Achieving financial independence is not that complicated. You just have follow a few basic rules.
Rule number one is put your money to work. No matter how they got their money, nearly everyone who is financially comfortable will tell you that wealth is built by putting your money to work making more money.
Using money to make more money is not a secret; anybody can do it, and it’s been going on for thousands of years. Due to human nature, however, it’s not as easy as it sounds. For starters, having a good job and making a big salary is not enough to achieve financial independence. It’s certainly a good start, but it’s all too easy to spend everything you make as “lifestyle creep” is a pretty much inevitable living in a 21st century capitalist society. That means getting serious about savings is the first step in the process of financial independence.
Once you have a built up a nest egg, then you are ready to start putting your money to work.
Assessing Your Risk Tolerance
Everybody wants to get rich quick, but do you really want to take the risk that a high rate of return generally entails? For most people, the answer to that question is no. Most people would have trouble sleeping at night if they owned volatile biotech stocks or Argentine government bonds where they might see a 15-200% annual return, but are also assuming a significant risk of a loss of a substantial portion of their investment. More conservative investments, such as AAA bonds or blue chip stock funds, are typically going to offer a much smaller annual return, but the risk of substantial losses is minimal.
A few people, however, do have the stomach to take thoughtful, planned risks, and those that are fortunate enough to not roll snake eyes with their first few investments often end up doubling or tripling their stake in a relatively short time. Those risk takers who are not so lucky and hit a loser on their first investment, however, may have put themselves in a deep hole that makes it much more difficult to meet their financial goals.
Investing is a bit like the old Aesop’s fable “The Tortoise and the Hare”. You can seek fast returns like the fast-running hare but there’s a good chance you’ll get knocked off the path along the way. The tortoise’s long, steady path of low-risk, low-return investments, however, is the only reasonably sure road to financial independence.
Bonds are a type of debt instrument, basically a legally binding IOU. When an investor buys a bond, you are loaning you are loaning money to a local or national government or a corporation. Generally considered among the most conservative of investments, bonds are rated based on relative quality by financial ratings agencies. The higher the rating, the safer the investment and the lower the rate of return. Note that bonds are considered less risky than stocks as bondholders get paid ahead of stock holders in the event of bankruptcy/liquidation.
Thus, a top AAA-rated bond like a 10-year U.S. Treasury bond might only pay 3% interest a year, whereas a BB-rated bond from a country with a large public debt might offer a 7% annual yield to compensate investors for the risk of the bond issuer defaulting (not paying back the money loaned).
Investing in stocks means buying shares in a publicly held company that is listed on a stock exchange (such as the New York Stock Exchange (NYSE), or NASDAQ, or the London Stock Exchange (LSE). The value of a share in a company goes up or down based on public perceptions of the current status of the company. You can think of the stock price as a barometer of the “health” of a company – if the company is highly profitable with few clouds on the horizon, the stock price will be high (and likely to continue moving up. If a company is not doing well, and they announce profits are slipping as competitors are taking market share, then the stock price is likely to move lower.
However, things can change very quickly in today’s global economic markets, and stock prices tend to move up and down quite a bit based on news flow about various public companies and macroeconomic events (price of oil, chance of recession, etc.). This means you need to have a higher risk tolerance if you are going to invest in stocks.
Financial experts highlight that stocks offer a strong long-term return, and most people should include stocks in their investment portfolio despite the volatility. You can always go with a long-term “buy and hold” strategy for select blue chip stocks – with a long-term perspective you don’t care if profits are down this quarter or even there’s a recession on the horizon. You don’t plan to sell for five, 10, maybe 20 years, and history shows stock markets nearly always move up over that kind of time frame.
Another strategy to reduce the risk of owning shares in just a few companies by investing in mutual funds, which invest in dozens or even hundreds of different companies.
Investors today are not just stuck with investing in stocks and bonds. In fact, investors today have a bewildering array of alternative investment choices, including commodities (gold, silver, coffee, sugar, etc), hedge funds and insurance-related investments (annuities, etc). You can even invest in a P2P lender like Lending Club or Prosper, and be paid interest on loans you make to individuals or small businesses.
Don’t let your savings just sit there under your mattress or making less than 2% in a CD or savings account. Put your money to work. Do some research or talk to a financial professional about your investing ideas and risk tolerance. Remember that most retail financial brokers today will let you set up an online account with an initial deposit as small as $250 to $500. Best of all, you can easily manage your investment account using your home desktop PC, or on your laptop or smartphone.
Featured image via Lending Memo