How I became financially independent in 5 years

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My journey towards financial independence was not always with financial independence in mind per se. Had that been my sole goal all a long I would have done things differently and probably faster e.g. 3-4 years instead of 5. If I had a six figure income, which I never had, I would be able to do it in 2 or 3 years. However, that’s the thing. As we gain in knowledge and wisdom our priorities change as that which was once important becomes less important as things are put in a different and hopefully bigger perspective.

First of all I have to confess that I have never been dumb with money. I believe I once made an accidental overdraft because I forgot about an automatic payment, but otherwise I have never been in the red zone. I also suspect I was born with certain miserly qualities so that I did not need to change my basic personality too much. Spending money on “spontaneous fun” e.g. perishables like candy, ice cream, parties, beer, going out… have never meant much to me. Instead I was more interested in gadgets and electronics. Basically I would discover some new hobby. Then I would save until I had the money, and then I would go out and buy a new computer, then a SLR camera, then a HiFi rack, then another computer, then a telescope, etc. Since I enjoyed gadgets a lot more than sugar, alcohol, cab fares and other things that seems to make everybody else happy, I was already ready to save for big items and thus it was not so hard for me to aim for something bigger.

The first thing I realized was therefore that my expensive hobbies had to go and be replaced with “free” hobbies, which meant no more buying toys. Instead I become interested in system administration, linux, and geopolitics, in particular resource depletion and overpopulation – which of course makes for great ice breakers at any cocktail party. I did not immediately make the connection to think of hobbies that make me money. At the time when I started saving money to keep it rather than spend it on the next big piece of electronics, I was a grad student living in a dorm room. There were 18 other people on the floor and we all shared the kitchen, 3 showers and 3 toilets. Most grad students I have known all had their own apartment, their own car, etc. and thus leave school with a degree and a ton of student debt. I did, however, not live there to save money but to meet other people more easily. In addition it was only a 10 minutes walk (or a 5 minute run) from my office and 5 minutes from the closest supermarket. Thus I did not need a car nor a bike.

The two personal finance books that have influenced and inspired me the most and which I caught hold of at that time was Rich Dad Poor Dad and Your money or your life. If I could have only two personal finance books those would be it!

Your money or your life can easily be summarized. There are two main ideas. The first idea is to calculate your real wage by subtracting taxes, transport, business clothes, cost of living (for instantly, suppose your job requires you to live in New York City), and dividing by time spent on the job, time spent on commuting, and time spent unofficially preparing yourself for your job. If you do this calculation you might find some particularly scary numbers. For instance, the hourly real wage of a commuting grad student (e.g. a highly skilled and competent person who would fetch $40-60k in the private sector) is certainly below the minimum wage. The second idea is to use the real wage to calculate the cost of something in hours. Suppose a Wii is $400 and your real wage comes to around $8/hr. Then you would have to work for 50 hours to get it. Since we only live once and never get this time back, those 50 hours have to be weighed against the game system. 50 hours seems fair to me, however, there was no way I was going to add 10 more hours on top of that by buying it on credit. In particular, I did not want to pay for my house 3 times over by getting a mortgage. Thus my initial motivation was to save for a house to avoid the mortgage interest.

Apparently the personal finance blogging community doesn’t like Rich Dad Poor Dad because it does not contain enough “actionable” items and/or because the author gave some questionable real estate advice in some of his subsequent seminars. For me, though, that book was like striking gold. It completely changed my attitude towards money from being something one spends to buy stuff to being something one invests to make more money. Leave it to me to figure out the details, I am a smart guy, but it takes a genius to create a paradigm shift and I am not a genius.

By Rich Dad Poor Dad standards I was still thinking like a poor person, saving and paying in cash and I was probably on my way to thinking like a middle class person who buys everything on credit. Instead I started thinking like a wealthy person and having my money work for me while cutting down on my liabilities and avoiding having me work for money. My guess is that it is probably easier to go from poor to wealthy than from middle class to wealthy. The middle class is weighed down by a large set of liabilities in the form of house payments, car payments, credit payments, educational payments, … Once you have those liabilities, they are very hard to give up to replace with assets.

Initially I was just putting my money in savings accounts and watching it grow. In retrospect pure savings accounts turned out to be a good idea, since that was the period of 2001-2004 which was mostly a bear market. But an important point is that I did not invest for the first 3 years out of the 5 years it took me to gain financial independence. For extreme savers, financial independence is not achieved through investing. There is simply not enough time for compounding to make much of a difference. Instead compounding becomes somewhat irrelevant as the eventual portfolio becomes more focused on preserving principal, generating income, and not suffering too much in terms of inflation and taxes.

