How to Become Financially Independent?

How to become financially independent? Are you saving and investing wisely to become financially free?

Retirement is one of the most important goals which is ignored by the majority. Retirement does not mean to stay home and do nothing. Some may never want to retire, however, anyone would want to become financially independent. Financial freedom means that you have the freedom to do what you love and live the life that you enjoy. Aya Laraya, widely known as an investment advocate said, “When you invest, you are buying a day that you don’t have to work.” When you save early and invest wisely, you grow rich over sleep. You will not work for money, but make money work for you. 

American financial security statistics

In a 2018 financial security special report by the Stanford Center on Longevity, it was indicated that the majority of Americans are not financially ready to fully retire at age 65.

In a 2020 retirement study by the Transamerica Center, 36% of Millenials, 33% of Generation X and 25% of Baby Boomers are afraid of not being able to meet their family’s basic financial needs when they retire.

In order to achieve retirement goals, researchers at Boston College Center suggest that individuals who plan to retire at age 65, need to contribute 10% -17% to their saving plans if they start savings at age 25. That contribution increases 15% – 20% and 25% – 27% if they start saving at age 35 and 45 respectively. 

How to become financially independent?

Don’t wait to invest. The sooner you start to invest the better. Warren Buffet, one of the most successful investors in the world expressed, “ Never depend on a single income, invest to create a second source.” The majority of Americans rely on a single source of income. It is risky to have one source of income because you never know when that income source will stop. Therefore, you should develop your income from a variety of sources. 

Save early, wisely invest and become financially free. Grant Cardone, one of the best selling authors and a millionaire said “Save to invest, don’t save to save. The only reason to save is to invest.” You cannot save your way and become a millionaire, however you save and invest in order to allow your savings to grow. 

It takes time to become financially independent, however you don’t have to wait until 65 to retire. Save early and invest wisely. Allow enough time for the power of the compound growth rate or exponential growth rate to work for your financial freedom. 

Where to invest?

There are a number of ways to invest such as through real estate and the stock market, bonds, mutual funds, exchanges traded funds (ETFs) and commodities such as gold, silver and so on.  While real estate investment is not for everyone, some choose to invest in mutual funds and ETFs because it may take time to obtain information in order to invest in individual stocks or bonds. 

Your small savings can add up to a big amount of money. Have you ever kept track of how much you spend on cups of coffee every week or every month? and how much will it grow if you save $5 on a cup of coffee and invest in stocks? The $5 saving on a cup of coffee can bring you a lot of money if properly invested.

You can use the investment calculator to have an idea how much the $5 savings from a cup of coffee can grow with the compound interest return of investment. Assuming that the S&P 500 average return of 10%, with 3% variance range for inflation and $0 initial investment, lets say you save $20 every month ($5 per week), and you start to save and invest when you are 18 until you reach 65. Your $20 savings and investment every month in 47 years ( from age 18 to age 65) becomes $209,274. However, the total return can reach a half of a million if the return rate is 13% compared to $74,000 if the rate return is 7%. 

How do stocks and bonds work?

Companies give investors opportunities to invest either in bonds or stocks. Bonds can be corporate bonds issued by companies, municipal bonds issued by states, cities and other local entities and treasury bonds or T-bonds issued by the U.S government. When you buy bonds, the bond issuer promises to return your money plus interest. 

For instance, an ABC company issues stocks and bonds. After doing research, you decide to buy a $10,000 ABC bond with a 7% interest rate. So, you will collect 7% interest once or twice per year depending on the ABC bond regulations, plus the principal on the bonds when the bonds reach the maturity date. You can also sell the bonds at a higher price when their market value increases. However, if ABC goes bankrupt, you may lose your money on ABC bonds.  In this case, any money left will be paid to bondholders before stockholders. 

On the other hand, if you decide to buy ABC stocks instead of its bonds, you may make more money than from investing in its bonds. When ABC has great potential growth and is profitable, its stocks can go significantly high. Your stock investment can increase in value. Also, you may collect dividends if the company pays dividends to stock investors. However, if ABC business does not perform well, you may lose a portion of your money or the entire investment. 

How do mutual funds and ETFs work?

Mutual funds and ETFs run by professionals, are pools of different stocks, bonds and other securities and assets. You can trade ETFs like stocks. However, mutual funds can only be traded at the end of the trading day after the fund managers make a decision about how to allocate the investment fund and do a calculation for the share price which investors have to pay when they purchase mutual fund shares. Therefore, when you buy a share of a mutual fund during the day, you may not know the share price until the fund manager allocates the fund and has the share price calculated. Due to its management practices, mutual funds typically have higher fees and expense ratios than ETFs. 

