Vanessa and I recently published a detailed account of our minimalist lifestyle, explaining how and why we lived on less than $1,000 per month in our first year of marriage. In the discussion section at the end, I explain how our lifestyle decisions have allowed us to save more than 80% of our income each year in an effort to achieve financial freedom.
Minimalism is powerful as a stand-alone lifestyle concept, but it’s far more interesting within the context of financial freedom when accompanied by a discussion about saving and investing. By minimizing our expenses, increasing our income, and investing wisely, we accumulated a net worth of approximately $1 Million in less than five years.
This article will use our personal financial situation to explain how financial wealth can be used to purchase an unending supply of lifestyle freedom. The discussion at the end will explain why we believe that financial freedom is one of the most important and meaningful topics of our generation.
Table of Contents
- What is Financial Freedom?
- Freedom Begins with Healthy Savings
- How Much is Enough?
- Invest Your Savings Wisely
- The Cash Cow Couple Example
- What’s the Point?
What is Financial Freedom?
If you are unfamiliar with the term financial freedom, I would recommend that you begin by reading my recent article – What is financial freedom?
Without repeating every word of that article, the concept of financial freedom is fairly easy to understand. Individuals begin their adult life by obtaining a skillset and finding employment. In other words, most of us trade our time for money. Instead of spending all of that hard-earned money, you can choose to minimize your expenses and spend less than you earn, creating a pool of savings. If you invest those savings responsibly, you can realize a return on your investment, compounding the growth of your savings.
Eventually, your investment portfolio will produce enough income each year to support your living expenses, at which point you will no longer require a regular paycheck and can choose to spend your time however you would like. That is called financial freedom, or financial independence, or retirement.
Don’t miss that last paragraph. Spending your time however you would like is the point of financial freedom.
I’ve read dozens of articles on the topic that completely miss the point. In some of these articles, the author gets bent out of shape about the premise – “No one can save 80% of their income in America today!”
Other times, the author is overly concerned with the outcome – “Financial freedom is nothing more than slang for retirement! Only fools would choose to skimp and save 80% of their income, only to retire at age 40 and sit at home alone!”
Clearly, these authors don’t understand the concept. Financial freedom is not about how you choose to spend your time, it’s about having the freedom to choose.
This is an extremely important distinction because the concept of financial freedom speaks to the intimate relationship between time and money. Vanessa and I wholeheartedly believe that time is our most valuable and limited resource in this life. Therefore, we use our financial resources to purchase more free time.
What you choose to do with your freedom is entirely up to you. Would you like to work fewer hours and spend more time with your children? Would you like to change careers or start your own passion business? Would you like to take a break from society and travel the world? All of these things (and many more) are possible when you embrace the concept of financial freedom.
Freedom Begins with Healthy Savings
The financial component of financial freedom can be broken down into two tasks – saving and investing. Saving is the process of spending less money than you earn, creating a pool of financial resources. Investing is the process of using those resources to obtain additional profits, which will compound the growth of your savings. By definition, there can be no investing without saving.
The most intuitive definition of saving is what is called your “saving rate.” The government itself regularly measures and publishes the average saving rate in America. Sadly, the most recent estimates show an average savings of approximately 3-4% annually.
There are a variety of ways to calculate your saving rate, but the easiest way is to divide household savings by after-tax income over a specific period of time (usually one year).
To find your total annual savings, you need to first understand your expenses. When you know how much money you spend, you can subtract your household expenses from your after-tax income to arrive at your total annual savings. Then you can divide the total savings by after-tax income to arrive at your annual saving rate.
You don’t have to calculate all of these numbers manually. You can track your income, expenses, saving rate, and net worth using a free Personal Capital account (see my detailed review). We have used Personal Capital for almost five years and continue to be impressed by the platform and functionality.
You can increase your saving rate by reducing your expenses and/or increasing your income. As you will see in our example, doing both at the same time will supercharge your savings. I’m working on a guide that will help you earn more income and plan on sharing that with our email community upon completion. If you are trying to reduce monthly expenses, I would recommend that you read our minimalist living guide to find ideas and inspiration.
Your Saving Rate and Financial Freedom
Your saving rate is an important benchmark that can be used to evaluate your financial progress over time. Specifically, within the context financial freedom, your saving rate is an important calculation for two reasons:
1) As you spend less, you save more.
Holding income constant, a reduction in expenses will result in a higher saving rate. As your saving rate increases, so too will the value of your investment portfolio. As your investment portfolio grows, it will produce more income, which will allow you to find freedom much sooner.
2) As you spend less, you require less.
In the final stage of financial freedom, your investment portfolio produces enough income to cover all living expenses. If you can reduce your living expenses, you will require a smaller investment portfolio to support your lifestyle.
A Visual Explanation
A free financial calculator called Networthify can help illustrate the relationship between savings and financial freedom. This program allows you to input your financial information to calculate your expected retirement age. Here, retirement is defined as the point when your investment income exceeds all expenses, making the term synonymous with financial freedom.
Networthify requires that we input the following information:
- Annual (after-tax) income
- Current saving rate
- Current portfolio value
If you click the little icon that says (+ show more options) you can specify your expected annual return on investment (ROI) and expected withdrawal rate (). In practical terms, Networthify does basic Excel calculations using these inputs. It’s nothing revolutionary, but I like the program because the interface is easy to use and understand.
Intuitively, the relationship between these inputs is straightforward. An increase in total income, saving rate, or ROI will reduce the amount of time required to reach financial freedom. The expected portfolio withdrawal rate is trickier, as discussed in the “safe withdrawal rate” section later.
