An Introduction to Financial Independence: Part Four – Investing and Tax


  • A basic introduction to the various types of asset classes that can be used to speed your journey towards financial independence.
  • Covers Shares, Bonds and Real Estate investments and establishes the difference between speculation, investing and hedging.
  • A basic introduction to tax advantaged accounts and why you may or may not want to use them.
  • Approximately 4800 words.

The second most important concept in FI is making your money work for you. Most people reading this will be living in a western capitalist society. Capitalism, is based upon the ability of Capital to earn a return. Your money is a form of Capital, therefore there is no reason why it cannot be making a return for you.

Once you’re money starts to earn you money you get to be on the right side of Compound Interest. That is, by ploughing the money you earned from an investment back into the investment itself you’re ability to earn more money is increased. A useful heuristic here is the rule of 72. 72 divided by your return on capital gives you the time in years for your investment to double. Let’s say you’re earning 7% on an investment, dumping this back into the investment means it would have doubled in value in ten years, quadrupled in twenty and is worth eight times as much after thirty years.

The power of compounding is deceptive. On a day to day basis nothing really changes, but over the long run your potential growth can be truly impressive.

The remainder of this section will cover three methods for getting your money to work for you. There are others, but these are the three most common. They are; The Share Market, Real Estate and Debt Instruments (Bonds).

Disclaimer: Nothing in this article constitutes financial advice, do your own research. I will not be liable to any losses you incur as a result of following information contained in this article.


Investing in Shares, Mutual Funds and Exchange Traded Funds

Investing in the share market is scary the first time you do it. There’s a whole new world of acronyms and terms that you need to understand just to get into the door. You don’t know if you’re pissing away your money, throwing it into a garbage bag or unlocking the secrets to wealth.

Unfortunately, if you want to continue on the pathway towards FI you’ll need to educate yourself on some of the terminology. This section should help.

There are three broad classes of financial instruments to talk about in this section:

  • Shares – An ownership share in a company. Purchasing this entitles you to a share of the company proceeds. If the company increases in value your share will also increase. These are purchased off brokers who will charge you a small fee for the privilege. Alson known as stocks.
  • Mutual Funds – A mutual fund is an investment vehicle where you park your finances with a trusted entity and they take care of the rest. These funds will charge you a fee for the privilege which can range from 0.1-2.0%. These fees must be taken into account when looking at the returns an investment in a mutual fund makes over time.
  • Exchange Traded Funds (ETF) – Similar to a Mutual Fund, an ETF holds a broad class of shares under a particular theme. There are all forms of ETF, total US stocks, Asian stocks etc. ETFs have greater liquidity than mutual funds and represent a midway point between an individual share and a mutual fund. The difference between an ETF and a Mutual Fund is how you buy them. An ETF is bought in the same way as a Share, through a broker. A mutual fund on the other hand can be bought directly from a provider.

Why is it important to understand these investment vehicles? Simply put, banks and governments will not pay you a lot of money for your capital, they can’t put it to as much use since they must make a return on it whilst guaranteeing the principal. Banks and Governments are risk adverse and if there is one thing to take away from this article it is:

Risk is strongly correlated with Return.

A company on the other hand is in the business of making a return on capital. It is one of their primary reasons for existence, companies are not charities no matter what some of us would like to believe. Before we continue we need to discuss the difference between speculation, investing and hedging. This isn’t necessarily the best definition but it is sufficient for our purposes.

  • Investing – Is the process of making a decision with your capital because an analysis of the fundamentals and risks associated with the decision are likely to pay off (in risk adjusted terms).
  • Speculating – Is the process of making a decision with your capital because you believe someone else will pay you more. This is inherently related to Greater Fool Theory.
  • Hedging – The process where you seek to mitigate a risk that you are exposed to through the application of carefully selected financial instruments.

In this section we’re going to be speaking more about investing than speculating or hedging. If you want to speculate then go for it, there is nothing stopping you from taking an alternative view to the market on the value of an asset. Likewise, if you’re in the business of requiring hedges then this article is too basic for you.. As such, there are two questions we need to ask ourselves.

