Good personal finance principles – budgeting, saving, and investing properly – are not intuitive for most people, but are the exact steps for how to become financially independent. If you want to achieve the common financial goals to gain financial independence retire early, and live on your own terms, you must master the acts of saving and investing properly.
The society we live in today is driven by consumerism and marketing pressuring you to buy the next best thing, society and media reinforcing “wearing your money” and “keep up with the Jones” to prove your status as the best way to live, and pushing buzz and sensationalism driven investment tips based in speculation (crypto, NFTs, “X” Elon Musk stock) over value (real estate, growth stocks, index funds, businesses).
Though this all sounds exciting, gets your adrenaline up in a fun way and can be addictive, the most tried and true principles of building wealth that lead to financial independence run complete counter to these commonly pushed approaches.
Luckily, the principles of good personal finance that lead to financial independence through wealth accumulation are simple, easy to follow, and require only diligence and awareness. Though the principles won’t make you rich overnight, they will lead to a better, lower stress life through health personal financial management.
In this article, I will share a summary of the essentials of personal financial management, investing, and financial independence.
Contents of this Guide to How to Become Financially Independent
- These are the things I wish I’d known earlier regarding financial independence
- The Basis of Good Personal Finance and Achieving Financial Independence
- The Process of Becoming Financially Independent
- The Process of Getter Wealthier
- Tenets Of Personal Finance, Investing, and Achieving Financial Independence
- “Don’ts”: Essential things not to do on your financial independence path
- The Financial Awareness, Planning, and Reprogramming Process
- Recommended Reading on Personal Finance
- What is financial independence?
For most people, proper financial management skills, budgeting, and investing aren’t things commonly taught in younger years. Though there are some families that benefit talks around the dinner table about proper investment practices and small business operation, the vast majority of people go the entire period of their younger years (0 to 18) without an understanding of what habits truly lead to wealth (saving, proper investing) and what habits push us further away from it. I was one of those people.
Though I come from an incredibly hard-working family on both sides, and my siblings and I learned early on how to budget and save money, learning good investment practices and how to grow wealth in a sustainable, low risk way wasn’t part of our bringing.
Fortunately for me, over the past 20 years, I’ve been fortunate to stumble into enough conversations and have valuable personal finance books handed to me that I was able to learn just enough just in time. Better late than never, and over the past 10 years I’ve applied all of the ideas almost religiously.
As a result of strategically avoiding debt, keeping my living expenses low, and investing in stocks, businesses, and myself, I am financially independent. For the foreseeable future, working is purely an option.
My only regret is that I’d learned and applied these ideas sooner.
The ideas I will share with you, and how I will share them
Very few of the ideas you are going to read are my ideas. Most of these were borrowed, applied, and repeated more vigorously as I trusted them more. Additionally, I was introduced to most of these ideas via conversations with “more enlightened” savers and investors then studied the source material (books) they learned it from. As such, I will share this knowledge in the same fashion, by sharing the idea, and giving you the opportunity to read the source material and understand the research backing each principle.
This way, in a single “intellectual bite” I can share everything I wish 18 year old Carlos had learned to start the path of digging deeper and changing his life.
After reading, please reference the books section (at the end of the post) to learn the knowledge and build the confidence in these methods that you’ll need to start your own journey to financial independence.
The Basis of Good Personal Finance and Achieving Financial Independence
The Financial Independence Process and Building Healthy Financial Habits
Avoid future debt 🡪 Get out of existing debt 🡪 Spend less than you earn 🡪 invest the surplus in stocks, businesses, and real estate 🡪 cultivate additional sources of income 🡪 reinvest surplus income
The process of achieving financial independence is very straightforward, starting by aiming to build a lifestyle wherein your expenses are lower than your income, then cultivating habits in which the surplus is invested.
Note that this approach of using lifestyle as a ratchet to minimize cash outflow (reducing expenses) is the most important tenet that most “everyday millionaires” researched follow. This approach also runs counter to the common belief that financial independence starts with a first step of a massive income boost (lottery winnings, job promotion, wins on a single stock “gamble”).