Using Networthify, I’ve created several different scenarios to highlight these relationships. If you click each scenario title below, you will be taken to Networthify and all the assumptions will be pre-populated so that you can follow along.
Networthify Scenario #1 – Typical American Household
- $100,000 after-tax income
- 4% savings rate ($4,000 per year)
- $0 beginning portfolio balance (building wealth from scratch)
- 5% real annual return on investment (net of fees, taxes, and inflation)
Using these assumptions, it will take roughly 70 years to reach financial freedom. Remember, here we are defining financial freedom as the point in time when investment income exceeds expenses.
If you scroll down on the Networthify website, you will see a section that resembles an Excel document. Here you can see that around year 70, this household accumulates roughly $2.5 Million in wealth (assuming a 5% real return on investment, every year). Using a 4% annual withdrawal rate ($2.5 Million * 0.04 = $100,000), this household has finally reached financial freedom because their investment income ($100,000) can support their annual expenses ($96,000).
Networthify Scenario #2 – Unique American Household
All assumptions remain the same, except we now assume a 50% savings rate ($50,000 per year).
Changing the annual savings rate highlights the important relationship between expenses and financial freedom. At a 50% savings rate, this household can obtain financial freedom in less than 18 years. By reducing annual expenses from $96,000 to $50,000, this household shaved 50 years off their hypothetical freedom timeline.
If we apply these numbers to American society, a recent college graduate who maintains a 50% savings rate should be able to retire around the age of 40.
Networthify Scenario #3 – Extreme American Household
All assumptions remain the same, except we now assume an 80% savings rate (saving $80,000 per year).
At an 80% savings rate, it takes a little bit longer than 5 years to reach financial freedom. This is the perfect illustration of the points mentioned earlier in this article. Specifically, a higher savings rate implies that this household is simultaneously spending less money ($20,000 of expenses) and saving more money ($80,000 of savings). The reduction in expenses means that less supporting income will be required by the investment portfolio each year, while the increase in savings implies compounded portfolio growth.
What’s the Takeaway?
The point of Networthify is not to say, if you save 50% of your income, you can retire in exactly 16.61 years. Or, if you save 80%, you can retire in 5.6 years. That’s nonsense.
Networthify is just a tool that illustrates the exponential relationship between savings and financial freedom. Some of the underlying assumptions can be misleading when taken at face value; for example, assuming a constant 5% real return on investment each year is overly generous. Over the last 100 years, the stock market has delivered an average real return of approximately 6.5% annually, but few very investors maintain a 100% stock portfolio.
Use Networthify as a motivational tool to increase your saving rate and don’t get overly concerned with the assumptions. If the economy stagnates and your investment portfolio performs worse than expected, it might take a little longer to achieve financial freedom. That’s not a problem you should worry about because it’s outside of your control. But the relationship between savings and financial freedom is concrete and something that you can control directly.
How Much is Enough?
Recall that the end goal of financial freedom is to create a sizeable investment portfolio that produces enough income to fund your living expenses each year. Intuitively, that statement should make sense, but we need something more concrete than intuition to proceed.
What we really need is a target financial freedom number, which can easily be calculated using two pieces of information.
First, you must know how much money you plan to spend each year when you achieve financial freedom (your estimated future living expenses). This is why calculating your saving rate is such an important step in the process – because your current income and expenses will provide insight into your current lifestyle choices, which will help you better understand and estimate your future financial needs.
Don’t assume that your future expenses will exceed your current expenses because it’s quite possible that your total living expenses could decrease over time. A large body of financial planning research has shown that many work-related expenditures disappear in retirement, which could be applicable if you stop working a traditional job after achieving financial freedom.
Beyond your estimated living expenses, you need to understand the “withdrawal rate” input that is observed in Networthify.
Finding a “Safe” Withdrawal Rate
Finance researchers have spent almost three decades trying to answer this question – How much money can retirees spend each year without depleting their investment portfolio? Stated differently – How much can retirees withdraw from their investment portfolio each year without running out of money?
That is the exactly the question we would like to answer within the context of financial freedom. The only difference is that traditional retirement planning implies a 30-year time horizon (usually age 65 to 95), while financial freedom could imply a much longer time horizon because it’s possible to reach financial freedom at any age.
Researchers have done excellent work in determining this “safe withdrawal rate.” Bill Bengen was the first to publish his findings in 1994, ultimately concluding that a 50% stock / 50% bond portfolio would support a 4% annual withdrawal rate. Using more than 60 years of financial data, he showed that in every historical time period, retirees could withdraw at least 4% of their investment portfolio each year (adjusted upward with inflation) over a 30-year retirement period without running out of money.
In other words, at no point in history has a 50/50 portfolio failed to provide 30-years of retirement income at a 4% rate of withdrawal. Bengen updated the study several times after 1994 and ultimately concluded that retirees can likely consume 4.5% of the portfolio each year without issue.
His estimates were later revised through the Trinity Study, which used slightly different research methodology. The Trinity Study confirmed Bengen’s earlier work, reaffirming the 4% rule over a 30-year retirement. Wade Pfau, PhD, now releases annual updates on safe withdrawal rates. His latest 2018 update uses financial data from 1926 – 2017 to show that a 50/50 portfolio has never failed to provide 30 years of retirement income at a 4% withdrawal rate.
Perhaps more relevant to this article, Pfau found that a 3% withdrawal rate has never failed over 40 years of retirement (re: financial freedom). His research suggests that a lower annual rate of withdrawal will improve the longevity of the investment portfolio, which is an important concern for individuals who want to “retire” early and live on investment income for 40, 50, or 60 years.
Wait, There’s More!
