Designing Your Life: 3 Skills to Master Financial Freedom
Financial Freedom. It’s a term that gets thrown around a lot, but do you know what it means? Everyone’s definition may vary slightly, but at its core, it means you are not constrained by money. You have put yourself in a position where you can make choices based on your values, not your bank accounts. There are three primary skills you need to master to achieve financial freedom: Cash Flow, Planning, and Investing.
Cash Flow: Every Dollar Has Its Place
Cash flow is the balance between your income and your expenses, and it’s important to have a well-defined plan for how things add-up each month. If your income and expenses don’t balance out at the end of each month: you are either spending too much or you are not being intentional enough with your income. The ultimate goal is to direct every dollar that you earn to a specific place.
Telling your money where to go is the key to 1) keeping your finances organized, which in turn allows you to 2) stick to your plan (more on plans later), and 3) putting yourself on the right path. One of the most overwhelming parts of managing your finances is answering the question, “Do I have enough for this?”
Do I have enough to eat out for lunch today, and still pay off my credit card at the end of the month?
Can I afford to splurge for my wife’s birthday present without having to worry about covering the rent/mortgage?
Do we have enough to take that trip to Greece we have always wanted while still being able to afford the holiday gift giving?
By organizing your cash flow, you get clarity. Clarity is the key to managing your cash flow.
I like to break down expenses into several buckets so you can allocate a percentage of your income to each. Every person's situation is different, but in general I like to shoot for the following:
Fixed Expenses/Bills (20-30%)
Debt (0-10%)
Saving (10-20%)
Investing (20-30%)
Variable Expenses/Spending (20-35%)
The basic idea is to start first with how much you make each month. Then subtract the things that absolutely have to be paid for (debt, bills). Next allocate what remains into the saving, investing, and spending buckets based off of your goals (more on goals next).
Once you’ve determined the monthly dollar amounts for each of those buckets the magic of modern banking can take over with automatic transfers. Giving everything it’s own bucket, and setting up automations means you don’t have to do the mental math to pencil out whether you can afford something in the #5 bucket and still cover your #1-4 buckets each time you want to make a purchase.
Planning: Have a Plan, Work the Plan
Setting up your cash flow is just where we get started—it ensures at the very least that you’re not going backwards, and then we can start planning how to move forward. In order to move forward you need 3 things, you need to know where you're going (what’s your goal?), where you are now (what’s your starting place?), and the path between the two.
Defining your goals is the first step in having a plan. You need to have a clear outcome that you are shooting for. Every person’s goals are different, and these often change throughout the course of your life. Consider: that trip you have always wanted to take; paying off debt; purchasing a home; saving for your children’s college; financial freedom at a specific age.
When determining what your end-goal or desired outcome is, be sure to use SMART goals (specific, measurable, achievable, relevant, time-bound). It’s good to know you want to purchase a home, but what type of home/how expensive (specific)? And when do you want to purchase it (time-bound)? A goal without a timeline is just a dream.
Once you’ve determined where it is you’re going, you’ll need to assess your current situation in order to determine your starting place. With your cash flow organized into buckets, it is easy to see where your money is going. Are some buckets getting more or less than they should? What assets do you have now? What debts do you have? What is your income? Do you anticipate any of these changing significantly in the near future?
Comparing your bucket percentages to the values listed above, gives you a baseline for understanding if you are high or low in different areas. You can also look at some simple metrics. For example, take the total of all of your assets and divide that by your annual living expenses (bills, spending, debt only - no saving or investing). This will tell you how long you could live on your current assets. This is a good gauge of how close you are to financial freedom. You could also look at how long you could live on only liquid assets (bank accounts, investment accounts, no real estate or hard assets that you couldn’t easily sell within a couple days).
The final step is to connect the dots: once you know how much money you will need and when, there are only so many ways to get from where you currently are to that number by that date. Some simple calculations can give you a baseline understanding of what it will take to get from Point A to Point B.
For a savings goal, take your desired dollar amount and subtract the current amount you have in savings, then divide that by the number of months between now and when your target date. This gives you the amount you need to save per month.
Need $10,000 for a trip in 12 months: $10,000/12 = $833.33/month you need to save
For an investing goal, use the compound interest equation. Future Value = Present Value * (1 + interest rate)^(number of compounding periods). Make sure the interest rate and compound periods match. I.E. if you are doing monthly compounding use a monthly interest rate (if annual, use annual for both).
$100,000 at a 7% annual return for 10 years: $100,000 * (1 + 0.07)^10 = $196,715
The most important thing is to map it out. Once you can see a path from A to B, it becomes more tangible. You know what it will take and you can track your progress to make sure you stay on the path.
Keep in mind that inevitably, your plan is going to change. Life happens, and that's okay. The point of the plan is that you have a general idea of 1) where you’re going and 2) how you’re getting there. Then, as things happen, you adjust.
Investing: Compound Your Wealth
Investing is the act of taking something and turning it into more of something. There are all kinds of different kinds of investments—getting a college degree is an investment of time and money which hopefully turns into more money. When we’re talking about purely monetary investments - taking money and turning it into more money, that is the dream.
Keep in mind there is always a risk and that is why you are compensated: because someone else is not willing to take that risk. Investing is a critical component to any strategy for achieving financial freedom. As Warren Buffet said, "If you don't find a way to make money while you sleep, you will work until you die."
To demonstrate how important investing is, consider the difference between saving $12,000/year, versus investing $12,000/year:
Saving $12,000 / year for 40 years = $480,000
Investing $12,000 / year for 40 years = $2,600,000*
*Assumes 7% annualized returns
That is an incredible difference. And the best part is you didn't have to put in much effort to make that extra $2,120,000. This is the magic of the compound effect—the investment builds on itself, so the longer you compound the more value you get out of it. Without investing, you’re strictly limited to the number of hours per day you can work, and the value of the work you do in those hours.
Mastering cash flow gives you a solid foundation to build on.
Mastering planning puts you on the path to your goals.
Mastering investing compounds your work so you go further faster.
If you can do all this for 20 consecutive years (or less) while growing your income at the same time, chances are you will reach financial freedom. More on that next time.