As the researchers behind the book The Millionaire Next Door discovered, it is very common in American society to have an extremely high paying job (doctor, lawyer, CEO) and still be broke, with low net worth due to lifestyle habits. Just as well, it is possible to work a more common, middle-class job or perform blue collar work and, thanks to lifestyle choices, become a millionaire by reducing expenses, creating more saved cash that you then invest and make work for you, generating income passively.
The take away: The best way to get rich is by focusing on spending less before focusing on earning more
The Process of Getter Wealthier:
Invest the surplus in stocks, businesses, and real estate –> earn passive income –> reinvest –> earn passive income –> reinvest
Once you’ve cultivated the financially sustainable lifestyle and habits that can lead to financial independence, the next step is to optimize investing and reinvesting to make your money work harder for you, generating more dollars per dollar invested, taking you to financial independence sooner, and increasing your wealth and assets exponentially.
The Take away: After ingraining healthy financial habits, cultivating more sources of low effort / passive income is the quicker path to financial independence
Now that we’ve covered the general idea behind the kind of proper personal financial management that historically more often leads to sustained financial independence, I’ll share the specific principles that most financially independent people of first generation wealth have followed, that have been crucial on my path, and that I wish I had learned decades ago.
my biggest financial mistake was being in 8th grade in 2009 when I should’ve been buying foreclosed real estate— Money with Katie ☕️ (@moneywithkatie) September 9, 2022
- Save from day 1
- Keep a consistent budget until your savings rate exceeds 15% of your net income
- Pay yourself first (investing minimum 15%) to create artificial scarcity
- Save at least 15% of your income
- Maintain a liquid (cash) emergency fund of 1 to 3 months expenses
- Start investing early and invest regularly
- Keep investment simple: Invest in passively managed index funds (ETFs) pegged to broad stock market indexes and with less than .05% fees
- Avoid managed mutual funds and stocker pickers
- Best stock ETFs for beginner investors: VTI/VTSAX for stocks, VBTSX (Total US Bond Market)
- Later: Consider buying real estate and businesses with clear plan for positive net profit
- Asset Allocation Approaches (for balancing stock investments and lower risk investments)
- Start frugal. Stay frugal
- Avoid investing in things that won’t make you money or reduce long term costs with a positive ROI
Mindset, Outlook, and Philosophy
- View money as “life energy” storing the hours of your life used to earn it
- Trust that the stock market will come back: Buy and hold + double down in dips
- Use your knowledge of financial history as an emotional stabilizer
- Beware of the 4 mental states that affect investing: overconfidence, biased judgments, herd mentality, and loss aversion and recognize when they are driving your investment actions
Saving and Investing Principles with (just enough) notes
With that obsessive list of bullet points above, you now have everything you need to know to build healthy personal finance habits and achieve financial independence!
But, there is a chance that you’re just like me and need a little more detail, explanation, and corroborating sources. I hope that one day you too can waste your days away on a beach sipping coconuts. To speed up that process, in the next section I will share a little more detail on our tenets for saving, reducing expenses, investing, and cultivating a mindset that will lead to financial independence.
Feel free to jump to the end for the source material and recommended reading that backs up these ideas for real research
Saving, or the act of putting away unspent income and growing the unspent portion of income, is the first step to building wealth because savings is the fuel for investments which we make to generate wealth.
The more we save, the more we can invest, the more passive income we can make and save, thus repeating the cycle. Thus, optimizing our habit of saving is the first step on the path to financial independence and a tool to “ratchet” how quickly we can retire by increasing how we save.
Here are tactical steps for optimizing your habit of saving income:
Save from day 1
As soon as you have a discretionary spending money in your account (money not required for essential expenses), you can save and you should save at least a portion of it.
Saving as soon as possible is important to build the habit of saving. Even if your initial savings aren’t significant, ingraining the habit of saving first is nearly priceless as it allows you to focus your mental energy or more complex aspects of personal finance than remembering to save.
Additionally, the savings that accrues over time – think, 1 month of savings vs. 48 months of savings – buys more stocks, real estate, or other investments when the time comes.
Start saving now.
Keep a consistent budget until your savings rate exceeds 15%
Once the habit of saving at least a portion of your income, create a budget and track spending and saving accordingly, to assess how you can optimize spending or income to achieve at least 15% savings of your after tax income.
Once you’ve reached 15% savings, continue budgeting for at least 6 months to further ingrain the habits making the financial decision that leads to more savings nearly autonomic.
