Financial Independence, Financial Freedom? (Part 3 of 3)
Equity, building your engine for financial growth
As we look to round out this series, we've been discussing practical steps at a high level that can be taken by anyone looking to control more of, or even just adjust, their personal finances:
Part 1: The importance of setting and revisiting financial goals
Part 2: Knowing your current financial status in terms of cash flow
When we covered our financial status, it was kept simple to the point of being perhaps too one-dimensional. This was intentional as to not dilute the essence of what was being discussed—working towards and keeping a positive cash flow. This can be a game-changer for many.
In the world of finance, personal or otherwise, it is very easy to get carried away.
Even the most experienced investors succumb to this. While history doesn’t necessarily repeat itself, it definitely tends to rhyme, reminding us time and time again that we’re not infallible to our own biases when we get ahead of ourselves.
In Part 3 below, we start to show how just keeping things simple with our finances can help us better manage your assets and debts, allowing your equity to grow over time.
And while these are technically more complex ways to improve your situation, they still largely constitute the "basics" in the world of finance.
I try to follow two rules:
If I don’t truly understand a financial opportunity, product, or service, in the sense that I'm not confident that I’d be able to explain it to my friends and family in a way that they’d understand and even potentially be supportive of it, then I steer clear of it in terms of my main investment activities.
If the first rule applies, but there’s some kind of emotional bias (e.g., gut-feel, curiosity, etc.), I try to make a more concerted effort to try and understand it. And even if I continue to struggle, I may potentially dabble in it hypothetically (e.g., paper trading) or even invest a small amount to learn the hard way (fully aware and very worried that I may lose that amount).
It goes without saying that, outside of exercising financial common sense and getting advice from licensed professionals, I wouldn’t recommend my rules to anyone without first having sufficient experience in investing and managing their own finances.
So what do we mean by the “basics?”
Focusing on “basic” financial health (Equity)
To keep things as simple as possible when looking at our financial health, or equity, we can think of it as a combination of our financial status and our financial potential.
Equity (financial health) = Assets (investments, money owed to you, money on hand) - Liabilities (taxes, money you owe)
Having a good financial status, or cash flow, will keep our heads above water and provide the ability to fuel our financial potential—the investments we make and the loans we take to drive growth.
It is important at the outset to determine whether your cash flow is positive, effectively making it an asset, or negative, making it a liability.
For most of us, it’ll be very difficult to make any meaningful progress on our equity if our cash flow is a liability. It is therefore essential to focus our efforts there first (covered in Part 2).
The “basics” on liabilities
For anyone starting out or looking to improve their financial health, the fundamental guideline with respect to liabilities is quite simple: generally speaking, avoid taking on liabilities whenever possible.
And if you have any liabilities, you may want to focus on minimizing them or paying them off in a legal and ethical manner as soon as possible.
Obviously, liabilities like taxes are unavoidable. But you may still want to talk to a licensed professional to make sure you're filing and paying your taxes properly and to see if there are any appropriate ways to reduce your tax liabilities.
The big ticket item, however, in liabilities is the money that you owe, otherwise known as debt. A few paragraphs trying to explain debt simply won’t do it justice. I highly encourage anyone considering taking on debt to do as much research as possible before doing so.
While debt can technically be anything you owe to someone, it usually involves money that you borrow.
It will include both the amount borrowed (the "principal") and the amount of interest (the "premium" or "price" of taking on the debt). Repayment is typically done in fixed amounts over a set period of time, also known as “amortization.”
The amount of interest, determined by the interest rates that drive credit in financial markets, is inextricably linked to the concept of debt.
Whether you're the borrower or the lender, as a general rule, a higher interest rate means that you're taking on more risk (which could mean a higher return), while a lower interest rate means that you're taking on less risk (which means a lower return).
A guideline to keep in mind regarding debt: don’t take on debt unless it directly contributes to a measurable and tangible economic gain.
There are exceptions to this, as an example, one of them could be a personal or family emergency for which you have no other option but to borrow money.
Common types of debt
One of the most common types of debt are loans, such as a loan to buy a car or start a business. Getting a loan for a house, also known as a mortgage, is a little different because of how it is collateralized, or secured, relative to other types of loans.
Taking on a loan can make sense when starting a business. It’s a riskier venture that comes with a potentially outsized economic and financial reward. This often requires more upfront capital (i.e., money) than you may have on hand.
A car, on the other hand, is seen as a depreciating asset, making it a less than ideal candidate for a loan based on our guidelines above. But if you think about it, for many people, we rely on transportation to secure income (i.e., to get to work), a direct economic gain.
A house, an apartment, or any kind of real estate is the most invested asset class in the world. Even though real estate is expensive and usually requires a mortgage, it is thought to be a safe investment with long-term growth prospects because people need places to live and for businesses to operate. This is why it is so popular as an investment asset.
For most people in good financial standing, the aforementioned examples are popular loans to take on that can boost your financial health down the line, as long as they’re properly managed.
Whenever considering a loan, you’ll want to shop and negotiate for favorable terms that provide you with as much leverage as possible (e.g., a low fixed interest rate).