  • Am I happy passively investing and accepting the broad market returns?
  • Do I want to actively invest my funds to try to beat the market?

Active investing involves doing research on the fundamentals of a company and allocating your funds accordingly. This takes time and energy to do well and there are many companies around the world, particularly on Wall Street attempting to do this. Mutual Funds are the easiest way to get involved in active investing. A mutual fund does it on your behalf, they try to beat some predetermined index through their own skill and energies.

Passive investing on the other hand involves parking your money into a Mutual Fund or ETF that attempts to track a broad market index, such as the S&P500 for example. In this strategy you won’t out perform the market but neither will you under perform it.

There has been a famous bet, which recently finished, between Warren Buffet and a Hedge Fund investor. Buffet beat that over 10 years the S&P500 would beat the returns of the hedge funds after fees. Buffer won the bet quite handily, helped by a buoyant US market for stocks. An exception to this, if you’re starting to talk 8 figure wealth then you probably shouldn’t be reading this blog. Hedge funds may be worthwhile for you to mitigate specific risks. For example, you may be over exposed to a particular country or a particular asset class through inheritance or company ownership. A hedge fund is one of the better ways to diversify that risk.

So this leaves Mutual Funds and ETFs that are designed to track a broad market index. When working towards FI you are looking at a very long time horizon. Investing in assets that you expect to hold for many decades. In this context, you can’t expect to out perform the market every year and one year of catastrophic losses can set you back substantially. The old adage is that the share market has gone up 7% year on year. But this doesn’t mean it will continue to do so. There is also the difference between the arithmetic and the geometric means to deal with. Simply, averaging out the returns made each year will give you the arithmetic return, however your true return will be difference as the order in which you made the returns will be important. Compounding works both ways unfortunately.

I would only recommend Mutual Funds over ETF if you will be investing small regular amounts that are in the hundreds not thousands of dollars. For example, many funds will let you automatically transfer them amounts as small as $200 a pop. You can easily automate this with your bank to take out the amount each paycheck. For the best example of this I would recommend Vanguard retail funds. I’ve personally found them very easy to automate, just dedicate a portion of your paycheck to go out each time you get paid into the fund and you’re done. Rebalance every year or so to get back to whatever asset ratio you’re interested in.

An ETF on the other hand will have a small brokerage fee attached to it. As such, you need to invest a larger sum for it to be worthwhile. Investing $200 in an ETF when you’re paying $10 brokerage is an automatic 5% hit. Ouch. Investing $2000 and it shifts to 0.5%. The higher you go the better in terms of brokerage fees. For me brokerage is a fixed $8 up to $8000 and then 0.1% of the trade beyond that. As I’m investing larger chunks ETFs make more sense for me. But do your own research on the situation that works.

Either way, you’ll likely be investing in Vanguard or an equivalent style provider. These companies provide access to market indices for a small fee, typically much less than 1% and as low as 0.09% in some cases.

Investing in Real Estate

Real Estate is another option for investment, one that you can have more control over that can still have exceptional returns. That being said, do your research careful as unlike with shares your capital will be stuck into a single asset and is thus exposed to more concentrated risks.

When investing in real estate there are three factors to consider:

  1. Rental Yield, taking into account expenses
  2. Land Appreciation
  3. Dwelling Appreciation

Real Estate is first and foremost an emotional investment for most of us. We often have a deep rooted attachment to the land and physically owning something can be extremely emotionally satisfying. That being said, as a physical asset it will require upkeep.

Cap Rate

The Capitalization Rate (Cap Rate) is the rate of return on a property based upon the income that property is expected to generate and the current market value of that asset. Here, the devil is in two things:

  • The income that a property is expected to generate is net of all operating costs associated with generating it (note, this can have large taxation implications).
  • The current market value of an asset is used, not the purchase price.

