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Most of what you learned growing up about personal finance, income, and wealth are not true. This is understandable — think about whom you first learned them from… where they financially independent?
Whether you are already financially well-off, or a minimum wage worker you will be able to learn some tips from these 12 lessons to achieving financial independence.
I’m sure you’re wondering who I am?
My name is Mike from Retire On Dividends. I am now 34 years old and have achieved financial independence having built up a portfolio from scratch to earning six figures in dividend income.
Want free money?
I have done it by compulsive saving and investing whatever spare cash I had. The journey (so far!) has been enjoyable but a lot of patience and the right mindset is definitely required.
I have listed some of my more important lessons to achieving financial independence below:
1. Treat stock market investing as “business-like”.
Ben Graham said in “The Intelligent Investor” that “Investment is most intelligent when it is most business-like”. It is important for you to know exactly what you are buying. If you buy a stock then you are buying an ownership piece of the underlying business. You should concern yourself on how that underlying business performs in much the same way you would if you bought your local restaurant.
If you owned a local restaurant then you’d be interested in the number of customers coming in, the revenue you earn from them, the number and cost of your chefs/employees, the rent on the property, the cost of food, your profit margins, etc. It is unlikely you’d be calling a business broker every day for a quote on the value of the business.
In the same way, if you own McDonald’s shares you should focus on their revenue, margins, earnings, balance sheet, cash flow, dividends etc. You shouldn’t concern yourself with the day to day value of the business (which is the stock market quote). Ultimately if you buy a piece of a business that performs well and you didn’t overpay then it is highly likely that in the long run, you’ll earn a good return on your investment.
Graham summed this up by saying “the market is there to serve you not to instruct you.”
2. Focus on high-quality businesses.
Over the years, I’ve invested in some great businesses and in some distinctively average businesses. Trust me, investing in a good business is far more enjoyable if you haven’t overpaid! What makes a good business, though? A good business is one that has high barriers to entry that enables it to earn high returns on its invested capital over a long period of time. Average businesses do not have barriers to entry which means that they cannot earn much above their cost of capital over long periods of time as if they were to, then competition would come into the market and reduce their returns.
It is not always easy to pick out barriers to entry but certain clues are that the company has pricing power, captive customers, strong cash flows, a consistent and high market share, and earns very high returns on capital employed over a long period of time.
3. Be careful with value and dividend traps.
If a stock is cheap then there could be a good reason for it. It could be a “value trap”. This means the stock looks cheap on its price/earnings (p/e) ratio but the earnings may be about to plummet which means the p/e ratio will shoot up again and the stock may not be so cheap. The same can be true for dividend traps where price falls make the dividend yield look very high when in fact what happens is the dividend gets cut. Cheap shares and high dividend yields can result in bargain investments but often they are traps so require very close examination to see if they are good long-term investments.
4. Price is important.
We’ve mentioned above that you should focus on high-quality businesses but you should be careful not to overpay. Think about it this way, if you buy a stock that is trading on a p/e of 50 then your earnings yield (100/50) is just 2%. Currently, you can buy 10-year risk-free treasuries at around 2.2% so the only way it would make any sense to buy a stock at a P/E of 50 is if the company has very quick earnings growth.
Betting on that earnings growth reduces your “margin of safety” and adds a lot of risk to your investment. Ultimately if you buy very high-quality companies you’ll probably do ok but, if you overpay, you could be waiting a long time to realize a decent return on your investment as earnings “catch up” with the price, so be careful with the prices you pay.
5. Be patient!
Phil Carret was one of the best investors of the 20th century and when asked what the secret of his success was he replied with one word – “Patience.” If you manage to get hold of high-quality businesses at reasonable prices then just keep hold of them because the wonders of time and compounding will work their magic for you. Einstein was reputed to say that compounding was the eighth wonder of the world. Its power can be enormous. You can read more about it here.
6. Don’t let “the market” control your emotions.
One of the most important aspects of investing is to keep a steady temperament. The market will play around with your emotions all the time but it is important not to get too excited when things are going well or too depressed when times are tough. Try to remain objective, rational and unemotional. Focus on what matters which is the underlying securities and how you value them. When differentials open up between the quoted price and your intrinsic value then act on your judgment!
7. Read and learn as much as you can.
There are so many great investors out there and you can learn something from them all on how to become financially independent. I have spent years reading and learning from so many. You can read all of Buffett’s letters to shareholders, read the likes of Graham, Lynch, Schloss, Fisher, Templeton, Munger, Marks, Greenblatt, etc etc. They all offer valuable lessons from their experiences both good and bad – why wouldn’t you want to learn from these greats if you are to be a good investor yourself?
