This post is about lessons I have learnt in achieving financial freedom. To be honest, I am not rich or financially free by any means, yet. But I confidently apply the financial principles mentioned below in my life because I believe in these principles and their efficacy. Please keep in mind that these principles are for ’employees’ who earn a regular paycheque and have modest retirement dreams. If you’re someone with big retirement dreams such as a vacation home in France, this blogpost is not for you. Also, if you’re an entrepreneur looking to build a business of your own or an artist/freelancer, you may not find these principles useful.
Saving is, of course, step 1. Financial freedom begins here. It doesn’t matter how much you can save. What matters is that you save a percentage of your salary from every paycheque and that you start doing this as early in life as possible. The more time you have to save, the richer you are going to be.
How to save?
You should set up a bi-weekly or monthly pre-authorized transfer to a savings account/investment account depending on how often you get paid. The key is to have your savings automated. Most employers have an RRSP or 401K savings plan where the employer will match your contributions up to a certain percentage of your salary which is generally around 4-5%.
What if I have no extra money left at the end of the month to put towards savings?
That’s okay. Pledge to start saving next time you get a raise. You might be an associate at Walmart or a lawyer at a law firm, it doesn’t matter because both of you will get a raise eventually. This can be the annual raise given by most employers for increase in cost of living or any raises given as a performance reward.
How much should you save?
Try to save at least 5% of each and every paycheque. Even better if you can save more.
All the money you save must be invested. Why? So as to reap the rewards of compound interest and time. Compound interest and time are the only two weapons in the arsenal of an average middle class worker. And of course there is always the lottery but that old rusty gun only fires once in 30 million times.
How to invest my savings?
You should invest your savings in two separate buckets – growth bucket and safety bucket. The purpose of the growth bucket is to take some risk on your principal investment amount and grow your money over time whereas the safety bucket is to ensure that no matter what happens to the markets, you never lose the principal investment amount. The split between the two buckets will depend on your needs. If you are going to buy a house in a year or two and will need 80% of your savings for it, then you should put 80% of your savings in the safety bucket and 20% in the growth bucket. But if you have no big expenses such as cars or weddings coming up and do not plan to withdraw from your savings in the next 10 years, then I would suggest you put 80% in the growth bucket and 20% in the safety bucket for any unforeseen circumstances such as an illness or loss of employment.
Safety bucket comprises of high interest savings accounts, guaranteed investment certificates, money market funds, structured bank notes, and similar investment vehicles. These investments offer very low interest rates but guarantee your principal. Check with your local bank to get the best interest rates possible for these investments.
Growth bucket comprises of stocks, bonds, mutual funds, ETFs, REITs, commodities, and similar investments. These investments offer the potential to earn higher interest on your principal but they come at the risk of you losing some or all of your principal amount.
Note: All of your investments should be in your TFSA and RRSP investment accounts. In the United States, they should be in Roth 401K and 401Ks. This is very important so that you can let your investments grow in a tax sheltered account.
Which investments to hold in the growth bucket?
I like to keep it simple. I am not a security analyst and most ’employees’ with nine to five jobs aren’t. So I like to buy the entire stock and bond markets aka index funds. There are three ETFs that should be a part of your portfolio – your home country stock index ETF, an international stock index ETF, and a home country bond index ETF. For a stock index ETF in Canada, I would recommend buying an index that represents all the companies traded on the TSX. For a bond index ETF, buy an ETF that has a mix of government, municipal, and corporate bonds with varying maturities. For an international index ETF, buy an ETF with stock indexes outside of Canada, such as the U.S., Europe, and developing nations. You can learn more about which ETFs to buy here.
A word on FEES!
When you’re picking a mutual fund or an ETF to invest in, please make yourself aware of the associated fees. You can find the fees mentioned as Management Expense Ratio (MER) on the prospectus of the fund. Mutual funds in Canada typically have fees ranging from 2-3% and this is ridiculously high. It may not sound like a lot but every 1% increase in fees can cost you hundreds of thousands of dollars in fees over the lifetime of your investment. For example, let us say you earn $50,000 a year and invest 4% of your salary each year. And let’s assume you invest for 40 years in a mutual fund or ETF with 2% in fees. That amounts to $386,000 in fees if the investment grows with a 9% annual rate of return. Let’s say you don’t think the market will grow at 9% rate of return and you believe it will grow at 5%. Even then, you’re paying $124,000 in fees. The investments I own are mentioned below in the post and they average at about 0.35% in fees.
So next time your bank tries to sell you on a high fee mutual fund, beware. Ask them for a fund with less than 1% in fees. That should be your target, at least less than 1%.
What is the best asset allocation for the growth bucket?
That depends on you. Do you want to use the money in the next 5-10 years? Or are you planning on letting your investment grow for 10+ years? What is your risk tolerance?
If for example, you are approaching retirement and plan to withdraw the money in less than 10 years then your portfolio should be heavily weighted in government bonds. But if you’re just fresh out of college and starting to invest, then your portfolio should be heavily weighted in stocks.
My advice is to invest the same percentage as your age in a bond index ETF and the remaining percentage should be split equally between the home country stock index ETF and the international stock index ETF. I like to keep it simple but if you’re a seasoned investor and you know what you’re doing then you could add commodities, gold and REITs to the portfolio as well to weather the storm during various economic seasons such as inflation, deflation, rising economic growth and declining economic growth.
I live in Canada and I am 30 years old so my portfolio is 30% bond ETF, 35% TSX composite index ETF, and 35% international index ETF. Here are the holdings in my portfolio:
What are the best assets to hold in the safety bucket?
I personally park my safety bucket money in a high interest savings account. I have my money at EQ Bank which offers 2.3% interest per annum as of today. I prefer to hold my money in an online bank such as EQ because of the high interest rate. Although this can be an issue if you have more than $100,000 to put into savings. Please keep in mind that these online banks are not the same as your more secure traditional banks. But nevertheless, deposits in these online banks are generally guruanteed by CDIC up to a maximum of $100,000.
Rebalance your portfolio!
This is the most important step. Rebalance your portfolio at least once a year and do not rebalance more than twice a year. Rebalance on the same day of the year, every year. For example, let us assume this day is Christmas Day for you and you decided to put 70% of your funds in stocks and 30% in bonds on Christmas Day this year. Next Christmas, let’s say you now have 75% in stocks and 25% in bonds, which can result from stocks going up and bonds going down. Now it’s time to rebalance your portfolio, sell 5% of your stocks and buy bonds with it.
That’s it! It is that simple to invest and get rich, slowly but surely. Just sit back and relax. Let time and compound interest do it’s job.