Having a good credit track record and being able to pay more upfront, that is, a larger down payment for your loan, can help in getting you more favorable terms. This will mean a lower amount of interest you'll have to pay and could even shorten the length of the loan term.
Credit cards
Another common form of debt is credit card debt. Credit cards are often used for everyday expenses, but in effect, they're a short-term loan.
Credit cards can be considered a “double-edged basic.” When used properly, they can really help, but they can also be detrimental if you’re not careful.
Let’s briefly go over some of the benefits and risks.
In some parts of the world, they've become a must-have and can be an effective way to build your credit history. Especially in the United States, using a credit card responsibly can help open doors down the line, like taking out a more favorable loan if you have a good credit score.
The use of credit also provides a layer of security that you cannot get with cash or a debit card if you happen to be a victim of a scam or fraud.
One of my former clients used to run their whole life on credit cards so they could get the most interest out of their bank accounts back in the day when interest rates were higher. That is, all their expenses were done through credit cards, and all of it was paid in full manually when it was due at the end of the month.
This meant that the actual money owed could sit in their bank account for an extra month, accruing that little bit of extra interest down to the very last minute.
Now don’t get me wrong; I do this too, but I would never advise paying manually at the last minute. Far too risky; either set your payments to pay in full automatically or leave sufficient time when paying manually.
Always pay your credit card bill in full and on time. If it’s within your means, never pay the minimum amount, and never miss a payment. In addition to this, certain markets like the United States, keeping your credit card utilization low can also go a long way in improving your credit score.
Credit cards, as debt instruments, typically have high loan interest rates associated with them. When you don’t repay in full on time, you’re subject to the loan interest and are immediately worse off.
Unfortunately, a lot of people stay in the loop of making minimum payments, allowing the interest rate to continue to accrue on new expenses. Given that these high interest rates can be easy to avoid, this is one of the worst cycles to be in.
If you have debt, and credit card debt is one of them, that is usually the debt you should prioritize paying off as soon as possible.
If you’re new to credit cards or considering how to use them better, my advice is to keep it simple.
You’ll be inundated with all kinds of amazing credit card products out there. Don’t be swayed by any of them. If the deal seems too good to be true, that’s because it kind of is.
Don't get me wrong; there are plenty of "deal hunters" out there who reap many of these benefits, like loyalty programs, but there’s usually a fair amount of effort you'll need to put in to get there. It’s not always realistic or practical for most people.
Credit card perks should be treated as such. They’re nice to have and can be on your priority list, but not at the top.
What you may want to consider as top priorities are: reach (how widely accepted it is); security (what insurance coverage is provided on purchases and protection from fraud); reputation (whether it is backed by a reputable financial institution); and low fees (preferably no annual fees and low transaction and foreign exchange fees).
Only once you have more experience and familiarity with credit cards would I advise branching out, but always keep things within your means. Just like with discretionary spending, it is very easy to get carried away with credit cards.
The “basics” on assets
Assets can be just as complicated as liabilities, and there’s no shortage of ways that both can go hand-in-hand to supercharge your financial health.
Personally, I do wish I knew more, as I do believe more sophisticated approaches can help improve one’s overall financial situation. But even just getting your foot through the door can be so overwhelming for many that you never end up getting started.
You don’t need to be an expert trader or investor to take advantage of the benefits that come from investing. The “basics” alone can be more than enough to grow your equity over time.
Cash and savings
As mentioned at the beginning, a positive cash flow is very important. The liquidity keeps you afloat and can be used to start and grow your investments.
Depending on your situation, many financial experts believe that you should aim to have at least three to six months’ worth of income set aside in savings, with six to twelve months being ideal, especially if times are more uncertain.
I think what's usually missing are some qualifiers to this advice. When calculating the amount of income to be saved, it may be prudent to ensure that you’re using a monthly income amount that keeps your current cash flow positive.
The other qualifier that you don’t often hear is that you don’t have to wait until you reach your savings goal before you can begin growing your investments.
I would still suggest that you save up enough money for at least three months and manage any debts before you do anything else.
You should always continue to contribute to and maintain your savings, but once you hit your savings goal, that contribution amount can be lowered. The difference can then be used to accelerate any debt that you’re paying off or to grow your investments.
Finally, investments
One of the lowest-hanging fruits, before even talking about what to invest in, is to invest through “tax-advantaged” accounts, including retirement plans.
I highly encourage you to do further research on these types of accounts in your respective country (e.g., Roth IRA and 401k in the United States; ISA in the UK; superannuation in Australia; NISA and iDeCo in Japan; etc.).
While the catch here is that you don’t get to benefit from these accounts until retirement, or only within a fixed period, the benefit is that they’re tax-advantaged in some way (for example, not taxed when you contribute or not taxed when you withdraw).
In many countries, you’re usually required to contribute something towards your pension. These kinds of accounts can afford you more control over how that money is invested, and given the long time horizon, you will have a very good chance of generating retirement savings that will be superior to a typical pension plan.
Maximizing these kinds of accounts doesn’t make sense for everyone, however, especially if you’re not sure where you’ll be spending most of your time working and subsequently retiring.
