If you've been following retirement trends in the news recently, then you know that the situation looks grim for a lot of Americans. For instance, a study by the global bank HSBC (released in September 2013) found that 18 percent of U.S. workers will never have enough money to retire. In other words, they'll keep working until they get sick or drop dead. For most of us, that's not a very appealing way to spend our twilight years. What can you do to avoid that fate?
To begin with, we need to discard the traditional notion of retirement and replace it with the idea of financial independence. Financial independence is the ability to support yourself without relying on a wage (or government assistance). Retirement tends to occur at a particular age -- maybe 55 or 65 -- whereas financial independence can happen at any age, once you've accumulated the resources.
Reaching financial independence requires some effort, sacrifice, and learning on your part. Many people shy away from planning their finances because they lack an understanding of economics and financial markets. In my own practice as a financial planner, however, I've found that managing finances wisely depends on some basic principles that anyone can understand. Whether you're 55 or 25, you need to follow these six principles to reach financial independence:
1. Know how much you own and how much you owe.
This principle of financial planning requires that you know your net worth -- your assets and liabilities. It also requires that you know the rate of return on your investments and the fees and commissions you pay on those investments. Just as importantly, it requires that you know the interest rates and annual fees on your mortgages, credit cards, auto loans and other debts. How long will it take you to pay off those debts? Is it possible for you to pay them off at a faster rate or transfer balances for a better rate?
2. Spend less than you make.
You probably could have figured this one out on your own. It's pretty obvious, yet so many people ignore this cardinal rule. Quite often the problem arises from housing and transportation costs, since these are the expenses that cause most people to fall into debt. Before locking yourself into a long and costly mortgage or auto loan, think about how much of your income will go into those categories, and what else you could do with that income.
3. Acquire appreciating assets, not depreciating ones.
Speaking of auto loans... cars are a good example of depreciating assets. The minute you drive a new car off the dealership lot, it loses thousands of dollars of its original value. As the car continues to age, its value slowly trickles away as the parts gradually wear out. Real estate or stocks, by contrast, are assets that usually appreciate in value; their values rise with time. This means that they're resources for helping you increase your wealth in the long term.
4. Utilize the value of your greatest asset: Time.
The earlier you start investing, the more time your money has to grow, and the more risk you can tolerate in your investments. Investing at age 25 gives you a huge advantage over someone who started investing at age 35. Because investments in stocks and bonds grow at an exponential rate, a difference of a few years can add up to staggering amounts. As some anonymous sage once said, "The best time to plant a tree was 20 years ago. The second best time is today."
5. Guard your assets against risk.
A life-threatening illness or a debilitating injury can wipe out your finances in a hurry. It takes most people months or years to save $10,000, but that money doesn't last long when you're in the hospital. We can't prevent ourselves from ever getting sick or injured. We can, however, get adequate medical and disability insurance to minimize the damage of health-related misfortunes.
In the investment realm, you can mitigate risk by diversifying your investments -- that is by divvying them up among different companies and types of assets (bonds, stocks, currencies, real estate and more). Diversification acts as a buffer that insulates you from the shockwaves of market disasters.
6. Improve your knowledge of finance each day.
Several academic studies have found that Americans with higher levels of financial literacy, on average, have lower debts and greater savings. The more your knowledge grows, the closer you'll come to reaching financial independence.
Some Americans are lucky enough to have jobs they enjoy. They find fulfillment in work and delay retirement for as long as their health allows them. As we saw earlier, though, not everybody is so lucky. Don't let yourself become one of the millions of workers who can't retire. If you channel your current income toward achieving financial independence, you always have the option of continuing to work if you like your job. Then your financial future will be determined by one thing alone: your personal choice.