The research I just covered concludes that a 50% stock / 50% bond portfolio can support a 3-4% annual withdrawal rate, depending on the expected length of retirement (freedom).
What I haven’t told you is that these studies assume a very basic asset allocation in the portfolio. The 50% stock allocation utilizes the S&P 500, which is an index that tracks the 500 largest American-based corporations. But that begs the question, why stop at large companies? Why not also include smaller corporations, which have historically outperformed large corporations? The answer is that it makes the research more confusing to interpret – but that shouldn’t stop you from implementing in your own portfolio.
The 50% bond allocation in Pfau’s study is comprised entirely of intermediate-term bonds issued by the federal government. Again, there is no need to stop there. In our modern economy, it’s easy to invest in corporate bonds, municipal bonds, and government bonds. Using a combination of bonds should reduce volatility and provide a slight increase in income, which will ultimately increase the safe withdrawal rate and expected longevity of the portfolio.
Why stop at stocks and bonds? We can also introduce real estate investments which will further diversify the portfolio and provide strong growth potential.
Furthermore, another strand of research has shown that a dynamic approach to asset allocation can further boost safe withdrawal rates. Dynamic asset allocation is the process of modifying the original 50% stock / 50% bond allocation in response to objective economic measures. For example, adjusting the stock allocation according to the cyclically adjusted price/earnings ratio (CAPE), or adjusting the bond allocation according to the slope of the yield curve. Combining these strategies can boost the safe withdrawal rate to almost 5% annually.
What’s the Takeaway?
Taking into consideration everything I’ve written in the sections above, I conclude two things:
1) The 4% withdrawal rate appears sustainable over 30 years.
If you plan to work most of your life and “retire” in a traditional sense, it probably makes sense to plan for a 30-year time horizon. As the research has shown, a 30-year time horizon implies a sustainable withdrawal rate of approximately 4% annually. If you need less than 30 years of income, or if you can implement some of the advanced portfolio management techniques discussed above, you can consider a slightly higher withdrawal rate.
2) The 3% withdrawal rate appears sustainable over much longer time horizons.
If you plan to “retire” early, which really means achieve financial freedom, I believe a 3% target rate of withdrawal makes the most sense. Choosing a lower rate of withdrawal will extend the life of your investment portfolio and decrease the probability of running out of money ahead of schedule. Again, it’s possible to boost the sustainable withdrawal rate using advanced planning techniques, but I don’t think that’s a feasible strategy for everyone.
Calculate Your Freedom Number
Armed with your estimated expenses and a robust understanding of safe withdrawal rates, you are ready to calculate your target financial freedom number.
Suppose you require $30,000 each year from your investment portfolio over an estimated 30 years of financial freedom. To find your financial freedom target, multiply the desired income by the safe withdrawal rate:
- $30,000 x 25 = $750,000
If you were planning for a longer period of financial freedom, you could assume a safer 3% annual withdrawal rate, and the calculation would be:
- $30,000 x 33 = $990,000
The 25x multiple is just a mathematical function where (1/.04 = 25x). Similarly, the 33x multiple is derived as (1/.03 = 33x).
If that’s doesn’t make sense, think about it this way. If you have $990,000 invested in a 50% stock / 50% bond portfolio, that portfolio could reliably produce about $30,000 of income each year ($990,000 x 0.03 = $29,700). If you increase the withdrawal rate from 3% to 4%, you would need a smaller portfolio to produce the same level of income ($750,000 x 0.04 = $30,000), but you could jeopardize the longevity of the portfolio if planning beyond a 30-year time horizon.
Using hypothetical values that might accurately depict your lifestyle, I’ve created a table to showcase the relationship between expenses, withdrawal rates, and the required size of the investment portfolio.
I love this table because it reemphasizes everything I’ve written about the important relationship between lifestyle, savings, and financial freedom.
Stated bluntly, if you spend a lot of money each year, it’s much harder to accumulate the wealth necessary to achieve financial freedom.
Invest Your Savings Wisely
Once you have estimated your target financial freedom number, the only remaining step is accumulating the necessary wealth. Increasing your savings is the most important step on the journey to financial freedom, and your saving rate is far more important than any specific investment decisions.
With that said, your investment decisions still play an important role. If you maintain a high saving rate and choose to stuff all of that money under your bed, your savings will not experience any growth or compounding. In fact, your savings will depreciate over time because inflation will erode the value.
Instead, you want to maintain a high saving rate and invest your savings wisely, realizing a return on your investment that will compound the growth of your savings. By simultaneously saving and investing, you can accelerate your financial freedom timeline and accumulate more wealth in a shorter period of time.
What is Investing?
If you are unfamiliar with the concept of investing, please read my introduction to investing.
The most crucial aspect of investing is understanding the tradeoff between risk and expected return. Most commonly, investment risk is defined as the potential for loss. If an investment increases or decreases in value (called volatility), the future value of that investment must be unknown. If the future value is unknown, there is potential for loss, which means that investment is “risky.”
If you need to sell that investment at some point in the future, it could be worth more or less than you originally paid, which is the definition of investment risk. The more volatile (up and down) the investment, the greater the potential for gain or loss. The potential for loss directly reduces the current market price that other investors are willing to pay, which results in a “risk premium.” This risk premium is defined as the difference between the return of a risky investment and the return of a “risk-free” investment over long time horizons.
What that means is, if you purchase and hold risky investments for long periods of time, you should expect to receive a greater return on your investment (ROI) for bearing that risk. That doesn’t mean risky investments will outperform safe alternatives every single year. By definition, the investment is risky because it is expected to underperform in some years. But over long periods of time, the average ROI of risky investments should exceed the average ROI of safe investments. If that isn’t true, you aren’t being compensated for the added volatility (risk), and there would be no reason to purchase or hold risky investments.
