Forget about financial freedom or mastery for a second, are you even financially healthy or fit? And if so, are you really on track to becoming financially free in the next 10 years (the min no. of years it takes for even the most disciplined)?
I’ve spent the last 8 months summarising and deconstructing the top 8 most relevant and practical personal finance books I and google could find including “Money: Master the Game” by Tony Robbins, “I Will Teach You to Be Rich” by Ramit Sethi, “How to Make Your First Million” by Warren Ingram, just to name a few.
My #1 objective for doing this, as it is for virtually everything I do, was to identify, quantify, and rank the most common objective and universal metrics, by which these financial geniuses have defined financial success, in a single hierarchical framework as both a diagnostic and prescriptive reference for guiding you towards financial mastery.
I’ve identified in this post 9 such metrics in hierarchical order using health, fitness, and mastery as developmental milestones, or levels that cannot be skipped (with a few exceptions of course), towards achieving the ultimate goal of financial freedom.
Level 1: Financial Health (4 Markers)
- Income: How much do you need to earn monthly to achieve financial freedom?
- Savings: How much of your post-tax income do you need to save each month?
- Credit Score: How credit-worthy are you really?
- Debt: How much bad debt do you have? What is your debt-to-income ratio?
Level 2: Financial Fitness (3 Markers)
- Emergency Fund: Do you even have an emergency fund and how much?
- Retirement Fund: Will you at least have enough for retirement if not FF?
- Dream Bucket Goals: Do you save for the things that matter to you most?
Level 3: Financial Mastery (2 Markers)
- Asset Allocation: Have you allocated your assets for optimal security and growth?
- Financial Freedom: Are you on track to becoming financially free in your lifetime?
Level 1: Financial Health (4 Markers)
Definition: Physical health can be defined as the physiological condition in which there is an absence of disease or pathology and that invariably maintains the necessary biologic balance between its anabolic and catabolic states.
So too, financial health can be defined as the financial state in which there is an absence of debt and bad credit ratings and that invariably maintains the necessary cashflow balance between total monthly income and expenses.
#1: Income (Income Streams & Total Monthly)
If you have no income, you have no financial situation. Unless you won the lottery, married someone rich, or received an inheritance of course.
Nevertheless, it all starts with the creation and nourishment of one or more economically-valuable assets (products, services, trades, investments, inventions) that have income-generating potential in some shape or form (emolument, profit, interest, dividends, capital gains, commission, or royalties).
How much you earn makes all the difference on the path to financial freedom. But how you earn how much you need to earn makes an even bigger difference.
Though beyond the scope of this post, always aim by default to develop and nurture the assets that fall within the highest expression of your highest values. This way you don’t make a ephemeral income, but a lasting personal return.
So how many income streams do you need and how much do you need to earn (and save) each month to become financially free in 10 years or less?
- Income Streams: To have only 1 income stream is pathological. But to strive to have too many can lead to a dilution in focus and resources. Most financial experts suggest, as a general rule-of-thumb, to focus on developing a maximum of 3 different income streams, 2 passive (investment income) and 1 active (emolument).
- Total Monthly Income: Assuming you need R20K/month in passive investment-generated income to cover all 4 types of your desired monthly expenses (living, insurance, recurring debt, and vitality costs), you’ll need to make at least R75K/month. This is assuming you save and invest at least 40% of your after-tax income in the right places for at least 10 years. Learn how to calculate this in the rest of this post.
#2: Monthly Post-Tax Savings
Spending less than you earn (and saving the rest), or paying yourself first (a designated amount each time you get paid), is perhaps the single most important financial habit you can adopt. But how much should this designated amount be? 10%? 20%?
While there’s no magic one-size-fits-all number here, research shows that saving the old conventionally wise number of 10-15% of your post-tax income may not be enough to secure sufficient capital for retirement, let alone financial freedom.
Needless to say, how much you’ll end up saving depends on your income, lifestyle preferences, and future financial goals.
But if you’re serious about achieving financial freedom in your lifetime like I am, aim to save no less than 30% (and work your way up to 50%) of your post-tax income each month. This alone will double (and sometimes triple) your returns.
