Filed under: Personal Finance, Investing, Planning, Saving
Today life is a bit more complicated. Yet the path to financial freedom is as simple as it's always been. In fact, it comes down to just three steps:
- Save: Aim to save 20 percent. of gross income (or more).
- Invest: Embrace a low cost, tax smart, diversified portfolio of index funds.
- Grow: Stick to your investment plan, rebalancing periodically.
Simple doesn't mean easy. Golf is simple; it's not easy. Just ask Tiger. With this distinction in mind, let's look at each step on the way to financial freedom.
Step 1: Save
Arguably the most difficult step, saving any amount can be difficult. For some, the idea of saving 20 percent is insane. There are three things that can help.
First, start small. Even saving 5 percent of income is a good first step. As you receive raises (hopefully), increase the amount you save. Eventually, your savings rate will increase.
Second, question every expense. For some reason the American Dream now means owning more home than we can afford, a car based on whether we can make the monthly payment, and a cable package with 500 channels. The point here isn't that you should or should not have these things. Rather, the key is to question what's really important to you, not what fits into an American Dream stereotype.
Finally, automate your savings. Whether it's contributions to a company 401(k) or automatic deposits to an IRA, taxable investment account or savings account, automating the process increases the likelihood that you'll stick to a savings plan.
If you're wondering why a savings rate of 20 percent, we'll cover that at the end of the article.
Step 2: Invest
While investing for the first time can be intimidating, it's actually the easiest part of the process. Thanks to low-cost index funds, It's easy to create a well diversified tax efficient portfolio.
Using Vanguard and other index fund providers, one can build a diversified portfolio with as few as three mutual funds. Alternatively, one could follow the portfolio David Swensen recommends in his book "Unconventional Success." Swensen is the chief investment officer at Yale University, where he manages more than $20 billion in assets. His model portfolio and specific mutual funds to implement his portfolio can be found here.
Alternatively, you can consider using one of several automated investment services. These low-cost investment options make it easy to build a low-cost diversified portfolio. The services automatically rebalance your portfolio, and they also reinvest dividends.
Step 3: Grow
Growing your wealth largely involves repeating steps one and two above, but with a twist. It's critical to stick to the investment plan you establish in step two. This is where many people falter.
Think back to the stock market crash of 2008 and 2009. The banking system was convulsing, real estate was in a free fall, and unemployment was on the rise. Against this backdrop the market crashed. From October 2007 to March 2009, the Dow fell 50 percent.
Investors panicked. In October 2008, Bloomberg reported that both individuals and institutions were running scared:
Those who stuck to their investment plan, however, enjoyed remarkable returns. As of March 6, 2015, the Dow stood at 17,856.78 (after a 278 point single-day loss). Yet in March 2009 the Dow bottomed out at 6,594.44. Those who sold in fear back 2008 and 2009 lost out on significant gains.Not only are stock traders running scared, so are financial institutions. "You've got panics not only among individual investors but panic in the industry itself," says John Merrill, chief investment officer at Tanglewood Wealth Management.
The key is to stick to your investment plan by rebalancing your investments periodically.
Why 20 Percent?
Now to the big question. How much should we save? We can try to answer this with a rule of thumb. Most such rules suggest 10 percent to 20 percent of gross income. The problem is that it's difficult to put these numbers into meaningful context. Whatever rule of thumb one might choose, it's quickly followed by a very difficult question to answer -- why?
One way to answer that question is in the context of financial freedom. How long does it take to save enough money so that you can stop working? The answer depends on several factors, one of which is your savings rate. Save 20 percent of your gross income and you should be able to retire in 25 to 35 years, depending on your investment returns.
If you are wondering how these numbers are calculated, check out the free Financial Freedom Calculator.