Historically, some investments have paid a significant risk premium. For example, the “risky” stock market has provided an average return of roughly 10% annually over the last 100 years, while “safe” cash-equivalent investments have provided roughly 3.5% annually over the past century. That is an enormous risk premium considering that stock market declines have always been a temporary phenomenon, with the long-term trend being overwhelmingly positive.
Can you guess why the stock market provided a 6% risk premium over the last century? Many investors avoided stocks because they never studied to understand what stocks represent or how the stock market operates, which reduced aggregate demand, which reduced the price of stocks, which increased the market risk premium among participating investors.
On a side note, that is also the reason why many finance scholars are predicting less generous stock market returns over the next decade. Since the 2008 financial crisis, the stock market has been in record demand. The increase in aggregate demand has driven up the price of stocks relative to earnings, which ultimately drives down the expected risk premium. Higher current prices (relative to earnings) imply less future growth potential, which suggests a lower risk premium among participating investors.
I chose the stock market risk premium to illustrate because it’s a great example that has left researchers puzzled for decades. All investments are expected to increase in value over long time horizons. There would be no reason to invest at all if the expected return was negative. The implication is that long-term investors should invest in risky assets like stocks to capture the growth potential, but research has shown that a large percentage of American households never do. This produces a significant risk premium for the remaining investors who do participate in these financial markets.
This same risk-return framework applies to all of the asset classes discussed below.
Over the last century, there have been five primary asset classes that investors have used to build wealth. Each of these asset classes includes a variety of subclasses, which are explained in the sections below.
Cash equivalents include physical currencies, checking accounts, savings accounts, money market accounts, certificates of deposit (CDs), and short-term government bonds (Treasury Bills).
Cash equivalent investments have historically been called the “risk-free” asset class, offering the lowest combination of risk and return. In fact, almost all cash-equivalent investments are insured or backed by the federal government. Another defining characteristic of this asset class is liquidity, meaning that your money is readily available for withdrawal.
Because of the safety and liquidity, cash-equivalent investments are suitable for short-term financial needs. For example, if you need money in six months to fund an upcoming life event, you can invest in a high-yield savings account or No-Penalty CD. You will earn some interest, but more importantly, the funds will be readily available when you need them. If instead, you chose to invest in the stock market, you might realize a much better return on investment, or you might experience a loss. Remember the risk-return framework.
Traditional bond investments include intermediate and long-term bonds issued by the federal government (Treasury Notes and Treasury Bonds), inflation-protected federal bonds (TIPS), municipal bonds, and a variety of corporate bonds.
Bonds represent an investment in debt. When you purchase a bond, you lend a lump sum of money to the bond issuer within a well-defined legal agreement. In exchange for your investment capital, the bond issuer will pay you interest for a specified period of time, and then return your capital at some point in the future (defined in the contract).
Like many cash-equivalents, bonds pay interest. Bonds issued by the federal government are subject to federal income tax, but not state income tax. Bonds issued by local government bodies are called municipal bonds. All municipal bonds are exempt from federal income tax, and many are exempt from local and state income taxes (depending on where you reside and the issuing entity). Corporate bond interest is subject to all forms of income tax.
The implication here is that corporate bonds should be held within tax-sheltered retirement accounts, while municipal bonds should be held within taxable brokerage accounts. The best option for federal bonds depends on your federal and state income tax bracket.
Bonds are not risk-free and the amount of interest paid by each bond varies according to risk. Treasury bonds (issued by the federal government) pay the least amount of interest because they are considered free from default risk (in theory, the federal government cannot default on its debt obligations). All other types of bonds are subject to default risk, which means the issuing organization could go bankrupt and you could lose your investment. Corporations are more likely to default than local governments, which is why corporate bonds generally pay more interest than municipal bonds (in addition to the structural tax differences).
All bonds are subject to interest rate risk. As interest rates rise, issued bonds decrease in value and as interest rates fall, these bonds appreciate in value. Long-term bonds are subject to more interest rate risk than short-term bonds, all else being equal, which means that “safest” bond investment is a diversified mixture of short-term bonds.
Bonds have historically provided a better return on investment than cash, but a lower return than stocks. By now, you should understand why. Bonds are riskier than cash (they can appreciate and depreciate in value) but less risky than stocks (subject to less dramatic price fluctuations). More importantly, bonds tend to perform well when the stock market is in turmoil. As a result, most investors include bonds within a well-diversified investment portfolio.
Stocks are the most widely discussed asset class in America. Unfortunately, much of the discussion is initiated by uninformed pundits and salespeople. I’ve discussed the stock market with hundreds of people. The vast majority have absolutely no idea what they are talking about.
Stocks are issued by corporations for the same reason that bonds are issued – to raise capital. When you purchase a stock, you are purchasing a small ownership interest in the issuing corporation. By law, stockholders are entitled to the specific legal and financial benefits that are outlined in my introduction to stocks. There is nothing subjective about the legal and regulatory framework that guides the issuance of corporate stock.
Stocks can be purchased directly from the issuing corporation through the initial public offering (IPO), but the vast majority of investors trade stock in the secondary (stock) market. The stock market is nothing more than the collective of participating stock investors, where the price per share of any stock is determined by supply and demand.
The stock market is volatile (risky) for two primary reasons. First, stocks are valued in relation to earnings, because earnings reflect consumer demand. Stock-issuing corporations release regular financial statements that disclose earnings, and investors trade that company’s stock according to the findings. When a corporation offers unsatisfactory products or services, consumer demand shrinks, which results in a reduction in corporate earnings. Because stocks are priced in relation to earnings, that implies a reduction in the fair market value of that firm’s stock.
