9 Steps to Financial Freedom

This article is based on the book Your Money or Your Life by Joe Dominguez. This article will not substitute reading the book, nor it is intended to do so.

The following 9-step guideline is a modified version of the process outlined in the book Your Money or Your Life.

Practical tips for successful implementation of The Plan:

Step 1:

• The total amount of money earned throughout one's life can be found on the annual statement from Social Security Administration. However, it needs to be adjusted for any unreported income, for example: gambling winnings, gifts from relatives, jobs paid under the table, money you've stolen, etc.
• Create an inventory list of all your assets. This is a list of all your liquid assets (cash on hand, debit accounts, savings accounts, any bonds and stocks, etc) and fixed assets (house, car, computer, furniture, bicycle, books, DVD collection, etc). Do not count things you won't be able to sell (towels, shower curtain, kitchenware, clothes, damaged furniture, etc).
• Check eBay.com for the approximate current market price of your hard assets. You can find the market value of your house on the website of your local real estate appraiser. Look on Kelly Blue Book for market value of your car.
• Make a list of all your debts (credit cards balance, borrowings from family and friends, mortgage, etc.). That's your liabilities.
• Add value of the liquid assets and value of the fixed assets, and substract the liabilities. This is your current net worth. Compare your net worth to the amount of money you have earned throughout your entire life.
• Update the balance sheet monthly. Practically, it will be easier to watch only liquid assets. The only hard assets to be remaining on the balance sheet are a house and sometimes a car - only if you live in a big city, and can get without it.

The Millionaire Next Door has a simple test to calculate what your net worth should be right now:
"Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by 10. This, less any inherited wealth, is what your net worth should be."

Step 2:

Determine your true hourly wage - use this spreadsheet file: LifeEnergy.xls

Step 3:

Keep track of every penny that comes into or goes out of your life - use these two spreadsheet files: BankAccounts.xls, and CreditCards.xls.

Categorize your spending and express in hours of your life energy - the spreadsheet file Expenses.xls is just an example. Establish your own categories. Check the book for details.

Calc/Excel tip: after adding a new row, click on the cell in column amount (Expenses.xls) or balance (BankAccounts.xls and CreditCards.xls) in a row just above, then place the mouse cursor in the bottom-right corner over a small black square until the cursor changes it's appearance to a cross. Then right-click and drag it downward. The Calc/Excel copies the formula to the cell below and updates that cell with a corresponding value.

Step 4:

Evaluate your expenditures. Take a look at each category with the following three questions in mind:

1. Did I receive fulfillment, satisfaction and value in proportion to life energy spent?
2. Is this expenditure of life energy in alignment with my values and life purpose?
3. How might this expenditure change if I didn't have to work for a living?

First of all, you have to determine your own "life mission", set your priorities straight, and know what you expect from your life. Before you can set your financial goals, you need to know what your dreams are. Just having money by itself wont make you happy. If you can identify that, then you can learn how to calculate the minimum amount of income you will need to live the way you want. The book is really helpful in this step.

For some people their dream lives involve fantasies of being incredibly rich. But most people would enjoy a different life which is tied to their true values much more. Would it be worth selling your entire life away to earn these types of luxuries? Would you sacrifice your life to earn it?

If you received fulfillment from the expense in question, that you'd even like to increase spending in this category, place a "+" sign (plus) in the box. If you received little or no fulfillment from it, put a "-" (minus) in that box. If the expense is just as it is, put 0 (zero).

Wherever you put a minus sign, think about that expense. What are you going to do about it? Think of possible life scenarios and how would these expenses change. For example: moving to some other place, like a small town in one of those states with minimal or no state taxes, where life is cheaper, air is fresh, and all you could do is your favorite sport like mountain biking, climbing, hiking, canyoning, you name it. How would your expenditures change? Would you get more fulfillment and satisfaction?

Step 5:

Visualize your progress:

1. create your personal financial statements: balance sheet, income statement, and cash-flow statement. Example spreadsheet file: Statements.xls
2. create two charts based on your income statement and balance sheet
3. on the first graph put lines: earned income, expenses,and passive income
4. on the second graph put the lines: total assets, net worth, debt excluding mortgage, and cash.
5. update your statements and graphs every last day of the month
6. make a screenshot of your income-expenses graph and use it as wallpaper or just print it out and leave in a place where you will look at it every day
7. tip: always focus on the income statement graph, but always keep in mind the graph of the net worth
8. tip: watch your credit card debt and any other payable on-demand type debts. Thus, watch two things on the balance sheet graph: net worth, and liquidity (just compare debt line with liquid assets line).

Step 6:

Minimize spending, look for ways to save money. There are multiple web sites abut frugal living with thousands of tips about saving every penny (examples: FatWallet.com, GetRichSlowly.org, the SmartSpending blog on moneycentral.msn.com, MoneyHacks.org, Moolanomy.com, TheSimpleDollar.com, and many more). Searching for ways to save money is a never ending task. You will be constantly scanning the Internet for new ways to save money. With time you'll get creative, and you'll be inventing your own tips.