One thing I noticed early on was that small expenditures could quickly add up. $100 there, $50 there, $5 every day for a month,… In the months were I bought very little my savings seemed to go up very fast. If I spent more my savings would go up less. It isn’t rocket science that sweating the small stuff IS important. Therefore I canceled my radio subscription and eventually my gym membership. Of course it goes without saying that I did not have a TV. I did have a cheap internet connection though. I stopped shopping for clothes outside of thrift stores. I also changed my diet into what was basically two different types of meals for dinner for which I could cook up a 6 day supply in 30 minutes: Lentil soup and tuna salad(*). For breakfast I had oatmeal with water, seeds and raisins, and for lunch I ate a couple of bananas. Maybe once a week, I would buy more interesting things (spices are my friends). Of course when I went home to visit, eating different food was quite a joy, but it is not that difficult to eat the same kind of healthy food day after day. It only takes a little getting used to. A large part of the world eats nothing but rice and while it is hard in the beginning one quickly gets used to thinking of food as fuel for the body rather than snacking entertainment.

(*) You don’t need to eat this boring. This strategy was mainly due to me being in grad school and not wanting to spend very much time cooking. Many grad schools rely on ramen because of the time pressure.

One year I believe I only bought three new books. My savings rate of my after tax wage income was pushing 80% that year. However, that was so boring that I vowed not to skimp on things that somehow improves me i.e. makes me smarter or in better shape. I think that is a good rule to go by even though it pushed the rate down to 70%. I think one can get too extreme. Today I allow myself more “frivolous” expenditures thanks to my substantial passive income. We even have cable now. Still my savings rate on my after tax wage income is around 40% which my passive income bumps up to almost 80%. The main reason for that is that since I think a lot about my purchases, I simply don’t need to spend a lot of money to be comfortable.

Financial independence is only one form of independence. I was interested in other forms of independence as well. After all, what do you do if people wont take your money or your money becomes worthless or you lose it all? Therefore I experimented with simplified cooking, raw eating, solar ovens, and growing my own vegetables (not a success). I also tried to make things last longer. I mended socks, repaired electronics, etc. Most of the times I found that I could do without something or jerry rig a simpler solution without heading down to the store. It may seem like trivial example but rather than buying an energy saving gadget, I simply got used to switching things off manually when I didn’t use them. Simple to understand but the difference in attitude is huge and results follow when this attitude is taken to other levels as well. For instance, how would I deal with 90F heat? I could buy a AC unit, buy a fan, or I could simply learn how to sweat. Sweating may sound uncomfortable, but after a while the body adapts and the heat is no longer an issue. It is only when you live in an air conditioned society that you never get a chance to adapt always being subjected to the bad effects of going between hot and cool and consequently adopt the preconception that it is impossible to live without AC. Well, people managed to live without AC less than a hundred years ago. The same goes for heating. Even though the heating was included in the rent where I lived, I experimented one winter with whether I could do without heating in a temperate climate. This meant long underwear and sleeping in a thick bathrobe under a sheet, a fleece blanket and a sleeping bag, but I managed just fine. Today I am comfortable in a t-shirt down to 65F relying on a larger than average metabolism from a vigorous exercise plan. This in turn means that I can eat well and maintain a single digit body fat percentage. It all fits together.

I began simplifying my lifestyle trying to rely more on skills and adaption to the environment rather than on tools (think money). I have researched this with a fairly open mind. I have looked into car-living or boat-living, places where every cubic inch of space counts to get ideas for how to maximize my use of space and thus minimize my need for space. I know a thing or two about homesteading from researching in how to be creative in making solutions from scratch. I know how to make soap from scratch (though it’s easier to buy) and what common household items to substitute for shampoo or toothpaste. I even know how to make baking soda! I can cook with almost no heat and very few utensils. There is of course a lot of “actionable” details to this story, but in trying to convey the idea to other people the biggest obstacle has generally been the frame of mind rather than things to do. We have become so used to heading down to the store and thinking that we need everything we can buy there! It is a lot easier to learn techniques than it is to change one’s entire belief system of how the world hangs together. The end result of all this was to make everything I truly needed to live well fit into a couple of large suitcases and reduce my expenditures to what is considered somewhat below the poverty level while maintaining a comfortable lifestyle. In terms of quality I live somewhat above the ordinary consumer class standard of living since I own more luxury items but in terms of quantity my life style is quite a bit below.

