Financial management is an all important skill in life that I believe should be taught in every school. The fact that this important life lesson is not taught in school is what motivated me to create this blog. For this reason, I am very excited to be sharing about how to begin your journey to financial independence in this post and I hope that you will feel motivated to take your first steps.
As financial independence is a lifelong process, I am a proponent of starting as early as possible. Thus, I hope you find this blog useful no matter how young you are as it is never too early to start planning for retirement (for reasons I will cover later).
Financial independence refers to the status of having enough income to pay for one’s living expenses for the rest of one’s life without having to be employed or dependent on others. In other words, an ideal retirement.
Why do people not plan for retirement?
Before we begin, it may be helpful to understand why some people fail to plan for retirement. I hope that when you face these common pitfalls, you will recall this article and make the best decision.
The main problem here is one of instant gratification. Psychologically, people place a greater emphasis on satisfaction gained from consuming a good or service now than in the future. For instance, when weighing the satisfaction from the latest iPhone, PC or TV today versus the benefits of a secure retirement 40 years later, many will place a greater weight on the former. Furthermore, the fact that retirement seems very far away (especially for someone in their 20s who just started to work) only exacerbates the issue as the benefits of financial freedom seems very intangible and tends to be underestimated, compared to something tangible like the latest gadgets today.
Another common reason is that people fail to see how their small actions today can have profound impacts their future well-being. For instance, saving $10 today might not seem like much when you require hundreds of thousands to buy a house. However, the small amounts of money that you save can quickly add up to a significant amount. Furthermore, owing to the power of compound interest, money saved and invested early can grow exponentially to a substantial amount! Another benefit of these seemingly small actions is that it will help you form a habit of saving, which you will undoubtedly find beneficial throughout your lifelong journey to achieve financial freedom, especially when your income increases and you start managing more money.
Finally, many people think that they have a long time to plan for retirement. As it is human tendency to procrastinate, it is no surprise that many fail to start planning ahead. To this, I have one very compelling reason to urge you to start as early as possible: the earlier you start, the easier your journey to financial freedom will be.
The final reason is also why I am a huge proponent of starting as early as possible. Let me now elaborate on why starting earlier will only help you on your journey to financial freedom.
Why you should start to plan for retirement as early as possible
Firstly, starting earlier will mean that you have a longer run up to take advantage of compound interest. This will allow you to compound your investments exponentially and make it easier for you to achieve financial freedom.
In order to illustrate this, let us take a look a hypothetical example.
Tom, who is 30 years old, and Jerry, who is 20 years old, begin to invest in the same S&P500 ETF that has an average annual rate of return of 10%. Assuming that both retires at 60 years old, Tom will have 30 years to invest while Jerry will have 40.
Tom makes an initial investment of $500 and subsequently, makes monthly contributions of $500. Using an investment calculator, he will have almost $1,050,000 at the end of 30 years. Not bad! But let us take a look at Jerry, who makes an initial investment of only $250 and makes monthly contributions of merely $250. At the end of 40 years, he will end up with more than $1,400,000. This is $350,000 greater than what Tom has! Furthermore, at age 60, Tom’s total contribution will add up to $180,000 while Jerry’s will equate to only $120,000. In other words, Jerry has contributed less and ended up with much more. You can now see how much difference 10 years can make and why it is easier to hit your retirement goals if you start earlier.
Secondly, starting earlier will give you more leeway to make mistakes. While we want to minimise the number of mistakes we make, it is inevitable that we will make some mistakes along the way. Thus, starting earlier will mean that we have more time to recover from any mishaps. Additionally, learning how to handle small amounts of money will train you to handle larger sums of money. This will make you more adept at managing your money in the future. As you approach retirement, you will want to avoid any mistakes that will cause severe capital loss and set your retirement plans back by several years. Thus, the values you cultivate, lessons you learn and habits you form will only serve to make you a better manager of your own finances.
Now that you understand the pitfalls that people face when planning for their future and the reasons to start early, let me go through some crucial steps to kick-start your journey to financial freedom.
Things to do before investing for financial freedom
The first step is to save more money. This might sound like common sense but many people often take this for granted and unknowingly overspend. To put this into context, the extra money you save can easily add up to be greater than the returns on investment of a small sum of money. For instance, saving an additional $10 per week will equate to $520 a year. In order to earn an annual return as high as this, an investment of $5,200 will be required (this is assuming an annual rate of return of 10%). That is a considerable sum if you are just starting out.
I hope to motivate you to save more by introducing the 21/90 rule. The rule states that it takes 21 days to build a habit and 90 days to build a lifestyle. While it will require a lot of self-discipline to spend less initially, it will eventually become a habit and you will do it subconsciously after some time. Hence, I strongly encourage you to consciously make an effort to spend less and save starting from now.
Next, it is of utmost importance for you to pay off any high interest debts. For instance, credit card debts in Singapore has an average interest rate of 25% per annum and will eat away at your investment returns. In comparison, the S&P500 index, which tracks the largest 500 companies in America, has a returned an average of 10% annually. Few investors can achieve a return on investment higher than 25% consistently. Thus, interest payments on such debts will likely be greater than your returns, making you suffer losses and eroding your savings.
In order to visualise this, imagine that you have a credit card debt of $1,000 with an interest rate of 25%. If you pay off the $1,000 today, you will be saving yourself $250 in interest which will go straight into your savings.
If you had invested the $1,000 instead, you would have made $100 (assuming annual rate of return of 10%). However, you will have to pay $250 in interest. You will thus end the year with a net loss of $150 ($250-$100).
In other words, paying off such high interest debts can be seen as a guaranteed rate of return of 25% since you will be saving yourself from paying such high interests in the future.
It is also crucial for you to build an emergency fund in case you require money at moment’s notice due to unforeseen emergencies such as accidents, medical illnesses or loss of job due to a recession or pandemic (touch wood). When such incidents happen, you will not want to liquidate your investments without enjoying the full compounding effect or worst still, at a loss. Thus, it is crucial to put aside enough money for a rainy day. The amount recommended by experts ranges between 6-12 months worth of your monthly expenses. However, this is just a rule of thumb. You may want to put aside more money if you are planning to buy a house or have a wedding in the near future.
While trying to build your safety fund and pay off your high interest debts, it is essential that you take this time to learn the basics of investing. This will help you build a strong foundation that you will undoubtedly find helpful when you start investing. To get started, check out my my other posts related to investing here.
Once you have built a sufficient emergency fund, paid off all your outstanding high interest debt and learnt the basics of investing, you are ready to move on to the next step and start investing in order to achieve financial freedom!
If you are just starting out, it may be hard to build a sufficiently diversified investment portfolio with a small capital. I highly recommend you to check out my other post where I share how to start investing with little money.
To end of this post, I would like to quote part of a famous saying by Hillel the Elder: “If not now, then when?” So start planning for your future today!