But determining the fair market value of a stock is always subjective. You and I might both know the earnings of Amazon, but our interpretation of that number could differ dramatically. By definition, that means the current price of any stock reflects aggregate investor sentiment.
For example, an investor who is selling Amazon stock today must be unhappy with Amazon’s current or expected future earnings. If other Amazon shareholders are also unhappy, they too will attempt to sell Amazon stock. When the majority of shareholders are selling, and very few investors are looking to purchase, Amazon’s stock will continue declining in value until it reaches a new equilibrium price (where supply meets demand).
Historically, America has enjoyed more times of economic prosperity than hardship, which has allowed corporations to realize a steady increase in earnings. The increase in corporate earnings results in a steady increase in the price per share of publicly traded stocks. This is the primary explanation for the long-term positive trend of the stock market over the last 100 years.
Of course, not every corporation does well all of the time. Investors regularly exchange shares of stock because they disagree about the direction, leadership, or earnings of a particular company. This exchange results in modest price fluctuations for each stock, with the overall stock market trend being positive. This is also the reason to invest in a diversified bundle of stocks instead of individual companies, to avoid being exposed to risk factors that affect only one stock-issuing corporation or industry.
Occasionally, there are unexpected events that result in a widespread reduction in current or expected corporate earnings. The 2008 financial crisis provides the most recent, salient example. When economic turmoil leads to a reduction in corporate earnings, many investors become fearful and panic. Years of finance research has shown that fearful investors make terrible financial decisions, often choosing to sell their stock holdings without regard to earnings or any other objective economic measure. As the negative sentiment snowballs, more and more people sell their stock shares, driving the current market value down further, which ultimately leads to a massive decline in the value of all publicly traded stocks.
The good news is that these declines matter very little over long time horizons. The worst stock market declines in the history of America have lasted less than five years, on average. In fact, the best time to purchase stocks is when everyone else is selling.
Be fearful when others are greedy and greedy only when others are fearful.
– Warren Buffett
Real estate has been a viable investment option for thousands of years. As civilizations grow and expand, land and housing become increasingly important. Because there is a limited supply of desirable real estate, this results in a steady increase in the value of physical property.
Historically, investors have built wealth through the ownership and sale of real estate. A common strategy is to purchase land or housing at a discount, then resell at a higher price. It’s also possible to purchase homes as rental properties, creating a consistent income stream each month. The biggest problem with investing in physical real estate is the required time commitment. It can take many hours to source and purchase each property. It can take even longer to renovate a home or find responsible tenants.
Finance innovation has largely solved that problem for modern investors. It’s now possible to invest in a variety of real estate investment trusts (REITs) that offer professional management. These REITs operate very similarly to a stock market fund, providing liquidity and diversification in exchange for a reasonable ongoing fee.
Investors can purchase shares of a REIT, and the REIT uses that money to make investments in commercial or residential real estate. The REIT then earns income from property appreciation, rent payments, and interest on real estate debt, which is later distributed to shareholders. By law, REITs must distribute at least 90% of earnings to shareholders each year to remain classified as a REIT.
Another benefit of investing in real estate is diversification. The value of real estate doesn’t always correlate to stock or bond prices, which means you can reduce the volatility of your investment portfolio by combining all three asset classes within a diversified portfolio.
A commodity is any type of material that can be freely exchanged, such as steel, oil, wood, or coffee. Commodities are valuable because the worldwide population keeps growing, consuming more and more resources over time, and because their production can be limited.
Like the other investments I’ve discussed, commodities are priced according to supply and demand. If more corn is produced than is demanded, corn producers will be desperate to sell their supply, driving down the current market price of corn. Similarly, if coffee demand exceeds production, coffee will be a limited resource, which will result in higher prices.
It’s possible to invest directly in the exchange of physical commodities, but most investing is done through the futures derivative market. I don’t have time to fully explain derivatives, but futures contracts are complex products that are suitable for well-informed, experienced investors. Even though I have a Ph.D. in financial planning and have studied these markets, I choose not to participate for a variety of reasons.
If you would like to invest in commodities without spending hundreds of hours reading about futures, you have two viable options. First, you can invest in a diversified commodities fund that offers professional oversight. Most of these funds invest in futures contracts, but they vary widely in methodology and approach. The main problem with commodity funds is that they are often expensive compared to other diversified investments, and they don’t always accurately track the performance of commodities (known as tracking error in finance).
The second option is to invest in commodities indirectly through stocks. Remember, stocks represent ownership in a corporation, and many commodities are produced by corporations. For example, if you think the price of crude oil will increase, you could purchase the stock of several large oil producers. Better yet, purchase the entire stock market and you will have exposure to the universe of commodity producers. That’s my exact approach, detailed in the sections below.
Create a Diversified Portfolio
Creating a diversified investment portfolio is the process of combining the various asset classes mentioned above in a way that allows you to reach your financial goals. In this article, I’m discussing financial freedom because that is our primary financial goal.
I understand that the end goal of financial freedom can be intimidating. If you’ve never been exposed to the concept, the thought of accumulating a large investment portfolio can be overwhelming. For that reason, I believe it’s better to break financial freedom down into two actionable steps (I borrowed these steps from my introduction to financial freedom).
Step 1) Create Temporary Freedom
Everyone begins the journey by relying on a regular paycheck from an employer. If you are unhappy with your current employment and would like to pursue something different, you must first create a pool of savings that is easily accessible.
