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Over the past year, I have spent many hours reading about personal finance and investing. The biggest takeaway from this experience:
I have learned just how much I don’t know about money and how it works.
While some financial bloggers might be upset about this, I am excited! Learning new things and sharing that knowledge with others is one of my greatest passions. As an educator, I have carefully cultivated an ability to teach difficult concepts – first in a simplified manner, and then in greater depth.
In this post, I will aim to simplify the complex pursuit of financial independence.
The educator within me developed the following acrostic, which is intended to remind you of the SIMPLE nature of financial independence:
Start as soon as possible
Invest in funds with strong track records and low fees
Manage risk wisely
Practice stealth wealth
Leverage your strengths
Enjoy the process
Start as soon as possible
It is no secret that getting an early start on building your net worth is one of the most basic fundamentals of achieving financial freedom. I have used this illustration in the past, but it is so effective that it warrants repeating here:
Ben and John are both 20 years old. Ben begins investing $250 per month in index funds, and he continues until he is 30 years old, at which time he never invests another cent, allowing compound interest to grow his money until retirement at age 59 ½. John decides to lease a vehicles for $250 per month during this same 10 year window, and wisely snaps out of it when he reaches age 30, at which time he begins investing $250 and continues until age 60. For the sake of argument, let’s assume that both gentlemen invest in similarly-performing index funds, which average a 10% return each year. Surely John must catch up to Ben? Take a look below:
|Ben’s Investments||John’s Investments|
At age 59 and approaching retirement, Ben will have invested a total of $30,000 and hold a portfolio valued at $917,725.45. John will invest $90,000 over 30 years -three times what Ben invested-yet he will only hold a portfolio valued at $542,830.31! John never caught up due to the avalanche of compound interest that worked in Ben’s favor.
What secured Ben’s advantage and prevented John from catching up?
Invest in Funds with Strong Track Records and Low Fees
Recently, I was talking with Superhero Dad about his 401k. Fortunately, it is doing well, as he and I rebalanced his portfolio a few years ago in order to take advantage of mutual funds with more successful track records and lower fees. Simple awareness and diligence saved Superhero Dad money.
This, however, isn’t the norm. According to a 2010 AARP study, a staggering 70 percent of surveyed 401k participants were not even aware that they paid fees to maintain their accounts. More specifically,
When plan participants were asked whether they pay fees for their 401(k) plan, seven in ten (71%) reported that they did not pay any fees while less than a quarter (23%) said that they do pay fees. Less than one in ten (6%) stated that they did not know whether or not they pay any fees.
Why are 401k participants so unaware of fees paid? It turns out, according to Kipplinger, that it isn’t entirely their fault.
Mutual fund returns in 401(k) plans are normally reported as net returns, meaning that fees for managing your investments are subtracted from your gains or added to your losses before calculating the annual return. Other costs, such as administrative and record-keeping fees, are often divvied up among plan participants but are not explicitly listed on individual investment statements.
My recommendation: Do not invest in anything unless you fully understand every component of the individual investment, including the structure of fees. When evaluating your options, seek funds with a strong track record and low fees. Most people should consider investing within an automated portfolio service, such as Betterment, which minimizes fees, improves diversification, performs automated re-balancing, and provides greater returns.Open an IRA with Betterment today!
Manage Risk Wisely
Of all the recommendations contained in the above acrostic, this one is perhaps the most difficult to act upon. To manage investment risk requires many steps: an understanding of what risk truly is and is not, an understanding of personal risk tolerance, and methods to evaluate risk.
In practical terms, risk is a phenomenon that most humans naturally seek to avoid. It is the reason that I personally do not drive 20 miles per hour beyond the established speed limit in inclement weather or eat fried foods at every meal of my day. I associate risk with a consequence which is to be avoided at all costs.
When it comes to investing, however, a certain degree of risk is necessary. As Investopedia notes, investment risk is commonly defined as “deviation from an expected outcome.” In the broadest possible terms, an investor expects to profit from her investments; of course, the risk is that the opposite –loss– may happen.