Tips:

• Learn how to distinguish needs and wants.
• Start using shopping lists to overcome the spending urge while shopping.
• Take care of what you have, it will last longer.
• Wear your clothes until they wear out.
• Learn how to estimate price/quality ratio.
• Buy Consumer Reports before any major purchase, and do some research.
• Buy used things.
• Stop paying for something you can get for free. For example: a credit card with no annual fee.

Step 7:

Maximize income, search for ways to increase your income - first start hiring yourself to do things that you usually pay others to do. For example: change engine oil, wash your car, etc. This is where the Step 7 blends with Step 6 (saving), but in reality you are working extra hours to make those savings.

A penny saved is a penny earned. - Benjamin Franklin

Sell your stuff you no longer need on eBay.com, sell your old books on amazon.com. This is a good experience, after that you'll know that it's easier than you might think.

One more possible way to increase income is to learn a new profession and change of job. It's recommended for people making less than national median which was about $50K in 2008.

Step 8:

Capital and the Crossover Point.

Capital: money that makes more money.

The Crossover Point: a point in time when the passive (investment) income line crosses the expenses line.

The whole idea of all that effort of saving and living below one's means, is to switch from living on earned income to living on passive income. First, one has to save a lot of money. Second, one has to invest it wisely not to lose the Capital. Third, accumulate the Capital until the passive income is sufficient to pay all expenses (the Crossover Point). Fourth, accumulate Capital to build Cache, the extra money that can be spent on higher purposes or just on higher standard of living. If you really want to buy a new car, you can use Cache.

Practically, for the first several years the passive income line will crawl on the bottom of the chart. Especially when one is still building Emergency and Safety-Cushion funds. It may be quite discouraging. What is more, if all the savings are left in a savings account, on CD, or even in corporate bonds - the line will not get much higher. Even people saving aggressively for many years at a saving rate above 30%, will see the passive income line rising very slowly. The solution to this is investing. But not only investing in stocks. According to many financial advisors annualized total return from stocks is between 8-12%. After inflation, taxes and brokerage fees it's very close to zero. Tax-sheltered investment accounts like 401(k) or IRA don't help here eiter, as the whole point is to retire on passive income before the retirement age. A person planning to achive the Financial Independece needs at least 15% after-tax annual return.

In the example below, a person saving about 30% of income will need 15% rate of return to get the passive income line cross the expenses line in 10 years:

The spikes in the income line on the chart above represent annual bonus (December) and the tax refund (April). The huge spike in expenses is the purchase of the car (used car, off course). All those smaller spikes in expenses line that's vacation. The income line is rising about 7% a year. Giving up on vacation and avoiding any huge expenses is very crucial for the first 3-5 years. The chart above was craeated from the example spreadsheet file available here.

Step 9:

Learn how to manage your finances and how to invest:

1. ignore inflation and whatever media have to say about the current state of economy
2. build two basic personal funds (cash reserves): Emergency Fund, and Safety-Cushion Fund
3. learn how to invest in bonds, stocks and other investment instruments
4. learn how to invest in your own house for higher return
5. build Capital, the income-producing portfolio of investments
6. continue to save money even after achieving Financial Independence. The extra money reserve is your Cache. It's to be used on materializing your dreams.
7. use Cache to start a business

Final thoughts

It was easy for the authors of Your Money or Your Life to recommed investing only in Treasury bonds. Around the time the first edition of this book was written (1992), the 30-year Treasury bond yields were much higher than today. In the period 1980-1990 the 30-year Treasury bond yields were in range 8-15%. Especially in the first half of that decade the yields were above 10%. In the nineties the yields were in range 6.4-8.2%. For the last decade the yields were in range 4.5-6.2%. Historical rates: TreasuryDirect.gov.

Back then in the eighties and then nineties it was much easier to save and build capital in 30-year Treasury bonds. Right now it's not so easy. With rates close to inflation rate, the compounding works too slow, and the period of building capital is at least twice as long as back then. This days, anyone who wants to achieve the Financial Independece has to use other investment vehicles.

The Treasuries are still a good and safe investment vehicle. But it's more suitable to keep the cash reserve for times of hardship (Safety-Cushion Fund). But event for this purpose a better solution is to invest in I Savings Bonds than 30-year Treasuries.

One of the reasons the book recommends Treasuries instead of corporate bonds and stocks, is that the latter are not liquid and fluctuate in price. However, the investor who built Emergency and Safety-Cushion reseves doesn't have to care about price fluctuations as long as the investment doesn't lose value and produces a steady dividend.

Many people may perceive Financial Independence as unethical. Because most people despise those who do nothting, don't work and live well. But it's not the point. Financial Independence is the freedom to choose what you do and do what you choose. After achieving the Financial Independence, you may take some vacation, you deserve it. However, you will probably notice, that doing nothing is quite boring. You will finally be able to comfortably start doing what you always wanted to do. For example, many people dream about inventing or improving something, and in many cases that something would greatly improve lifes of the other people too. But they can't do that, simply because they have to work for living. Imagine that you have enough money, so you don't have to worry about what you're going to eat the next day. Now you can focus on your dream project or invention that may radically change the world in the future.

The best things in life are free. Including software for tracking finances - available from here: OpenOffice.org.