Path to Financial Independence
by Rachna Bijlani, CFP®
February 04, 2021
What is financial independence? To me, financial independence isn’t about not having to work, or retiring early. It is the freedom to make life and career choices, without having to worry about the financial aspect. It is the ability to quit an irksome job, work on your own startup, go back to school, take an extended vacation, send your child to a good college without burdening her with student loan, pay for roof replacement or other large unanticipated expenses without incurring huge debt, support your elderly parents, and most importantly, financial independence is not having to worry about running out of money to support yourself and your family for the rest of your life. It is the power to take time off to think, imagine, and pursue what’s truly important and meaningful to us. It is the luxury of experiencing life at your own pace, soaking in the swetness of "dolce far niente". This line from One Republic’s song, I lived, beautifully captures the true essence of financial independence- “Hope when the moment comes, you’ll say, I did it all”.
The first step towards achieving financial independence is to make a plan. Assess your financial goals, analyze your current financial situation, risk tolerance, time horizons, liquidity needs, tax situation, and devise an investment strategy for yourself based on these factors. Planning for the future gives us peace of mind, thereby allowing us to live worry-free in the present. Just planning isn’t enough, you’ll need to muster up the discipline and mental and emotional strength to follow through your plan. Here are some good financial habits that can increase your odds of being financially independent.
Start early- It is so much easier to achieve your financial goals and work towards financial independence if you start saving and investing at an early age. If you start late, you’ll most likely have to save a greater amount of your gross earnings every year, to compensate for the missed years of contributions and compounding of investment returns. Needless to say, you’ll feel the pinch a lot more if you’re required to save 40% of your earnings every year versus saving 15% a year. Based on your age, income, remaining work life expectancy and expected rates of inflation and investment returns, determine your required savings rate to achieve your financial goals. Set up automatic periodic transfers to your investment accounts to ensure consistency. Invest in a well-balanced portfolio based on your risk tolerance, time horizons and liquidity needs. Saving requires foregoing certain amount of current consumption, and it’s difficult to reduce consumption by a higher percentage, especially when you’re accustomed to maintaining a certain standard of living. Some investors approaching retirement might panic and try to make up for lost time by taking on more risk in their investment portfolios than they're capable of handling, which can prove to be further detrimental to their financial situation. Bottomline- the sooner you start, the lesser it’ll hurt.
Manage risk- Tragedy often strikes unannounced and leaves us with depleted resources and strained emotions. It is important to identify, evaluate, and manage risk exposures that upon occurrence, can lead to severe financial hardship. Unexpected large expenses, job loss, disability, long term care expenses, or death of the primary income earner in the family can make the best laid financial plans go awry. Start by building an emergency fund to cover 6-12 months of non-discretionary expenses, in a highly liquid account. If you have dependents who rely on your income, make sure you have adequate life insurance. Besides your basic health, disability, auto, and home insurance, consider getting a personal liability umbrella policy and maybe even long-term care insurance to protect your financial resources. Another important risk to mitigate is the risk in your investment portfolios. Assess your risk tolerance and only take on the level of risk that you’re capable of handling. Do not let fear, greed, or external noise cloud your investment decisions. Let this sink in- Your investment portfolio needs to go up by 100% to recover from a 50% loss. Carefully analyze your financial risks and have a solid plan in place to mitigate those risks so you can protect your assets and prepare yourself for any unforeseen financial disasters. Hope for the best, be prepared for the worst!
Understand debt- My dad is an old-time money lender, who made his fortune by charging compound interest on the money he loaned. He never incurred any debt in his life (not even home loan) and doesn’t possess a single credit card till date. In his world, interest should be earned, not paid. So, this is probably the most scandalous statement that my father has heard me make (other than “I will choose who I want to marry!”), - Not all debt is bad. There’s good debt, bad debt, and even reasonable debt. Debt management has an impact on savings and investments, so understanding the quality and cost of your debt is imperative to financial success. High interest credit card debt is obviously bad, but federal student loan to procure education that could lead to a lucrative career for a person with a reasonable work life expectancy, may not be a terrible idea. Similarly, a 30-year fixed home mortgage at a low interest rate, with a payment that fits within the housing ratios, especially when the property prices and your income are expected to increase, sounds reasonable. Be cognizant of your debt ratios. Keep your home mortgage below a fourth of your gross income and your overall debt to a third of your income. Also, your debt to total assets ratio should decline as you grow older.
The most important factor to evaluate before taking on debt is whether the interest rate on the debt is relatively low in comparison to expected inflation and expected investment returns. For instance, if I’m hypothetically paying 2.5% interest on my home loan, inflation is expected to be 2%, and the expected return on my investment portfolio is 12%, I might not cringe while making those mortgage payments, despite being a money lender’s daughter. Leverage in investing means borrowing capital at a specified rate for investing, with the objective of earning a higher return on the borrowed capital than the interest paid on it. Margin trading and taking on a mortgage for a rental property are forms of leverage. Leverage can magnify investment returns as well as losses. Analyze the investment thoroughly and make sure you clearly understand all associated risks before taking on leverage to invest.
Keep emotions in check- Unlike a rational, number crunching automaton, most of us are “normal” people with emotions, exhibiting cognitive biases or heuristics. Being aware of how these biases can manipulate our investment decisions is a crucial step towards becoming a prudent investor. Availability heuristic, where decision makers simply tap on their short-term memory or rely on information that is readily available (heard from friends, advertisements, latest news), instead of taking the time to conduct extensive research and due diligence, can cloud an investor’s judgement of risk and probability. Another bias recently clouding the financial markets is herding. Stock prices driven up by herders create overvaluation that in the long run can mask issues with the underlying fundamentals of the actual investment. During periods of market volatility, it can be hard to keep your nerves and go against the crowd, but try to ignore the noise, and always focus on your own goals and do what’s right for you. I do believe that in the long run, fundamentals and common sense prevails. Overconfidence bias is when investors are unrealistically optimistic about their chances of success. This can lead to investment portfolios that aren’t well-diversified, excessive trading by investors, trying to time the market, and making rash choices, while being overconfident of their ability to outperform the market. Loss aversion is another common bias, where the mind celebrates gains less fervently than it mourns losses. In periods of market volatility, this bias can lead to panic selling amongst investors. Our minds can be our worst enemies during periods of market volatility. Instead of focusing on short-term volatility, focus on your long-term financial goals to keep things in perspective. Make sure you have a well-diversified portfolio, which is in alignment with your risk tolerance, and most importantly, stay objective.
Why do YOU want to be financially independent? Find your “why”, it’s all the inspiration you need.
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