In order to reach financial independence, you need to do three things – make money, save money, and invest money. It’s really that simple.
But like many things, it’s easier said than done.
Succeed with each of these three activities and you can move yourself out of the dreaded world of living paycheck to paycheck and move into the financially independent world.
And it really doesn’t matter how much you make. I have seen plenty of people making multiple six figure incomes that had nearly nothing saved. They spent everything they earned. And in fact, because their expenses were so high, these folks were worse off than those living paycheck to paycheck with low-paying jobs. Any disruption in their monthly income and they were wiped out.
What is important isn’t how much you earn, it’s how much you spend relative to how much you earn.
Without these first two pieces of the puzzle, you won’t have any savings and won’t have any money to invest. And you’ll never reach financial independence.
This is why I created Simple Investing The Financial Slacker Way.
Simple Investing The Financial Slacker Way
Assuming you have an income stream and your spending is under control, the next step is to focus on investing.
One of the great things about investment income is that unlike actively earned income, it’s not correlated to the number of hours worked. But it is correlated to both the amount invested and the duration of the investment.
And while there is no shortage of possibilities for investing your hard earned and diligently saved money, over the years, three primary investments – stocks, real estate, and small business ownership – have been proven time and time again to increase wealth and ultimately allow investors to reach financial independence.
While these three investments have historically generated the highest returns, they also have the greatest risk of either permanent capital loss or more likely, short-term and medium-term changes in value.
Return vs Risk
It’s useful to talk a little finance theory here. For any investment, there are two criteria – return and risk.
Return is measured as the expected payout from an investment which can be in either capital appreciation (i.e., the value grows over time) or in cash distribution (i.e., a dividend or interest payment).
Risk is typically measured as the potential variability in that expected return. For example, a high-grade bond that is held until maturity has low risk. The return is equal to the annual interest payment and at maturity, the principal will be repaid. The risk that one of those things will not happen is relatively low. And therefore it’s easy to determine the expected return and the potential for that return to be greater or less than expected is also relatively low.
Conversely, the risk of a high-growth stock is much greater. The return is completely dependent on the value of the stock when you sell. And there are many factors that can impact the price – company performance, industry events, the entire stock market.
Any of those factors (and others) can move in your favor or against you and impact the price per share. It is much more difficult to estimate the expected return. It might be as high as 15% or 20% or even more. Or it might be zero if the company fails.
Other investments such as bonds, commodities, and life insurance may not generate the same expected returns as other investments, but they tend to have lower risk and therefore can be used to protect your capital from the potential value swings of other high return investments.
Cash is King, Except When Investing
When you start investing, you may be reluctant. For many, the fear of capital loss is stronger than the desire for gain. Those folks fear the market and tend to hold most of their money in cash. Although cash has a low risk, it also has a low return.
Let’s look at a simple example. You start investing when you’re 25 and want to retire when you’re 65. You expect to spend $100,000 per year at a 4% withdrawal rate in retirement and want to make equal contributions to your retirement account throughout your working years.
If you consistently generate a 6% return on your invested money, you will need to contribute $14,706 each year. And over the 40 years you invest, you will have made a grand total of $602,944 in contributions. At the same time, your investment earnings will total $1,897,056 over this same time period (more than 3x the amount you contributed).
But here’s the kicker. If your portfolio only generates 4% because you have a heavy concentration of cash, you would need to contribute $24,552 per year for 40 years, for a grand total of $1,000,648, or 67% more.
So the take-away is that you need to start investing as soon as possible. Saving is great (and necessary), but it will only take you so far. Take advantage of the long-term benefits of compounded investment earnings.
But before you are ready to invest, you need to take a financial fitness test. We’ll discuss that more in part 2 of the series, Simple Investing The Financial Slacker Way.
Readers, thanks for following along with my new series, Simple Investing The Financial Slacker Way. Are you or were you anything like the beginning investor I described above? Do you hate losing more than you like winning? If so, how have you compensated and forced yourself to invest even if it makes you uncomfortable?