#3: Credit Score
Your credit score is an objective credit-rating tool used by lenders to determine your credit worthiness. It is calculated based on your total debt status, payment history, and CUR (credit utilisation rate) and the higher you score, the more credit worthy you become. Why is this so important? It’s a no-brainer really.
You see, when you have a high credit score (above 926 points in South Africa), you become entitled to lower interest rates on loans, get higher loan-qualification rates, immediate preference in car and apartment rentals, greater access to more credit, and enjoy VIP like financial status where it actually matters.
Naturally, bad credit scores can cripple your cumulative financial efforts when left uncorrected and un-monitored. Visit TransUnion (South Africa) or google credit score and your country for a free credit report to see where you stand.
#4: Debt (Total & Your DTI Ratio)
To be in debt is to be in a chronic catabolic state. That is to say, to be sick. Financially sick. But unlike when you get physically sick, you’re numb to the discomfort and pain signalling you need to prompt you back towards homeostasis.
- Total Debt: You get short term (credit cards, personal loans, tax), medium term (student loans, car loans), and long term debt (mortgages). All kinds of debt, with mortgages and low-cost credit-based products (mobile payment plans, clothing accounts, etc.) as relative exceptions, are bad and should be avoided at all costs.
- Debt-to-Income Ratio: Your debt-to-income ratio, or DTI, is a percentage ratio of your total before-tax income divided by your min monthly debt repayment amount. If I had an income of R45K and I had R80K total debt outstanding, with a monthly repayment amount of R8K, my DTI would be 18% (R8K / R45K = 17.7%).
A DTI score of 30% and above is considered pathological and anything below 5% is optimal. Like your ‘Total Debt’ status and CUR (credit utilisation rate), DTI is a principle marker credit lenders use to qualify you for (additional) credit.
Level 2: Financial Fitness (3 Markers)
Definition: Again, using biology as an analogy, physical fitness is the body’s ability to withstand, recover from, and adapt to environmental threats or stressors that exist above the resting threshold capacity of the body. In other words, physiologic headroom.
Financial fitness is your ability to withstand, recover from, and adapt to financial threats (unexpected financial demands) that exist above the resting threshold capacity of your financial condition (existing monthly cashflow and future financial goals).
#5: Emergency Fund
An emergency fund is a high-interest savings account, usually a bank-linked money market account, that serves to hedge you against sudden loss of income and unforeseen emergency expenditures such as medical, maintenance, tax, or legal bills.
It is a personal financial health insurance policy designed to keep you financially healthy (out of debt) and financially fit (adaptable to immediate financial demands). Like personal or business insurance, emergency funds are a must.
How much should you save and keep in your emergency fund? According to most financial experts, you should have saved capital equal to the amount of your current monthly expenses x 6 (E.g. R20K monthly expenses x 6 = R120K).
#6: Retirement Fund (Total Capital & Monthly Contribution)
A retirement fund is like an emergency financial freedom fund in case you don’t achieve financial freedom (work independence) before you reach retirement (age 55 – 65).
Not many people will achieve financial freedom in their lifetime, but should at the very least be on track to retire with sufficient capital to replace 100% of their desired monthly expenditures for the rest of their lives. Especially when you don’t plan on working.
Whether as a pension with a company, or an independent unit-trust based RA as an entrepreneur, your retirement fund forms as an integral part of your security-asset portfolio and serves as your emergency financial freedom fund in case you derail from your 10 year financial freedom plan.
- Total Retirement Fund Capital: If you needed R20K/month in retirement-income to replace 100% of your total desired monthly expenditures, you’ll need at least R6Million in retirement capital by the time you retire (age 65), assuming an annual withdrawal rate of 4% (the max recommended amount). To calculate this just take your monthly income, multiply it by 12 (annual income), and multiplying it by 25.
- Monthly Minimum RA Contribution: Again, let’s assume you need R20K/month to replace 100% of your total monthly-expenditure value, you’ll need to save and allocate a min of R2.5K each month (with an annual savings increase of 6% to offset inflation) to your RA until you retire (age 65). This assumes you start at age 29 (37 years of saving) and that your retirement fund generates an annual return of 8%.
