Financial independence gives you the key to a fuller and more satisfying life. It can have different meanings at different stages of life. For instance, as a young person leaving home, it is about having sufficient income to support yourself away from the protective cocoon your parents had provided. Later on, it might mean the ability to take out a mortgage and buy a house. In later years it is about having sufficient income to live on after you have stopped working.
At any age, we think of it as having sufficient income to cover your living expenses without worry. Being financial independent implies income, but it really means building an asset base from which to derive your income, and not be dependant on your job.
There are 5 steps to financial independence:
- Goal setting and planning – knowing where you want to get to;
- Budgeting and daily spending discipline – spending less than you earn and having investment funds available;
- Knowledge and understanding of risk – considering different forms of investments and their associated risks;
- Tax Strategies; and
- Investment Portfolio.
1. Goal Setting and Planning
#1 – Think Long Term, Set Longer Term Financial Goals
Don’t just dream about your finances getting better. Set longer term financial goals and commit yourself to accomplishing them. Financial goals won’t be realised in the short term – they take persistence and time.
An example of a suitable longer-term financial goal is how much passive income you need to cover your living costs at retirement. Passive income is income derived from investments, not from your job. When you stop working – be it at age 70 or age 40, this is what you will live off. Exclude pensions and government support – the objective is to be financially independent, so you can live the life you want to lead.
#2 – Translate Longer Term Financial Goals into Specific Objectives
A more detailed example might be a desired income of $50,000 per annum, enough to cover a comfortable lifestyle. This is the basis of a simple equation – divide the income wanted by the percentage return expected from your investment assets.
If we assume a low risk return on assets of 4%, this means you need to accumulate $1.25m of income producing assets (i.e. $50,000/0.04).
If we assume a higher income goal of $200,000 and a higher level of return of 6% (higher risk), the asset goal becomes $3.33m.
Your goal should include desired income, target assets and return and of course a time span – 5, 20 or 50 years.
The retirement income formula is quite straightforward and has 4 components:
- Your desired income – e.g. $50,000 a year, $200,000 a year etc. The amount will depend on your lifestyle and your regular spending commitments such as mortgage, car repayments etc.
- Income producing Investment assets – non-income producing assets such as artwork, bullion, classic cars end the like don’t count, as you would have to sell them to generate any income (although they can provide a type of insurance buffer).
- The return you earn on your income producing assets – e.g. many treasury bonds today is in negative territory – i.e. they earn -1%. Term Deposits may return 2 or 3%, equities may be in the range of 3-5%, commercial property 6% and so on.
- Your tax liabilities – unfortunately income has a habit of being taxed, so you need to be thinking about your after-tax return. This is where it can get much more complicated, but we’ll leave that complexity for now.
The simple equation to remember is that – the lower your desired income, the fewer assets you need to cover it, and the lower return (lower risk) needed from them.
The more you can pay off things like your housing mortgage, cars, household equipment and the like, the easier the task becomes.
#3 – Accumulate Income Producing Assets
The goal of financial independence is having sufficient income to live the life you wish to live. Longer term this will mean passive income. To generate passive income, you need to have income-producing assets. Your plan should be about how to acquire these. The first rule is to reduce your spending to below your income, so you have some left over to begin accumulating income producing assets.
#4 – Keep Track of Your Progress in a Spreadsheet
Instead of hoping that your finances will work themselves out, stay on top of your financial future by keeping track of everything in a spreadsheet. This is often the difference between success and failure in personal finance.
Your goals will alter over time – as you become more successful, your lifestyle is likely to change (and become more expensive). It is useful to keep track of these changes and continually update.
There are a number of useful metrics we recommend:
- Current passive income level
- How many years can you live on that without reducing capital?
- How many years left at current income before you reach your goal?
- What if analysis – e.g.:
- How many years if current income (or available income) increased by 10%, 20%?
- How many years if desired income reduced by 10%, 20%?
- And so on.
These, and similar metrics have the advantage of getting you focussed on your goals and your future, together with your current investment strategy.
#5 – Keep the Big Picture in Mind, But Stay Focused on the Short-Term Process
The big picture is important. It tells you where you are and where you’re going. However, in some situations, it can distract you from the task at hand. If you want to attain true success, then you have to know how to stay focused and effective on short-term problems, while also working within the greater framework of the big picture.
Short term issues you want to stay focussed on is how to increase your available income, reinvestment of current passive income, how to what returns you are getting from your assets and the like.
#6 – Understand the Miracle of Compound Interest
Start saving early. Investing $10,000 at age 30 will yield you much more in retirement than $10,000 invested at age 50. This is because you earn interest on both the capital amount AND on the interest you have previouslyy earned.
$10,000 at an annual interest of 5% reinvested, becomes $15, 513 in ten years (an increase in value of 55%). But in twenty years it becomes $25,270 (an increase of 153%). In forty years it becomes $67,048 (an increase of 570%).
At an annual interest rate of 6% – that $10,000 becomes worth $97,035 in forty years time!
2. Budgeting and Daily Spending Discipline
#7 – Spend Less Than You Earn
Continually revise your cost of living and make efforts to cut your expenses. For instance that daily cup of coffee on the way to work – might give you $15 a week to invest (assuming 5 x $3 – I know this varies from place to place). That’s $780 a year! Doesn’t sound like much – but these little things all add up.
If your expenses are too high, then cut them. Move into a cheaper apartment. Buy bargains at the grocery store. Use coupons. Cut back on entertainment expenses.
