Introduction to FI
So you want to become Financially Independent (FI)? Well, as they say a journey of a thousand miles begins with a single step (thanks Lao Tzu). This section of the blog is an outline of 12 steps to help guide you along the road to FI. Obviously this process will be a little bit different for everyone. After all, one of the key aspects of personal finance is that it is personal and thus unique to each individual. However, I believe there are certain guiding principles that can help each of us achieve that ultimate goal of freedom through financial independence.
Remember that becoming financially independent means that the money you have saved and invested (your assets) generates enough passive income (money your assets earn and you don’t have to work for) to exceed your expenses. At that point you no longer have to trade your time for money by working and you are financially independent. To achieve this, the FI community relies heavily upon something called the 4% rule. I will write an entire post about this in the future, but for now I will just summarize the 4% rule, otherwise known as the safe withdrawal rate. At the most basic level this means that if you withdraw 4% of your assets or less to live on each year, your money should last you through your entire retirement without running out. Playing with the math and looking at it from an expense standpoint, it means you would need to save 25 times your annual expenses to live within the 4% rule. For example, if your annual expenses were $40,000, you would need to save and invest one million dollars. If you withdrew $40,000 or less each year, your money should generate enough income for you to live on through the rest of your life without running out.
Before diving into the 12 steps I have outlined to help you achieve FI through following the 4% rule, I want to discuss what I consider to be the four core principles of FI. These principles are at the root of each of the steps I recommend and form a foundation from which to build a portfolio with enough assets to reach FI. I want to make sure we take a step back and understand how to reach FI from a more philosophical perspective. Pursuing FI is about making many changes, some big and some small, in your financial life. The net effect of these changes is the adoption of a whole new financial philosophy. In order to make these meaningful life changes and follow this path, you have to understand the core principles behind it. After all of the research I have done on this novel way of thinking, I believe there are four key concepts that comprise what I consider to be the core principles of FI:
Maximize Income
The first core principle is maximizing your income. In sports lingo, this means developing a good offensive strategy. To reach FI you need to bring in as much money as possible to increase the rate at which you save and invest. Maximizing your income includes negotiating for the highest salary you can get, receiving the company match for your 401(k), and making sure you are getting all of the benefits your employment has to offer. It may even mean switching jobs or careers or getting more education. It can also include developing passive streams of income through real estate, starting a side hustle, or other business ventures.
Reduce Expenses
The second core principle of FI is reducing your expenses. This will be your defensive strategy. This is probably the most widely known and discussed aspect of FI (think minimalism, tiny homes, and frugal living), and perhaps rightly so since, after all, defense wins championships, right? The pursuit of FI is significantly accelerated by reducing expenses for two primary reasons. First, it leaves more money for you to save and invest. Second, if you can live on less by reducing your expenses, it decreases the goal amount you need to save and invest to live by the 4% rule. Based on my example above, if you reduced your expenses to $30,000 per year from $40,000, you would now only need to save $750,000 to live by the 4% rule instead of one million dollars. Much of the focus in reducing expenses is typically on the big three: housing, transportation, and food. But other small changes can also have a big impact in the long term. I think the important thing to know about reducing expenses is that you don’t have to buy a tiny house or live like a monk to reach FI. What you do need to understand is the real life impact your expenses have on you and the great benefit there is to cutting out things that don’t bring real value to your life.
Increase Savings
The next core principle of FI is increasing your savings. This may seem like a given if you are taking steps to maximize your income and reduce your expenses. However, for most of us, the natural tendency when we have a little more money is to spend it. In today’s culture of consumerism, when most people get a raise at work or pay off a major purchase such as a vehicle, they immediately find something to fill this new gap between their income and expenses, buying something they think will bring them happiness. This keeps them living paycheck to paycheck; living at or even above their means. As our lifestyle expands to fill these income gaps this is known as lifestyle inflation or lifestyle creep. In the FI community, however, the opposite is true. Frugal living is a way of life and your savings rate tends to be a badge of honor. If you are on the path to FI, as your income increases or your expenses decrease, you strive to maintain the same lifestyle and increase your rate of savings. Contrary to traditional financial advice advocating savings rates of 5-15%, many in the FI community are able to save 50-75% of their income. While this may seem far out of reach for many, don’t close your web browser and forsake my blog just yet. Achieving astronomical savings rates such as these is something that typically occurs stepwise over many months and even years, and you don’t have to save half of all you earn to begin the path to FI. You just need to start saving something and make consistent efforts to increase that amount over time, and soon enough you will be the one with a stellar savings rate.
Invest Wisely
The final core principle of FI is invest wisely. It is not enough to just save money, you have to invest it. If all you ever do is save your money in a simple savings account at your local bank or credit union, you are likely earning less than 1% interest, not even enough to keep up with inflation. Thus, you are essentially losing money. Therefore, in order to have your money work for you earning more money over time, you have to invest it. But the key to this core principle is the word wisely. When you begin to substantially increase your savings, you will be surprised how many people will come out of the woodwork and how many opportunities will cross your path promising you the next great “investment.” But this is where it is crucial to make the distinction between speculating and investing. On the path to FI, there is no get rich quick, find the next best thing, time and beat the market strategy when it comes to investing. Those seeking FI choose investments that minimize risk, have low associated fees, are well diversified, and don’t seek to beat the market. The most common ways to do this include investing in low cost index funds and investing in real estate, both subjects I plan to write on extensively in the future. It is investments like these that will generate the passive income necessary to become financially independent.
These four core principles form the foundation of FI and are at the heart of the 12 step plan I outline in this series of blog posts. Now that you understand the fundamentals of this liberating financial philosophy, you are ready to move forward and begin your own journey step by step to Financial Independence. Remember that these 12 steps are simply an outline that I recommend to direct you to FI. While I believe they serve as a general framework for most, you may need to adapt this process to your own situation and needs. You may have already completed certain steps or you may decide to change the order of steps based on your individual priorities. You may also choose to work on certain steps simultaneously. There is no one single path to FI. Here are the 12 steps I recommend:
Step 1: Define Your Why?
Step 2: Where Am I Now? Determining Your Net Worth
Step 3: How Did I Get Here? Tracking Your Income and Expenses
Step 4: Where Do I Want to Go? Developing a Financial Plan
Step 5: Insuring Against Catastrophe
Step 6: Establishing an Emergency Fund
Step 7: Maximizing Your Employment Benefits
Step 8: Work to Become Debt Free
Step 9: Maximize Your Tax Advantaged Accounts
Step 10: Paying Off Your Home Mortgage
Step 11: Investing in a Taxable Account and Alternative Assets
Step 12: Developing an Income Plan for FI
With that, good luck as you begin your own personal journey step by step to FI. I look forward to taking this journey together. Please refer to my own progress under the My Path to FI section of this blog to benefit from some of the lessons I have learned along the way. If you’re ready, then go on to the first step, Step 1: Define Your Why?
