If you want to know the secret to financial freedom, read on…
To many people, the word "capital" just means "money" but to the economist, it's something altogether different. "So what?" you might think, but understanding the distinction between the two can make the difference between working flat out until you're 65 or calling it a day much, much earlier.
To economists, capital is assets used to generate income or wealth. The capital works to create goods or services and isn't itself consumed. These last three words are crucial to understanding the true nature of capital.
The nature of capital
Let's say, for example, that you're left with £100 over at the end of the month and you decide to stick it into the bank with the intention of treating yourself at a later date, that's not capital. If, however, you've put it in the bank with a view to spending the interest only, that is capital in the sense that it is there only to provide income (even if that interest is more or less non-existent these days!).
If you started a small business, you'd very probably have had to contribute some capital to get the business up and running. Let's say, for example, you needed £25,000 to buy you the means of setting up in business. This would be capital. You might have this capital yourself, or you might have to borrow to start up your business. If the business did well, it may be worth a lot more by the end of the first year, but this is the capital value -- not what you decided to pay yourself. And it's the capital that must remain as capital rather than be used up to get you financially free.
Income vs. capital
Similarly, with an investment property, you may invest capital in a house to let and decide to spend the profit of the rent minus costs. But what you shouldn't do is to borrow against any rise in the value of that property to spend on anything other than more capital. In other words, you could borrow against it to buy another house to let, if that made financial sense, but not a new car -- unless, of course, you were going into the car rental market, or really needed the car for the business -- in which case it would be capital. You could, however, buy a new car from the accumulated rental profits once you'd saved enough.
This all may sound very obvious. But, according to the Bank of England's latest figures, each UK household is now carrying an average debt of somewhere around £10,000 -- excluding mortgage debt. Include mortgages and this figure rises to roughly £61,000. There's a lot of personal credit debt out there and, therefore, a lot of people not heading towards financial freedom any time soon.
Sticking to your guns
The trick is in deciding for yourself what is or isn't capital and then, crucially, sticking to your guns. This may take real will-power depending on your nature, particularly if the capital is very liquid like shares or money in the bank.
The simple "don't spend your capital" tenet is the key to financial freedom for those able to create a surplus, to designate that surplus as "capital" and to resist the urge to spend anything other than the income generated.
What's all this got to do with investing?
For many people in paid jobs, the road to financial freedom lies in investing their surpluses in ways that don't take up too much time and reinvesting the proceeds. Given this time limitation, of the five main asset classes (cash, bonds, commodities, property and shares), shares tend to produce the highest returns in the long run. And it's also important to understand how small differences in your annual returns make for big differences in the longer term. For example, let's say that you invest your surplus of £100 a month for 25 years in investments which earn either 6% or 12% a year. At the end of the period, at 6% a year, your cash grows to £67,958, but at 12%, the figure reaches £170,221; quite a difference.
Over the past nine decades, the UK stock market has returned around 11% a year, with dividends reinvested. It pays to stay invested in the long run. What'll happen during the next nine years, no-one really knows. But one of the cheapest and easiest ways to start out on the road to freedom by moving surplus income to capital is The Motley Fool's Share Dealing Service, though remember; you can only spend the dividends!
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