"The Seven Simple Secrets of Financial Independence"

Bert Whitehead, M.B.A., J.D.

1996 marked my 25th anniversary as a personal financial advisor. During those 25 years, I made myself an avid student of what works and what doesn't work in the financial industry. I learned from my clients and then tested my theories by trying them on myself. As a result, I've been able to identify seven key concepts that successful clients have in common.

To place these seven concepts into a usable personal context, you need first to understand how they apply to your particular stage of life. There are ten "stages" in what I call the "Cambridge Life-Cycle." Definite markers delineate the end of one stage and the beginning of the next, and specific strategies apply to each stage. A note of warning: the age ranges given here are arbitrary and are provided for the sake of discussion. Actually, there is a wide variance in the ages at which individuals pass through each stage, so don't start thinking that you are hopeless if you don’t seem to have reached a certain point in your financial development. Also, don't start gloating if you seem to be in a more advanced stage than others of your age, because individuals who are more advanced at one stage frequently end up falling behind later.

The Cambridge Life-Cycle

Life-Cycle Stages #1 & 2: Infancy and Early Childhood

As infants, we test everything by putting it into our mouths – money included. After a while we discover that it is neither a sound financial strategy nor a healthy habit to eat money. Money doesn’t begin to have genuine meaning to us until we are about 6 years old. From then until we are about 12, we learn relative values for money – for example that dimes are worth more than nickels even though they are littler, and that a quarter buys more than a dime. If our parents or other adults encourage us, we may begin to learn the rudiments of financial accumulation – that it is good to save money in a piggy bank. It is worth noting that our basic belief systems about money are usually formed during this period.

Life-Cycle Stage #3: Teen Years

As teenagers (ages 12-19), we start learning how it is possible for money to make money – that is to say, how money earns interest, how to make money by buying something and then reselling it for a profit, and how work is rewarded with money. A caution here: teenagers often are sidetracked, falling in love with the idea of earning their own way without understanding the full cost of supporting themselves. Many do not realize that a lifetime of working at McDonald’s cannot grant them the life-style they envision.

Life-Cycle Stage #4: Laying the Foundation

From about 20 to 30, we begin to "Lay the Foundation," i.e.: we begin to be completely self-supporting. During this stage it is vital for us to reach the Five Fundamentals of Fiscal Fitness (e.g.: buying a house, saving 10%, and so on). It is not at all unusual for some people never really to get beyond stage 4. They get "stuck" at this level, because they haven't fully grasped the concept of financial independence, nor do they understand what it takes to have it.

Anyone seeking financial independence must deal with the fact that there are three basic ways to get money: affiliation (you marry it, inherit it, or are given it), earning it by the sweat of your brow (honorable, but most people yearn to reach the point where they can do what they want to do without having to worry about how much money they make), or letting your money make money for you. It is this final means, correctly managed, that can lead to financial independence.

Life-Cycle Stage 5: Early Accumulation

When we are between 30 and 40 our net worth usually exceeds our annual income, and we move into the Early Accumulation stage. Basic investment begins, and it is about now that Cambridge starts to teach clients how to diversify their assets.

Life-Cycle Stage 6: Rapid Accumulation

Between the ages of 40 and 50, our net worth generally reaches the point where it is 3 times our annual income. Now the income from our investments exceeds our annual savings. We call this the Rapid Accumulation stage, for our net worth tends to increase exponentially.

Life-Cycle Stage 7: Financial Independence

Once our net worth has grown to between seven and ten times our annual income, we have reached the stage of financial independence – something that usually occurs between the ages of 50 and 60. We now are faced with options. We can change jobs, semi-retire, or – if we insist – have a mid-life crisis. We now are able to use part of the income from our investments to subsidize our living expenses. No longer do we have to work full-time at a job we don't really like.

Life-Cycle Stage 8: Conservation

Once net worth is ten to fifteen times greater than living expenses, the earnings from pensions are usually sufficient to make it unnecessary for us to work at all. We say that we have reached the Conservation stage.

Life-Cycle Stage 9: Distribution

When our net worth exceeds 15 times our annual expenses, we have more money than we can spend in our lifetime. Thus we enter the Distribution stage – gifting charities, setting up endowments, and giving money to our children.

Life-Cycle Stage 10: Terminal

Not all of us have the luxury of a Terminal stage in which to plan and must anticipate it during our Distribution stage. If it happens that we know that we have less than 12 months to live, we use the Terminal stage to provide for the orderly final distribution of our assets.

