6 steps to financial independence

For most people financial independence seems like an unreachable dream. However, becoming financially independent is more a matter of patience and persistence. The idea of financial independence is so popular right now that there are entire communities dedicated to the subject. The popular term is FIRE which is an abbreviation for ‘financial independence and retire early.’

The path to financial independence is the same for every person. Some might have more luck than others, but it is a level playing field for everyone. Below are six steps to ultimately achieve financial independence yourself.

1. Increase income

Increasing income is easier said than done. If you already have a decent salary then you might already be set. People with less luck may need to change jobs or ask for a promotion. Unfortunately taking either path is not easy. A somewhat lower salary doesn’t have to be a problem however. In combination with lowering costs (see point 2 below) you can still achieve financial independence. Even with a lower salary.

Besides increasing income there are other ways to make some extra money. Many FIRE people have a so-called ‘side hustle’ next to their primary job. Some examples are:

  • Photography
  • A YouTube channel
  • eBay trading
  • Ads on a blog

Sometimes it seems odd, but simple hobbies can make you loads of money. See the tweet below for example. Even some famous stars earn more money with their hobby projects than their actual jobs.

Having a side hustle will make reaching financial independence much easier. There is a matching side hustle for everyone. However, making money from it just doesn’t come easy. Some proactive energy is required to make it a success.

2. Lower expenses

Increasing income is one side of the balance. Lowering expenses is the other. You can increase income all you want, if 100% of it is spent than financial independence will stay unreachable. That is why lowering expenses might be even more important than increasing income. But before you can lower these expenses you need to know how much is drained from your wallet on a monthly basis.

Follow this plan to lower expenses effectively:

  1. Make a list of expenses for a given month
  2. Separate the list in wants and needs. Be critical!
  3. Pay off any debt
  4. Save money by eliminating wants

Many people who make such a list for the first time notice that they spend more than they thought. Small expenses add up. While making the list it is paramount to be critical of your wants and needs. Netflix, pizzas and expensive subscriptions for your phone are not needs! Needs are expenses like rent or a mortgage, electricity, taxes and most groceries.

Debt is an extra factor that can weigh heavily on your monthly expenses. Not only does debt need to be payed off, interest also needs to be paid. Try to pay off all debt as soon as possible. Afterwards you can focus on eliminating stuff on your wants list. At first that can be difficult, but you will be amazed with what you can live without.

3. Calculate the needed amount of accumulated wealth

To become financially independent you need an amount of accumulated wealth to live off. This amount needs to be big enough to cover your yearly expenses during your remaining lifetime. The lower your monthly expenses from step 2 are, the lower the amount needs to be. As a general rule of thumb the amount should be 25 times your yearly expenses. For example: if your monthly expenses amount to $2.000, that means you need to cover $24.000 of expenses on a yearly basis. Multiply by 25 and you can conclude that you need $600.000 of total wealth.

That seems quite high and unreachable, but investing will help to grow your wealth steadily. And again: a higher savings rate will make you reach the goal much faster. How long will it take to accumulate 1 year of expenses? Well, by saving monthly

  • 10% of your income, it will take 9 years;
  • 25% of your income, it will take 3 years;
  • 50% of your income, it will take 1 year.

And that is without taking any investment returns into account. Hopefully it becomes more and more clear that financial independence is not really an investment strategy. It is more of a mindset. The more you try to live with less, the easier it is to attain financial independence. Luxury destroys the potential to become financially independent.

“We make ourselves rich by making our wants few.”Henry David Thoreau

4. Calculate the needed investment returns

Now that we know how much wealth we need, we need to build it. Investing is the most reliably way to accumulate wealth, as long as you invest a fixed amount each month. The effect of compound interest will take care of the rest.

For example: in total you need $600.000. You want to be financially independent in about 30 years. At the moment you can invest $500 each month to reach that goal. How high does your investment return need to be to achieve success?

Luckily there are many online calculators to help with questions like these. Software like Microsoft Excel can also be a big help with such calculations. In any case, you will find out that it requires an annual return of about 7.5%.

The average return on the stock market was about 10% per year for the last century. So with a portfolio of stocks it does seem achievable. In the graph below you can see how the goal of $600.000 can be reached. As you can see, reaching such a goal is mainly a matter of patience. Especially in the first year the accumulation is slow.

Wealth accumulation
Accumulating your first €100.000 takes atleast 11 years. Afterwards compound interest causes an acceleration towards the end.

5. Build a portfolio

Now that we know the return on investment we need to make, it is time to build an investment portfolio. The average return you need also determines the amount of risk you will need to accept. It is far easier to consistently get returns of about 5% then it is to strive for returns of 25% per year.

Be realistic with the return on investment you can expect. Otherwise your portfolio will be comprised of risky assets which could end in big losses.

Building a portfolio has already been adressed in a series of posts on InvestAdvice.net. Check these posts here:

7. Evaluate on a yearly basis

Nothing is more unpredictable than life itself. A good theoretical plan can be completely destroyed by unexpected events. Therefore it’s necessary to evaluate at least once per year if the initial plan is still feasable. If it all seems to be falling apart, you can do a number of things:

  • Increase income; Lower expenses
  • Accept the fact that reaching financial independence will take more time
  • Review your investment portfolio (but beware of risk)
  • Take a break and reassess your initial plan…

Beware that the balance between income and expenses is the most important factor when it comes to financial independence. The higher your savings rate, the more you can invest each month. It will bring financial independence ever closer. Even your return on investment is of less importance.

A last warning

Many people tend to become obsessed about the idea of financial independence. A quick way to get there is by taking on a highly payed, extremely stressful job without spending a dime anymore. You accumulate wealth at an astounding rate if you choose to do that.

Just beware that those years of stress are not worth it. You can do a lot more with your life while your still young. It’s better to postpone financial independence for a while than to destroy your body from stress. Live a little, even though those expenses may not fit the plan for independence…