The Cap Rate gives you the current yield of an asset exclusive of any capital appreciation that asset may be yielding. For example, if your cap rate was 10%, but then there is a boom in property and the asset valuation doubles then your cap rate will decline to 5%.

As such, cap rate is not the be all to end of considerations when purchasing a property. However, it is a useful indicator. A very low cap rate implies that very high capital gains will be required to make the asset worthwhile. The likeliness of these capital gains is a speculative purchase. The age old age property always goes up is great, except for when it isn’t and local markets will have very large discrepancies.

In short, use the Cap Rate if you’re looking at the difference between two income yielding properties. Don’t use it if you’re looking to speculate on house or land prices increasing.

Purchasing High Yield Investment Properties

One of the benefits of real estate is that it can bring a solid weekly or monthly income stream into your life away from your current pay check. Unlike company shares or bonds which may pay quarterly or biannually this can be a huge boon to the FI individual in terms of managing their own expenditure. Done well, a solid real estate portfolio can easily make you financially independent as the rents from your tenants will be able to cover your own expenses.

A decent rule of thumb for high yield investment properties is the 1% rule. Is the monthly rent greater than 1% of the purchase price of the asset. This purchase price also includes any repairs or other investments you’ll need to make into the property.

Earning 1% per year is approximately 12% per annum. However, you will likely experience costs related to renting it at about half of the total take. As such, you’re down to 6% already. Ignoring any asset bubbles your house may only rise 2-3% per year in line with inflation and tada you’re at 8-9% return. The 1% rule is a decent rule of thumb but it isn’t the be all to end all. There are many other factors that can come into play here so doing your own research is critical.

If you’re looking into property then you should also be aware of what the local tax laws are in your jurisdiction. Property is often a special asset class which has been given favourable taxation treatment in order to promote home ownership and affordable housing. Use this to your advantage.

Speculating on real estate asset bubbles

Many cities and countries throughout have seen real estate bubbles over the past few years. San Francisco, driven by the Silicon Valley tech boom, Canadian, Australian and NZ real estate and many others have escalated at rates far above what dispassionate observers may consider rational. As a consequence, asset values have soared in these areas as an influx of debft financed capital has placed huge stress upon the available housing stock.

Many people have made huge sums of money. Others have not. These bubbles have tended to favour individuals who managed to buy into them early, or had existing ownership shares. If you’re purchasing late on in the piece then you’re likely being saddled with very high debt requirements and are incredibly susceptible to any interest rate increases that may occur.

As this process is not likely to be repeatable I don’t consider it a safe investment strategy. Taking a huge leveraged position on a single asset in a single market with a long term commitment on it seems to be the height of folly. That being said, perhaps I’m just bitter at missing the bubble? Who knows.

Flipping Houses

I’ve separated out the pure speculation from house flipping here as while they share some similarities the approach is different. When house flipping you’ll need some good solid home renovation and building skills, an eye for design and the ability to dedicate the time towards the renovation. The concept here is to purchase poorly maintained, depressed, assets in a high value location. These are typically unfashionable houses which may need substantial work. Over a period of time you invest as little as possible, plus your own labour, into fixing them up and improving the housing stock. Once this has been done you then resell the house for a profit.

To flip houses you’ll need a good understanding of housing dynamics in your local area and solid practical skills. It is still a high risk approach, you’re levering onto a single asset but done well it is not pure speculation. You’re actively using your labour and skills to add value to an asset and reaping the corresponding rewards.

Property and Leverage

One of the primary reasons for the escalation in property prices and the capital gains that have accrued as a result is the leverage afforded and the availability of low cost debt. Currently, interest rates sit at their lowest level in decades and loan to value ratios (LVR), also known as down payments or deposits, have soared. Historically, you could only purchase a house with 20% down (LVR of 5). Now you can purchase with 5%. A LVR of 20.

No other asset class will enable you to make such a leveraged bet on a single asset. As an example, if you put $50,000 down on a one million dollar house and that house goes up in value by $100,000 then you’ve tripled your money (less financing costs). However, the asset valuation has only increased by 10% for this to occur.

