Investment Strategy

The four steps to financial freedom

Poverty is not a pretty thing. I’ve known at least four middle class families destroyed by bankruptcy. I’ve known many more who lived beyond their means for decades and retired into poverty. There’s no reason why you should fall into the same traps. Today we look at how to ensure you achieve financial security, and the freedom that it brings.

When I was growing up in the 1970s and 1980s my parents had friends who seemed to live a lot better than us, at least in material terms.

They had well paid professional jobs with regular hours, whereas my Dad had a small agricultural business and worked from dawn ‘til dusk, seven days a week. They had exotic foreign holidays on sun drenched beaches, whereas we rented a cottage in a damp part of Britain and were marched up rain sodden hills.

They had newer and bigger cars, and new kitchens, whereas we often bought second hand vehicles and had a dirty old coal-fired stove, and the coal was stored on the other side of a rainy garden. Their kids had a lot more toys than me (although, to be honest, I was pretty happy sitting up a tree or making swords out of sticks).

But I know that quite a few of those same people – who lived large in middle age – ended up with hardly a bean to their name in retirement. They lived beyond their means for decades and spend their last one or two in poverty. I don’t know about you, but that’s something I’ll do my best to avoid.

When outgoings exceed income, capital is drained and debts are racked up over time. It’s obvious enough, but I’ve seen plenty of people fall into the trap.

The end result is bankruptcy, and all the unpleasant implications of that. It happens slowly at first, with pressure building up over decades.

The end result is bankruptcy, and all the unpleasant implications of that. It happens slowly at first, with pressure building up over decades. Then it happens very quickly as loan interest spirals out of control and everything implodes. Misery ensues as families and friendships are torn apart.

The victims become wards of the state, relying on government welfare just to eke out an existence. Freedom is a thing of the past.

If you consider yourself middle class then this outcome is totally avoidable. Even people with relatively low incomes could avoid it, although they have a higher mountain to climb.

Getting on top of your finances may not be sexy. In fact it may seem downright boring for a lot of people.

Many people make excuses, such as “I’m not good with numbers”. But absolutely anyone can do it if they want to. We’re adults. We need to act like them. It’s really not that hard, it’s just about applying yourself to a problem. And let’s face it, it’s a big problem but one worth solving.

Over time, as your financial security builds, you’ll find you feel more relaxed. You’re not worried about the next mortgage payment. You can quit your job if you don’t like the new boss. You can start a new life in a new region or country.

In short, you have what my friend Bill Bonner has called “F. U.” money. You have a serious amount of extra freedom to set your own destiny, instead of having it dictated to you by others.

There are four simple steps to financial freedom which I’ll explain in turn:

  1. Understand your finances
  2. Cut waste from your outgoings
  3. Make saving your top priority
  4. Invest to build your assets

Step 1: Understand your finances

You don’t need a financial training to understand your finances. You just need to be able to read (you got this far!), and be able to add and subtract numbers. Pick a quiet day, take a deep breath, and take the plunge. Once you get started, and jump the first hurdle, it’ll get easier over time.

Understanding your finances starts with working out what you have to your name today. This is simply done by making a list of all that you own (assets), and a separate list of all that you owe (liabilities). Add up each list and subtract the total liabilities from the total assets and that’s your financial position – your “net worth”, in monetary terms at least.

The easiest way to do this is on a spreadsheet. If you don’t know how to use those then just do it on paper. There are probably tools on the internet as well.

List all the assets on the left and estimate their values if you don’t know them exactly. Be conservative and realistic. House, bank accounts, pension fund, brokerage account, other real estate, cars, art, gold and silver coins, rare collectibles – everything.

Then list all your debts on the right. Mortgage, car loan, credit card debt, student debt, credit agreements for technology gadgets or furniture (what’s left to pay) – everything that has to be paid off in future.

Once you’ve done this you’ll have a pretty clear picture of where things currently stand. Congratulations: you’ve just drawn up a personal “balance sheet” even though you’re probably not an accountant. Your very own statement of financial condition.

Now you need to know how your financial condition is likely to develop. To do this you make a list of all sources of income and all outgoing expenses.

Start with net income from your job or business, after tax. Add any other substantial and reliable income sources, such as net rental income from property.

Then list all your outgoings each year. Rent or mortgage payments, property tax, service charge, property maintenance costs, utility bills, car insurance, car maintenance, fuel, food, eating out, taxis, trains, flights, hotels, club memberships, health insurance, help in the house or garden, fees for education….everything.

Some payments are monthly, some quarterly, some annually. Divide or multiply them so you work out two columns, one listing the annual totals and the other listing the monthly equivalents.

Add them up. Add another 10% to the total for the things you’ve missed – trust me, you’ll miss something, especially the first time – and for contingencies – those unexpected big bills that come around from time to time.