The Seven Secrets of Financial Independence

Now that we understand the ten basic stages of the financial lifecycle, we can apply the seven secrets of financial independence.

Simple Secret #1: Fund Your Future First!

Plan to save 10% of your earned income to "fund your future." Once a child has discovered that money has value, the most important thing you can teach him or her is to put aside 10% of everything earned – a dime for every dollar. You will invest these savings and then reinvest investment earnings until you are financially independent. Remember that, because of the miracle of compounding, the money you save when you are young is worth much more than money saved at a later age.

There is another reason for always saving 10% of your income, even after you have retired. The number one reason that people get into financial difficulty is that they have established a pattern of living beyond their means. One of the terrific benefits of always saving 10% is that you are, by definition, always living within your means. Continuing this practice after retirement means that: a) you will never run out of money; b) the resulting growth in your nest egg helps offset inflation.

Simple Secret #2: Don't Mortgage Your "Later" To Pay For Your "Now."

About 15 or 20% of new clients who come to us are over their heads in debt. Now, taking out a 20 year education loan is OK, because an education will last a lifetime. Even taking out a 3-year car loan, if that's the only way you can afford to buy a car, is reasonable. But running credit card balances month after month not only is devastatingly expensive, it also is a sure sign that you are living beyond your means. You are trying to be someone you're not.

Too often I hear the excuse, "I'm not really spending too much money. I can't afford to save because I have too many bills!" Those bills did not appear spontaneously. If you have too many bills, it's because you are spending more than you make. The only solution is an easy one: get rid of the credit cards for at least 6 months.

Plan never to pay more in interest than you are earning on your investments. Remember that we probably are not looking at mortgages when we say this. Because mortgage interest is deductible, unless you are in a very low

bracket with very conservative investments, the after tax return on your investments is apt to be more than the after-tax cost of your mortgage. Credit card debt is different, and this is our focus. If you are loaded down with credit card debt and associated interest costs, recognize that the reason you have so much of it is that you are no good at paying it back – just as the reason you have no savings is that you're not good at saving. The only way to break this cycle is to start saving that 10% while you pay off the debt. You have to discipline yourself to do both. Getting rid of the credit cards is a way to begin the process.

Simple Secret #3: Money is a Mind Matter

Living within your means does not necessarily mean spending less. Balance is usually more easily achieved by earning more. It can be easier to earn an extra hundred dollars a month than it is to cut a hundred a month in expenses. How can it be "easy" to earn additional money? Because most of us are prevented from living up to our earning potential by dysfunctional money belief systems.

Dysfunctional money beliefs usually are formed in childhood. They form strong subconscious barriers to charging others what we are worth. Money is the yardstick by which we value things. If you have carried from childhood the notion that making money means taking it away from someone else (and making them poor), you will always feel guilty about charging higher fees. Self-employed persons are made particularly vulnerable by this belief. They are forever trying to decide what is the "fair" rate to charge for services. Trust me on this: the fair rate for your services is the highest rate you can possibly charge that enough people will pay to keep you as busy as you want to be. If you charge less than the market will bear, your services will be discounted by your clients and they will not exercise the full value of what you have to offer. When clients are not charged what a service is worth, they show up late or skip appointments, do not follow through on your advice, and never really get the benefit of your professional advice.

Charging fees does not take money away from people – even from poor people; it involves all sorts of people spending money on what is important to them. Remember that poverty is not caused by a lack of money. It is a state of mind. Government giveaway programs demonstrate this again and again. Recipients find themselves poor once again when a government donation runs out, because their values, dependent on a poverty mentality, cause them to spend any gifted money unwisely. The basic dysfunctional belief of many poor people is that "money is to spend" – on cigarettes, on fast cars, on whatever brings immediate gratification. Operating under that belief, it is impossible to save money for things that have a long-term payoff – e.g.: education.

The other side of the same coin is that wealth – like poverty – also is a state of mind. Real wealth is not determined by how much money you have. Rich people with dysfunctional beliefs measure their worth according to the bottom line of their balance sheets. Many of the richest consider themselves "poor" if their earnings are less than the next person’s. And they are poor, because real wealth is the result of being properly valued in your society, being paid accordingly, and then living within your means and saving enough to provide for your future. The key to financial independence is knowing how much wealth is enough.

