You are ready to unlock the financial freedom secret!
When you have finally reached this step, you have already completed the following:
- Cleared your debts except for home mortgage
- Created an additional income stream
- Saved up a respectable emergency fund (3 to 6 months of living expenses)
- Insured your future earnings and security of your loved ones with insurances
If you have achieved all of the steps above, you are already ahead of 95% of the population in terms of financial security. And this is what you should strive for if you have not achieved the steps above.
Start with financial freedom guide step 1, and work towards your goal little by little. If you are saddled with heavy debts, you should be able to complete all the steps above in 3 years time. If you do not have any major debt problems, you should be able to reach this step within 1 year, or even faster if you put in more work on your side income streams.
So what does the other 5% of the population do? They have achieved the true financial freedom – they have sufficient passive income streams to support their lifestyle, and their assets generate income that is greater than their expenses. They can quit their job anytime they want and still be able to live on their passive income. And this is the true definition of financial freedom.
Concept of Financial Freedom
This is financial freedom – the true freedom
You don’t need to wait for 40 years to achieve financial freedom. You can reach there much earlier if you dedicate your time and effort into achieving it.
Simply put it, financial freedom is the state where income from your assets (bonds, stocks, real estate etc) produce enough income to cover your expenses. If you do not know how much is your monthly expenses, follow the exercise in Step 2 – Establish Emergency Fund and you will find out. You may need to track your expenses for 1 month to get an accurate number. Multiply this number by 12 to get your annual expenses.
Do you absolutely need a million dollars to become financially free? Well, the answer is yes and no. It depends on what kind of money is needed to support your desired lifestyle. If all you want is a simple lifestyle that can be sustained using just $2,000 a month, you will achieve financial freedom in a very short period of time. If you want a more luxurious lifestyle, of course you will need to work harder and create more income streams and assets.
The way to fund your financially independent lifestyle is to use both long term income producing assets and investments. Unlike other advocates who focus solely on investments, we use a twin engines concept to make a passive income lifestyle.
The reason is simple – depending solely on investments is more risky as there are ups and downs in market. A long term income producing asset, such as your own online business is definitely more consistent and predictable.
Anyway, investment is essential in your grand plan of financial freedom as it is true passive income. By investing your money, you are getting your money to work for you, not the other way round.
What should I Invest in?
Investment in itself is a huge topic, and there are many different school of thoughts in how one should invest. If you are new to investing, one of the safest way to make sure you achieve financial freedom is to invest in low cost index funds.
An index fund is an investment fund that holds a portfolio to track the components of a market index, such as the Standard & Poor’s 500 index (S&P 500). It provides a wide market exposure, low operating costs and requires almost no effort from the investor to analyze the market.
In many cases index funds outperform the majority of actively managed mutual funds. For example, the popular Vanguard 500 Index (VFINX) ranked in the top 20% of all large-cap blend mutual funds in the past 5 years.
One of the main reason index funds are outperforming actively managed mutual funds is due to the low operating costs. Index fund merely mirror the components of the market index, hence doesn’t require a high management fees. Heck, even a computer can mimic the components of S&P500 index.
Actively managed mutual funds, on the other hand has high management fees baked into it, and there is no guarantee that it will perform better than an index fund. In fact, most actively managed mutual funds underperform the index time and time again.
Consider the following scenario:
On average, an actively managed mutual fund has a 50% chance of outperforming the index fund, and 50% chance of underperforming the index. The management fees of an index fund is 0.5% annually, and the management fees of the actively managed mutual fund is 1.5% annually.
The historical annualized return of the market is 8% before fees. Of course, this is the average annualized return and return from years to years can fluctuate. An index fund investor can expect a 7.5% net return after deducting the management fees, while actively managed funds needs to achieve a 9% annualized just to stay equal with the index fund.
Even the world richest investor, Warren Buffett makes a strong case in favor of index funds:
I will take the market return and be happy with it – because I know the odds of beating the market over my investing lifetime are slim.
-Warren Buffett, Chairman and CEO of Berkshire Hathaway
Dollar Cost Averaging strategy
When the multi-millionaire basketball star Lebron James asked Warren Buffett for investment advice, Warren Buffett told him this:
“Just making monthly investments in a low-cost index fund makes a lot of sense.”