You can access information and analysis of over 18,000 mutual funds, exchange traded funds (ETFs) and exchange traded notes (ETNs) by using Fund Analyzer tool by FINRA. The tool can show an estimate of the value as well as the impact of fees and expenses on your investments.

Which one is better?

Real estate investment is not for everyone, but anyone can easily own a piece of a great business through  stocks. Research has shown that the top 10% of the wealthiest Americans invest in the stock market. After all, investing in the stock market remains one of the best ways to build a fortune. 

According to the Wharton School finance professor Jeremy Seigel’s research, a $1 dollar bill in 1802 was valued at $0.047 in 2011 however, a $1 stock in 1802 was valued at $1,601,684 in the same period. So, if you keep your savings in your back pocket and do not invest, your money will be depreciated significantly. Otherwise, if you save and wisely invest in the stock market, your savings can grow big multiple times. Seigel also expressed that bonds were negative many times, however, stocks were never negative over a 10 year period. 

How to invest?

“Don’t wait to get started. You can do it. It is easier than you think,” the U.S Security and Exchange Commission (SEC) instructed in the Saving and Investing guidelines. In order to achieve your financial goals, you need to make plans. You should have a budget on your income and your expenses. First, pay off debts with high interest rates, especially credit card debts, start to save and wisely invest to allow your savings to grow. 

All investments carry risks. So, you should invest wisely. According to SEC’s advice, if you invest with margins (use borrowed money to buy securities), options (contracts to buy or sell a stock for a specific price on a certain date) or conduct short sales (sale of stocks that you do not own), the risks of losing your money are significantly higher. 

How does a short sale work? 

A short sale involves sale of stocks that you do not own. As a short seller, you believe that the price of a specific stock will fall soon and you try to make a profit by selling borrowed stock at a high price and buying it back at a lower price when the price drops.

For instance, you are a short seller. GS stocks are valued $10 per share. But you believe that GS stocks will drop lower. So, you reach out to a B company that owns GS stocks and borrow shares of GS stocks at $10 per share and sell them in a short sale. A week later, GS stocks drop to $4 per share. Since GS stocks declined significantly, you buy GS stocks at $4 per share and replace the borrowed shares which were at $10 per share. So, you make a profit of $6 per share by doing the short sale. However, if GS stocks increase $25 per share, you can lose $15 per share. Therefore, short term trading in volatile markets carries significant risks of loss.

Long term horizon reduce volatile risks

While Warren Buffett believes in long term value investment, some choose to make a living by trading stocks on a daily basis. However, the majority of day traders lose money over the long term. The get rich quick mentality is the reason many short term investors are losing money from buying hot stocks with high volatility and trying to make a profit by short selling. This short sell trading can turn out to be a disaster. The short term get rich quick mindset combined with a lack of guidance, misinformation, and conflicting opinions keeps some away from the stock market and holds others back from making significant investments. 

Source: How time horizon affects risk and return by Getsmarteraboutmoney.ca

The chart shows the average annual return of stock becomes less volatile over a long time horizon. Stocks are exposed to higher risks over a short period. However, long term investing historically produces positive results.  

Stocks have historically proven to be good long term investments. The longer the time horizon of the stock investment, the less volatility you may experience over that holding period. Before investing in stocks, you should do research. Remember that you are investing in a business when you buy stock. Only invest in what you know, hold it for a long term and allow your investment to grow.  

What can affect shareholders’ investments?

There are many factors which can affect stock investments such as taxes for capital gains, commission and fees for investment professionals if any, inflation, etc. On the other hand, your knowledge and your emotions also can affect your investments. 

Source: Understanding Fees from Investor.gov

The chart shows how annual fee affects an investment with 4% annual return over 20 years. When the annual fees are 0.5% and 1%,  your portfolio is reduced by $10,000 (red line) and $30,000 (green line) respectively compared to the 0.25% annual fee (blue line). 

If you do not want commission and fees to eat up your investments, you simply do your own investments and control your own money. Open an IRA account and start to invest for your retirement. You can start with S&P 500 index which has consistently returned 10% ( 6%-7% after inflation) year over year over the last 50 years. Or you can subscribe to some reputable stock picking services such as Motley fool. It is better to invest when you can find good opportunities or when stocks are discounted. 