This pool of savings is sometimes called an “emergency fund.” There are no hard rules that determine how much you should save. If you hate your existing job and need to find something else immediately, you might begin by saving 2-3 months of expenses, which would represent 2-3 months of job-hunting freedom.
If you would like to travel for a year, return to school, or pursue anything else that will require your full-time attention, you will need to save significantly more money. Ultimately, you must find a way to accumulate enough savings to cover your living expenses over the extended unemployment period.
When investing these funds, the key consideration is liquidity and safety. You don’t want to work hard to save several months of expenses, only to invest that money in risky assets and incur a large capital loss. The money needs to be readily available without the possibility of significant financial loss, which is why cash-equivalent investments often make the most sense.
When you save enough money to find temporary financial freedom, you should celebrate that success. Accumulating a large investment portfolio might be the end goal, but every small financial victory is an important step in the journey.
Once you find temporary freedom, you should spend some time thinking about what comes next, because permanent financial freedom requires a much larger pool of savings. I can’t tell you how to find a rewarding job or career. That’s something that everyone must figure out on their own terms.
Step 2) Create Permanent Freedom
Once you leverage temporary financial freedom to find a viable career option, you can focus on increasing your rate of savings and investing in some of the more risky asset classes that offer significant growth potential. In doing so, you can reduce the amount of time required to reach permanent financial freedom.
When investing in any risky asset class, diversification is the most important consideration. Diversification can be broken down into two steps:
- Owning a variety of different asset classes (stocks, bonds, real estate, etc.)
- Owning a variety of different investments within each asset class (thousands of stocks, bonds, etc.)
Support for the concept of diversification can be traced back several decades to Nobel Laureate William Sharpe, who is the father of Modern Portfolio Theory. Later, Sharpe’s doctoral student (who was also awarded the Nobel Prize in the same year as Sharpe) built upon his work through the Capital Asset Pricing Model. Their combined efforts provide the mathematical proof behind the concept of diversification.
You don’t need to fully understand the math, only the intuition behind the math. By combining different asset classes, you reduce the expected volatility of the portfolio as a whole. For example, sometimes stocks outperform bonds and real estate, but other times the reverse is true. Thus, when you combine these asset classes within a diversified portfolio, there is an expected reduction in volatility.
By owning a variety of investments within each asset class, you avoid being exposed to the individual risk factors that affect specific companies or industries (called idiosyncratic risk, if you want to impress your friends). For example, if you believe that fast food represents a solid investment, you could purchase McDonald’s stock. But if you only purchase the stock of McDonald’s, you are exposed to specific risks that only apply to McDonald’s, such as their management decisions, franchising policies, and menu offerings.
Instead, you could purchase the stock of Mcdonald’s, Wendy’s, Taco Bell, and other fast food chains. As you add more companies to your portfolio, there is a reduction in some risks. For example, you no longer have to worry about McDonald’s menu options. If consumers don’t like the menu, they can go to one of the other fast food options and you’ll still benefit as a shareholder in those companies.
But why stop there? The fast-food industry as a whole is exposed to specific risk factors. For example, some consumers might never touch fast food because they prefer more healthful dining options, which reduces aggregate demand, which reduces corporate earnings, which implies a reduction in the fair market value of fast food stocks. This is still a diversification problem that can be solved by owning the universe of restaurant stocks.
Why stop at restaurants? Let’s just own the universe of publicly traded stocks, which by definition, includes every industry and sector available.
In modern society, it’s extremely easy to purchase the universe of publicly traded stocks, bonds, and most other asset classes through a diversified index fund, like those discussed in our example below.
The Cash Cow Couple Example
Thus far in this article, I’ve explained how to estimate your annual savings rate and calculate your target financial freedom number. I then described the asset classes that can be used to construct a diversified investment portfolio, which can help compound the growth of your savings to reach financial freedom sooner.
I’ll now share our personal financial situation to illustrate each of these points.
We got married and filed our first joint tax return in 2013. We just finalized our 2017 return, which means we have five years of applicable financial data.
Networthify Scenario #3 suggested that it will take approximately 5.6 years to achieve financial freedom at an 80% saving rate. When I create a Cash Cow Scenario using our average saving rate of 88%, Networthify suggests that it will take just 3.2 years to reach financial freedom. That estimate appears to be accurate given our real-world experience.
The total annual earnings came from three primary sources – employment, self-employment, investments.
From 2013-2017, I taught investment classes at Texas Tech University while finishing my PhD in financial planning. During that same period of time, Vanessa worked as an auto insurance claims adjuster and later took a position in administrative management. These jobs provided regular income, with a limited ceiling.
To increase our earning potential, we founded a content marketing company and several websites (including this one). We spent hundreds of hours learning the basics of internet marketing, branding, and search engine optimization, and then spent hundreds more implementing everything we learned. On frequent occasions, Vanessa and I shouldered a combined 120-hour workweek between our “day-jobs” and online business.
In 2017, we transitioned from employee to employer. Vanessa left her job and I declined tenure-track professorships to focus on growing the online business. We have received dozens of collaborative requests from large national brands who are interested in our story, website, and mission. We are excited and thankful to have this opportunity and look forward to leveraging our time and resources to create even more value for our community this year.
We have a few income streams beyond our business. We earn several thousand dollars each year by reselling items on Craigslist that were purchased on sale through a cash back shopping portal. We purchase everything with a credit card, which provides cash back, or airline miles, or hotel points on each transaction. Over the last five years, we’ve opened dozens of valuable credit cards, earning signup bonuses each time. Having multiple cards allows us to obtain the most rewards on each purchase because different credit cards offer different rewards at different merchants.