On the flip side, if that asset declines in value by 10% then you’ve lost $100,000, or double your equity portion. Even if you were to sell the property you’d still be on the hook for an additional $50,000 to your bank. You can easily see what impact leverage can have upon your returns, it magnifies them massively in either the positive or negative direction.

Bonds and Debt Instruments

A debt instrument is one where you provide capital to an individual or enterprise for that entity to undertake a profit seeking activity. Debt instruments have terms and conditions associated with them, notably the term of the instrument and the rate of the instrument.

For example. You could sell someone a $10,000 bond with a 10 year term and a 5% rate. Each year, they other party will pay you 5% of the $10,000 ($500 in this case) and is obligated to return the full $10,000 to you at the end of the term.

Where this differs from an equity is that the other party is obligated by law to pay the rate and return the principal (note, bankruptcy proceedings may be an exception). If you purchase a share in a company and the value of that share goes to zero then tough, you’re shit out of luck unfortunately. But, if you sell the exact same company a bond then you’re able to reclaim some or all of the principal from the company.

Simply put, a debt instrument has a different risk profile. Understand that risk governs return, as such, it may have a lower return with the standard being the US treasury bond. These bonds typically set the benchmark of the risk free rate of return. You should never go into an investment where the rate of return is less than that of US treasury bonds, you’re needlessly placing your capital at risk as the US government will guarantee it for you.

If you’re interested in fixed interest style assets then I’d recommend doing further research. There are a large number of options becoming available, particularly in the world of micro finance in developing countries. Company or government bonds are other option as are loaning money towards real estate ventures or other similar groups. As always, do your due diligence.

Automating Your Investments (Understanding Weighted Average Purchases)

One of the most common questions that arises is when should I invest. We are all irrationally terrified of overpaying for investments because we don’t want to feel like an idiot. If you’re in a professional environment you’ve likely heard a colleague bragging about how one of their investments paid off massively. Of course, they don’t brag about their losses but it can still sting.

So how do we avoid overpaying for our investments? How can we time the market? What’s the fool proof secret towards having the best water cooler conversation on Monday mornings?

It’s simple. You don’t.

You may be able to get a bargain once or twice. Statistically it can happen. But to time the market over the long run isn’t possible.

In fact, I would argue that it’s counter productive. There have been numerous pieces of analysis done on the impact of the “largest” days on the share market. If you missed the ten largest days on the S&P500 between 1993 and 2013 then your investment would have only returned 5.4%. Staying in, you’ll be netting a cool 9.2% annualised return.

Simply put. Time in the market beats trying to time the market.

The best way to avoid overpaying for our investments is to look into Dollar Cost Averaging (DCA). DCA, one of the tenets of Benjamin Graham, the author of The Intelligent Investor which Warren Buffet has called one of the best investment books ever, is a proponent of this strategy. In DCA you look for stocks that your analysis shows is good value and you average out your purchases over a period of time (e.g. one year). In effect, you’re taking the average price over the year as your purchase price as opposed to a single point.

This means that you’ll have a position in mind, or a particular fair value price point, and you will continue to purchase shares on a regular basis until you’ve reached your target level.

This approach has a cost, as opposed to lump sum investing. You’ll be holding a portion of your assets in cash which will have lower returns during the holding period.

If you’re goal is FI then this should be too much of an issue for you. Investing under FI is different as you’re focussed upon the extremely long term (30-60 years depending upon your age) and you are likely to be making continuous purchases from your pay check within the accumulation stage. This approach naturally dovetails with dollar cost averaging as you’ll be making continuous purchases over time.

To automate this process understand the maxim pay yourself first.

Paying yourself first means that after you get paid the first money to exit your account is investments (or debt repayment). You’re putting your future first and setting yourself up.

If you leave it to the end of each financial microcycle that money will be sitting there burning a hole in your pocket. The Headonic Treadmill is a cruel mistress and she will spend any resources you have sitting there. Little purchases will become necessities. Wants become musts. At some point you’ll be browsing on Amazon into the early hours of the morning and suddenly you’ve bought a Bouncy Castle.

