Real Estate Investing Money Toilet PaperHow is “wealthy” defined?  Amusingly, most people answer this question in surveys with incomes and asset levels roughly twice what they have.  Even the better-off, with $1-5 million in investable assets, overwhelmingly responded in a recent UBS survey that they do not consider themselves wealthy.

This does, of course, depend on where you live, and it changes over time.  While those indignant protesters at Occupy Wall Street a few years back loved to rail against the top 1% of earners, the average income in America (about $52,000 currently) puts the average American in the top 1% of earners worldwide.

People love to think of themselves as middle class, and that those greedy rich people are hoarding all the precious resources, but the average American is “The 1%” from a broader perspective, so let’s forget the thresholds and wealth minimums and talk frankly about what being wealthy is really about.

Level 1: Financially Protected (Entry Level)

Calculate a firm monthly sum of mandatory expenses (food, housing, utilities, taxes, insurance, transportation).  This is the minimum monthly expense rate; people who can cover these most basic living expenses for 3-24 months if the worst were to happen are protected by a buffer of liquidity.  Also required is disability insurance in case working becomes impossible, and life insurance for those with dependents.

Level 2: Financially Secure                                   

When a person has sufficient passive income from their investments to cover that minimum monthly expense rate, they are financially secure because even if they lose their job or business tomorrow, they could survive indefinitely.  This is a great feeling, because a job is no longer a survival need, it’s a want – a financially secure person does not work to put food on the table and a roof over their head, they work to maintain the lifestyle they want.

The most common types of investments that offer recurring passive income are stocks that pay dividends, rental properties and owning a business (not to be confused with self-employment).  Dividend-paying stocks are a good place to start, since there is a smaller minimum investment required.

Level 3: Financially Content

Minimum monthly expenses is all well and good for covering physical needs, but what about the things that provide texture and meaning in life, such as higher education for one’s children, hobbies, travel, new clothes?  Having financial contentment means that some (let’s say half) of one’s additional costs beyond basic needs are covered by income from passive investments alone.

If they haven’t already done so, investors should consider adding rental properties to their portfolios at this point, as a source of cash flow and diversification from the stock market.

Level 4: Financially Independent

If contentment is being able to cover half of one’s wants, being truly independent financially means being able to cover all of one’s “normal” wants with income from investments alone.  These are the kinds of expenses that were previously only affordable while working full-time, but now the person can walk out of their job today and live exactly the same quality of life as before.

Entrepreneurs should now be hiring and training managers to handle all aspects of their business, so that they as the owner can remain as involved as they want to and are no longer required for day-to-day management.  If additional rental properties remain part of the investment plan, they should be diversified to other cities and regions to reduce risk.

Level 5: Financially Free (Wealthy)

When a person’s investment income alone is so great that it imposes few (or no) constraints on their spending, they are wealthy.  For some people, this may not require a massive amount of money, if their wants are not extravagant.  Others may not be happy until they have a hotel-sized home on every continent and a private jet to travel between them on a whim.  Both of these people are wealthy, if their income from investments is sufficient for them live however they like.

One way to think of this five-step climb is the ladder from middle class to wealthy – the middle class must still work for their money, so someone who is financially secure is still middle class (albeit in better shape than most).  But the upper classes do not need to work in order to live comfortably, and therein lies the true distinction between the middle class and the wealthy.

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