How To Prepare For Your Financial Freedom

by: Loic LeMener, CFA

Summary

Preparing for financial freedom is an "invisible bill," and we all need a plan to “see” the implications of short-term spending on long-term savings.

Better spending decisions rely in part on contrasting purchases that will give pleasure (which is temporary) versus happiness (which is enduring).

Be conservative on big expenses, and track your short-term purchases. It's never too late to start saving and investing.

Financial independence allows you the freedom to spend your time as you see fit. Unless you have a saving and investment plan, however, preparing for financial independence is often ignored. This is made harder when spending decisions are made for pleasure rather than happiness. The first step towards healthy spending and investing is realizing that every day you put off saving makes your goals a little tougher to reach. Here are a few more steps for your path to financial freedom.

With the presidential election around the corner, many of us are thinking about the concepts of freedom and independence. The bedrock of the American ideal is our personal freedoms. We value our right to choose, our right to express ourselves and the right to spend our time how we want. Freedom is always hard earned, and while the U.S. Constitution and the right to vote guarantees national freedoms, it's how we spend and save our earnings that dictates whether we become financially free in the future.

Financial independence is having a large enough pool of investments (not cash savings) to never run out of money while still living the life you want to live. Financial freedom is not being dependent on the kindness of loved ones or the paycheck from an employer, both of which can change over time. For most people, financial independence begins at retirement, but the more important concept is having the freedom to spend your time as you see fit.

Charlie Munger once said, "Like Warren Buffett, I had a considerable passion to get rich, not because I wanted Ferrari's -- I wanted the independence. I desperately wanted it."

I like talking about financial freedom in the context of an "invisible bill." How many of us consider blowing off our mortgage bill? Unless families are in distress, missing a mortgage payment, much less several, almost never happens. The lack of a physical bill is a huge obstacle in getting people to save and invest. Unless someone has hired a financial advisor to create a saving and investment plan, preparing for financial independence is a nebulous responsibility that is mostly ignored. That's in part because, if you haven't created a plan, it's almost impossible to "see" the implications of your short-term spending on your long-term savings.

Spending for Happiness versus Pleasure

There is an old Chinese proverb that says the best time to plant a tree was yesterday, and the second best time is today. No matter where you are in your quest for financial freedom, every dollar saved today will yield more in the future. Of course, that's easier said than done, particularly when we make spending decisions for all the wrong reasons.

We've all likely made the assumption that someone who drives a luxury car must make a lot of money. But possessions only tell us what people spend, not what they make -- or what their balance sheet looks like. Not long ago, a friend wanted to refer a gentleman to me as a client. He said this gentleman had seven figures in credit card debt and drove a Ferrari. I politely said there probably wasn't much I could do for the guy.

The reason we buy things we can't afford often comes down to envy. Humans are social animals, and we constantly compare ourselves to others in our "tribe." We want to be seen as a successful member of our tribe, which too often means having the same things as the people around us. This leads to a host of poor spending decisions. Choosing a neighborhood in which to live, for example, that has the spending level you'd like (given fiscally conservative plans) is a wonderful idea. It's much better for your finances to be the slightly richer family in a more modest neighborhood and underspend a little than to be the family in a richer neighborhood that is "faking it until they make it."

This moves us towards a larger insight on how we measure value in spending. One nuance to making better spending decisions is contrasting things that will give pleasure versus happiness. Pleasure is something temporary, something with which you get bored and is many times motivated by vanity (i.e., your outer scorecard). Happiness, however, is more permanent and about your "inner scorecard." It's argued in recent studies that people derive much more happiness from spending on experiences as opposed to "stuff."

Take a new car purchase as an example. Unless you're a car enthusiast, how long will you sustain the pleasure from driving a car for which you had to stretch financially? How much happiness will you miss out on if you're forced to tighten your belt because you're paying off a car that is beyond your means?

I'm a fan of "small luxuries." If you drive a reasonable car for your salary and have an easy-to-afford mortgage, you can take some nicer trips, have some nicer dinners, and still be well ahead of the game. The conclusion of a recent study found the number one criteria for a happy life was the quality of relationships. Aligning your spending for this fact can be a game changer in your life. Traveling across the country to see an old college friend or visiting grandchildren on a frequent basis can provide happiness through relationships and experiences -- experiences you may miss out on if you are financially strapped because of pleasure-focused spending.

Some important questions to ask when you are about to make a purchase:

  • Is this spending making me happy (not just pleased)?
  • Am I setting the right priorities for my spending?
  • Am I forgoing my financial freedom for "stuff"?

Answering these questions will keep you focused on the long-term goal of financial independence.

Steps Towards Saving for Independence

The first step towards healthy spending and investing for independence is realizing that every day you put off saving for financial freedom makes your goals a little tougher to reach. When you take that first step, you're ready to take a few more.

You may have heard of common ways to save, such as paying yourself first or making sure you get your 401(k) matching. Here are three less commonly discussed things you can do to increase your savings.

  • Get a credit card with 2% cash back (and not miles or store points). The big caveat here is to only get a card if you can be disciplined about paying it off every month. If you spend 50% of your take-home pay on a 2% cash back credit card and then invest the 2% over a 40-year career, you'll have almost 200% of your starting take home pay saved, and that's assuming you never get a raise. Conversely, airline miles and Nordstrom points are really just an avenue to spend rather than save. When you spend on "stuff" you should feel it without any additional upside, such as a lowered price because of card benefits. This will encourage you to make smarter decisions.
  • Be conservative on your big expenses. Spending an extra $20,000 on a car or home that you'll need to finance can cost you hundreds of thousands of dollars in the long run. In absolute dollars, the last dollar of your mortgage that you pay back in 30 years costs you roughly 100% of your starting dollar to finance.
  • What gets measured gets managed. It's been my experience that as I scrutinize my personal expenses, they tend to naturally come down, almost subconsciously. You begin to realize how silly some expenses were for things you don't value at all just a few weeks later. The easiest way to do this is to load your credit card and bank account expenses into an aggregator. Most banks or investment houses offer an aggregator for free, and if not, you can use something like Mint.com to do this for you. It takes a little time to link all your accounts, but once you do, you'll have much better clarity into your financial life.
  • Start saving early. People are amazed to hear that putting the same dollar amount away for 11 years starting at age 20 yields more money than if you started saving the same amount at 31 and saved for 35 years. That is the power of compounding! Unfortunately, not all of us have this luxury, and many of us did not start saving in our youth. This is a life lesson to teach your kids. For younger children, have a "save for later" jar where a portion of their allowance goes to save for a goal (e.g., a bigger toy) in the future. For older working children, and if you can afford to do so, make a deal with them that for every dollar they put in their IRA, you'll match it. Forgoing the wonderful gift of IRAs early in life is truly a financial tragedy.

But no matter where you are in preparing for financial independence, it's never too late. Be disciplined and thoughtful. Good spending habits and a focus on regularly saving is the most critical thing you can do for yourself and your family. Either spend time on it, or find a good advisor who can help you.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.