Questions and Answer – How to become financially independent

1. How to start to invest?

Make your own balance sheet on your income and expenses. Figure out how much you spend and can save monthly. Save early and start investing wisely. If your employer sponsors a retirement plan such as 401k, you should take advantage of the employer’s matching contribution and tax deduction by contributing to your 401k retirement and let your retirement fund grow. Plus, you can also have an IRA account which may give you tax benefits. Then, you can also open normal brokerage accounts ( not 401k or IRAs) with companies such as Robinhood, Webull, Fidelity and Charles Schwab that do not charge fees for trading. 

If you are new to the stock market, you can start with the S&P 500 index which has consistently returned 10% ( 6%-7% after inflation) year over year over the last 50 years. Or you can subscribe to some reputable stock picking services such as Motley fool. You can work with an investment advisor, however, you have to pay commissions or fees for services. Do research before you invest. 

2. When should you start to invest?

Don’t wait to invest. The sooner you start, the better your return will be. It takes time to become financially independent, however you don’t have to wait until 65 to retire. Save early and invest wisely. Allow enough time for the power of the compound growth rate or exponential growth rate to work for your financial freedom. 

3. When is it good to invest in stocks?

It is better to invest when you can find good opportunities or when stocks are discounted.  Around the year end, stock traders may want to take sell and write off their losses to reduce their taxes. Or some may want to sell to rebalance their portfolio. Therefore, stock prices seem to decline in November and December. However, no one can know exactly when stocks will be up or down. Stocks decline during stock corrections or market downturns.   

Buy on the rumor, sell on the news is a paradigm that many stock traders use.  Sometimes, you will notice stocks climbing to record highs and then declining sharply. If you dig deeper, you will find that there was a rumor circulating about the stock which resulted in the stock price going up. When the company makes the news official, the stock drops – even if the news confirmed the rumor. Many traders take advantage of this market dynamic, and sell the stock to take a profit before the news becomes official.

If you invest in long term stock investments, you should do research, research and research. Be extremely cautious of bubble stocks, momentum or rumor stocks. 

4. How to diversify your portfolio?

Warren Buffett said that you don’t have to have more than 20 stocks in your portfolio. You should diversify your portfolio, spread your money amongst different investments to reduce risks. Depending on your financial goal, you should decide which stocks you should select for your portfolio. However, you should make a plan and keep track of your investment goal. For instance, you should categorize your portfolio into categories such as low risk stable long-term stocks and higher risk aggressive growth stocks. Then, you should pay more attention to the higher risk investment because you may need to take action to sell or buy more based on market conditions, company updates and industry changes. You may need to rebalance your portfolio when it is necessary. 

5. How often should you rebalance your portfolio?

The ideal rule to rebalance your portfolio is when a certain asset is over 5% of your portfolio. However, not all investors follow that rule strictly. You can rebalance by selling and buying investments or reallocate assets in your portfolio. 

6. How often should you look over your portfolio?

When you invest in long term stocks, you don’t have to look over your portfolio every day. But, you should not leave your portfolio for over a year and never look at it. Depending on the investment goal which you want to achieve, you can select stocks at the appropriate risk level for your investments. Stocks with higher risk definitely should get more attention than stocks with lower risks. It also depends on how often you rebalance your portfolio. Mutual funds and ETFs can be checked every 6 months or a year. Individual stocks need more attention. 

7. Should you invest in the latest hot stocks?

You follow social media or discussion forums where people talk about some latest hot stocks. Should you invest? You should be extremely cautious about these investments. Due to some reasons such as rumors and hot market trends, many buyers are so optimistic or confident about specific stocks. A high buying volume can push stocks to rapidly rise. This rapid rise is often followed by a panic drop. So, you should be careful, do research before investing in order to avoid loss.  

For instance, “pump and dump”  are cases in which a fraudster spreads false information about a company’s stocks and misleads others in order to cause many people to buy which in turn makes the stock price to rapidly rise. Then, the fraudster sells the stocks at a high price. On the other hand, fraudsters also spread negative rumor information about a company causing many people to sell and as a result, the stock price sharply drops. Then, the fraudster takes advantage of the artificial low price and buys those stocks.  

8. Do you need an investment advisor?

If you do not feel comfortable making your own investment, you may want to work with investment advisors. Before you select an investment advisor, you should do some research to understand what services you need. Importantly, you should check out the firms if they are registered, reliable, have a good performance record, and what commissions and fees you have to pay. Check their website, brochure for investment plans, and ask many questions to make sure that you choose the right service.