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Your Investing Life: Gaining financial independence

August 13, 2015

Taking the reins of your financial future is exciting, whether you're new to the workforce or starting over after a change in your personal or professional life. But excitement can turn into inertia if you're not prepared—so keep the tips below in your back pocket and set your sights on the horizon. Your trek toward financial independence starts today.

Identify your starting point

Before you can plot your course, you have to know your starting point. Take stock of your current financial situation—how much you earn, how much you spend, and how much you save. Also factor in the balance of your existing checking, savings, and investment accounts and outstanding loans.

Chuck RileyTo get started, jot down what you spend in a notebook or use a note-taking app on your smartphone. If you aren't inclined to save every receipt or use complex spreadsheets, use estimates. Chuck Riley of Vanguard Advice Services says, "A lot of people think they have to create a detailed budget and track every penny, which can seem overwhelming and even sap your motivation. In fact, the best budgets are easy to stick with and simply give you a good idea of where your money is going—both coming in and going out."

Your budget is your business, but you don't have to do it alone. Linking your accounts directly to a secure website like mint.com makes it easy to get a bird's eye view of your finances, while other sites, like budgettracker.com and budgetpulse.com, allow you to manually enter the accounts and transactions you want to monitor.

Determine your destination

Now that you know where you stand, you're ready to decide: Where do you want to go? Creating a plan that reflects your priorities can help you keep your long-term goals on the horizon, even if you occasionally have to shift your focus to more immediate needs (a realistic possibility, especially if you're just starting out).

Consider including these steadfast goals in your plan:

Save for retirement
Want to take a voluntary pay cut? Not likely. If your employer offers a retirement plan, sign up and contribute regularly. Check to see if your employer offers a match; if so, contribute at least as much as they'll match. If an employer match is part of your overall benefits package, take advantage of it—choosing not to participate is essentially like taking a voluntary pay cut.

Maria BrunoIf you don't have access to a plan through your employer or you have additional money to save for retirement, invest in a tax-advantaged account like an IRA. Vanguard's Maria Bruno, an investment analyst in our Investment Consulting & Research Group, says, "We recommend saving 12–15% of your salary each year, including any employer matches, for retirement. But don't panic if that savings target isn't realistic right away—you can work toward it incrementally." Setting up an automatic investment or direct deposit service and increasing the amount you invest by 1%–2% each year is a disciplined way to increase your savings over time.

Pay off debt
Paying off debt can reduce the number of bills you have to pay and improve your credit score, but that's not all. Taking control of your debt can reduce stress, improve your physical and emotional wellbeing, and give you the financial freedom to pursue your dreams.

Here are two possible strategies to tackle debt:

  • Pay off high-interest, short-term debt that's not tax-deductible (like credit cards and car loans)—one balance, one payment—at a time. Start with your highest-interest debt and pay as much as possible (more than the minimum payment) each month while making at least the minimum payments on other cards.
  • Or, you can focus on the smallest balance you owe, regardless of the interest rate, and pay it off as soon as possible. "The psychological lift you get from actually seeing progress on your goals can provide even more motivation to tackle those larger debt amounts," Mr. Riley says.

Build an emergency fund
Create a financial safety cushion that you can draw from in a pinch or use to cover a few months' living expenses if there's an interruption in your cash flow. Focus on having enough liquid assets (in a money market fund or a bank account) to support your living expenses if you encounter an unexpected bill, injury, or job loss.

Put your foot on the gas

After you've charted your course, hold yourself accountable. Break broad goals down into smaller, actionable steps with specific expectations and commit to a set schedule to review your progress. You can even "go public" with your plan and ask a trusted friend or family member to check in on your progress every now and then.

Keep in mind that while you're in the driver's seat, managing your finances doesn't have to be a one-person job. You can work toward your goals with the amount of help you want—whether you want support to do it yourself or a trusted professional to do it for you.

Here are some tips for your trip:

Think long term
There's a difference between saving and investing. The goal of saving is to preserve the money you have while keeping pace with inflation—something you may be able to accomplish by investing in a money market or shorter-term bond fund. Generally, it's smart to save when you have a short or unknown time frame (like you would for an emergency fund).

The goal of investing is to increase the value of your money over time or use it to generate income. If you're investing for a long-term goal—like retiring in 30 years—allocating a larger portion of your portfolio to broadly diversified stock funds can help you increase the value of your portfolio over the long term. When you don't have an immediate need to withdraw the money you invest, your portfolio has more opportunity to take short-term market fluctuations in stride.

When investing, keep in mind that your asset mix—the combination of stocks, bonds, and cash you choose—will impact your returns and how your portfolio reacts to market ups and downs. Diversifying your portfolio is a good way to strike a balance between different types of risk, including market risk (the likelihood your investments will lose value with short-term market movements) and purchasing power risk (being unable to outpace inflation or reach your longer-term goals).

And don't miss out on a simple way to make your future self happy: Take advantage of the power of compounding right now. Compounding occurs when your investment earnings generate even more earnings, helping your money grow faster over the years. Compounding can have an especially big impact on long-term investments, like retirement accounts.

Prepare for the possibility of a detour

You have a state-of-the-art GPS, so why keep a paper map in the glove compartment? For the same reason you get insurance—to be prepared, just in case.

Take cover with insurance coverage
Having insurance coverage is essential to protecting yourself from unforeseen expenses.

  • Health insurance can give you access to preventative care, reduce your out-of-pocket costs for sick visits, medication, and emergency care, and defray the weight of staggering medical bills if you become seriously ill, which can preserve your credit. And if you can afford health insurance and don't have coverage in 2014 and beyond, you may have to pay a penalty.
  • Disability insurance may be included in your employer's benefits package, but if it isn't, consider purchasing a policy that can provide you with an income stream if you sustain an injury or illness that interferes with your ability to work.
  • Home insurance is generally required when you're borrowing money from a mortgage lender, but feel free to shop around for the best policy to meet your needs. If you rent, you can purchase renters' insurance, which is similar to home insurance but doesn't include coverage for the physical dwelling.
  • Auto insurance can vary in cost depending on the amount of coverage you opt for and a variety of other factors. So when you're comparing your options, find out if reduced premiums and price cuts are offered to drivers who meet certain criteria (like owning a home, having a good driving record, etc.).
  • Life insurance isn't necessarily just for people who are married with children: it can be a good choice for people who want to leave a monetary legacy for a loved one, protect others (especially co-signers on loans) from absorbing your debt, or cover your funeral expenses.

Have fun en route

Gaining financial independence requires planning and patience to handle the inevitable bumps in the road. As you're chugging along, remember to refuel by celebrating achievements and accomplishments along the way. Getting there is half the fun, so enjoy the ride!

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does note ensure a profit or protect against a loss.
  • An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
  • We recommend that you consult a tax or financial advisor about your individual situation.
  • Vanguard is not responsible for the accuracy of information on third-party sites.
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