“The more you learn, the more you earn” is another Buffett quote and a lifetime of learning could end up being very rewarding for you in many ways.
You can also benefit from reading some of the best investing books that’ll help you learn how to choose the best price to buy stocks at.
8. Pay attention to the balance sheet.
The balance sheet is split into two. You have what you own on one side (assets) and what you owe on the other (liabilities). If assets are greater than liabilities then the difference is equity. What I have learned is that you can’t write down the value of liabilities (if you want any equity value) but you can write down the value of assets. What looks like a solid balance sheet can very quickly turn sour with impairment charges and losses eating into equity.
A company that can’t meet its obligations will go into bankruptcy. Clearly then, the greater the proportion of liabilities to assets, the greater the risk to the company. Clearly, debt is a big risk but other liabilities such as pension deficits, trade payables or lease obligations can result in bankruptcy. My lesson is to have a good look at the balance sheet and be very careful about investing in companies with a lot of debt or significant liabilities. You can learn more about reading the balance sheet here.
9. Good management is vital.
If you own a stock then you own a piece of the business. The management are the “guardians” of your asset. They have a fiduciary duty to act in your best interests. You should monitor potential investments and your current investments carefully to make sure management is running the company for the owners and not to line their own pockets.
Management should, therefore, be excellent capital managers as well as business operators. It means they shouldn’t overpay for acquisitions or share buybacks. It means reported profits shouldn’t consistently differ from “adjusted” profits. It means their pay and compensation (including stock options) should be reasonable. Ideally, they’d have a significant ownership interest in the company as well so their incentives are aligned with yours.
10. Stick to what you understand.
We’ve made this our last lesson but is probably our most important. It is vital that you stick to buying securities and businesses that you fully understand. Warren Buffett calls this your “circle of competence.” It doesn’t matter how big your circle is but it is important you know where the boundaries are. If you start buying shares in companies that you don’t understand or can’t explain then your margin of safety is diminishing and you are taking on unnecessary risk. You would never buy a private business that you don’t understand so you shouldn’t buy stocks (or other securities) that you can’t understand.
11. Buy the best index funds to buy and hold for 2021.
Another surefire way to become financially independent is buying proven and quality investments.
Index funds are popular with investors because they promise ownership of a wide variety of stocks, immediate diversification and lower risk – usually all at a low price. That’s why many investors, especially beginners, find index funds to be superior investments to individual stocks.
Here are some of the best index funds that you should consider investing in order to help you become financially independent:
Best S&P 500 Index Funds
|VFIAX: The Vanguard 500 Index Fund Admiral Shares||Expense Ratio: 0.04% | Minimum investment: $3,000|
|FUSEX: The Fidelity Spartan 500 Index Fund||Expense Ratio: 0.015% | Minimum investment: $0|
|SWPPX: The Schwab S&P 500 Index Fund||Expense Ratio: 0.02% | Minimum investment: $0|
Best Total Market-Based Index Funds for 2020
|VTSAX: The Vanguard Total Stock Market Index Fund||Expense Ratio: 0.04% | Minimum investment: $3,000|
|SWTSX: The Schwab Total Stock Market Index Fund||Expense Ratio: 0.03% | Minimum investment: $0|
Strongest Aggressive Level Index Funds for 2020
|VIGAX: The Vanguard Growth Index Fund||Expense Ratio: 0.05% | Minimum investment: $3,000|
|FNCMX: The Fidelity NASDAQ Composite Index Fund||Expense Ratio: 0.3% | Minimum investment: $0|
|VIMAX: The Vanguard Mid-Cap Index Fund||Expense Ratio: 0.20% | Minimum investment: $3,000|
|VBMFX: The Vanguard Total Bond Market Index||Expense Ratio: 0.16% | Minimum investment: $3,000|
|FTBFX: The Fidelity Total Bond Index||Expense Ratio: 0.45% | Minimum investment: $2,500|
Being Financially Independent is Possible
Just remember that every dollar counts. So if you can find ways to make $100 fast in your portfolio by rebalancing or choosing an index funds with lower fees — it’ll matter in the long term.
People in debt think they will never reach independence, but that is a limiting belief. No man or woman should limit themself, those limits hinder one’s growth.
To chalk it up, learning how to become financially independent is possible with these 11 actionable steps.
I hope you enjoyed these and can stop wondering “how to become financially independent?”.
Let me know what your thoughts are on these lessons that will lead you to become financially independent?