Save at least 15% of your income
15% minimum is a significant number because it was the most common savings rate of “everyday millionaires” studied and detailed in the book “The Millionaire Next Door.” 15% is a significant enough savings rate, relative to expenses, that the returns can lead to financial freedom with the right investments.
Pay yourself first (investing minimum 15%) to create artificial scarcity then live on the rest
Saving and investing before paying bills creates an artificial, yet beneficial, trap that we must plan our way out of.
Just as moving into a larger space commonly leads to purchasing more furniture, whether or not it is necessary, and tasks tend to fill all time allotted before a deadline, spending tends to naturally fill all available cash for most people. Avoid the pitfalls of this psychology by paying yourself (your future self) by investing your 15% savings before anything else
Maintain a liquid (cash) emergency fund of 1 to 3 months expenses minimum
Accidents and emergencies happen, and when they do, it may not be perfectly timed with market performance (making cashing in stocks an “inconvenient” task) and we want to avoid debt as much as possible. Having cash on hand for unexpected emergencies can help prevent financial health from getting derailed.
To avoid losing money in stocks by locking in losses or being forced to use debt, maintain an emergency fund a high interest bearing bank account or savings account that covers 1 to 3 months of your life. Note that an emergency is not an opportunity. An emergency is a threat to life or livelihood – a medical accident, a lost job, a crashed vehicle used for work. Avoid tapping into this financial cushion merely to maintain a healthy habit of using only the resources available according to your plan.
Once you’ve mastered the act of saving – avoiding spending a portion and setting it aside for investing – it’s time to learn how to invest or optimize how you invest your income in a way that grows your assets with as much return and as little risk as possible
Investing is the process of buying assets that increase in value over time (called appreciation) or generate an income return over time.
Examples of appreciating assets are real estate and stocks, whose prices generally increase over time.
Examples of assets that generate passive or semi-passive income returns are also real estate rental properties (which generate rental income) and stocks (which pay dividends).
Additionally assets such as businesses can be income generating investments, although they may not be passive and require more knowledge/experience to hold, thus making them suitable for certain investors.
Investing is essential to achieving financial independence because it allows us to grow our money, which either means an opportunity to grow more wealth, or an opportunity to live on the investment income while preserving the underlying asset.
Here are the key tactics to follow when investing with good personal finance habits:
Start early and invest regularly
Just as saving early builds essential habits, investing early allows us to program a habit, investing, early on.
Investing early allows us to hedge inflation and preserve buying power of unspent money, and start using the value of compounding interest over time as soon as possible. Because of these principles – inflation and compounding interest – saving early, to enable investing, has exponentially more benefit vs. the present, and saving later has exponentially more costs compared to investing in the present.
Additionally, investing early on gives us firsthand knowledge of and experience in the stock markets. As we experience the stock market through various cycles of bull and bear, and observe what happens before, during, and after recessions, we can trust our own observations, succumbing less to emotion, and trusting that in the long run, our investment strategy will lead to the financial situation we want.
These lessons give us an investor education through experience and can help us overcome anxiety throughout the stock market’s cycles.
Keep it simple: Invest in Index Funds that Broadly Cover the Stock Market
Invest in passively managed index funds (ETFs) pegged to broad stock market indexes and less than .05% fees. Avoid managed mutual funds (Best Source: The Bogleheads Guide to Investing)
This is the best approach for consumer investors (like us) because it saves money in fees and ensures our investments perform at the same level as the stock market.
Avoid managed mutual funds:
A reported 77% of fund managers actually lose money on their funds, while charging exorbitant fees (.5% to 1.25%) that eat away at gains. Data has proven that in the long run, most fund managers will not be the market (I learned the hard way).
Index funds perform with the market which regularly beats most managed funds, and index funds tend to have expense ratios ~1% per annum or more lower than managed funds
“According to a 2004 study by Dalbar Inc., from 1984 to 2002, the average annual return of the S&P 500 index was 12.2% per year Over the same period the average equity mutual fund investor had an average 3.4% return per year.”