To calculate this, just pick a rough monthly estimate, multiply that by 12, and then multiply that by the # of years left until retirement, with 8% compounded on each of those years.
#7: Dream Bucket Goals (Total Dream Value & Monthly Contribution)
- Total Dream Bucket Value: Your dream bucket is a strategic personal finance goal list and spending plan for buying the med-to-high purchase items and experiences you value most. Like debt, you have short term (travel, toys, events, education), medium term (weddings, cars) and long term (children, real estate) dreams to plan for.
- Monthly Minimum Dream Bucket Contribution: How much from your total monthly savings do you need to allocate to your dream fund each month to save for all or your next best dream? I recommend you save a min of 6% of your after-tax income for your dream bucket, 15% for your security fund, and 30% for your growth fund.
Level 3: Financial Mastery (2 Markers)
Definition: Financial freedom is the optimal financial condition in which you’ve saved and invested sufficient capital (excluding your emergency fund and retirement capital) that generates monthly investment income equal to the amount of your total monthly expenses (living, insurance, recurring debt, and vitality expenses).
#8: Investing: Asset Allocation (Security and Growth)
Accumulating and stashing capital in a savings account (with emergency funds as an exception) is not a wealth-building strategy. In fact, it’s a surefire way for you to lose your money to inflation over time.
You need to take your hard-earned cash and allocate it in a way that offers you both guaranteed financial security (inflation protected investments) and growth (high-yield investments) and have it compound over time (make returns on your returns).
Asset allocation, or diversifying your capital across different asset classes (security and growth funds), across time (dollar-cost averaging), across different economies (markets), and in different proportions, is not a game limited to the ultra-wealthy, but is the single most effective, low-cost, and hassle-free passive-income generating investment strategy the average person can employ for achieving financial freedom.
But while there’s no one-size-fits-all asset allocation strategy – as each individual’s risk tolerance, age, existing capital, and financial goals vary significantly – there are a few basic and universal asset-class principles (as recommended below) all beginner and advanced investors should follow alike if they are to be successful in the long run.
- Security Fund (25 – 65%): No matter how skilled or how high risk-tolerant you are, you need to protect a min of 25% to 65% of your total wealth as cash (such as your emergency fund in a fixed-deposit or money market fund), retirement capital (in a unit-trust based RA), and bonds (inflation protected government bonds).
- Growth Fund (35 – 75%): And no matter how old or conservative you are, you need exposure to growth assets if you are to outperform inflation and generate any kind of meaningful return. You need a min of 35% to 75% of your total wealth in the form of equity and property (in index-funds, real estate, and/or individual stocks).
#9: Financial Freedom (Total Capital & Monthly Contribution)
Your financial freedom capital is like an early retirement fund. It represents the sum total value of your asset allocation portfolio (total cash, bonds, equity, and property value) with the exception of your retirement fund (as you won’t be able to draw income from this security asset until you actually retire).
What is your financial freedom fund target amount and how much do you need to save and invest each month today to reach financial freedom in 10 years or less?
- Total Financial Freedom Capital: Let’s say you needed R20K/month in passive investment-generated income to cover your monthly expenses, you’ll need at least R6Million in growth asset (equity and property based) capital assuming a 15% average annual return (not unusual in South Africa) with a 4% annual withdrawal rate (the max recommended amount). To calculate this, pick a rough capital estimate, multiply it by 0.04, and divide it by 12. Adjust until you hit upon your desired monthly income amount.
- Monthly Minimum Asset Allocation Contribution: Again, let’s assume you needed R20K/month post-tax to cover your desired monthly expenses, you’ll need to save and allocate a min of R19K each month (with an annual increase of 6% to offset inflation) to your growth assets (equity and property) for at least 10 years (assuming an average annual return of 15%, which is not unusual for South Africa).
To calculate this, pick a rough monthly estimate, multiply that by 12, and then multiply that by the # of years in which you want to achieve financial freedom (10 years or less), with 15% compounded on each of those years. Adjust the monthly amount until you hit upon the desired total capital target.