Financial independence can be confusing. Spend even a little time on a personal finance blog or Facebook group and you will soon get lost amongst all the novel concepts, acronyms, and alternatives.
You don’t have to be a genius to figure out that this rarely ends well.
Motivated to reach financial independence as quickly as possible, people try to do EVERYTHING. They take on too much, trying to re-engineer their lives from scratch. And more often than not, they fail.
It’s kind of like running a marathon. If you go full speed ahead in the first 5k, you quickly run out of steam. Good luck posting a good time – or finishing at all.
But what if there’s a better way? One that doesn’t involve trying to do a black diamond run the first time you put on a pair of skis?
The 80 – 20 Rule
If you have ever taken an economics class at university, you may have come across the 80 – 20 rule. Also known as the Pareto Principle, it’s a simple concept that boils down to the following statement:
In many areas of life, about 80% of outcomes can be attributed to 20% of the causes.
For example, many businesses find that 80% of their sales are often generated by 20% of clients. A negative interpretation may be that 80% of car accidents are caused by 20% of drivers (you know who you are!).
And inevitably, 80% of healthcare costs are incurred by about 20% of the population.
There are two possible applications of the 80 – 20 rule. The first one is the proverbial “if you throw enough cr*p at the wall and some of it will stick”.
It may be simplistic, but it works. When I think about personal experience, many of the things I’ve done in life have generated zero value for me. The two foreign languages. That accounting designation. The failed business venture in my 20s.
But then, I hit gold with my MBA degree and landed an awesome, well-paying job.
The more nuanced interpretation is not increasing your overall workload but rather focusing on the 20% of things that drive the vast majority of positive outcomes.
Nurturing your high-value clients. Getting the right advanced degree. Developing the soft skills that really move the needle in your profession.
The problem with the second approach is that while hindsight is 20/20, no one can predict the future.
You still need to do a hundred cold calls to find the 20 loyal clients. Ten job applicants will walk through the door before you find the right two.
In M&A, the majority of the deals go nowhere and it’s the few that do close that pay the bills.
The good news is that when it comes to building wealth, you can predict the future. After all, this is not like putting a man on the moon.
The path is well-trodden. Even better, it’s well-signposted. And when all is said and done, there are just three key ingredients that will get you from start to finish.
Start With The Basics
As I’ve said before, one of the fundamental truths in life is that people who don’t understand money rarely get wealthy.
The ones who do buck the trend, usually do it through pure luck – such as getting an inheritance or winning the lottery.
They are also the ones who typically squander their wealth in a short period of time and quickly end up back at ground zero.
Thankfully, the list of financial concepts you need to understand to become financially independent is very short.
You start by spending less than you make. Create a simple budget that tracks all your expenses for a month.
Once you understand where your money is going, look for ways to save anywhere between 25% and 50% of your income. Focus on the big items (housing / transportation / education / eating out).
The reason I picked a savings rate of between 25% and 50% is that your savings rate is the only thing that determines how long it will take you to reach financial independence. If you manage to get to 50%, it’s just 17 years to financial independence.
No, it won’t be quick. But it’s better than a poke in the eye.
Once you’ve figured out how to put some money aside every month, it’s time to think about investing. Fundamentally, this one boils down to just two simple things.
There’s inflation, which means that the purchasing power of your money declines over time. Therefore, you shouldn’t keep your savings under your mattress – or in a bank account for that matter. Therefore investing is a must.
And then there’s compound interest. You can get very theoretical about it, but the bottom line is this: you put money to work. That money makes some more money. That additional money then goes to work for you as well.
It’s slow going at first but give it enough time and you’ll have a whole load of money working away for you. If you keep at it long enough, that money will start making more money than you do.
This is the magic of investing.
Now that you are convinced about the merits of investing, there’s one final pit stop we have to make before we dive in:
No, it’s not the most exciting topic – but it’s a crucial one. Hopefully, you have figured out by now that giving a cut of your earnings to the taxman, while socially important, doesn’t exactly accelerate your path to FI.
Minimizing taxes is important, so we’ll come back to this one below.
Put Your Money To Work
For many people, this step takes far longer than it has to. There’s the eternal fear of being a loser. And then there are the perceived complexities of investing.
In reality, investing isn’t hard. There is an easy, cheap, and universally accessible way to do it. It’s called the stock market. And the sooner you start, the more time you have for compound interest to work its magic.
Don’t get distracted by the fancy lingo, the advanced concepts, and the empirical arguments. Instead, focus on the following:
Step 1: Investing in a tax-efficient manner.
As mentioned above, taxes make a MASSIVE difference to your net worth. There’s absolutely nothing wrong with legally minimizing the amount of taxes you pay. As a matter of fact, many governments put in place incentives that can help you do so.
Here in the UK, the easiest way to go about it is by using a workplace pension or an ISA. In the US, 401(k) is your best friend.
Step 2: Investing in a low-cost, diversified index tracker.
This one is real simple. Fees decimate your investment returns over time. Diversification reduces the risk (i.e. the variability) of your returns. And passive investing beats active.
So keep it simple. Open up a Vanguard account. Put your money into their global index tracker fund. Keep adding every single month. Done.
Leverage Real Estate
This is the third and final building block in your future financial empire.
Once again, people in the FI community often spend too much time arguing about it. Some have true religion on the fact that renting is the way to go.
Many others treat home ownership as a pre-requisite for financial independence. So which one is it?
As with many things in life, an evidence-based approach may be the way to go. If you look at the universe of people who have achieved FI, you will find that the majority of them own their own houses.
There are good reasons for that. Owning a house eliminates one of the biggest expense items in your budget. Taking out a mortgage helps you supercharge your returns.
And if you want to move into real estate investing down the road, owning your first property is the ideal springboard for it.
The bottom line is that it is very hard to go wrong with real estate, provided the following apply:
- You buy a house in an area with a growing population
- It has a good economic backdrop (i.e. it is attracting new businesses as opposed to being full of factories that are slowly going bankrupt)
- You plan to stay there for at least five years, which will minimize selling costs and impact of short-term price changes
- The housing market regulations aren’t punitive (the UK is a great case study)
This is it. Yes, you can build a case for renting over owning. But the fact pattern suggests that if you want to reach FI, owning your home is the way to go.
And with those three components, you are 80% there. Will it take time? Sure it will. Is there more you can do to get there faster? Absolutely.
Just don’t lose sight of the fact that life needs to be lived, not spent fretting about getting to financial independence as quickly as possible.
Putting the above building blocks in place leaves you well ahead of the game. What you do with the rest of your free time is up to you.