Investing in an actively mutual fund due to good past performance is bad in the long term because years of good returns they generally regress back to the mean (Best Book Source: A Random Walk Down Wall Street)
The management fees and transaction fees of managed funds eat away at gains and generally would have cost 70% of gains in a 25 year period as compared to index funds ( ~.25% to 1% every year) while index funds like VTSAX have a .05% expense ratio by comparison (Best Book Source: The Bogleheads Guide to Investing)
ETFs are a lower risk, higher return approach.
VTI, VTSAX, and VBTSX should be the first ETFs you research investing in.
ETF Index funds tracking the total market such as the VTI/VTSAX for the US stock market, VBTSX (Total US Bond Market) are great places to research your start investing.
These funds follow the entire stock market passively with only a .05% expense ratio.
Allocate Your Assets Across Stocks and Bonds/Cash according to your risk tolerance how close you are to retirement
How you allocate your assets, such as 40% in stocks, 40% in real estate, and 20% in bonds and cash, affects the volatility and risk in your portfolio and investments (risk being the risk that an asset will decrease in value) as well as the returns you receive (returns are generally correlated with risk, meaning higher risk assets have a potential for higher gains as well as higher losses).
You will need to research the best asset allocation approach for your situation accounting for your risk tolerance and how close you are to retirement. Generally, the younger you are, the more calculated risk your portfolio should have (more stocks) while the closer to cashing in on your retirement fund you are, the less risk your portfolio should have.
Again, you should research the best asset allocation approach for you, but these are some common approaches to start your research with.
Asset Allocation Approaches
- My Preferred Approach: 70% to 85% Total Stock Market ETF + 30% to 15% Total Bond Market
- Asset Allocation Alternative 1: 1/3+1/3+1/3 split between 1/3(Total US Stock Market) + 1/3(Total US Bond Market) + 1/3(Global Stock Market)
- Asset Allocation Alternative | For investors close to retirement: (100%- [Your age in %]) + ([Your age in %]) –> [Total US Stock Market ETF] + [Combination of Total Bond Market ETF and cash]
As you accrue assets and become a more sophisticated investor, if you which to further diversify your portfolio, consider the following suggestions/limits for your preferred asset to add
For additional diversification of the equities portion of portfolio:
- Consider adding a Value/Small Cap Index fund to further reduce volatility
- Consider adding up to 20% International Index Funds for diversification of risk
- Consider adding up to 10% REITs for diversification of risk
- Do not add more than 10% in sector funds (energy, tech, health care) due to sector bubbles and sector volatility
Rebalance your portfolio at least annually to maintain your target asset allocation balance
As your assets perform, appreciating and generating returns, and you invest more and more savings, your portfolio will fall out of line with your chosen asset allocation strategy. Additionally, as you get closer to retirement or a large investment purchase (e.g., home) you will want to “rebalance your portfolio” shifting assets from stocks to real estate or bonds and vice versa.
This act of actively rebalancing maintains your target amount of risk, and locks in gains when the stock market is performing well in bull markets.
Additionally, rebalancing forces a purchase of “buying low” with money from bonds while stocks are “on sale” during bear markets.
Buy things that work for you (assets): Stocks, bonds, real estate, businesses
Anything that you purchase that makes you enough money to be a net profit, through income or appreciation, is an asset. Buy these.
Avoid purchasing things that result in a net loss of money in the end, and don’t contribute to another income stream.
“The poor work for money. The rich make money work for them.” (Rich Dad Poor Dad)
Avoid picking individual stocks to invest in. If you do, invest based on value, not speculation
Very, very, very few people choose stocks and beat the market in the long term. Though you may experience an astronomical gain in a single stock (Apple, Tesla) these gains will be erased by the losses experienced on other stock purchases.
You are better off investing in ETFs which track the entire market thus experiencing the gains of the entire market which is ~12% on average.
History shows you can’t pick the next great performing stock based on historical data for most investors (and nearly all retail). Better to just capture the returns for the entire market
Additionally, the average person can buy an index fund, and outperform professional stock pickers
If you do invest in the stocks of individual companies, consider the “value investing approach”
If you do intend to invest in individual companies’ stocks then study the value investing approaches, which entail analyzing the intrinsic value of companies vs. liquidation value of their stock (Best Source: The Intelligent Investor and Ben Graham’s other writings)
The value investing approach ultimately targets stocks trading at prices below there “liquidation value” at present (value investing), vice targeting companies because their stock price is expected to go up (speculation). If you are unfamiliar with or unsure how to do this analysis, stay away from investing in individual companies for now.
