Rules and strategy for achieving financial freedom quickly

2nd November 2018 15:23

by Peter Alcaraz from interactive investor

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In the latest of a series of articles, former lawyer and City money man Peter Alcaraz sets out a plan to achieve financial freedom and has some early tips for success.

Peter Alcaraz read law and economics at Durham University and spent 24 years advising small and mid-sized companies on mergers, acquisitions, IPO's and fund raisings, first as a lawyer and for the last 20 years in corporate finance. At the age of 46 after reaching 'O' he left city life to write, study, travel and spend more time with his wife and two daughters. His first book, The Wealth Game - an ordinary person's companion was published in 2016 and has become a staple among wealth managers, business schools and private individuals wishing to develop their personal finance skills.

Many people have a natural tendency to over engineer and complicate matters; to waste effort and time on the unimportant; to clutter minds, days, and lives with fruitless activity; and to chase, accumulate, and expand rather than discern, inquire, and focus. When this approach meets the unavoidable complexity of finance, the result is confusion and unsound actions.

It's no wonder that we seek solace in step-by-step guides and simple formulae for achieving goals, that we love systems and sound bites, and that we latch on to rules and regimes. They tantalize us with hope, and our optimism knows no bounds. The problem is that rules, regulations, principles, and procedures can rapidly take over as major subjects in themselves, restricting free thought and creativity, stultifying us, and sucking in precious time so that we lose sight of the game.

No rule should be accepted unless it is either unavoidable or materially helpful to your cause. Reject and ignore all others, and keep what you accept to a minimum. By doing this, you will escape all manner of distractions and dead ends.

Ask yourself this: What is the origin of a rule? Is it a natural law of nature, science, or mathematics, or is it man-made? If the latter, is it your own self-imposed rule, or one that others seek to bind you with?

In finance, there are certain natural laws that it pays to understand, as they can work powerfully in your favour or against you, and they can't be ignored. Fortunately, beyond these and outside of tax rules and general criminal law, we are largely left alone to do what we want. You should, therefore, aim to develop the smallest possible kit of the most useful multipurpose rules. If you carry around a vanload of them, it is hard to remember what you have or to find the ones you want. Travel light on the rule front!

A Foundation

Before considering laws specific to finance, such as the time value of money, risk and return, and compounding and debt, there are three universal concepts to understand.

1. Impermanence and change

Our natural instinct is to crave security and stability, to be able to anchor ourselves to something solid, reliable, and constant, but since all things are impermanent and subject to change, this is an impossible and futile task. It is better to accept that nothing stays the same for long or exists forever.

Furthermore, can you think of anything that is not dependent (in part or whole) on something else, that is not related to anything and exists in complete isolation? Temper your craving, and recognize that clinging is misguided. This promotes detachment, objectivity, and balance, and it reduces suffering.

Once you accept that everything is (a) transient and in a perpetual state of flux, and (b) dependent to a degree on something else, you lift one of the veils that otherwise masks your ability to see things clearly. Think about this for a minute.

How does this apply to wealth?

Earning ability

We move from being useless and dependent as infants to being useful and able to contribute; then we go back to being useless again when we're infirm or dead. During that pitifully short time, nothing stays the same for long. The lesson from this is to make hay while you can. By squandering any of the few good seasons that you have, your barn will be emptier than it could be.

Not only are our working lives short, but during them, earnings don't stay the same or follow a consistent path. They will go up or down or stop altogether when you are between jobs. In good years, you might receive a profit share or bonus or cash some share options; in bad ones, you may be fired or forced to take a pay cut. Furthermore, your earnings are dependent on many factors, and you can't control all of them. It is good to recognise this.

You also have a finite period of maximum earning capacity linked to physical and mental abilities and the state of your industry. And there are no exceptions; footballers, actors, supermodels, designers, engineers, bankers, production workers, nurses, electricians, carpenters, and plumbers all have shelf lives. I have seen many people behave as if the good times will last forever. They basked in money, but they became slack and complacent, and instead of being psychologically or financially prepared, they were shocked and upset when the inevitable happened, and they lost their earning power. By failing to recognise earnings highs as the short windows they are, these people overlooked the opportunity to squirrel away funds for the inevitable tougher times.

If you own a business or have accumulated a property portfolio or library of valuable rights you can employ managers to run the thing. If all goes well, your business will continue to thrive as long as you need it, but its profits and dividends will still fluctuate and cannot be guaranteed.

