Financial Freedom is a personal goal of mine but it is a goal that I believe every single human being should have. Financial Freedom is a simple concept, I want to earn enough money passively (not working) so that I can spend my time on what I want to do rather than be forced to work for money to survive. Sound complicated? Turns out not at all, if you have a job then you are good to go.
Most people are so busy spending their money they never realize that they are in-fact nothing more than a consumer ensuring the financial freedom of the owners and investors. They are so overwhelmed by the financial world (and rightfully so as the financial industry tends to use lots of jargon that makes even the simplest of concepts seem very complicated) that they just put it of indefinitely ensuring that they are forced to work for the rest of their lives just to survive. In this article we will explore the basic's that every single person should know to achieve financial freedom.
But first what exactly is Financial freedom? Financial freedom is when you own enough assets that you can safely withdraw from or live of the dividends without ever having to worry that it will run out. This might seem like an impossible goal but if you earn a monthly salary and you can manage to save some of it and invest it at low cost and let compound interest do its job financial freedom is the inevitable outcome. Each and every one of these fundamentals are critically important and in the future I will write an entire article on each one. There are no secrets to become rich and you never have to do anything illegal or dangerous to get there, all you need to do is apply these fundamentals consistently and your financial freedom is the only logical outcome.
1: Spend Less than you earn
Spending less than you earn is the most important fundamental, if you only get this one right you are ahead of 80% of people in the world. This might seem obvious and silly but is in fact the biggest reason most people cant ever retire. It seems so simple yet a staggering amount of people all around the world can not do this consistently. The norm seems to be that when someone gets a promotion they increase their debt to buy that new car or house. This might make them appear rich but the debt will never end and they will never achieve any sort of real wealth.
"Do not save what is left after spending; instead spend what is left after saving."
- Warren Buffet
If you want to achieve financial freedom you have to invest at least 10% - 15% of your salary every single month. In fact your entire budget should be created with the sole purpose of reaching this savings goal. If you can manage this then you have overcome that hardest part of this journey, it is all downhill from here.
Want to to be financially free earlier? Then push this 15% up as high as you possibly can, if you can keep your current lifestyle while allocating most of your increases towards investing instead of spending the extra income you will speed up the process significantly.
2: Start early - Understanding Compounding Interest
Understanding compound interest is the single most important concept in investing, it enables us to reach financial freedom that much quicker and once you have momentum it becomes very hard to fail. But dont take my word for it here is what Albert Einstein had to say about Compound Interest
"Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it."
- Albert Einstein
The thing about compound interest is that it can work for you or against you. When it works for you it is the greatest ally you can ever ask for, but when it works against you it can completely destroy your financial future and even your life as it has lead to countless suicides over the ages because it feels impossible to overcome the momentum that has built against you.
So how can I make it work for me?
Compound interest is simply the interest you earn on interest. So lets say you own a share in Apple and every time they pay you a dividend instead of spending it you simply use it to buy more shares in Apple. At first it might not seem like a big deal, when the numbers are small it appears like almost nothing is happening but as time passes the investment value will start increasing exponentially.
(Dividend: "a sum of money paid regularly (typically annually) by a company to its shareholders out of its profits (or reserves)." )
So lets say you buy a share for $10 and you receive a 10% dividend, at the end of year 1 you will have $11. Now at the end of the next year when you receive another 1% dividend it is not 1% of $10 it is 1% of $11 so now we earned $1.1. Again in the beginning it looks like nothing special but given the magic ingredient, time ,the increases start to feed of itself and your investment begins to gain momentum. Here is a graph that shows the difference between compound interest and non compound interest.
The more time passes the more exponential momentum you gain the harder it becomes for anything to stop you. How do you think Warren Buffet has managed to give away more than $28 billion to charity yet he is still floating around 1 - 3 richest person in the world thanks to compounding.