Our Freedom Number
We need about $15,000 per year to live comfortably or $20,000 per year to live luxuriously.
I am 28 years of age and Vanessa is 27, which means that our financial freedom timeline could span decades. A longer planning horizon implies a lower sustainable withdrawal rate from our investment portfolio.
Let’s use $18,000 as the target income goal and 3% as the target withdrawal rate. To find our financial freedom target, we multiply both numbers:
- $18,000 x 33 = $594,000
In other words, a $600,000 investment portfolio should produce about $18,000 of income each year at a 3% annual withdrawal rate. More importantly, the research I previously cited suggests that a 3% withdrawal rate is sustainable over 40+ years.
We have saved more than $600,000, which means we could further reduce the annual withdrawal rate, creating an even larger safety net. I believe that a withdrawal rate below 3% is sustainable indefinitely, meaning our investment portfolio should never be depleted.
If you are confused by these calculations, please re-read the “Safe Withdrawal Rate” section of this article.
Our Investment Portfolio
As of January 2018, our net worth exceeded $1 Million, which makes us the founding members of the millionaire mobile home club.
Our net worth includes the value of all assets minus all liabilities. We have no debts outstanding, which means our net worth is relatively easy to calculate.
The business equity is the net value of all business interests, where the fair market value is imputed using recent sale metrics from comparable businesses.
Possessions include our 1980 mobile home, 2015 Mitsubishi Mirage, and all personal possessions, electronics, and household goods.
The financial assets represent the current fair market value of all underlying investments, including stocks, bonds, real estate, and cash equivalents. These investments are housed in either retirement accounts (Traditional and Roth) or taxable brokerage accounts, depending on the taxation of each asset class and the capacity of each account.
Temporary Financial Freedom
To find temporary financial freedom, Vanessa and I developed a comprehensive cash-equivalent investment system that you are welcome to use:
- We established a cashback checking account at Discover Bank (see my review) which provides free ATM access when necessary. All checking accounts operate the same, so the most important features are free ATM access and a limited fee schedule.
- We then established a high-yield savings account (currently offering a $200 bonus) at Discover Bank that is linked to the checking account. This allows us to keep a minimal amount of money in the checking account, with the bulk of our short-term savings earning interest in the high-yield savings account. Transfers between checking and savings are instantaneous and free, plus Discover offers free account overdraft protection which automatically pulls funds from the savings account if the checking balance reaches $0.
- We use the Discover accounts primarily for bill payments and other immediate needs. But sometimes, we need more liquidity. For example, we needed to save a chunk of money in 2016 to purchase our vehicle with cash. For these needs, we currently use the CIT Bank No-Penalty CD (see my review), which offers a higher interest rate than any savings account. Discover allows free external transfers, which allows us to connect with CIT Bank to push/pull money whenever necessary.
- Finally, we established (10) different prepaid accounts through the Netspend Network (currently offering a $20 bonus, as detailed in my review). Each of these accounts operates as a combined prepaid card, checking account, and 5% savings account. They are a bit of a hassle to establish because you must transfer funds to the prepaid card before you can access the 5% savings account. But once established, each account pays 5% APY interest on up to $1,000 and is fully FDIC insured. We have $1,000 in each of the (10) accounts to use as hybrid emergency funds. In reality, we almost never touch this money because 5% guaranteed interest is better than any bond investment available today. But it’s nice to know that the money is readily available should we exhaust our other short-term savings. All of these accounts are also linked directly to Discover for easy access.
All of these investments are established as taxable accounts.
Permanent Financial Freedom
Beyond the strategy that I detailed in the last section, we restrict our investment in cash equivalents because of the limited growth potential. That means the bulk of our savings are invested in stocks, bonds, and real estate within taxable and tax-sheltered retirement accounts.
One unfortunate thing about retirement accounts is that most employer-sponsored retirement plans include a limited menu of investment options. Often, these investments carry excessive fees, eroding the value of your savings. For that reason, it usually makes sense to invest the lowest fee index funds available in the plan. If you aren’t sure how that works, I would recommend Blooom (see my detailed review), which will optimize all of your retirement account investment options for a flat $10/month (and offers Cash Cow readers the first month free).
We’ve partially addressed this problem by rolling over existing employer-sponsored plans into IRA accounts, which is a non-taxable event. You can’t transfer a retirement plan if you are actively employed by the plan provider, but after severing employment, you are free to transfer your account balance to a low-cost provider that offers better investment options. For Rollover IRAs, I would highly recommend M1 Finance (see my detailed review), which offers free stock and ETF trades (examples below) and a slew of other valuable features.
Outside of IRAs, we actively contribute to our 401k accounts. Our online business is incorporated as an LLC, and we established a full-featured 401k retirement plan through Guideline. If you are an employer, I would highly recommend Guideline, and you can receive a $250 cash credit through our unique link. The one-time startup costs are $250 ($500 minus $250 referral credit), and the ongoing monthly fee is a measly $8 per employee. That’s an insane value compared to other providers, which I know because I spent an entire week researching 401k plan options. Other than the fees I just mentioned, there are no ongoing costs. The investment menu is comprised of low-cost index funds through Vanguard.
We max out IRA and 401k contributions each year to minimize our tax liability, but these accounts have limited capacity. All savings beyond the retirement account contribution limits are funneled into taxable brokerage accounts, which have no limits.
