Friday, May 29, 2015

The Basics of Financial Independence

This list is actually in order starting with the most important item first:
  1. Set aside 6-12 months of expenses in a savings account as a rainy day fund.
  2. Pay off any debts you have. Start with the highest interest debts and work down until all is paid off.
  3. Maximize your savings rate. I recommend starting with spending less since there you have the most control but finding ways (side gigs, promotions, etc) to earn more is just as important. Another angle on this is getting the most out of your employer via pension/401K contributions, tuition reimbursements for education/training that will improve your earning potential, corporate discounts on existing bills (cellphone plans, childcare, etc).
  4. Invest in a low-cost (as low as humanly possible, aim for < 0.20%), tax-efficient (bonds in tax advantaged accounts such as IRAs/HSAs/401Ks), diversified (Total Bond, Total US, Total Int'l OR a Target Date fund to save all the stress), balanced (for your time horizon, 80-20 is a great starting point) index portfolio.
  5. Time...let it marinate. The sooner you get done with #1 (you can weather storms), #2 (you are debt free), #3 (you have grown your earnings AND/OR lowered your expenses so you are investing more), and #4 (your investments are growing with very little headwinds from fees and taxes) the quicker you can be financially independent.
And the above list is such that if you just get the first 1, or first 2, or first 3 done, you are better off for it. Don't look at it as a all or none to prevent you from starting. Best of luck.


Anonymous said...

So where does real estate fall in all this? Does it change the amount you keep in emergency funds?

Troy said...

Great question. "Real estate" can mean different things so I will do my best to answer the applicable meanings I can think of:

Real estate as your primary residence will affect your emergency savings (#1, rainy day fund) as part of your monthly expenses (mortgage, property taxes, HOA fees, etc).

Real estate as in real estate investing (#2, rental income and/or house flipping) can impact your savings rate by increasing your earnings. BE VERY CAREFUL as this can be very risky since it will require you tie up capital in illiquid investments. However, this method when done with with LARGE AMOUNTS OF DUE DILIGENCE has proven to be fruitful.

Real estate as in real estate investing (#4, REITs index) can offer some diversity (no more than 10% of equities) and a strong dividend stream in a tax-efficient low-cost broad-based portfolio. Please note that due to the way REIT dividends are taxed you will want to place them in tax-advantaged accounts such as a 401K or IRA.