payments, they pay

for all their other expenses with after-tax dollars, even after they pay off their mortgage.

3. My wife’s parents were shocked when the property taxes on their home increased to $1,000 a month. This was after they had retired, so the increase put a strain on their retirement budget, and they felt forced to move.

4. Houses do not always go up in value. I have friends who owe a million dollars for a home

that today would sell for far less.

5. The greatest losses of all are those from missed opportunities. If all your money is tied up in your house, you may be forced to work harder because your money continues blowing out of the expense column, instead of adding to the asset column—the classic middle-class cashflow pattern. If a young couple would put more money into their asset column early on, their later years would be easier. Their assets would have grown and would be available to help cover expenses. All too often, a house only serves as a vehicle for incurring a home-equity loan to pay for mounting expenses.

In summary, the end result in making a decision to own a house that is too expensive in lieuof starting an investment portfolio impacts an individual in at least the following three ways:

1. Loss of time,  during which other assets could have grown in value.

2. Loss of additional capital,  which could have been invested instead of paying for highmaintenance expenses related directly to the home.

3. Loss of education.  Too often, people count their house and savings and retirement plans

as all they have in their asset column. Because they have no money to invest, they simply don’t invest. This costs them investment experience. Most never become what the investment world calls “a sophisticated investor.” And the best investments are usually first sold to sophisticated investors, who then turn around and sell them to the people playing it safe.

I am not saying don’t buy a house. What I am saying is that you should understand the difference between an asset and a liability. When I want a bigger house, I first buy assets that will generate the cash flow to pay for the house.

My educated dad’s personal financial statement best demonstrates the life of someone caughtin the Rat Race. His expenses match his income, never allowing him enough left over toinvest in assets. As a result, his liabilities are larger than his assets.

The following diagram on the left shows my poor dad’s income statement. It is worth athousand words. It shows that his income and expenses are equal while his liabilities arelarger than his assets.

My rich dad’s personal financial statement on the right reflects the results of a life dedicatedto investing and minimizing liabilities.

Why the Rich Get Richer

A review of my rich dad’s financial statement shows why the rich get richer. The assetcolumn generates more than enough income to cover expenses, with the balance reinvestedinto the asset column. The asset column continues to grow and, therefore, the income itproduces grows with it. The result is that the rich get richer!

Why the Middle Class Struggle

The middle class finds itself in a constant state of financial struggle. Their primary income isthrough their salary. As their wages increase, so do their taxes. Their expenses tend toincrease in proportion to their salary increase: hence, the phrase “the Rat Race.” They treat their home as their primary asset, instead of investing in income-producing assets.

This pattern of treating your home as an investment, and the philosophy that a pay raisemeans you can buy a larger home or spend more, is the foundation of today’s debt-riddensociety. Increased spending