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Four Simple Rules to follow for Financial Independence
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posted 08-02-2003 07:38 AM
Four Simple Rules to Financial Independence
This rule may seem obvious but many people have difficulty following it. If you’re spending more than what you earn, you will never be able to become financially independent. You will be paying money to others for the rest of your life. By managing your expenses so that you spend less than you earn, you will create spare cash to invest or meet unexpected expenses. The earlier you start living by this rule, the better, but remember, it is never too late.
Popular thinking, states 10% of your income should be saved. You should identify a percentage of your monthly income to save and then stick to it. Identify, save and wisely invest a certain portion of your income every month and your wealth will grow significantly.
It may surprise you but the average Australian, earning between $30,000 and $50,000 a year for 40 years, will earn somewhere between $1,200,000 and $2,000,000 throughout his/hers working years. Yet most of will retire poor.
Saving just 10% of your income along the way would provide a nest egg of $120,000 to $200,000 that could be used as the basis for an investment program. So the level of your income has no bearing on the level of wealth you achieve, what is critical is the amount you save.
Many studies have shown that a sensible and knowledgeable private investor can expect their investment portfolio to out perform those of many professional fund managers. This is because the individual investor has flexibility, agility and low overheads.
Major rules to follow are:
- protect your capital (don't speculate);
‘If you fail to plan, you plan to fail’.
If you want to achieve your investment goals, whatever they are, it is critical to develop an investment plan. Then you must adhere to the plan and only change when there are significant changes in the basic factors. Ideally, leave your investment alone and let the magic of compounding do its work.
But start now!
On average, people need about 75 percent of their pre-retirement income to maintain their standard of living throughout their retirement. That translates into consistently saving about 10 percent of your income throughout your working years.
The longer you wait though, the harder it gets. Every decade you put off saving nearly doubles the amount you have to save to meet your retirement goals. For example, if you need to save 5 percent a year starting in your early 20s to attain retirement bliss, you'll need to scrimp and save 10 percent annually if you wait until your 30 to start saving. And if you wait until your 40, the amount jumps again to 20 percent.
The principle of compounding suggests that even a small sum of money can grow into a huge investment over time.
Compounding is money multiplying itself, which allows investors to earn income on their income. Income payments grow each year because the amount upon which the payments are based also grows each year.
The following example assumes a tax-deferred investment.
If you invested $100 on the first business day of each month for 10 years at a 6% rate of return compounded monthly, you would accumulate $16,470, including your principal of $12,000. If you invested the same amount at a 10% rate of return, the total investment would be worth $20,655, a difference of $4,185.
But imagine investing that $100 over a longer period. After 20 years, your principal investment of $24,000, earning 10 per cent compounded monthly, would be worth $76,570. Your $100 a month invested over 30 years would be equal to $227,933, a substantial increase. Extend that over 40 years and your money would grow to $637,678.
Combine a higher rate of return with your regular savings and the effects of compounding are further improved.
Perhaps the best way to understand the effect of compounding is to consider two individuals who have similar investments of $10,000 each, both earning 10 per cent each year. Their attitudes towards saving are very different, however. The first person is a spender while the second is an investor.
For illustrative purposes, assume that each individual uses another source of cash to fund the tax liability each year, so that the $1,000 earned in income in year one is truly $1,000 available for saving or spending.
The spender spends the growth each year and continues to receive the same $1,000 year after year. After 10 years, the spender has only the original $10,000, having spent the $1,000 of earned income.
The other investor reinvests their earned income each year. So, in the second year, the investor earns 10 per cent on the $11,000. As a result, the value of the investment is constantly increasing as income is earned on the income of previous years.
That's called compounding. After 10 years, the investor has $25,937 - more than 2˝ times as much as the spender. It's a painless way to invest and have your investment grow at the same time.
These examples illustrate important factors when making an investment decision: length of time and rate of return. The longer you allow your investment to grow and the greater the rate of return, the larger the future value of your investment will be.
What this means to you is that if you invest, even a small amount, in an asset that grows in value over time, and you reinvest the income from your investment (the interest you receive, or the rent you receive from your property investment, or the dividend you receive from your shares), the magic of compounding will work miracles for you.
It also means that you can no longer use the argument " I can only save $10 a week, so it’s no use. It will never amount to much." Even small regular savings compound to large sums over the years.
All times are ET (US)
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