Financial Prisoner: tied to your paycheck, often due to a lifestyle you can’t really afford (or would not be able to maintain if that paycheck were reduced or lost).
The difference between achieving financial freedom and forever being a financial prisoner has a lot to do with the habits we form and our discipline around money. There is no shortage of personal finance literature out there, and one could get lost in all the books, blogs, and podcasts on the subject. But taking action, forming good money habits early, and developing the discipline to stick to a plan are what actually move you toward financial freedom. Building wealth is a lot like eating healthy and staying fit…both are simple, but neither is easy.
Here are the habits I most often see in those who achieve financial freedom (and conversely do not see in those who struggle with money):
Stay Out of Debt
I have this listed number one because it’s the one habit on this list that can set you back in ways none of the other items can. You can theoretically dig a hole with debt that you can’t climb out of (or at least it may feel like you can’t get out). Debt reduces your net worth dollar for dollar, and high interest debt can compound your net worth in the wrong direction very quickly.
Maintain an Emergency Fund / Cash Reserve Fund
Emergencies are more like inconveniences when you have the money to deal with them. Of course, I’m speaking of the types of emergencies that are not life-threatening here. Things like your home AC or water heater going out, car trouble, or even losing your job. A fully funded cash reserve can reduce the stress associated with any of these situations, prevent untimely withdrawals from investment accounts, and reduce the need for debt.
Pay Yourself First
Treat savings like a non-discretionary expense that must be paid. I prefer the “save first and live on what’s left” method over true budgeting, but the two go hand in hand. Essentially, by “paying yourself first,” you are limiting the amount of money you have left to live on. Ideally, you have a general budget built out that leaves some discretionary spending money after all bills are paid so that you can make that daily Starbucks run or go out for sushi on Fridays or save it up for a trip or something you’ve been wanting. But the key to success in saving for financial independence is to take care of your savings goal first and then build your budget around what’s left over after you’ve paid your future self.
Automate Your Savings
In conjunction with paying yourself first, automating your savings to retirement accounts will make saving much easier and more consistent. There have been times in my life where I attempted to save manually. I had the best intentions of depositing that $500 a month into a Roth IRA account. But regardless of how disciplined I thought I was, something else would often consume that money before it got into the Roth account. When money is automatically pulled from your paycheck (best case scenario) or a bank account, inertia kicks in and you don’t think about it. But if you try to fund your savings manually after it lands in your checking account, so many things can get in the way to prevent that transfer.
Take Advantage of Free Money
I consider it a crime against your future self to miss out on free money your employer is trying to give you. The most well-known free money comes in the form of a 401k matching contribution. All you have to do is contribute a certain percentage of your paycheck to the plan, usually around 6% to get the full match, and the employer will GIVE YOU FREE MONEY! Do not miss out on the employer match!
But there are other opportunities to get free money from your employer, like an employer contribution to a Health Savings Account (HSA) or the discount you get through an Employee Stock Purchase Plan (ESPP). Make sure you are getting ALL the free money your employer wants to give you!
And don’t stop at the employer match…max out tax-advantaged retirement accounts. Take off the training wheels!
Never, Never, Never Carry a Credit Card Balance! Pay in Full, Every Month! Period.
Although this falls under the “stay out of debt” habit, it’s worth calling out specifically. And I know, I can hear some folks now talking about taking out a credit card with a retailer offering zero percent interest for the next 12 months. Avoid it. It’s not worth the hassle.
And if you’re doing that because you can’t pay cash, then you can’t afford the item.
Live Below Your Means
My goodness, this one is so often repeated it has truly reached cliché status. But simply put, you will never achieve financial independence unless you live below your means. The alternative is to spend everything (and too often, more than) you earn. I’m certain that anyone reading this article knows, understands, and believes this. But if you don’t save first and then spend your entire paycheck before saving…you are not living below your means. You are at best living AT your means…which makes an HVAC or water heater issue a real emergency.
Set Clearly Defined Financial Goals
Begin with the end in mind. Know what your goals are. Define them explicitly, and then develop a plan to achieve them.
