When you’re aiming to achieve financial independence, having a process to guide you will dramatically increase your chance of success. Today I thought I’d share my 12 steps to help you achieve financial freedom.
Step 1: Understand your cash flow
Getting a good understanding of your cost of living is crucial because it will help you to estimate how large your portfolio needs to be in order to reach financial freedom. At the FFE house most of our spending is done using our credit card which gives us a break down of where the money goes. To help with our understanding, each month we’ll use this information to fill out a budget spreadsheet manually.
Tracking expenses will give you an understanding of how much money is going towards different categories such as food, utilities, housing, insurance, entertainment, holidays, gifts etc. Because expenses can vary drastically month to month, I recommend looking at them over a 12-month period.
The other part of the equation is to understand your cash inflows. You need to know how much cash is coming in as well as the frequency that it enters your bank account. Do you get paid weekly, monthly or sporadically when various jobs are complete?
Step 2: Figure out what is important to you in life
Take time to think about what gives you happiness and joy; what you want to achieve and what gives you fulfilment. The world is full of opportunities and amazing things. Unfortunately, there is no way to experience everything; so, focusing effort on the things that give us the most value is crucial.
Step 3: Optimise your spending
Money is a tool that facilitates the lives that we want to live. Like any resource it is not infinite which means it’s important to use it on the things that give us maximum value. Using your understanding of your cash flow and what gives you happiness start cutting expenditure that does not bring value to your life. For the rest of the expenditure items that are important, find cost effective ways to achieve them.
Step 4: Pay off non-productive debt
Non-productive debt is the type of debt that is not used to build your investment portfolio. It is typically used to fuel the consumption of things that depreciate in value; and often carries a high interest rate. The biggest culprits for this are car loans and credit card debt. Just in the way that money and positive cashflow creates opportunity, non-productive debt reduces opportunity and pushes financial freedom further out of reach.
Step 5: Build your savings account
Having a well-stocked savings account is going to help you with any large expenses as well as create opportunity for you to purchase investments. I recommend having around 4-6 months’ worth of living expenses in a high interest savings account however there are other considerations that I have discussed previously in this post.
Step 6: Build your understanding of risk
In the field of investing risk tends to be correlated with returns, meaning that riskier investments tend to have the potential to deliver higher returns. Conversely, this implies that riskier investments have the potential to deliver greater losses. In personal finance it is important to remember that risk extends to any event that has a negative consequence on your personal finances.
Being able to manage risk through diversification; building a cashflow buffer; scenario planning and adjusting debt levels are all important skills when working towards financial independence. For me, managing risk is about providing the FFE house with the highest probability of achieving our financial goals.
Step 7: Get the right level on insurance cover
Insurance is important for managing downside risk when it is undesirable to manage the financial consequences using savings or investment income. This typically includes things like home insurance and income protection insurance. I recommend using a risk-based approach to choosing the type and level of insurance cover you require.
Step 8: Estimate how much you need to retire and how long it will take to achieve
If you wish to retire without government support you will need a portfolio that is approximately 25x your annual expenses. This based on a number of studies looking at diversified portfolio longevity. How long it will take you to achieve this is going to depend on your savings rate and your investment returns. We typically model our portfolio growth based on 50-60% savings rate and a 7% p.a. portfolio return.
If you are unsatisfied with your initial estimates of how long it’ll take to reach financial independence, you’ll need to increase your investment returns and/or savings rate. I believe that increasing your savings rate through increasing income and optimizing expenses is less risky than aiming for higher investment returns. This is because aiming for higher returns is likely to come with higher risk which often decreases the probability of achieving your goal.
Step 9: Develop an investment strategy
Your investment strategy should be based on the return you need to achieve to meet your goals and the risk you are willing to take. You can increase risk by using leverage or through investment selection. However, it is crucial that you have a good understanding of how risk pertains to your household before doing so. In my opinion, making consistent investments in broad based index funds is a reliable method for generating long term wealth that has a high probability of success.
When developing an investment strategy getting the correct level, and type of risk exposure for you is the primary objective. Reducing taxation is an important, but secondary objective.
Step 10: Work on building excess cashflow and push as much as possible into your investment accounts
To create a meaningfully sized passive income stream, you’ll need to invest a meaningful amount of capital. For most people this will mean diverting as much of their excess cashflow as possible into their investment portfolio.
At lower income levels, the most effective way to build excess cashflow is to increase income. This could take the form of developing your skill set to move into a higher paying position; working multiple jobs; or starting a business. At higher income levels cutting expenses is often the more efficient way to increase your savings rate.
Step 11: Track your progress and make adjustments to stay on course
Life is ever changing so you’ll need to ensure that your financial situation is moving proactively to suit your needs. Remember that making small adjustments frequently is much easier than making a huge lifestyle change occasionally.
Step 12: Rinse and repeat
Keep your eyes on the prize; stick to your plan long-term; reward yourself along the way; and remember to enjoy the journey.
Engineer your freedom