Financial independence is a goal for many people. Financial independence is when work becomes optional. It’s when your investments are large enough to support your annual spending indefinitely, without the need for employment income. Reaching financial independence frees you from the typical work/money/time equation. When you reach financial independence you no longer have to trade your time for money.
How much you need to reach financial independence is different for everyone, but the quick and most common metric is 25 times your annual spending. Once you reach this level of savings and investments (not including your home) you can withdraw 4% of your portfolio indefinitely. With the right portfolio your investments will grow enough each year to pay you 4% of the original principal and still keep up with inflation.
Taxes are obviously a big consideration when growing your investments. Tax free growth allows your investments to grow faster and lets you hit your goals earlier.
In Canada we have two main accounts that provide tax free growth, the TFSA and RRSP. With the TFSA you pay tax now but don’t pay tax later. With the RRSP you don’t pay tax now, but you do pay tax later. Regardless of when you pay the tax, the investment growth within an RRSP or a TFSA is tax free. Using your TFSA and your RRSP to its full potential means you can hit financial independence much faster.
In this post I’m going to break away from the typical personal finance blog post. I’m not going to share a tip. This isn’t going to be some humble brag about how much money I’ve saved. It’s going to be quite the opposite actually. In this post I’m going to share with you my biggest financial mistake. One that cost me over 5-figures.
As a fee-for-service financial planner it’s somewhat embarrassing. Not many people know this story. This happened almost ten years ago, before I learnt everything I know about personal finance. I could have saved myself a lot of stress had I known what I know now. For that reason, I’m going to share my big secrete with you and I hope it inspires you to learn more about personal finance.
I’m going to share with you my biggest financial mistake and then I’m going to break down each of the mistakes I made… because like any BIG mistake there was more than one.
Bonds seem like a really boring investment. They’re low growth. They won’t make you rich. Plus, bond prices fall when interest rates increase. And if you use a bond ETF they usually pay a tiny monthly dividend, typically not even enough to buy another share via DRIP unless you have a lot invested.
So, why would anyone invest in bonds?!?
There are a few good reasons to invest in bonds but there is ONE reason in particular that I think is very important. It’s not a typical reason you see mentioned when people talk about investing in bonds, but I think it’s one of the best reasons. It’s based on investor psychology and behaviour and it can make a big difference during a stock market dip or a full blown downturn.
Many DIY investors may not realize it, but they are their own worst enemy. There is plenty of research around investor behavior, in particular how investors like to time the market. Timing the market means investors try to buy low and sell high, but this rarely happens, if anything they do the opposite, buy high and sell low. For most DIY investors time in the market is more important than timing the market.
Morningstar does an analysis that measures fund inflows and outflows. They use this to approximate when people are trying to time the market. Vanguard did a great summary of this analysis and they found investor returns lagged the market by 1 to 2%. They estimated that behavioral coaching can be worth up to +1.5% per year for the average investor.
So as a DIY investor how do bonds help you avoid timing the market? Let me explain…
Do you have an investment plan? Do you know what an investment plan is? Did you know that an investment plan can save you $1,000’s and keep you sane during a downturn?
Why do you need an investment plan?
Having an investment plan is critical for every investor because we’re not always the rational, logical, disciplined investors we’d like to be. We’re emotional. We fear loss. We suffer from behavioural traps.
The performance of individual investors has been repeatedly shown to lag the index they invest in.
Investing is risky. That’s the price you pay in exchange for higher returns.
If you wanted zero risk you’d put your money in high interest savings account. But then your returns wouldn’t even keep up with inflation. Over the long run, a no risk investment is essentially losing money because its worth less and less each year.
Buying bonds offer a slightly higher return, usually above inflation, but that comes with additional risk. Bond prices are sensitive to interest rates and the economy. There is also the risk of default.
Equities provide an even higher return. This is exchange for much higher risk.
So how do you go about reducing your risk for little to no cost? First let’s discuss exactly what we mean by risk.
Banks are biased. That’s obvious. Banks are public companies in the business of making money and therefore are biased towards activities that produce a profit. This isn’t necessarily a bad thing but when making personal finance decisions it’s good to keep this top of mind.
This bias is especially apparent when banks advertise their mutual funds. They use a few different forms of bias to make their products look extra appealing.
Everyone has probably seen a mutual fund advertisement. It’s the one with the line that keeps growing towards the sky. It usually says how $10,000 invested 10 years ago could have grown into $xxx,xxx today.
There are a couple of problems with this advertisement.