For me, the driving force was to achieve financial freedom by age 45. When I started my professional life after college, the why wasn’t really there. I thought, like a lot of folks, retire, travel, live the good life. Ha! That’s not really a goal. But I was committed to the financial freedom part of that equation. Annually or more, I would evaluate my family’s finances to make sure we were still on track for financial freedom.
It wasn’t until I got to my mid-forties having saved enough money to make work optional that I realized I needed a true passion to pursue. Retiring in the traditional sense had no appeal for me since I didn’t have hobbies to keep me busy like my parents do (my mom hikes and does Geocaching, and my dad builds disc golf courses and plays disc golf…and he’s raised pigeons (twice), spent several years canoeing, and been a geocacher as well). My passion was in personal finance, the very thing that helped me start building wealth as a junior in high-school and was the subject of most of my study and research over the last couple of decades.
Pay Cash for Cars (and Drive Them ‘til the Wheels Fall Off)
This one can be hard for a lot of folks to swallow. Cars are expensive, and saving up to pay cash for one takes real discipline. However, taking on debt to pay for a depreciating asset is rarely a good idea (and takes you further away from financial independence). I know, it’s hard to watch all your friends drive nice new cars and trade them in every couple of years while you’re driving the same (reliable) old car year after year. The peer pressure to keep up with the Joneses can be tough to overcome. And that brings me to the next habit for building wealth…
Don’t Try to Keep Up With the Joneses…THE JONESES ARE BROKE!
If you don’t believe it, read “The Millionaire Next Door.” Probably a good idea to read it regardless.
Start Saving Early for Your Kids’ College
The earlier you start putting money away for your kids’ college expenses, the less painful it will be. There’s a fine line here between overfunding and being left with college bills you can’t afford when the time comes. Saving to 529 accounts can make a lot of sense; however, too much in a 529 can leave you with money you’d like to use for other things, but now you’re stuck having to pay a penalty if you don’t use it for educational purposes. The beneficiary can be changed on a 529, but the new beneficiary must be a family member of the current beneficiary. So, if your own kids don’t use the money and you have other family members in mind that you’d like to help, you may have that option without triggering taxes and penalties (see “Changing the Designated Beneficiary” on page 55 of IRS publication 970).
The bottom line is this: If your desire is to pay for your kids’ college expenses, start saving early but plan for the possibility that your kids may go another route. And don’t sacrifice your own future financial freedom just to pay for Junior’s college expenses. Junior doesn’t want your retirement plan to be living in his basement simply because you spent several hundred thousand dollars for a private or out-of-state university! There are many great in-state public universities. Junior will thank you for the tough love later when you are financially independent and don’t have to move in with him.
Keep Your Investments Simple
Avoid the noise, stock tips, fads, and the latest financial products. The financial services industry is full of scare and FOMO tactics to try to get you to buy expensive investment products (and insurance products disguised as investments). Avoid all the noise, pick low-cost index mutual funds or ETFs, and just keep buying! You don’t need hedge funds, private equity, private real estate deals, and other alternative investments to build wealth. A diversified portfolio of domestic and international stock funds and a fixed-income allocation to reduce the volatility enough to help you sleep at night regardless of what happens in the stock market is all you need to build wealth and achieve financial freedom.
If you are a do-it-yourselfer when it comes to your investments, I highly recommend you read “The Little Book of Common Sense Investing” by Vanguard founder John Bogle and all of William Bernstein’s books, starting with “The Intelligent Asset Allocator.” If you prefer to have someone help you with your asset allocation, seek out a fee-only financial advisor, preferably one who recommends low-cost index funds rather than trying to “pick winners” (which is nearly impossible to do over the long term).
Don’t Try to Time the Market
My oh my, we could sit here for a while. Where to start.
It seems like everyone you talk to about their investments thinks they can time the market. Oh, they may not tell you explicitly they can time it, but their actions seem to indicate they believe they can. How many people do you know (and I’m sorry if you are one of these people) who have gone to cash when the market dropped?
I guess I would call that “really bad market timing,” actually (sorry, I couldn’t resist).
Let’s think about that for a minute. You SELL your investments AFTER they have fallen in value. Hmm. Wouldn’t that be the time to buy more? And of those folks who claim they got out of the market just before the bottom fell out, how many of them told you when they got back in? They likely left that part out (or avoided the conversation) once the market recovered, which it usually does much faster than we expect.