Instead. Set up a recurring payment to either your broker, a high interest savings account or a mutual fund. Better yet, understand the various taxable accounts and try to make a pre-tax contribution to one of these. If you never see the money come into your accounts (or it leaves immediately) then you will never have the opportunity to adapt to a higher expenditure level.

When approaching FI you need to understand that your mindset is the most important component. Placing huge financial pressure upon yourself is a quick way to sabotage things. Instead, implementing a smart budget and paying yourself first will let your investments kick on to autopilot. You don’t want to spend all of your time obsessing about finances. You have a life to lead.

Rebalancing Your Portfolio

When you first start out investing you’ll put some money into different asset classes. In a hypothetical case, 50% shares and 50% bonds. Over time, one of these asset classes may perform better than the others, you’re now overweighted towards a particular asset class and as such your risk has changed.

Remember, we’re not seeking to judge our portfolio performance on the basis of any one good or bad year, diversification is used to help mitigate the worst years, not the best.

When we rebalance we sell the overweighted portion and buy the underweighted portion so that we return to our desired asset allocation. This can be as simple or as complex as you want it to be.

If you hold individual shares then this will likely take more work and require more brokerage costs to hit the desired ratios. An ETF on the other hand could be as simple as selling the stock ETF and purchasing the bond ETF.

Rebalancing may also occur within an asset class. For example, you may want to hold a basket of 10 stocks in equal amounts or weighted according to their market cap. If you were to rebalance this every year you would have to sell the high performers and buy the under performers in order to bring the weighting back to the desired level. This is exactly what an ETF does for you and one of the reasons they charge a fee for their service.

Understanding Taxation Structures

Tax is a dirty word. We’re not paying enough, we’re paying too much. The wrong people are paying too little, the right people are paying too much. Income taxes are too low, income taxes are too high.

The truth is. No matter where you live in the world tax likely has a major impact upon your decision making and your lifestyle. When you’re working towards accumulating more significant financial assets the impact of tax upon your lifestyle is likely to increase into the future.

As taxation has a strong locational component here this section will be shorter. I am going to mention a few points that can be researched in various areas. You will have to do your own research here and expert financial advice will be worth it’s weight in gold in the long run. The only thing I really want to cover here is to introduce you to tax advantaged accounts.

Tax Advantaged Accounts

A Tax Advantaged Account is one that gets special treatment under the taxation system in return for a number of restrictions being placed upon it. For Americans these are your 401ks and IRAs, retirement vehicles that can be used to defer taxation and optimise your returns. For Canadians this is the TFSA and for Australians this is Superannuation. New Zealanders have Kiwisaver as their vehicle and other countries are likely to all have their own equivalents.

These accounts come in a number of flavours, but they all share similar characteristics. By imposing a number of conditions about when the money can be withdrawn they are taxed at a lower rate or even zero.

Given what we know about compounding from Part Three we understand that any reduction in our rate of return will have a major impact on our investment returns over time. If we’re able to minimise the taxation obligations of our investment through these restrictions then financially we’ll be better off.

But, there is always a catch. The restrictions placed upon these accounts that qualify them for their special status. The most common restriction being a withdrawal restriction that prevents you from accessing the money until you reach a certain age. These restrictions exist as these accounts are intended for retirement at a certain age. Not so good if you’re seeking financial independence and the ability to retire much much earlier.

You cannot claim to be financially independent if you cannot access any of your funds for another twenty years. You’ll be forced to continue working in order to maintain your lifestyle until the point you can access them. So do your research on the options that are available to you. Tax advantaged accounts can be a massive boon to your journey towards FI. But the liquidity premium you pay to get access to them may be too steep.


This article has covered the major forms of investments that are available to the FI seeking individual. You should understand the basic options and what is available to you.

Investing is the process through which your money starts to work for you. Master the process and I can guarantee you’ll see a dramatic improvement in your financial situation.


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