When I finally got my PhD, I had no student debt. Furthermore I had saved enough of my grant/paychecks to actually make up half of my current net worth! After finishing my PhD, I became an academic researcher and was now making about as much as a state trooper or a long haul trucker. As I have hinted in earlier posts, I did not become financially independent by having a six figure income. Far from it. Rather it was through creative ways of increasing my savings by being increasingly more independent of the general economy. Quite an adventure.

I think it has been argued before whether a college education is really worth it. My answer is that it depends. A college education is certainly not a magic bullet to financial success. Monetarily, a college education and a tradeable skill are probably equally valuable, since going without a college education means earning money sooner and not accruing any student debts. What is important is money handling skills, not income. On the other hand, although I could have had a much higher income by NOT getting a PhD (entering grad school is almost financial suicide) and choosing engineering or accounting rather than science (that’s a specific as I am going to get), I did not think of expected income or even employability when I picked my major. However, unlike the higher income educations, my particular major has allowed to visit more than 10 countries for conferences and workshops without paying a dime out of my own pocket, publish many articles and part of a book as well advise on million dollar projects and thus have some influence in the scientific world. Having a “blue collar” job would probably not have been as intellectually satisfying to me, but that’s just me. For those who have their heads and hands screwed on right, spending up to 10 years in the educational system just to learn how to research arcane details that are interesting to maybe only 5 or 10 people in the world probably sounds crazy as well whereas building a beautiful house is a great accomplishment.

Having just graduated with a PhD and paired everything I could possibly need into a couple of large suitcases (except for my humongous book collection) I moved to my new job. With everything in a couple of suitcases it is quite easy to move. It takes maybe a couple of hours to pack and clean the place and off you go. I had also made sure not to exceed the airline weight limit for either suitcase to get the added freedom of flying with my stuff and not paying for excess weight.

Prior to my arrival I had decided that after 4 years of sharing a kitchen and bathroom with 18 other people, I wanted the luxury my own kitchen and my own bathroom. Luckily I found such a room on the top floor of a house which the landlord rented out to visiting students and researchers. This was within walking distance of my new job, so I was good to go. Groceries were acquired during lunch breaks by hauling a messenger bag over to the nearest supermarket which unfortunately was in the opposite direction. I kept eating like I used to.

One problem was that I hadn’t moved my bank accounts, so after a week of eating out with my new boss, etc. I was down to a couple of cans of tuna, a large bag of rice, and some soy sauce for the second week until I got my pay check. I suppose I could have gotten a payday loan, but I was used to eating simple, so eating rice three times a day for a couple of days was no big deal. After all most of the world does just that. Shortly after that I got the bank connections in order, but I did learn an important lesson. It does not matter how much money you have, if you can not buy food. Second, if you can rough it a little, you have choices e.g. I could attend to the social arrangements for my new job (the cost of having a job) even though I didn’t really have money to eat.

It was shortly thereafter that I met DW who in addition turned out to work just a couple of buildings over from where I worked. After the incident at the karaoke bar dating comprised mostly hanging out at either her place or my place. After several months of dating like that we decided that we might as well move in together. After having looked around, we found a nice little house for rent within walking distance of our work. In my case walking distance usually means less than 4 miles but this house was less than 2 miles away, had a huge backyard and was located in a quiet neighborhood just at the edge of the city. Nice! At $660 a month it was hard to beat (except for the $400 apartment we found later just before we moved to CA). Of course since the house had been empty for a couple of years prior everything and I do mean everything started failing in short succession just after we moved in. The nice thing about renting though is that the landlord is usually responsible for maintaining the appliances.

DW was used to eating more varied than I was, so I gave up my lazy spartan diet figuring that I could afford the luxury given that I now had a real job. Besides, not eating lentil soup 6 days a week interspersed with tuna sandwiches anymore seemed to be worth the $70 increase in food expenditures. I mean, in 30 years, I might not have any taste buds left to appreciate the $700 of monthly food money that this increase would compound into.

We got most of our furniture used. Some of it was donated from people at our workplace moving on to better things. Other things we bought used. We also bought a few crappy particle board pieces new. You generally get what you pay for unless you buy used. In that case you tend to get a lot more than what you pay for. When we moved, we freecycled a lot of our furniture, sold other furniture. On a net basis I don’t think we paid anything for the furniture that did not come with us. Buying used often means that depreciation costs are fully factored in, so effectively, we got free use of a lot of that furniture.

