Here I’m going to write my first post on a new series on Principles. I’m going to introduce concepts that are widely know to the Personal Finance community that you, my dear reader, may not be very familiar with. I’m going to talk about higher values and my philosophical and ethical approach to personal finance. In this series I’m going to talk about my ideal society, the meaning of work, the meaning of money, time economy, life energy, consumerism, minimalism, frugality, stoicism, self reliance, renaissance man, happiness, nature, pleasures, passions, purpose,… Not all of them in this post, obviously 🙂
Here I’m going to talk about Financial Freedom.
In last chapter of my financial story series I explored the why I want to reach Financial Independence (tl;dr: to achieve self actualization). Here I’m going to define what it actually means and what are financial steps to walk along this very path.
In the amazing book Your Money or Your Life, that is the main reference for this post, the authors (Joe Dominguez and Vicki Robin) introduced the three Financial stages a financially healthy person would pass thru their life. Let’s take a closer look at them. Bonus: Here‘s an amazing collection of chapter reviews by Trent Hamm.
Let’s pretend we’re following a journey of a person from the very financial bottom to financial independence. If you need a real scenario, you can read the story of Trent Hamm, founder of The Simple Dollar, who perfectly documented all the stages in his life, from his financial bottom to the celestial walk to FI.
So, let’s assume you’re in financial trouble, maybe full of debts, maybe working on a job you hate, maybe living paycheck to paycheck. That’s a very common situation, actually the most common one. In Italy, for example, we use to say “I can’t reach the end of the month“, that basically means that the fourth week of each month is very lean and you need to cut expenses to survive till next paycheck. It’s a so desperate and so common situation that we just assume it’s normal. But it isn’t! One works very hard and all they get is to be able to almost reach next paycheck.
[ Well, in Italy none asks “ok, I’m in this shitty situation. How can I make some improvements?“. We’d rather blame the government, the immigrates that steal our jobs, the inevitability of the (third for the family) car loan payments,… There’s no way you can have a chat with Italian friends or acquaintances for 15 minutes straight without having them start complaining about their inability to “reach the end of this month” ]
Dear Italian friend – just saying, I know I won’t have many Italian readers, I know you don’t speak English – first step is to get the so called Financial Intelligence.
Let’s make a food analogy: you’re overweight and feel depressed. You keep eating unhealthy food because it tastes good and gives you immediate – but false – joy. After yet another piadina with Nutella you feel like shit. You’re fat, you don’t like your body, you can’t walk the stairs without feeling dead for the fatigue. You can’t work out because you’re too fat for most exercises. Your doctor keeps telling you that you risk heart diseases, diabetes and other illnesses but you don’t care because it’s not an immediate threat. You watch other people running and you complain that they are “lucky”, that they have better metabolism, that whatever but you can’t survive without lasagna,…
Do you want to improve you life? Time to acquire the first but most important skill: Financial intelligence.
Level 1 – Financial Intelligence.
Financial Intelligence is awareness. Knowing the basics before trying to control them. Do you know what’s your Net Worth? Do you know what’s your Cash Flow? Your Incomes? Your detailed Spending? Do you know what are the interest rates of your liabilities? Do you know your actual hourly wage?
It seems it’s the simplest step one can do, but actually very few financially-in-trouble people do it. It takes willpower and/or desperation to make the first step. It also requires some knowledge. Many people don’t think they can actually make it, they feel doomed and it leads to a dangerous vicious cycle where one compromises their financial situation even more because “there’s nothing I can do. I can’t live like a homeless and still be full of debt. So, better to enjoy life and buy a shiny new car“.
The value of books like YMOYL or online communities come into play providing the information you need, assuming you’re seeking out for a cure to your financial disease. Blogs like Wise Bread, The Simple Dollar, Mr.Money Mustache, Early Retirement Extreme (and many others) are doing the incredible job of showing people that a different life is possible and you can make it, assuming you’re willing to make few important changes in your routines/habits/behaviors.
So you’re in trouble, full of debt and/or with an addiction to impulsive purchases and you feel doomed. First thing to do when you’re in such a hole – and this is valid outside personal finance too – is breathe and understand where you are. Get the full picture and be honest with yourself. Understand where your money are flowing away. Break numbers down into categories, measure the impact of your debts and negative interests, do budgeting. Then you’ll be Financially Intelligent.
In our food analogy, our financial intelligent overweight Joe decided to monitor his every day weight, his workout sessions, calories burned and calories eaten. He discovers, looking at food labels, that just a single marshmallows, that he really loves, is worth 5 tomatoes of calories. Wow. He discovered that 30 minutes of running is not enough to burn half Big Mac. It’s an eye-opener experience that may depress a little, but in the end makes him aware.
