Pop quiz: can you explain the difference between an asset and a liability?
Bonus points if you can name an asset you bought in the last year.
Here’s the answer key…
Assets are items that appreciate. This means they generally grow in value over time. Liabilities are everything else.
Take your home, for example. If you own your home, you have an asset. Over the long term, your home will increase in value. This will give you options in the future. You could sell the home to downsize to a more manageable property or enjoy a retirement community, giving you a surplus of cash to draw on in your retirement. Or, you could live in the home, “rent-free,” paying just property taxes, insurance, and maintenance. If you rent your home, you never receive the ownership benefits in the future; you continue to pay ever-increasing rental rates, even on a fixed income in retirement.
So what about your car? Super necessary, right? Unless you live in a city with a serious public transportation system, you probably need a vehicle. But that doesn’t make it an asset! Your car is still losing value every year. No matter how much you paid for it, it’s going to be worth just a fraction of that amount in a few years.
Assets vs. Liabilities
Let’s consider a few assets and a few liabilities that many American adults own.
Assets:
- Real estate (your home, rental properties, land, etc.)
- Financial assets (stock, bonds, mutual funds, REITs, etc.)
- Intangible assets (patents, trademarks, intellectual property, copyrights, licenses, etc.)
- Businesses (proprietary systems, client lists, franchises, etc.)
- Collectibles (art, wine, sports memorabilia, quality furnishings, etc.)
Liabilities:
- Tangible liabilities (cars, boats, electronics, mass-produced furnishings, etc.)
- Intangible liabilities (loan balances, credit card balances, etc.)
Notice that many of the liabilities are useful in our everyday lives. But, just because something is useful doesn’t make it an asset.
Buying liabilities reduces your net worth.
So, one of the most widely used principles among the wealthy is this: buy assets, not liabilities.
How to Buy Assets, Not Liabilities IRL
In real life, you need to buy useful liabilities regularly. Not everything you buy will be an asset. But, you have control over your discretionary money, and you can choose to waste it on liabilities or invest it in assets.
Bonus tip: instead of flat-out buying a liability you want, buy an asset that will pay for the liability!
Example:
Let's say you have a luxury item you desperately want: a fancy watch, designer handbag, or new VR set. You plan to spend around $5,000 on this splurge. If you spend your paycheck on that item, you've traded your cash for the item, and now you watch it lose value as you enjoy it.
Instead, what if you invested in a real estate development that would generate the $5K you need? Now, you can get the liability you want plus an asset that can generate income and grow in value over time!
Win, win!