Therefore all you really need to be rich is time, not a fancy job nor a huge monthly salary. If you can manage to use that 15% of your salary that we discussed earlier and you invest it each month into a low cost investment, given enough time, it will grow exponentially and you will be able to retire with more than enough money. Below is a graph from diyinvesting.org that shows you how compound interest works.
As we discussed it starts slow but then suddenly increases exponentially. So the keys is to start early and save as much as possible because once the exponential grow starts there is not much to do from your side anymore.
Not convinced my mister Einstein's first quote? Here is another.
"Compound interest is the greatest mathematical discovery of all time"
- Albert Einstein
3: Paying off and avoiding bad debt
If fundamental "1: Spend Less than you earn" is the most important fundamental to creating wealth then bad debt is the biggest destroyer and when it is empowered by fundamental "2: Understanding Compounding Interest" it will enslave you for life, the exact opposite of what we are trying to achieve.
So what do I mean by bad debt? Well anything other than your house and your car I consider bad debt because there is no real other good reason to borrow money (there are extremes of course). And the car only counts if your old car was un-usable, if you just bought a new car because you got an increase in salary then I consider your car bad debt.
Bad debt not only slows your ability to reach financial freedom it actually puts it in reverse, if you find yourself in this position then the best thing you can possibly do is pay off the debt as fast as possible as it is costing you time and as we saw earlier time is the true key to wealth and it is the very last thing we want to work against us.
If you are in the debt trap then here is a strategy to get out, and once you do be sure to come back and read this article again and take it from there.
Write down the amount and interest rate of all the different debt you have . Choose the one with the highest interest rate and put all the money you possibly can into it. Cut back on your lifestyle as much as possible and sell anything that you can to pay off this debt in the shortest amount of time. Once the first loan "pops" (is paid off) continue on with the second highest interest one, once you gain momentum you will pay of your debt way faster than you might think. This also gain back the most amount of time and as we know time is what we are after.
4: Low Fees and Diversify Diversify Diversify
So now we come to the fun part, what do we invest in?
In 1975 John C. Bogle create the world first index fund and since then it has truly become the golden standard for the amateur investor. Even Warren Buffet arguably the worlds best investor of all time often recommends index funds for amateur investor. After years and years of research I have not found a single well intentioned world class investor that does not, on some level , recommend index funds. The only criticism you will ever find is from companies that wants to manage your funds for you in order to make money for themselves.
What is an Index fund?
Simply put an index fund is a way of buying shares in a collection of companies without having to go and buy each individual share in each individual company. So for example the Vanguard S&P 500 ETF is a fund the buys shares in 500 of the largest U.S. companies at an incredible fee of 0.04%. This way we diversify across 500 companies with a single purchase for 0.04%.
But when should I buy?
Every single month no exception. You know that 10% - 15% savings we talked about, all of that should go towards low cost index funds. Again I will write an entire article about this but for now as a rule of thumb all you need to know is never buy any fund with a TER (total expense ratio) of more than 1%, in some countries like the US this might seem high but this is just a general global rule.
But 2% fee is nothing!
2% might seem like nothing but lets look how it plays with our old friend "time".
The best way I found to explain this is to see the numbers to try this.
Step 1
Use any compound calculator like this one
http://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php
Step 2
As you can see on the screenshots below in our little test case we start with $1000 and pay an additional $1000 each month for 40 years. The one has 10% growth per year while the other one has 8% growth per year, this simulates our 2% fee. Click calculate
Step 3
Cry. As you can see on the screenshots below the "small" fee of 2% over 40 year turned into a 56.3% fee
Again do this for yourself so that you can see the numbers, I have found that this is very hard for the human brain to process this correctly.
So screw high fees lets get some Index funds , what do I buy?
Well this is a little outside of the scope of this article and I am sure I will write many articles about this exact topic but for now lets just leave a Warren Buffet quote and move on
"Consistently buy an S&P 500 low-cost index fund keep buying it through thick and thin"
- Warren Buffet
5: Do nothing!
And now we come to the last part. For some this is easy for others this is almost impossible. Your next step is to do nothing. We have signed a debit order for our low cost index fund and now we are done. All we have to do now is each time we get an increase at work we increase the debit order to our index funds and that is it.