I’m lucky enough that I never had to see the financial bottom. I grew up with a basic but good enough financial education (thanks to my father) and I’ve never been in debt. I had to handle my finances pretty early in my life and thanks to this I’ve been monitoring Net Worth and Cash Flow since the dawn of time. My Net Worth has always been positive and I’ve never struggled to reach the end of the month. I’ve always been Financially Intelligent.
Ok, now you’re Financially Intelligent. You know your assets and liabilities, you started a budget and you are tracking earnings and expenses over time. Now it’s time to move up!
Level 2 – Financial Integrity
Financial Integrity means taking actions. Once you have a good picture of your situation, it’s usually easy to find and grab low hanging fruits: “huh… am I really spending 200 Euro per month on videogames?“. So, strategies like cutting superfluous expenses come natural and they are easily implemented.
What will happen when you start taking action is that you better define your values. You understand easily that you need to spend less than you earn if you want to get back in financial shape. To do that, you either earn more or spend less (or, better, both). The latter is simpler and quicker. To cut spending you need to take decisions and define priorities. Your own priorities. You need to define your “enough” for spending on each category.
You’ll quit unhealthy behaviors like impulse spending or buying advertised products just because they are popular. You may eventually discover frugality and/or minimalism, and actually like them. You make transformations in your lifestyle, in how you chose the people around you, in how you interpret consumerist signals from society (commercials, ads, the Joneses). You will probably look at purchases from a Life Energy point of view, i.e. “how much time do I need to work to cover this expense?“.
You may be enjoying the freedom not having to think about next paycheck brings to your life and start saving, building an Emergency Fund. Eventually, when you have enough cash to survive a year (people recommend 3-6 months) without working, you’ll stop hoarding cash and start investing and/or paying back your debts, sending your money to work for you thanks to the immense power of compounding.
You may also work on the earning side of the equation: once you ‘stash a year of salary you may consider working part time and take some classes or learn a new skill or start a side gig to boost your earnings. You may realize your commute takes too much time and it’s costing you a lot of life energies (opportunity cost) and living far from your office is not worth the few bucks you’re saving.
You’re taking actions, you’re a different person now. You took time to explore what matters to you. Your financial actions reflect your values. You achieved Financial Integrity.
In the food analogy, having acknowledged that you are not ok, you start a diet and do sports. At the beginning eating less was frustrating but now you feel full eating a quarter of what you used to. And you like that! It was hard to get your sneakers on and go running at dawn – you were able to run 5 minutes and then everything ached – but now you wake up happy to go running your 10 kilometers, it may actually be the best part of your day, and try to break your record on that distance. You’ll plan a half marathon and draw a working out plan to prepare yourself. You lost 5 kilos, then 10 kilos, then 15 kilos and the more you get in shape the more you like the process itself.
In my case, again, thanks to both my father who taught me the basics and to my genuine lack of passion for luxury I was born with some sort of Financial Integrity. I was educated to manage my money and do budgeting very early in my life. I started earning money at high school doing math lessons. I always spent less than I earned. I sought opportunities to earn more and implemented frugal tactics. I didn’t have big goals though. I didn’t investigate my values deep enough. It took me ~25 years to see the big picture.
You’re now in good financial shape and instead of spending your mental energies on “how to pay the pile of bills that are waiting for me at home” or “I hate my boss but I’ve no other options, I need to keep my job” or “the government approved another law that will move retirement age in the mid 70, holy shit I have to work forever!” you may relax and stop caring about immediate money problems. You’ll start focusing on what really matters and how to move your attention and money/time/energy toward these passions/people/projects.
From now on the path is not necessary a straight line. Not every financial healthy person wants to reach independence. I know a lot of people who genuinely like working and/or love some luxury and they budget for that. I know people who fear the freedom that Financial Independence will suddenly allow. Anyway, it’s a matter of personal values and none is here to judge. What happened to me – and apparently I’m not alone in this – is that I started to ask myself “what to do with this accumulated wealth?“. Buying more things didn’t seem too much appealing. So I started seeking freedom.
Bonus: here’s a link to the original 9 steps Financial Integrity program by the authors of YMOYL.
Level 3 – Financial Independence
Financial Independence means tasting freedom. You no long have to work to maintain your lifestyle, since your money are working for you instead. Your passive incomes (like stocks appreciation, dividends, rental properties income,…) cover your living expenses and you’re free to choose what to do.
You may keep current job, try a different career, go back to school, take entrepreneurial steps, work less, work none. You may have dreams you want to follow, people you want to take care of. It’s really up to you. You’ve got freedom.