For instance, what are the odds someone was able to get out of the market just BEFORE the Covid crash that started in late February of 2020? And even if they were so lucky to achieve that extremely unlikely feat, what are the odds they then got back into the market prior to 8/18/2020 when the S&P 500 fully recovered to the high of 2/19/2020?
In case you missed the timeframe there, that was six months from top to bottom to full recovery!
The more likely scenario occurred like this: They got out of the market near the bottom in March 2020. Then the market recovered 50% of its losses from the 2/19/2020 high within three weeks of hitting bottom on 3/23/2020. So, they sat on the sidelines waiting for the market to come back down to where they got out. Then they finally capitulated in September or October of 2020, getting back in after the market again hit new highs. I’m sure you have friends, co-workers, neighbors, or family members who executed this “strategy,” forever locking in those losses from March of 2020.
BTW – If you did sell at the bottom, it’s likely because your portfolio was too risky to begin with. The market goes up AND DOWN. You need an asset allocation that is in line with your tolerance for the DOWNS in the market. On average, the S&P 500 has a 10%-20% decline about every 2.5 years and a 20%-40% correction about every 8.5 years since 1946. But the S&P 500 is up about three out of every four years.
The bottom line is this: Don’t try to time the market. Just keep buying and stay the course. Your “time in the market” is much more important than your ability to “time the market.”
Avoid Short-Term Trading
Don’t trade stocks (or options or crypto or NFTs or any other financial instruments) in the hopes of short-term gains. This is a loser’s game, plain and simple. You may get lucky a few times and think you’ve mastered this game (and it is a game, make no mistake), but the likelihood of you winning at this game over the long-term is very low. Those that try their hand at this game (which is more gambling than investing, especially if trading daily) all think they are above average.
Let that last statement sink in. Can EVERYONE be above average?
Professional fund managers who actively pick stocks for a living (and get paid millions a year to do so) are below average as a group. So how can someone who does it a few hours a month be consistently above average at knowing when to buy AND when to sell a stock for a short-term gain?
Oh, and if you are under the impression that active fund managers are better than average, I urge you to research the subject. I’ve included two articles below, and some good books are mentioned in one of the articles, as well.
In one of the most volatile markets in decades, active fund managers underperformed again (cnbc.com)
Increase Your Savings First Before Spending Raises, Bonuses, and Other Extra Income
Just another way to pay yourself first
Transfer Risks to Insurance Companies Where Appropriate
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- Life Insurance during your working years
- Long-Term Disability Insurance during your working years
- You should be able to cover short-term (i.e., six months) with your emergency fund, but if you get Short-Term Disability coverage through your employer, even better
- Health Insurance
- Homeowners or Renters Insurance
- Umbrella Insurance
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Minimize Taxes, Both Current and Future
Find the balance by:
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- Making tax-deferred contributions to employer retirement plans or a traditional IRA to save on taxes now,
- Making after-tax Roth contributions to produce tax-free assets in the future, and
- Investing after-tax dollars in a brokerage account for easy, penalty-free access and lower long-term capital gains tax rates
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…so that you can control taxes through tax-efficient withdrawal strategies in retirement.
If you’ve stayed with me this far, my guess is that you are genuinely interested in building wealth and becoming financially independent. Some folks will look at this article and think, “This is garbage; I’m not living this way! Enjoy life now! Life is short! YOLO!” The problem with that way of thinking and lack of financial discipline is that you will likely end up nearing retirement in the position of HAVING to continue to work and earn at the current level just to maintain your lifestyle. Slowing down, earning less, pursuing a lifelong passion, and retiring will still just be dreams, as far away as when you started out.
I’m not suggesting you never have any fun, but if you start practicing these habits early in your working life, delaying gratification for a time, you will eventually be able to take your foot off the savings gas a bit and start to spend more even as you save more.
And if you practice these habits, the financial freedom will come faster than you expect.
But if you spend everything you make, live above your means, “enjoy life now,” and never save for your future, you will wake up in your fifties or sixties and realize that you no longer have enough time to build the savings you’ll need to replace your income.