Being normal, DW had a car even though we lived, worked, and shopped practically the same places even before we met. It’s been a subject of continuous debate ever since whether to keep it or not. One thing I noted was that I could get from our house to my office in 30 minutes by walking. Going by car, I could get there in about 20 minutes. Running I could get there in 10 minutes. Thus often I would simply take off on foot before DW got the car defrosted, etc. and we would arrive at the same time. Eventually I bought a used bike for $35 from a professor that was leaving for California. I ran that bike into the ground but it was worth it given that I could make the trip in 10 minutes instead of 30 minutes. Of course the bike was useless during winters. Sometimes I would brave the cold (-17F) and walk through the snow which was conveniently thrown onto the sidewalk. Walking was passively discouraged in the city we lived in. One might say the citizens were not particularly enlightened. One resident explained to me that the reason that there weren’t any more sidewalks was because the voters believed that sidewalks would provide poor people with an easy way of getting around. Yes and? Well, clearly poor people that otherwise could not afford a car are mostly criminals. Huh? Read that one again, if that did not make sense the first time. It still doesn’t make a whole lot of sense to me, but I guess there was something to it as I once got held up by a campus police cruiser (spot light in my face and the loud voices from a conversation at 30 feet – I could not see a thing) while walking home from work. He probably thought I was casing the bank I just walked by, but I eventually managed to convince him that that was my standard route for walking to and from my job. Next day I got a ride from him while walking to work. He was probably trying to make up for the episode the night before. I also got well intended albeit naive advice from people I passed on the campus parking lot ranging from how I should dress for the weather to questions from strangers about where I got the nice gear? So I kept walking although I must admit that I did get a ride from DW when the weather was particularly bad or when I was particularly lazy.

Meanwhile savings kept going up, but at this point I was starting to think about investments.

By cutting all expenses to the bare essentials, I have been able to save approximately 60-90% of my net income thru grad school and my subsequent jobs with an average percentage in the mid eighties. Initially all this money went into a savings account. I mostly attribute this savings rate to reaching my goals this fast(*). My early fumbling into investing are certainly not something worth replicating but quite a few people have asked for it so here goes.

In retrospect going for the savings account turned out to be a semi-good idea since I avoided the 2001-2002 bear market. On the other hand I also missed the March 2003 rally. At the end of 2004 I was getting tired of earning 1.5% in my savings accounts. Since I grew up in country where investing in stocks was considered too speculative, I called my bank and told them that I wanted to buy some bonds. My bank directed me to some Baa-rated (as far as I remember) bonds from a company that was financing ships at 3% and I put down $20,000 or about a quarter of my savings at the time. I quickly realized that while $20,000 at 3% was earning $600 a year, the same amount in a savings account was earning only $300.

A light bulb went on and I thought that maybe I should start thinking about the return of investments and not just on increasing my investments by saving. Trivial, I know, but growing up in a financially conservative middle class, this was a big step.

Contrast and compare to the US where people grow up believing that as long as they put their money in the stock market they are almost guaranteed, nay entitled to get 10% returns on average if they just hang around for “the long run”.

Soon I made a program (today I would use a spreadsheet) to predict my net worth. When I plugged in my assets, the return on investment (ROI), and my monthly contribution, it would calculate my net worth for the next 80 years (I expect to live for quite a while). I put in “if”-statements such as “financial independence reached at 4% withdrawal”, “financial independence at 3% withdrawal”, “my first million”, “my second million”, etc. and the program would show which month I reached which stage. It was quite empowering to run the program. I probably ran it twice a day. I knew my net worth down to the cent. One aspect of playing with the program was the ROI. I already had substantial assets hanging around in a savings account earning a measly 1.5%. If I could get 3%, I would double my returns. What if I could get 5% or 10%?

At the time I was a young and enthusiastic scientist and pretty much ignorant about business and investments. Basically I was clueless. However, I was quite interested in geopolitics and demographic trends, so I called up my broker again and said I wanted to buy some stock in a company producing insulin (because people are getting older and fatter), a telephone company (I read that it was cheap on several investment sites), a wind power company (Because oil was running out) and a small cap holding company (I liked their dividend). Later I also got an airline company (Random investment newsletter). As you see pretty haphazard! So today when I see people buying some company because they think it’s cool, I try to remind myself about the way I used to buy shares. As luck would have it, most of these positions turned out to perform spectacularly (except the airline) returning more than 30% a year. I sold the airline (smart) and the wind company (stupid) because they were too volatile for me. Of course today I wish I had put all my money in those stocks and not just the fraction I did (about $30,000) at the time.

Making these investments increased my ROI. In my program I also had my average estimated monthly investment income as well as my average monthly expenses. Watching these two numbers converge by reducing expenses, saving money and increasing ROI was quite empowering.