If you aim to buy the stock of undervalued companies (stock price vs. intrinsic value of a company), research Ben Graham’s strategy which is to hold until the mean reversion occurs, then sell.
Alternatively, you reach his pupil Warren Buffet’s approach which is to follow up by holding indefinitely (Best Book Sources: “The Intelligent Investor”,
Quick Review of Value Investing and Ben Graham: https://www.investopedia.com/articles/07/ben_graham.asp)
After starting an initial budget and assessing your income and financial situation, continually managing and reducing expenses is another ratchet to use in building wealth on the way to financial independence.
After we have ingrained a good habit of saving, instead of letting discretionary spending balloon, the more we can reduce expenses through basic lifestyle changes, the more free cash we will have invest and generate (more) passive or low effort income.
To effectively reduce expenses, consider the following tactics:
Avoid investing in things that won’t make you money
Anything that does not make you money and does not reduce your long-term costs or create a positive ROI from an income stream is an expense pushing you further from financial independence. Whether the purchase is a car, clothes, a smart phone, electronics, or anything else, if the existing item to be replaced is fine, consider skipping the purchase.
But be aware of expenses that “earn you money” or avoid a net loss, and purchase those
Certain “expenses” can actually investments over time. For instance, health insurance is a monthly cost. However, having medical issues and not having the safety net of medical coverage can lead to catastrophic physical and financial losses. Thus, not paying for health insurance can lead to a larger net loss and expense. The point – pay those “expenses” that reduce long term costs
“Buy it for life”:
When you do need to a make a purchase of anything that is not consumable, ensure everything you buy earns money or reduces cost in the long term, with low lifetime cost, and easy service repair (DIY if possible). In other words, opt for the option that will last the longest with the least maintenance.
Cultivate awareness of the “opportunity cost” of all purchases and expenses
Every time you spend $1, you trade something. Whether that $1 could have purchase a stock, or grown to the same pay as an hour of time, or could purchase a book, every dollar use spend costs the opportunity of something else. Be cognizant of these forgone investment opportunities, the lost energy, and the lost time to ensure that, of the opportunities available, you are seizing the purchase option or non-purchase option that suits your long term desires.
Practice a minimalist lifestyle
Force yourself to justify “why do I need more” and make “less” the default option. Not vice versa
As your income and assets grow, there is no reason for your lifestyle (and its expenses) to grow
Don’t wear or show your money, keep it and invest it
Don’t fall into the trap of displaying wealth for the appearance of high status, flashiness, instead of investing it (Best Book Source: Millionaire Next Door – Example: Sam Walton from Wal-Mart)
Don’t try to keep up with the Jones…they’re broke too.
Societal pressure to flaunt is why tradesmen, such as plumbers, electricians, etc., are more likely to save and invest properly than lawyers and doctors. People in high status positions tend to spend much more to maintain an external appearance (clothes, cars, homes) and expensive activities commonly associated with their professions while small business owners such as HVAC repairment and small service providers can live a frugal lifestyle without as much “societal pushback.”
However, for everyone, the decision to spend more money on what others see than on their investments is a choice.
Make the choice to invest instead of flaunting.
Cultivate the resources and mindset that afford “Financial Flexibility”
“Financial flexibility” is the ability to risk a dip in income or loss in assets allows while still being able to pay for your normal expenses
Such risks could be in investing in a business, changing a job, changing locations, etc.
Financial flexibility is achieved by amassing savings, amassing passive income sources, and the ability to immediately reduce expenses
Mindset, Outlook, and Philosophy
View money as “life energy”
Money is simply a means of storing the hours that earned it. View money as representative of your life and energy and you will be far less likely to squander it (Best Source: Your Money or Your Life)
Trust that the stock market will come back and hold through (or double down) during dips
Thus far, the market has always come back after a dip or recession, and thus will be the case for the global market in general and will also be the case for the US stock market. In the long run, the markets always bounce back.
This hints to another reason to start saving and investing early. Experiencing stock market cycles will build investment confidence and reduce fear in buying and holding, as well as buying when the market is in the trenches and the newsroom pundits are reporting the world is coming to an end.