Why not refine your estimate of lifetime employment earnings from earlier? Factor in your views on future economic cycles and the effects they will have on the health of your industry and your earnings; consider your total number of maximum earning years. When will you reach the top of your game, and how long might you stay there? Perhaps 10 to 15 years at most?

In sports, this might span an age range of twenty to thirty-five; in the professions, industry, or media, thirty to fifty-five; and in the arts, any age. When will you run out of steam and go part time? Now revisit your lifetime earnings and savings totals.

Needs

Since the age of 20, I have not known a period of more than two years without a significant change in my needs, and I don't expect this pattern to alter for some time. My own personal needs have steadily reduced and continue to trend down, but those of children and the wider family have grown. Layered onto this have been the big structural changes of moving house and buying and selling significant appreciators as well as changes in borrowing costs, each of which has generated a new pattern of cash needs. Continuous flux has been the order of the day.

Try overlaying a rough needs profile onto your earnings chart. The absolute numbers matter less than the interaction between the two. Over which periods are you likely to be most cash rich or poor, and how might these match wider market cycles?

Decay, depreciation, and death

As humans, we age and die, and most of us get sick in between. All physical things, whether living or not, also have finite life-spans.

Assets, whether appreciators, depreciators, or consumables, are in the same boat here. Show me a company that can survive indefinitely, however great its current generation of management or products, or a farm that will always remain economic. Appreciators, by their nature, grow in value over time, but only through continued demand and the efforts of man to maintain, nurture, and manage them. Without our appetite, attention, or interest, all will ultimately depreciate and become valueless.

Does this universal law mean we should eschew assets, ignore liabilities, and abandon the quest for net worth? Not at all. To me, it argues for a little more discernment between things and a lot more detachment, a change in our relationship with assets and liabilities, and sense pleasures and discomforts. Understanding the difference between appreciators, depreciators, and consumables is a good start, but we can go further. What is the lifespan of an item? What, if anything, will I need to do or spend to keep it fit for its purpose? How will I feel about it when it is a few years old and surrounded by shinier, newer, better-specified versions?

In the United Kingdom, people change their cars on average every four to five years, their mobile phones every two to three years, and PCs or tablets every four years. We introduce our own changes to an ever-changing world. Do these really benefit us, or do they just

distract and occupy our attention? Is it wise to anchor your financial security or happiness to any asset or circumstance?

You should consider this carefully, as it will change your perception of material things and sensual experiences. When you dwell only on decay, depreciation, and death, you risk becoming maudlin. To ignore or deny these things risks wasting time chasing illusions and denting your personal wealth prospects, as well as bringing about a good deal of unnecessary suffering.

2. Opportunity cost

In microeconomic theory, the opportunity cost of a choice is the value of the best alternative foregone, where a choice needs to be made between several mutually exclusive alternatives, and you have limited resources.

Opportunity cost is a foundational plank in economics that expresses relationships between scarcity and choice and applies to anything that provides utility, such as money, time, or pleasure. In personal finance, it lies at the heart of commercial nousand rational behaviour and forms the basis of a sound financial strategy. In simple terms, can you spend your money more effectively in the quest to reach O?

Imagine that you buy a Mercedes SUV for £50,000, which depreciates at 15% of the purchase price each year. What is the best available alternative? Let's assume that you can buy a Ford Focus for £5,000 and generate a post-tax return of 8% on cash and that both cars cost the same to run and maintain and depreciate at the same speed.

The financial opportunity cost of your decision in year one is the extra cost of owning the car (i.e., its depreciation versus that of the Ford, plus the benefit you have lost by ignoring the best alternative):

Extra cost of Mercedes = (15% × £50,000) − (15% × £5,000) = (0.15 × 50,000) − (0.15 × 5,000) = £7,500 − 750 = £6,750

Foregone return = 8% × £45,000 = 0.08 × 45,000 = £3,600

Opportunity cost = £6,750 + £3,600 = £10,350

This doesn't account for any additional utility or pleasure you have received. Is this worth an extra £10,350 for a year? That is the question you should answer before you make the purchase.

You can also measure the opportunity cost over the life of your car. At annual depreciation of £7,500 for the Mercedes and £750 for the Ford, both cars will be worthless in 6.67 years. Your opportunity cost becomes the difference between the initial price of each car plus the foregone interest on cash.

extra cost of Mercedes = £50,000 − 5,000 = £45,000

foregone return = £45,000 × (1.08 6.67) − 45,000 = £30,188

opportunity cost = £45,000 + 30,188 = £75,188

Over 6.67 years, your pleasure has cost you £75,188 versus the best alternative, equivalent to £11,273 per annum. This effective annual loss exceeds the year-one loss because of returns compounding on the cash saved. Imagine what you could do with £75,188 compounding over another five or ten years!