Freedom here stands for freedom from selling your time for money. You no longer need it. You’ll rely on your passive incomes robustness, like betting on average market returns of 7% per year (inflation adjusted) on the long run or a combination of good tenants, rent/house appreciations and low vacation rate for your rental properties.
Before you call it FI, you’ll have ran your numbers and considered several safety margins. Eventually you’ll have planned an exit strategy if things would go south. I love the “Oh Crap, Oh Shit” idea shown in livingafi blog.
You adapted to a lifestyle you like and have a good strategy to support it with passive income for (hopefully) the rest of your life, which is a very bold statement since you may retire pretty early, in your early 30s or even in your late 20s. Yes, if FI is what you seek, you may go extreme frugal and obtain it as quickly as possible. Reducing your spending by a lot makes things way easier, since you both save more money and need less money to maintain your lifestyle. It’s a win-win scenario!
The extreme frugality path has been perfectly explained in the amazing book Early Retirement Extreme, in the associated blog or in other frugal-centric blogs like the frugalwoods family’s one.
Sadly the food analogy can’t keep up with the financial story I’m telling here. There’s no such thing as compounding: you can’t exploit “accumulated weight loss” to keep losing weight and thus eating what you want and still be healthy. Actually it works the other way around: the fitter you are the stronger you have to keep up with diets and workouts or else you lose benefits quite soon. Bye bye (former) overweight Joe.
Here’s where I’m heading to. I’ve been financially “Integral” (is that the right way to say? It sounds weird!) since forever but I had no clear vision for my future. I have been naturally frugal, I’ve accumulated some kind of wealth but then what? Just for “financial security“? With the income boost provided by Hooli I started dreaming high. I plotted an actual plan, threw out some numbers and found a break even point, a target NW to call it FI. The so called FU Number. The plan is going to change, the FU Number is going to change according with life decision like: do I want a family (spoiler: yes)? How many kids (spoiler: >= 2)? Do I want to retire in Switzerland (spoiler: no)? In Italy (spoiler: maybe)? Somewhere else (spoiler: maybe)? Is there a wealth tax there? Do I plan for windfalls? Should I account for annuities at one point? Social security? How much per month/year do I want to allow my family to spend? What should be my withdrawal rate? Do I plan to keep “working” on activities that may earn money, like renting a room on airbnb? All these factors will impact the actual dynamic strategy.
Anyway, as you see one has to take decisions, cutting corners, making plans to be able to achieve FI. It’s freedom, but it comes at some costs.
So you’re now part of the club of the few people who are walking on the heaven of FI, who can avoid caring about job market, unemployment rate, bosses that suck, shitty jobs, economy (well, not exactly). Life is awesome and you’re not scared at all by the future.
Or… are you?
Level 4 – Financial Freedom
Financial Freedom means removing money from the equation. It means, as Mr Money Mustache suggests in his Rule of Free:
I try to make all spending decisions as if the price were $0.00
And I make all work and income decisions as if the wage were $0.00
That’s true Financial Freedom.
Note: this is not one of the YMOYL steps. I first read about the concept of FF on this very good post by Financial Mentor. Then I got enlightened by the above mentioned MMM post. Financial Mentor says:
For example, extreme frugality would limit my ability to take my family to France for a month (like I did last year), which honors my values for adventure and life experience. I wouldn’t be able to honor my values on education by paying for quality, private school for my kids.
I wouldn’t be able to honor my health values by paying for professional services like sports training, physical therapy, or expensive organic food. All these things would be luxuries in a world dominated by frugality thinking.
These would all be limitations to my freedom and would dishonor my values. In my personal experience, that’s antithetical to true wealth and personal freedom
I don’t fully agree with the above quotation, but I do understand his point.
You can think of FF as FI with almost International Space Station’s security measures against unplanned events. Rock solid FI, with a monthly budget well beyond your most desirable spending regime at your safe withdrawal rate. Or, equivalently, a withdrawal rate of 1% or less at your current spending regime.
No economic event in the foreseeable future (excluding catastrophes, world war or a sudden depletion of earth resources) can put your plan at risk.
I’m not heading there though, at least not for now. FF means you’ll cross FI threshold and either keep building wealth, to reach passive income streams that total well above your wettest dreams – a là Financial Samurai – or you reach a state were you don’t know what you would do with more money – a là Mr Money Mustache or Jacob, with 117 years of spending stashed at the time of writing this article, August 2016. Either you become very very wealthy, or you become very very frugal with no desire of spending more.
Pursuing FF should be planned while walking toward FI, it’s not something that comes natural. Pulling the Early Retirement trigger too early prevent you from following the super wealth path, leaving you with only the Zen one available and not everybody is suited for it.
Where are you on this ladder?
What? Level 0? What are you waiting for?? 🙂