You might think but what about buying low and selling high? The problem is each additional decision you make you increases the probability of making a mistake, you have already done lots of research and found the index fund you like and that is where the work stops.
This brings me to another all time favorite quote by Charlie Munger, Warren Buffets partner in crime.
"The big money is not in the buying and the selling, but in the waiting"
- Charlie Munger
But what happens when the market crashes?
Because we invest monthly we invest in both the good and the bad times, this means that it doesn't matter if the market crashes or not over the long run we have averaged the cost. This truly allows us to completely relax when the market crashes as we have removed any emotion out of the equation, we know we bought a good fund and we are averaging costs so market up or down doesn't matter at all, in fact you can completely forget about the market and continue on with your life.
But I want to do something, can I?
To increase your profitability beyond what the index fund provides will require allot more effort and I mean allot allot more effort. Most likely you will not do your research well enough, buy single stocks and in the end of the day you will make less than the person who just bought the index. I am not saying it is impossible as we can see Warren Buffet has done very well buying individual stocks but you have to remember two things, first he is Warren Buffet and second Warren and many others do this all day every day full time, for you as a full time working investor to compete with these guys are very hard indeed.
In fact lets look at the latest stats taken from www.marketwatch.com from May 13, 2017.
"Over the last 15 years, 92.2% of large-cap funds lagged a simple S&P 500 index fund. "
- www.marketwatch.com
This means even 92% of large-cap fund managers who do this every day for 8 hours a day cant beat the S&P 500, so for you to beat it will be hard indeed and overestimating your ability could cost you dearly. This also proves that any active investor charging you more than 1% fee us literally (and i mean literally ) robbing you (more on this latter).
If you feel like you do want to buy shares then read a couple of Warren Buffet books and go ahead but always be sure to keep at least 70% of your money in index funds.
But what about Crypto
Seeing as I am posting this on a blockchain based social media site and most of you probably invest in crypto currency already I am going to add this section.
As a full time Software Engineer and technology and finance enthusiast I can truly say that I am excited about where crypto is going. I am not talking about the price or the bubble or any of that short term irrelevant information. I am excited from a technological and philosophical point of view. I have studied and continue to study decentralized technology and I can see great potential out of them. The best way to describe how I think of Crypto currency is with this Bill Gates quote.
"We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don't let yourself be lulled into inaction. "
- Bill Gates
But how does this fit into our investment portfolio
As I said above I recommend keeping at least 70% of your net worth in index funds and here is my reasoning. The stock market and more recently index funds have proven without a doubt to be most profitable and reliable investment over the long run. When I say the long run I mean the last 100 + years.
The modern crypto scene has existed for about a decade now, this is nowhere near the time periods we have seen the stock market prove itself. To ensure the best possible retirement with the least amount of risk the stock market is still the way to go. Will this always stay the same? No it could very well be that crypto will become the king of the castle but we have no where near enough data to even start to prove that.
So what am I saying.
You need to see the big picture here. This is nothing more than a risk reward asset allocation decision. How tolerant are you towards risk? Being in the crypto sphere here I bet allot but I actually need you to give a number. Before spending any money in crypto decide beforehand how you want to break up your risk allocation.
Lets look at an example
70% Index Funds <--- Long term low risk
20% Single stock blue chip picks <--- Long term medium risk
10% Crypto Currency <--- High Risk
As these technology evolves we will see more solid evidence of which of the crypto's are actually being used and which ones are redundant. As products come out on Etheureum that are actually replacing parts of the financial sector or parts of the Insurance sector then we can start allocating more capital towards Crypto.
We are so early in crypto that 10% of your funds invested in the right project will be more than enough if you really think the technology and philosophy is solid as I do. But also be aware that probably 95% of coins today will disappear without a trace. As a buy and hold investor because of reasons in this article my approach is a buy and hold strategy.
Any feedback is greatly appreciated.