Minimize the entrapment period: Financial management basics
So I’m 41 years old with a wife and three young children, and in six days I will no longer be going to work. At least not in the conventional sense. I’ll be free from the daily commute. I’ll be free from department meetings and weekly emails summarizing what the hell I’ve been doing over the past five days to justify the thousands of dollars that my employer will push into my bank account at the end of the month. The price that I’ll pay for this new-found freedom is to forego that salary. How did we get here?
First let me say this: we are not yet to the point of having reached complete financial independence. I will define “financial independence” as having accumulated 25x our annual spending/consumption in liquid assets. The 25x calculation is simply the inverse of the “4% rule,” which provides a somewhat scientific projection of how much of your savings you can withdraw each year and still have something left at the end of your retirement/freedom period (or at least at the end of 30 years, but more on that later). Others have discussed this concept in wonderful detail. But we have banked enough in cash to maintain (most of) our current lifestyle for at least two years while we pursue other passions and side-hustles. We’re not very far from reaching the 25x marker, and we could do it with some modest downward adjustments to annual spending. But the immediate objective is to move into this transition period unencumbered by a daily 9-6 obligation, and determine whether we can do other things that (a) we are passionate about, and (b) provide income. We’ll also be assessing during this period whether we want to simply further reduce our consumption and declare ourselves financially independent. That will probably depend somewhat on the success of item (b) above.
As we get going on this freedom journey, I thought it would be helpful to provide an overview of our financial philosophy. Here are the simple principles that we have employed over the last 16 years to get to this freedom launch-point:
1. Save as much of your paycheck as you can. I have never set a fixed percentage of income to save each month/year because I didn’t want to be limited by an arbitrary figure. I wanted to save AS MUCH AS POSSIBLE every single month. But it can be a powerful motivational tool to consider that for every year that you save 50% of your income, you buy yourself 1 year of freedom. And if you can save 66%, well, you bought yourself 2 years of freedom. My approach to saving as much as possible is to evaluate every purchase from a cost/benefit analysis, with the cost being evaluated from a future-value perspective. The first question is: Do I really need this? If “yes,” the second is: “Does the value I get now exceed the future value of the cash at 6% in 20 years?”
2. Immediately invest every dollar saved so it can grow. Waste no time in investing these saved dollars. Once invested, they are sacred. You do not touch them to consume. All dividends are reinvested. Other than purely strategic moves such as portfolio rebalancing trades, tax-loss harvesting, and zero-cost tax-gain harvesting, you do not touch the invested dollars. This includes a 3-6 month cash emergency fund (although that should be in a money market account earning something close to at least 1%).
3. Minimize investment costs. This is critical. Low-cost index funds and a solid portfolio allocation plan are all that you need to be a successful long-term investor. This approach is not only cheap and easy, but also good for you. Not many other things in life offer those two features simultaneously. Use a portfolio tracking tool to monitor portfolio allocation and costs. I strongly recommend Personal Capital.
4. Maximize tax efficiency. You must take advantage of all the tax-saving options that the government gives you. The tax code is terribly hostile to Working Joes that bring home a paycheck every month–especially large paychecks. Max out all tax-deferred account options, including a 401(k), IRA (even if non-deductible because of income levels), and the mac-daddy tax vehicle–the HSA. Then you need to look at Roth conversions and maybe even the mega-back-door Roth option. And if you have kids like we do, you should be funding 529 accounts for each from date of birth (unless you have reason to know that they won’t need large sums for college, maybe because they have a good in-state school and scholarship option).
5. Track your spending. Your financial data is valuable. If you are trying to modify your spending behavior, you have to know in great detail what your spending behavior actually is before you can do anything to change it. I’ve always been a big believer in Quicken, Intuit’s personal financial management software. I have tried to use online services like Mint and Personal Capital for this purpose, but they are simply not robust enough at the transactional level. You need a system that allows you to create a chart of spending categories that makes sense for you based on your spending patterns and the way you process spending decisions. Quicken is also necessary for tracking historical tax basis in investments (although this is becoming less necessary now that the brokerages must track your basis post circa-2011), and for things like tracking business income and expenses for tax reporting. I have recently converted from Quicken Deluxe 2013 (pc edition) to Quicken 2016 for the Mac, and so far I find it quite acceptable.
6. Avoid lifestyle creep. It’s an interesting phenomenon to see how as your income increases over time, your core spending tends to do the same. By “core spending” I mean the expenditures that you incur every single month, and that become a part of the core of your lifestyle. These are the kind of monthly recurring payments that affect your perception of how you live. As you layer on a lawn service, a cleaning service, the deluxe cable package, the gym membership, and even cross the Rubicon of ponying up tens of thousands of dollars for the privilege of joining a country club, you are subconsciously ratcheting up the level of income REQUIRED to support your lifestyle. Unless you are willing to go backwards and give up these core “life basics,” you are trapped in work and held hostage by the paycheck it offers.
7. Get buy-in from your spouse. This one can be tough. If your spouse already has a mindset consistent with seeking financial independence, consider yourself lucky and keep moving. But if frugality and financial independence are foreign languages to your partner, you’ve got some work to do. This was the case for me. Mrs. JF does not possess an innate sense of frugality. She came to the relationship with a view that “money is for spending.” So I have had to work hard–really hard–over the years to get her to meet me halfway (OK, I’ve asked for more than halfway). We’ve made great strides, but certainly would be further ahead in our trek if we had both had the FI mindset from day 1. But you have to at least reach some understanding of your mutual objectives or it will be a rough road.
8. Become impervious to the “Facebook” syndrome. I don’t do Facebook. To admit a personal failure, I have never had much urge to keep up with people. An ancillary benefit of this is that I don’t have the pressure of watching my peers hyper-consume in real-time. Do people actually use the button on Amazon.com to post their purchases to their peers? I guess so. And I know they post pictures of their lavish vacations. New research has shown that watching this consumption absolutely negatively impacts your ability to build wealth. Eliminate this obstacle to wealth-building if at all possible.
9. Seek out appreciating assets and avoid depreciating assets. When confronted with the prospect of buying a DEPRECIATING asset–think a new car–it should make you retch. You know with absolute certainty at the moment of purchase that the money you are putting into the asset is going to shrink over time, no questions asked. When you compare this result to the result you would get if you put the same amount of money into an APPRECIATING asset–think stock index fund–it should become utterly painful to put your money in the depreciating asset.
10. Fully internalize the truism that wealth really is built $10 at a time. Most people are not forward-thinking enough to evaluate every $5-$10 purchase as negatively impacting their future wealth. But the reality is that it all adds up over time in a significant way. And frequent small-dollar impulse buying conditions your consumption-psyche in a negative way. It’s a slippery slope, and every $10 impulse buy further justifies the next and the next. People will tell you that their daily Starbucks indulgence “makes them happy,” and that $3/day and $21/week can’t affect their financial situation. Don’t believe them. It can.