Another example is university fees. If annual tuition fees are £9,000, and living expenses are a further £6,000, you might think that the opportunity cost is £15,000 for each year you study. This is not the case, as the best alternative is that you use the time to work for money.

Assume that while you are at university, you could alternatively earn £20,000 per annum after tax. These foregone earnings are a further cost to you, making an opportunity cost of £35,000 per annum before factoring in possible investment returns on any savings.

The question to ask before signing up to a three-year course is whether a cost of £105,000+ is likely to be outweighed by extra future earnings or other benefits from having a degree.

3. Virtuous and vicious circles

A virtuous circle is a recurring cycle of behaviours or events, the result of each one being to promote more and to increase the beneficial effect of the next—one good thing leads to another.

A vicious circle or spiral is a sequence of reciprocal cause and effect in which two or more elements intensify and aggravate each other, leading inexorably to a worsening of the situation—a domino effect of damage.

These are extensions of cause and effect, and personal finance provides a rich source for both.

The car purchase scenario earlier also contains the seeds of both. Imagine that you borrowed half of the £50,000 purchase price for the Mercedes and that interest rates go up. Both your purchase and choice of funding contribute to a worsened situation that may in turn lead to further negative events, such as missing payments on other loans, suffering stress at work,

losing productivity and pay, discord at home, traumatized children, and so on. The best alternative delivers a profit of £75,188 in comparison. This could be the difference necessary to fund a much bigger home in a richer neighbourhood, which in turn will deliver a gain, an improved living environment, better schools, a happier family, and so on.

The economics of agglomeration are used to explain the benefits that firms obtain by locating near each other. These clusters of economic activity provide enhanced networking opportunities and a chance to save costs. An old proverb is "Money begets money"—the more you make, the easier it becomes to make still more. A more recent saying is "The first million is the hardest."

In personal finance, there is no doubt that money earns money. Cash is a productive depreciator, and money in the form of appreciators grows whether the appreciators are productive or not. The effects of compounding are profound, as you'll see later.

Whether there are additional financial upsides from having a cluster of assets and managing them holistically against ongoing needs hasn't as far as I know been the subject of studies, but it seems highly probable and has been borne out by my own experience. Economies of scale can arise, and savings, both cost and time are spread over a larger base of wealth. More wealth justifies and provides resources for more research and analysis, leading to better decisions. Greater wealth presence inexorably leads to more networking, not least because wealthy people are sought out by others. These effects can foster a positive and productive environment for wealth creation.

There is overwhelming evidence to support the phrases "Success breeds success" and "Cycles of poverty." Your task in the wealth game is to spot possible virtuous circles and take steps to promote them, while avoiding any of the vicious variety. You are in one or more circle of some kind right now…but which?

Making a Plan

In order to achieve a set objective, however simple the task, you must make choices and trade-offs to achieve it. These choices and trade-offs constitute your strategy. To fix O as your goal and set off without a strategy is a sure way to somewhere, but it's unlikely to be O.

This seems self-evident, yet a surprising number of people jump on the bandwagon, enjoy the company and party spirit for a while, and then find themselves out of road, in a dust bowl in the middle of nowhere.

Furthermore, your finance skills, cash chips, understanding and application of the rules and chosen strategy, link to your objective like the connections in a circuit. If one fails, the whole system fails.

So, what is a good strategy to achieve O?

A good personal financial strategy should be short and clear, help you every day, and endure so that you don't have to change it.

In my book, The Wealth Game - an ordinary person's companion I'm not interested in the source of your earned income, simply the question: "How do you use surplus cash flow to generate net worth and manage your net-assets-to-needs gap to achieve O?"

Here is the strategy I recommend to achieve the first part of this: maximize surplus cash and apply it to a mix of appreciators that you understand; use leverage (where appropriate) and compounding to boost returns while maintaining adequate liquidity throughout.

The second part of the question is about managing needs, and the generic strategy is simple:

design the needs package that most helps you reach O, and stick to it.

Before we delve deeper into the strategy and begin financial skill building, how can your temperament assist you and what guerilla tactics can you employ to help you win the game?