And this is exactly what we will do – we make monthly investments into a low cost index fund, such as the Vanguard 500 index. This strategy is called dollar cost averaging, and it’s good to smooth out the fluctuating market returns (market volatility) over a long period of time.
Dollar cost averaging, or DCA is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. Therefore, more shares are purchased when prices are low, and fewer shares are bought when prices are high. It’s also referred to as “constant dollar plan”.
Eventually, the average cost per share of the security will become smaller and smaller. After all, the market tends to rise over time. Dollar-cost averaging helps to lessen the risk of investing a large amount in a single investment at the wrong time.
There are 2 main reasons we employ dollar cost averaging in our investment strategy:
- Prevent emotional intervention – Psychology is a major determinant in investment success. Majority of inexperienced investors pull out all the invested money at a loss when they see a market downturn. DCA prevents us from putting in a large sum of money just before a market downturn or a depression, thus preventing regret and knee-jerk reaction of pulling out investments.
- Sustainability – DCA is a long term strategy that keeps you on a steady path to financial freedom. Most people do not have a lump sum for investment and DCA is a solid technique to get started in the investment world.
How much of a nest egg do I need?
The rule of thumb for investment withdrawal rate to make a passive income lifestyle is 3 – 4% a year. In other words, you can withdraw 3 – 4% of your portfolio each year without depleting the principal. The goal is to primarily consume the investment dividends, interest and appreciation.
Let’s take a look at Joe’s scenario, where he can survive on $2,000 dollars a month. Do note that Joe’s only form of debt is a home mortgage, so $2,000 can provide him a bit of leeway in how he spends his money.
To obtain his “financial freedom” number, he would multiply his annual expenses by 25 for a 4% withdrawal rate, and 33 for 3% withdrawal rate:
$24,000 x 25 = $600,000
$24,000 x 33 = $792,000.
This means that Joe needs an average of $600,000 to $792,000 in investments to live his desired lifestyle without having to worry about his finances. He will be completely self-sufficient and be able to live on his passive income.
If the number seems unattainable to you, worry not. In reality, we need much less in investments because we employ the twin engines concept to fund our financially free lifestyles. Remember the long term income producing asset we talked about earlier? It is an important part in your new lifestyle. The side income stream we produced in the Step 4 – Create extra income will eventually grow into steady stream of monthly income to support your lifestyle in addition to investment withdrawals.
If Joe’s online business generates $1,000 monthly (which is attainable if you are willing to dedicate a bit of time everyday), he only needs $1,000 from his investment income to fund his lifestyle. His financial freedom number will look like this:
At 4% withdrawal rate:
$12,000 x 25 = $300,000
At 3% withdrawal rate:
$12,000 x 33 = $396,000
Joe will need only between $300,000 to $396,000 in his investment account to become financially free. When his mortgage is finally paid off, he can make lower withdrawals from investments and keep his standard of living, or he can keep withdrawing the same amount and enjoy a more luxurious lifestyle. This is the true reward of financial freedom – freedom of choice in life not bound by shackles of finances.
Remember – becoming financially free is a life-long goal. It is by no means easy to attain, but armed with the knowledge throughout the steps, you are now in a much better position to achieve your goal. Setup your online business, keep your day job for the time being, and focus on investing into low-cost index funds using dollar cost averaging strategy. If you can channel $1,000 into investment monthly, that is superb. If you can only channel $200, by all means do it. The important thing is to get started, and be consistent with it.
Play around with the numbers using this compound interest calculator. You will realize that achieving your financial freedom number is easier once you start investing and have compound interest working for you.
Push on and realize your life goal! Leave a comment if you found this series helpful or share with us your financial freedom goals below!
To Do List
- Calculate your financial freedom number
- Start your online business for free if you have not started
- Channel money monthly into low cost index fund such as Vanguard 500 fund
- Be consistent in investment and building up your long term income producing asset (your online business)
- Achieve your financial freedom number and realize your life-long goal
This article is one of 6-step series “Achieve financial freedom in 5 years time”.