Subtract the total outgoings from the total net income. If the result is positive you are saving money. If the result is negative you’re spending more than you’re making. Simple. You’ve now created a personal “profit and loss” account (P&L).

Once you’ve done these two things – preparing a balance sheet and a P&L – you’re set for the next step.

Step 2: Cut waste from your outgoings

Chances are, if this is the first time you’ve tried summarising your finances, or if you haven’t done it for a long time, you’ll be shocked by the size of some of the expense items. I know I was the first time I did this properly.

This next point is extremely important. Cutting your outgoings doesn’t mean living badly, unless you are extremely poor.

Instead it’s about cutting out waste. In my case, when I first did this about 15 years ago, I realised I was wasting a huge amount of money on insurance cover I didn’t need. It was an easy win to get rid of it and save thousands of dollars every year.

Well, the form filling was dull. But it was more than made up for by the satisfaction of knowing I wasn’t unnecessarily lining the pockets of faceless insurance conglomerates. There were plenty of other easy wins as well.

Of course each person’s situation will differ.  But overall you won’t make a big dent in your costs by trimming a bit here and a bit there, or by collecting discount coupons. I’ve learnt this in business. You need to make structural changes if you want to make serious savings.

Get rid of unnecessary insurance cover…cancel or don’t renew the club membership that you hardly ever use…fly in economy instead of premium…stay at cheaper hotels when on holiday…change your car less often by keeping it for longer…sell the two seat sports car that’s rusting in the driveway…(see here for more on cars)…downgrade your premium bank account and avoid the pointless account fees (hundreds of dollars a year)…perhaps get rid of your fixed line phone (you have a cell phone already)…

Et cetera, et cetera, et cetera….you’re bound to find something substantial that you can do without, and probably many things. Companies exist to sell you goods and services. Many turn out to be pointless after the initial buzz.

But for the stuff you can’t get rid of you need to make sure you aren’t getting ripped off. When was the last time you shopped around for a mortgage, or insurance on your health, home and car?

Every year I do a little dance with my parents’ health insurance company. They send the annual renewal letter and typically want 20-30% more money than the year before. Dad used to deal with it, but can’t any longer, so my mother gives me a worried call.

I phone the insurance company and politely but firmly explain that there’s no way way my parents are going to pay that much. The operative explains that health costs are going up much faster than everything else. I grunt understanding and tell them to look for a better deal.

Typically, once all’s said and done, my parents end up paying less than the year before. In fact I don’t think the premium has gone up for years, even though they are ageing. That’s 30-60 minutes well spent. Dull but worth it.

…everyone could save hundreds of dollars a year – and in some cases many thousands – without a noticeable difference to their quality of life.

Bottom line: everyone could save hundreds of dollars a year – and in some cases many thousands – without a noticeable difference to their quality of life. Certainly without any real hardship.

Step 3: Make saving your top priority

This one is easy, conceptually at least. Saving should be your TOP priority, not an afterthought.

Work out what’s coming in each month. Save at least 10% of it. Ideally save more, especially if you’ve started later in life and don’t have substantial net assets. “Saving” includes paying off all debts as fast as possible, and cutting out the interest costs.

A reader, George T. from the USA, suggested saving 10-20%, or “until it hurts”. He could be right, but for most people it doesn’t have to hurt. Just cut the pointless waste.

What’s left is what you can spend. If it’s not enough for your current lifestyle, having already cut out unnecessary waste, there’s no real alternative: you gotta change your lifestyle.

Downsize the house, the car, the holiday – whatever suits you best. Just don’t let your current lifestyle destroy your future life. Don’t be a slave to your assets, your outgoings, or your social standing in the local community.

One of the easiest ways to deal with that last one, if it’s an issue, is simply to move somewhere else. Start anew, without the social and emotional baggage.

Actually, having less stuff is liberating. You unclutter both your physical and mental world. Less stuff means less admin and less maintenance.

Actually, having less stuff is liberating. You unclutter both your physical and mental world. Less stuff means less admin and less maintenance.

Trust me, I know. I’ve been through this process. I still live extremely well. I have all I need and great friends. But I don’t live excessively well. I feel richer for it.

If you follow those first three steps you’re already a long way towards financial freedom. You know where you stand financially, you’ve cut out waste, and you’ve made saving your top priority.

Have you already tried any of these steps? Where did you make the biggest savings? Do you find it so daunting you don’t know where to start? Let me know how you’re getting on.

Next time I’ll look at what to do with those savings, and how you can use them to achieve financial security and freedom. You can do it!

Stay tuned OfWealthers,

Rob Marstrand

Financial Freedom: It’s really not that hard, it’s just about applying yourself to a problem. via @ofwealth Click to Tweet
Previous ArticleNext Article
Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.