One important lesson was than if you have $100,000 and a ROI of 5%, then spending 20 hours figuring out how to increase ROI from 5% to 6% is worth $1000 or $50 an hour. I was certainly not getting paid $50/hour in my day job. This meant that dealing with investments was now more profitable than my job, economically speaking. I decided that since I had saved the assets, I should learn how to invest them.

Since I was interested in (macro)economics, I was quite concerned about the systemic risk of index funds. This was probably fueled by my initial bear market experience from the sidelines. An economy can crash and bring down an index while individual sectors and companies will be doing quite well. Yet whereas my home country has maybe a few hundred listed stocks, the US has close to 10,000 which is quite a mouthful. Thus I wanted to go with mutual funds. I got my suggestions from various authors at I then downloaded the prospectus and read about the manager’s philosophy. If I agreed with the manager, I invested in the fund. I have never picked a fund based on historic returns. Rather, I pick from the conviction that I am right and that the rest of the world crazy as it may be will eventually come around to see things my way even though it may take years. In other words I pick investments based on fundamentals, not trends. I can modestly claim that my predictions usually turn out to be true even though I don’t know whether it is because I’m really right or because of random chance :-)

My investment story turns out to be complicated by the fact that I was learning more rapidly than the market was moving. Thus within a year I started pulling money out of the funds to start a broker account. I read tons of 400 page books about how to use options to manipulate the return structure. During that year (2006) I matched market returns but at half the volatility and covered my living expenses three times over. In other words, I did as well as the S&P 500 but at half the risk. I also demonstrated (to myself) that it was possibly to turn potential gain into instant cash.

(*) For the math geeks consider this: Saving 70-80% means spending only 20-30%. If expenses can be covered by extracting 4% from savings and investments annually, one needs to save a total of 20-30%/0.04 = 500-750%. Without considering compound interest, this will take 500/80 = 6.25 years or 750/70 = 10.7 years(*) . There are two important conclusions here. First, the 10% difference between 70% and 80% makes a big difference in the estimated time it takes to gain financial independence! Second, compound interest will play only a minor role. It would move the retirement date to 4 or 5 years instead of 6 years. The standard recommended 15% savings rate results in 25 years. This is not a coincidence as this is also comparable to the time most people spend working before retirement. For such a long time compound interest does make a difference. Finance geeks would want to use a financial calculator and use PV=0, i = 8% (or whatever ROI you think you can get), PMT=-0.70 (or however much you’re saving), FV = (1+PMT)/0.04 = 0.30/0.04 and then solve for n. If you have no clue what I am talking about, you might want to find out ;-)

Doing covered calls is a nightmare when it comes to filling out tax returns though. Besides, since I could never get the timing right, covered calls did not make any extra money for me. It was time to learn again. Therefore I started reading financial statements and began to learn methods to estimate the value of a company. In particular I started reading financial statements of companies that were not followed by Wall Street. Wall Street is mainly run by banks and big (pension) funds. First, this means that they need to invest billions of dollars which naturally restrict them to the largest companies. Second, if you are in charge of a big pension fund there is more job security in going along with everybody else than being the sole contrarian. If it turns out that you were wrong and they were right, you will surely get canned. If it turns out that you were wrong and they were wrong, you’re safe (who could have known, right). Finally if you are right and they are right, everybody wins. This also means that everybody shares the profits and losses. Conformist portfolio managers with this attitude are essentially charging money for nothing. Since conformity is a common human trait (if I had a dollar for every time I’ve heard “normal people” as a justification for some action) this explains is why index funds are generally superior. There are, however, managers that don’t follow the crowd and they can make outsized returns. Thus my present (2007) strategy is to buy undervalued companies that are generally hated by the market and wait for a turnaround. Once the tide of conformist managers and the blind indexers that follow them come around, I expect to be at the front of the wave. This might happen in 2009 or maybe I even have to wait until 2011. Who knows? Crowds are fickle.

Things have changed a lot since I started. I remember celebrating when my investment went up by $2 – “Honey, I earned $2 on the stock market today!”. These days my portfolio sometimes fluctuates by a paycheck on a daily basis and gaining or losing four digit figures is not a big deal anymore – “Oh, by the way honey, I lost/made $5,000 last week”. I sleep well at night.

Today I look at myself as “Me, Inc.” instead of “Who Cares, Inc.”. My day job would thus be a way of generating a consistent alpha (time based performance), but much of the my income performance is beta (market based performance) related. Taking control of my own investments has essentially turned investing into a second job for me. I can earn more managing my investments than I could taking on a second (minimum wage) job. This is also why I no longer need a “real job”.