It should also be noted that there’s a limit to what you can invest in with retirement accounts. They typically only allow investors to invest a certain amount per year and in less risky choices. I’d argue that this is a good thing overall, as you wouldn’t want to inadvertently speculate your retirement away.
For most people, the main way to invest is by opening a taxable brokerage account, wherever you happen to be a tax resident (i.e., working and paying taxes over a specified period).
A good brokerage account will allow you to invest in all kinds of assets, ranging from currencies (e.g., the US Dollar, Euro, etc.), commodities (e.g., oil, gold, etc.), and securities (e.g., stocks, bonds, mutual funds, exchange-traded funds, etc.).
Similar to tax-advantaged accounts, extensive research should go into picking your broker, as this is where you’ll be taking on financial risk with potential tax implications. Make sure that your broker has a reputable and reliable track record with fees that won’t blow you out of the water. This is in addition to double-checking that you’ll have access to the assets and markets that you want to invest in.
As for what to start investing in, my advice is to take your time with your research, get advice from reliable sources (ideally, licensed professionals), and keep it simple.
A general rule to follow is that over time you will want to have a diversified portfolio where your risk is spread across different asset types and potentially even geographic markets as well.
As disclosure, I don’t invest much in individual stocks. As per my posts on doing better research (here), I primarily invest in mutual funds and ETFs (Exchange-Traded Funds).
If your investment time horizon is longer term (five years or more), my recommendation is to begin your journey by researching credible mutual funds or ETFs that track top stock market indices like the S&P 500 or FTSE Global. These are generally known as index funds.
Major indices are inherently diversified, as they typically cover companies of different sizes across multiple industries and also different geographies if you’re looking for global diversification.
As these funds aim to track and match the performance of an index, they employ a “passive investing” approach requiring less involvement by the fund managers. This results in significantly lower fees (known as “expense ratios”), a key thing to look out for.
If your time horizon is shorter, you may want to look at index funds managing fixed-income securities (e.g., bonds).
While these assets generally offer lower returns over time, historically, they’ve been a lot more stable. This means you can expect to have a better chance of preserving your capital and recouping your investments should you need to exit your positions earlier than planned.
Vanguard, BlackRock, State Street, Fidelity, Charles Schwab, and Invesco are all well-known fund managers that offer products across the whole spectrum.
It may be a good idea to start with flagship products that are broader and more diversified with low expense ratios. These products tend to be highly liquid, meaning that they’re easier to trade and also less prone to day-to-day trading volatility.
As your experience and confidence grow, you can then adjust your risk appetite by looking at more specialized funds or ETFs, or even try your hand at individual stock picks.
The key insight when it comes to investing is getting started sooner rather than later.
It can be overwhelming to find the right individual stock pick as a new investor, so investing in index funds and bonds are a relatively low-risk way to get started. This will increase your chances of benefiting from compound growth over time as companies and industries grow and return value to shareholders.
Taking a loan to invest (margin lending)
I wanted to make a quick note on margin lending or margin trading, given the guideline on not taking on a loan unless it’ll directly contribute to a material economic gain.
Technically speaking, this would apply to here as well, and many experienced investors do take advantage of it.
However, I would advise most people, especially newer investors, to stay away from margin trading. It is very risky, given the unpredictability of markets and the complexity of financial products.
While the upside can be very appealing, most people seem to forget that the downside can basically wipe you out. More often than not, when looking to protect and grow your financial health, the risk is just not worth it.
To recap
This has been a very long series, so thank you for seeing this one through. I thought I’d try to quickly recap with a bit of “TL;DR” (Too Long; Didn’t Read).
Firstly, before we can even begin to think about financial security or freedom, it really comes down to being realistic and committed to your planning and goal-setting. This isn’t a “one and done” kind of exercise but rather a feedback loop that you revisit and adapt as life goes on.
Things probably won’t go as planned, but if you’re being honest with yourself, setting challenging yet realistic goals, and working on the little things to get there, you will see progress.
The hardest part can be a reality check on your finances. It can be a lot of work to figure out exactly where you stand, but it’s absolutely essential to setting yourself up for success. If you don’t have visibility over your income and expenses, don’t expect to get very far before you hit a bump in the road.
The sooner you’re able to set goals and be disciplined with your cash flow, the better your prospects will be in terms of growing your equity. And as your investments begin to benefit from compound growth, you will find that you will have more options available to you over time.
Don’t be swayed by complex financial (or even unregulated) products and promises of high returns. You can end up being way out of your depth, or worse, be misled and even defrauded.
More often than not, if you conduct sufficient research, you should find that relatively simple and time-tested investment methods will stand out from the rest. And there’s a reason for this—they do actually work.
But they don’t guarantee riches or wealth, nor do they offer a shortcut on how to get there. It takes time, patience, and care.
This is the real secret sauce to financial independence and freedom.
Let’s hope we can all get there. See you in the next one!
P.S. As disclosure, I have long positions in Vanguard, BlackRock and Invesco funds and ETFs. This article is for general information purposes only and expresses my own opinions. Always perform your own due diligence and research.