Actively studying financial history, and experiencing the markets will give the confidence to invest and let the market perform. You can then use your knowledge of financial history as an emotional stabilizer
Beware of the 4 mental states that affect investing
For most investors, overconfidence, biased judgments (believing we have special knowledge), herd mentality (chasing, peer pressure), and loss aversion (refusing to sell a losing position) drive them to make poor investment decisions.
Most people lose money in the stock market because:
- We think we can time and invest right when a business will start performing well
- We think we can pick individual stocks that will perform well (most can’t)
- We think fund managers can pick individual stocks that will perform well (most can’t)
- We followed herd think, and “chase” stocks
Recognize when these mental states, vice sound investment strategy, are driving your investment actions.
Don’ts (Things not to do)
While there are plenty of things you can do to maximizing your savings, investments, and returns, there are also a handful of things you can avoid that will put you ahead of the pack in achieving financial independence
Don’t trust fund managers and individual stock recommendations
Market strategists have been wrong 77% of the time. Whether it is a hedge fund manager or a financial advisor you’ve hired, don’t trust specific stock picks. Once again, the best options for picking stocks, when accounting for performance and fees, is investing in passively tracked ETFs that invest “all stocks,” not just a single stock. (David Dreman – Four Pillars of Investing)
Don’t try to “time the market” for entries and exits
If you have or have received a large sum of money that needs to go into your investments, do not try to “time” when your investment takes place. Timing the market is impossible and if the delay to invest is too long, you will miss out on the returns.
If you do need to move a larger sum of money into the and are scared of potentially buying while the price is too high, consider leverage the technique of “Dollar Cost Averaging” instead
Don’t accept debt as normal
In American society, debt is commonly defaulted as normal. Under no circumstances, accept the possibility of living on credit. If you are living on credit card debt then technically you have a negative net worth, placing you position further from and less likely to reach financial independence than when you were born.
Financial Awakening, Planning, And Reprogramming Process
Assess your current financial situation and habits
- Assessing your financial situation
- Calculate your net worth
- Calculate your earnings
- Calculate your “real” earnings per hour
- Calculate your current expenses
- Highlight everything that can be removed, to note for later
- Calculate your current savings rate
- Analyzing expenses
- Exercise calculating what activities all of the money is going to
- List out all of the expenses for a month, and price, in categories
- Identify your hourly rate
- Assess every budget item in hours of your life. Make it
- Assess what you are spending too much on, and how to spend differently
- Consumer electronics
- Food and grocery
- Check for opportunities for improvement, expenses that can be reduced
- Make a reasonable budget and assess your monthly income needs
- Sculpt a budget that:
- Eliminates all debt (first)
- Targets a 15% to 20% net income savings rate (second)
- Planning how you will actually invest your money
- Starting specifics
- Specific ETFs
- Specific bond funds
- Specific real estate opportunities
- Investing in small businesses
- Planning to invest holistically (and what’s the ROI)
- Personal development (knowledge, learning, habit building, lifestyle planning
- Physical Health
- Physical Fitness
- Assess: benefits (hours, how good it makes you feel)
- Assess your path going forward
- Figure out your number (the monthly income you need, and the total liquid assets you need to retire)
- Calculate (using your savings rate and assets) how long it will take to reach “your number”
This section may contain affiliate links
- The Bogleheads Guide to Investing
- A Random Walk Down Wallstreet
- If You Can: How Millenials Can Get Rich Slowly
- The Four Pillars of Investing
- The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns
- The Intelligent Investor
- The Simple Path to Wealth
- Get a Life: You Don’t Need a Million to Retire Well
- Early Retirement Extreme
- Building Wealth And Being Happy: A Practical Guide To Financial Independence
Philosophy and Mindstate
- The Richest Man in Babylon
- A Guide to the Good Life – The Ancient Art of the Stoics
- In Praise of Idleness
- How I found freedom in an Unfree World
- The Life-Changing Magic of Tidying Up: The Japanese Art of Decluttering and Organizing
What is financial independence?
Having financial independence means having the financial resources or income to pay for one’s reasonable expenses and lifestyle indefinitely without being employed by or dependent on others.
As such, one who is financially independent no longer needs to rely on working for an employer for the income to survive.
In this guide, we will discuss the principles of the Financial Independent Retire Early movement to become financially independent