Generally speaking, while personal risk tolerance varies from investor to investor, the Prospect Theory asserts that most investors experience greater pain with investment loss than euphoria associated with gains. In other words, losses are far more emotionally scarring than ego-boosting gains.
As a result, risk tolerance is often dependent upon an investor’s past experience. For example, a relative who shall remain nameless recently shared that she and her husband are keeping all of their non-pension assets in low-interest bearing CDs because they cannot bear the risk of loss associated with mutual funds and individual stocks. As she explained it, they had been burned in the past decade and wanted to avoid a repeat occurrence at all costs.
Among many methods to evaluate risk, one of the most commonly utilized methods is standard deviation. As described by Morningstar, “Standard deviation simply quantifies how much a series of numbers, such as fund returns, varies around its mean, or average.” Based upon this information, an investor can examine a particular fund and weigh the risks of an investment by observing the fund’s performance highs and lows over a set period of time. The more a fund’s returns change over time, the greater its standard deviation. At the same, an investor who is armed with standard deviation data is hardly guaranteed to make money, as even funds with low standard deviation can still lose money, theoretically speaking.
For most investors, understanding risk, evaluating personal risk tolerance, and ultimately seeking to minimize risk will be vital to achieving financial freedom.
Practice Stealth Wealth
While the past steps outlined within the above acrostic have been on the heavier-side, the recommendation to practice stealth wealth is less critical, even optional.
However, I recommend it for a variety of reasons. First, while many of your friends and family will be happy and desire to celebrate your financial successes, you will certainly have to deal with critics. Second, many people will seek you out for hand outs and contributions. Third, publicly-recognized wealth will make it difficult for you to evaluate the intentions of new friends who suddenly enter the picture.
For more on this topic, I advise you to check out Financial Samurai’s fantastic article on this subject, “The Rise of Stealth Wealth: Ways to Stay Invisible From Society If You Have Money.”
Leverage Your Strengths
While most people would prefer to reach financial independence early, few are willing to put in the effort and practice the self-discipline necessary to do so. An overlooked key to achieving financial independence is leveraging your strengths to maximize the likelihood of your success.
As a culture, Americans tend to strive to improve upon their weaknesses as a primary means of self-improvement. In graduate school, I read StrengthsFinder 2.0 and my paradigm was forever changed. Recent theory suggests that you should strive to improve upon your strengths rather than minimize your weaknesses because you are more likely to significantly build upon your strengths than you are your weaknesses. While marginal improvement in areas of weakness is possible and even beneficial, the overall impact of these improvements pales in comparison to building upon your strengths.
Related: Forget About Working On Your Weakness, Play to Your Strengths: Your (Overwhelming) Reaction To The Idea by Paul B. Brown
Enjoy the Process
Lastly, while the pursuit of financial independence is marked with challenges, do not forget to enjoy the process. Perhaps the greatest example of this principle which comes to mind is ultramarathon Dean Karnazes, who launched his running career on his 30th birthday. As a runner who has run a 50k ultramarathon and aspires to soon run a 50 mile ultramarathon, I idolize Karnazes and remain in awe of his accomplishments.
When reading Karnazes’s book Ultramarathon Man: Confessions of an All-Night Runner, one piece of advice given to the author by a friend stuck with me:
Life is not a journey to the grave with the intent to arrive safely in a pretty and well-preserved body, but rather to skin in broadside, thoroughly used up, totally worn out, and loudly proclaiming: Wow!! What a ride!
While I note the extremism of this quote, particularly in its application to athletic pursuits, I have found that the underlying enthusiasm of this philosophy makes it applicable to all pursuits, even those which are financial. Pursuing financial independence may leave us with our fair share of scrapes and leave us worn out, but we would be wise to enjoy the process every step of the way.
Readers, in your experience, what are the keys to achieving financial independence?