Simple Secret #4: Money is Money

When we were children, most of us learned some variation of the envelope system of budgeting money. This envelope is for your lunch money; this one is for holiday presents; this one is for a new bike or vacation. As adults, we still find this sort of approach seductively comforting, and, in truth, it may still be useful for some short term needs. However, the envelope system does not apply at all to investments, most of which are long-term. I am convinced the idea of setting up separate investments (envelopes) for college planning, retirement planning, nursing home expenses, estate taxes, and other long term objectives was devised by life insurance agents as a way to make people feel guilty about not having enough permanent life insurance. The plain simple reality is that when you are investing money, you should invest it in the most efficient vehicle. When you need money you take it from the most efficient source.

An important note, here: retired people frequently become preoccupied with the belief that individual investments must produce income. Generally it is much more advantageous to structure a portfolio to include investments that provide growth and are tax efficient (like mutual funds) even if they don't provide income. Selling off some of these growth investments can provide the desired of cash flow, your portfolio will be more productive, and you may be able to cut your taxes substantially.

Simple Secret #5: Be an Investor, Not a Trader

The difference between being an investor and being a trader is this: the investor invests for the long term; the trader seeks immediate profit by exploiting short-term swings. Traders are full time professionals. They spend all day, every day buying and selling. An amateur cannot win at their game. Trying to time the market is the worst mistake an investor can make because doing so sacrifices the biggest advantage the investor has: time. The most frustrating question I get asked is "where do you think the market is headed?" I usually reply, "I don't know which way the next 20% move will be, but I do know which direction the next 100% move will take!"

Most of us are aware of the massive social and economic restructuring process sweeping across America today. No aspect of commerce is exempt. Causes of change range from foreign competition and industry globalization to government intervention and computerization. The financial industry also is undergoing a complete restructuring that was set in motion about 20 years ago with a change in the way most pensions are funded.

Because of the prohibitive cost of employee pensions and the increasing mobility of America’s work force, a great percentage of companies have shifted to "defined contribution" pensions. As employees fund their own pensions (e.g.: tax-deferred 401(k)s, TSAs, SEPs and Keoghs) there is a corresponding increase in the average citizen’s awareness of investment issues. This represents a blow to the traditional commissioned based advisor, because now people realize the cost of his or her commissions. As commissioned advisors falter, a whole new self-help industry has been spawned that is designed to assist the amateur investor. Unfortunately, these self-help sources emphasize the short-term activities of the financial markets, limiting their practical usefulness. A wise investor must realize that short-term market moves are important to traders, not investors.

Simple Secret #6: Cover Your Backside -- Diversify.

We have all learned the wisdom of the old adage "Don't put all your eggs in one basket!" A well-diversified portfolio ensures that you always will have something going up in value. Successful investors come to terms with the fact that having such a portfolio also means that you always will have some investment going down. Diversification among stocks, bond and real estate, long and short term, and US and foreign holdings lowers the risk of the total portfolio and enables investors to make selected individual investments that would be too risky undertaken as standalone investments.

The key is to stay the course. We all have a tendency to shoot where the rabbit was, shifting investments into whatever has performed best most recently. This is folly. Diversification remains the best strategy you have to reduce your risks in volatile financial markets. Your asset allocation should be determined by your stage in the financial life cycle, your risk tolerance, and your tax situation – not by whatever asset classification was hot last year.

Simple Secret #7: Build on Your Successes

The final secret is the simplest of all. Build on your successes. The most critical points in your journey to financial independence come at the transition points – the moment when we move from one Cambridge Life Cycle stage to another. As you begin that new stage, your goals must be reevaluated, your belief systems re-examined, and your strategies changed. It is at these times that we, as personal financial advisors, are of the most value to our clients.

Frequently transition points are marked with anxiety and confusion. Clients are not sure what they really want, what they can realistically expect, or how to go about achieving either. All too often they trade one set of problems for another and discover too late that they were better equipped to deal with old familiar problems than with new ones.

This is why building on past successes is critical. Don’t start all over. Look at strengths you have developed and knowledge you have acquired and find new ways to utilize them in a new environment. Learn to see transitions as growth – as whole new opportunities – rather than resisting change and thereby causing yourself pain.

And there you have them: seven unbelievably simple secrets whose value I have seen proven over and over through my own experience and that of my clients. For over a quarter of a century I have watched these seven secrets delineate the path that facilitates growth and leads clients to real wealth. You understand now that just becoming "unbelievably rich" is as unrewarding a goal as it is unrealistic. I urge you to make use of the seven secrets and enjoy the meaning of true financial independence.