In all of these accounts, we invest in diversified index funds, for reasons discussed in previous sections. Specifically, here are our chosen investments:
Foreign Corporations: Schwab’s Developed International Stock ETF (SCHF)(0.06% annual expense ratio), Vanguard’s Emerging Market Stock ETF (VWO)(0.14% annual expense ratio), and Vanguard’s International Small-Cap Stock ETF (VSS)(0.13% annual expense ratio)
U.S. Bonds: Schwab’s Total U.S. Bond Market ETF (SCHZ)(0.04% annual expense ratio), Vanguard’s Short-Term Corporate Bond ETF (VCSH)(0.07% annual expense ratio), and Vanguard’s Tax-Exempt Municipal Bond ETF (VTEB)(0.09% annual expense ratio)
Foreign Bonds: Vanguard’s International Bond Market ETF (BNDX)(0.11% annual expense ratio)
All of these funds can be bought and sold free of charge through M1 Finance. The only other way to trade these ETFs for free is directly from the sponsor. If you create an account at Schwab, you can trade Schwab ETFs for free. The same is true at Vanguard. Where each fund is housed (called asset location) is a matter of tax planning, and something I will address in a future article.
By investing in these funds, we own tens of thousands of stocks, bonds, and properties diversified across every industry, sector, and geographical location. More importantly, there is no ongoing maintenance. With diversified index funds, I don’t have to worry about how individual companies perform. I can spend my time creating more revenue-streams, not trying to pick individual securities (which is folly, according to decades of investment research).
If everything I’ve written above is like a foreign language to you, I have good news. You can delegate all portfolio management to a reputable “robo-advisor” who will invest is most of the same diversified ETFs on your behalf in exchange for a modest annual fee. Wealthfront (see my detailed review) and Betterment (see my detailed review) are the clear front-runners, with both firms charging 0.25% of your asset balance annually. Both firms handle all aspects of portfolio management, and both now include advanced tax planning and financial planning features at no additional cost. In my professional opinion, these robo-advisors are a no-brainer for anyone who doesn’t love researching, implementing, and managing an investment portfolio.
We haven’t needed to withdraw any investment income to date, as our business income exceeds our living expenses. All investment earnings are reinvested for growth.
What’s the Point?
Thus far, I’ve written almost 10,000 words explaining how to achieve financial freedom. In this final section, I’d like to explain why financial freedom is such an important topic.
When we got married in March of 2013, Vanessa and I had nothing. In fact, we had less than nothing (a negative net worth) because we owed more than $25,000 in student loan debt. That period of our financial history is not unique; an increasing number of young couples face crippling student loan debt each year.
What is unique is how we handled our financial situation. Instead of running away from $25,000 of debt, we tackled the problem with the utmost urgency. We modified every aspect of our lifestyle to increase our savings. We sacrificed comfort and consumption because we hated being in debt.
Our intentionality paid off, allowing us to eliminate the debt within our first year of marriage. When the debt was repaid, we felt such relief. It was like an enormous burden had been lifted from our shoulders.
With the debt eliminated, we had two options:
- Embrace Consumerism – Traditionally in America, individuals increase their spending (consumption) as they increase their available income. As we repaid the debt and began earning higher wages, we could have easily increased consumption without getting back into debt.
- Embrace Freedom – The other option (which we chose) was to continue living simply, increasing our savings and building wealth.
Our decision to embrace financial freedom has produced many of the same feelings and emotions that were experienced when the student loan debt was repaid. Having a reserve of financial wealth provides enormous freedom and flexibility in our daily life because it means that we never have to rely on someone else to determine our financial future. On multiple occasions, we’ve changed jobs without worrying about a monthly paycheck. We make financial and lifestyle decisions according to our wants, needs, and wishes.
The journey to financial freedom completely transformed our lifestyle, our marriage, and our finances. That is why I’m so passionate about this topic and that is why I wrote this article.
I didn’t spend weeks detailing our financial journey to boast or demand that you follow the same path. I don’t believe that everyone should save 88% of their after-tax income, as we do. Figuring out how much to save is a matter of personal preference, and something you must figure out on your own.
But I do believe that everyone should contemplate the concept of financial freedom because finding a meaningful work-life-money balance is universally important.
If you have a stable career and find your daily routine satisfying, you might not be overly interested in saving huge sums of money each year. Perhaps you would rather save a smaller percentage of your income so that you can consume and own the latest material possessions. Perhaps you are perfectly content pursuing a traditional retirement plan in your 50’s, 60’s or 70’s.
That is awesome, and I am genuinely happy for you. But I still believe you should set aside enough savings to ensure temporary financial freedom. You never know what lies ahead, and any number of future externalities could derail your lifelong plan. Temporary financial freedom represents a basic form of insurance that can hedge unknown future events.
With that said, I don’t think it’s easy to find the lifelong career balance that I just described. Over the past five years, I’ve discussed financial freedom with hundreds of people, including my family, friends, strangers, colleagues, and students. Very rarely do I hear these individuals talk about a meaningful work-life-money balance. The vast majority of the time, it’s a barrage of heartache, distress, confusion, and disappointment.
For every one person who describes their fulfilling career, there are nine who complain about the long hours, unsatisfactory pay, or unending boredom. For every one person who describes their intentional lifestyle, there are nine who are traditional American consumers. For every one person who saves 50% of their income, there are nine who save nothing. I’ve talked to so many people who struggle with the crushing burden of debt and the general unhappiness that accompanies a perpetual cycle of consumerism.
If you are reading this article, it doesn’t have to be that way. You can embrace a simplified lifestyle using the tips, tools, and resources in our minimalist living guide. As you begin living an intentional lifestyle, you will begin saving money. You can use those savings to find temporary financial freedom, and perhaps someday, permanent freedom.
My desire is that this article helps more people understand the oh-so-important relationship between money and freedom. If you have found it useful in any way, please share with your family and friends. If you have any questions, feel free to leave a comment below.