So you’ve paid off the last credit card and applied the scissors to the cards. You’ve paid off the cars and noticed that the ride is a lot smoother than before. Maybe you’ve even made the last payment on the house – really great! So that are the next steps to becoming financially independent?
Growing wealth is a simple matter of adding assets and reducing liabilities. Assets are things that pay you money each month. Liabilities are things that require you to pay money each month.
You have already reduced a great number of liabilities by paying off debts. Debts are particularly bad because not only do they consume some of your income each month, they also require paying interest. Still worse, debts place you at the mercy of those from whom you have borrowed. If you miss a few payments you are setting yourself up for all sorts of harassment, wage garnishments, and the like. The truth is, many creditors would like to keep you in debt all of your life so that they can keep making money from you. Ever notice all of the cash advance offers from your credit cards and home equity offers from your mortgage lender?
If you can reduce recurring liabilities further, that would help free up cash flow, which would increase the amount available for investment. For example, do you really need to own a boat and take care of all of the maintenance, or would it be a better deal to just rent one when wanted (probably true unless you spend most summer weekends on the lake)? As another example, do you really need to belong to the wine-of-the-month club, or book-of-the-month-club, or cheese-of-the-month-club, or whatever? This is not to say that you can’t buy some wine, or a book, or cheese when you want. The point is that you are not obligated each month to buy these things.
The purpose of limiting liabilities is to allow one to grow assets. As with the parable of the pipeline, think of your income as being water and assets like being pipelines. You can spend all of your time carrying buckets from the well – working – and you can do fine for a while carrying buckets and using the water as you get it. While you are young it may not seem like a big deal to be carrying water. It takes time and effort to lay a pipeline and you could be carrying more buckets instead for immediate gratification. Once completed, however, the pipelines provide extra water for you whenever you wish with no additional effort.
At first the difference may not seem like much. You can expect a return of about 10-15% per year from common stocks, for example. If you put $1000 in stocks, that would mean an extra $100 to $150 per year on average (note that this would be +$400 some years and -$200 other years, not a steady income) which is not much compared to a $60,000 per year income. With time, however, the income from these assets will grow as you lay more and more pipelines.
Another thing will also start to happen. If you resist the temptation to spend all of the extra income generated by the assets, you will have more money to buy assets. While this will be small at first, the effect over time is amazing. To see the power of compound interest, realize that if you start with a penny and double it every day for 30 days, you’ll have well over $1 million after the month.
So, here is the strategy:
1. Pay off debts, particularly credit cards and car loans (holding a house loan is acceptable, but still try to limit the size and get it paid off before the kids are in college).
2. When your final debt is paid, start saving the money you were using to pay debts into savings. A bank account is fine for this purpose.
3. Save up enough money to pay for various emergencies (a car repair, a broken furnace, etc…). This is called the “emergency fund.”
4. Once the emergency fund is fully funded, continue to save for investing.
5. Develop a list of 3-5 common stocks to own. Each time the amount in savings beyond the emergency fund becomes large enough to buy 100 shares of one of the stocks, do so. Select the stock that is the best at the time to purchase. (If desired, one could also pick a set of mutual funds. This would reduce the level of fluctuations in account value, although the potential return is also lower).
6. Continue this strategy until a portfolio of 3-5 stocks with 500-1000 shares each is obtained. Note that single positions should never be allowed to grow beyond the size that one would be willing to lose, which depends on personal risk tolerance and intestinal fortitude. If a position is larger than you’d like to hold, sell some shares and spread out to other common stocks. Once could also begin to build up some investments in mutual funds for greater diversification.
We’ll continue this thread and talk about what to do next in the following post.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.