When you’re poor, thriftiness is a virtue. If you’ve fallen on hard times, you would be wise to be thrifty, rather than delusional about the state of your finances.
If you’re currently over-budget, consider cutting your expenses by 10%. Even if it seems hard to do initially, figure it out and do it.
#8– Get in the Practice of Creating and Following Budgets
Budgets can play an important role in stabilizing financial outcomes. If you currently have no budget, you should start making one on a weekly basis. Try to keep your expenses and income flows under control, so you don’t get behind on payments.
Don’t waste money on expensive toys. Keep frivolous expenditure to a set proportion.
But don’t forget to live your life. One early boss of mine put aside a 10% fun factor into every project quote we did. This is a useful dictum for everyday budgeting as well.
As a general rule, we think that aiming for a regular investment fund equal to 10% of your net income is an appropriate level for longer term asset accumulation, and should be manageable for most people.
Obviously, the more the better. It also depends on your stage of life and the assets you have previously accumulated.
#9 – Pay Down Debts
Your first priority should be to pay down debt. It cannot be emphasized enough: unless you are young and are planning to get a number of very large raises in your lifetime (or are temporarily ill), then you shouldn’t be accumulating debt. You should be paying it down and saving for retirement. Successful people know and practice this.
#10 – Pay Your Bills on Time
When you miss a bill, you get charged fees. So, instead of paying your bills on the last day, pay them first. If you have money left over, then use it for other purposes, but don’t do so until you have paid the bills.
#11– Manage Your Credit Cards
Try to keep your credit card balances under 30% of the total allowable limit. If there is some emergency, you will have a backup reserve of credit that you can use to get through it.
If you can, pay your credit card balances in full each time. This will prevent you from ever paying interest on the debt you are servicing. Try moving from a credit card to a debit card – it’s a much better piece of plastic to be using, and will stop you from accumulting expensive credit card debt.
#12 – Shop Around for Major Cost Items Like Mortgages, Insurance
When it comes to car insurance, there’s a good chance that you might not be using the best place. Instead of being complacent and sticking with your current plan, consider shopping around to find a better one.
Another thing that people who are successful in personal finance generally do is shop around for a mortgage. Instead of simply taking the first that they are offered at the first bank they go to, they test the waters with a number of different companies to try to get a lower interest rate.
Visit a mortgage broker. Even if you ultimately do not use one of the companies she suggests, you can get a feel for what is out there in terms of payment sizes, interest rates, and other important features.
In addition to shopping around with different banks, you will also want to shop around for different mortgage product types. For instance, if the size of the mortgage payment will be high relative to your monthly income, then you may want to consider looking for a fixed rate.
3. Understanding Risk
#13 – Avoid Putting Yourself in a Precarious Financial Situation
The successful know that some risk is unavoidable, but where it is avoidable, it should be deal with intelligently. If you are constantly putting yourself in precarious financial situations, it may be time to rethink your finances and your approach to money.
How long it takes to recover lost, money – i.e. – lose 10% of $10,000 = $1,000 loss. Capital base is reduced to $9,000. To return to $10,000 you need to make a return of 11.1%.
If the loss was 20%, you need to make a return of 25% to recover. Always look to protect your capital.
#14 – Avoid Unnecessarily Risky Investments
Instead of picking stocks, put your money into a mix of high-yield and low-yield bonds. Or into a fund that is well diversified and offers a reasonable, but low-risk return.
Instead of putting money into individual stocks, put your money into index funds. Successful investors know that, over time, you cannot consistently beat the market without taking on a significant amount of risk in the process.
#15 – Seek the Help of a Financial Advisor
When you first start to invest, seek out the help of a financial advisor. The successful know that it is not possible to know everything; and that getting the advice of a professional is always a good place to start.
4. Tax Strategies
#16 – Seek Professional Financial Advice
Dependant on your level of income and investments, it is likely that at some stage alternative investment structures will give you better tax treatment. Tax is like any other expense, where it can be reduced (legally) you should do so. This can become very complex and will vary country by country, state by state and even by county or town.
5. Investment Portfolio
#17 – Don’t Buy a Big House if You Cannot Afford It
Locking yourself into a big mortgage payment is a very bad idea—especially if you have a shaky income. Instead of risking the possibility that might not be able to make the payments, settle for a smaller house or an apartment until you have financial capacity to make the payments on time.
#18 – Buy Quality Assets That Have Longevity and Look to Accumulate Rather Than Trade
Property transaction costs are usually quite high (as much as 10%), and they can have a deleterious impact on the accumulation of wealth. Adopt a long-term investment horizon. Don’t waste money on transaction costs which will delete your capital base.
#19 – Negotiate Selling Prices on Large Purchases
One stark distinction between the successful and the unsuccessful is that the successful are always willing to bargain. Even if it means that they’ll have a much less pleasant buying experience, they’ll spend hours haggling if it means they can cut hundreds or thousands off of the price tag.
#20 – Build a Diversified Portfolio of Assets
A diversified portfolio spreads overall risk, and leaves you less exposed. As a general rule, stocks and equities should be traded for capital gain, properties held for longer-term income (commercial is better for this that residential, but again a mix is recommended), bonds used to provide lower returns but with capital security, but many now have a negative return.
To Sum Up
If you wish to be financially independent, it will take some work. It’s a long game, not a short sprint. in any long game, discipline is a skill (habit) that pays off bigtime. We recommend Brian Tracy’s course if you need some help here.