13 Steps To Financial Freedom

Welcome!

You may not realise it yet, but this may be your ticket to financial freedom. We're talking about the kind of freedom where you're truly in control of your finances, both free to enjoy your money and free from worrying about it. It's about being money-confident: knowing how money works and getting yours to work for you.

The Motley Fool's 13 Steps To Financial Freedom takes you on a life-changing journey. Whether you are deep in debt, interested in the share market but don't know where to start, or already dabbling in shares and want to learn more, you've come to the right place.

This is… well, we'll be honest, it's a long post. But given the importance of the content and its potential impact on your life, we think you'll find the investment in time (do you see what we did there?) well worth it. To make it easier, we've also provided handy links below where you can jump to the area of your interest. But we strongly suggest reading the whole thing, and taking control of your financial life.

Enjoy your journey to financial freedom!

1. The miracle of compound returns

This one simple concept could change your life. Forever.

Albert Einstein called the deceptively simple concept the "greatest mathematical discovery of all time." We call it a path to financial independence.

Welcome to the miracle of compound returns.

In a nutshell, it's about interest, and how earning a slightly higher rate of interest can make a massive difference to the amount of money you end up with in the long run.

How does it work, you ask? Like this:

• You earn some interest.
• Next year, you earn interest on that interest.
• The year after, you earn interest on the interest on the interest.
• The year after that… and so on…
• You live financially happy ever after.

Rates matter, a lot

More than anything else, interest rates determine how quickly and how much your savings grow. The higher the rate at which you invest, the more – and the faster – your savings will grow, which is why you should make every effort to get the highest possible rate.

Since words cannot adequately describe the magical nature of compound returns, let's try a few visuals.

Here's how a single $1,200 investment grows over time in three savings scenarios.

How a single $1,200 investment grows

As you can see, simply socking away one lump sum and doing nothing else could turn $1,200 into nearly $40,000 over 40 years. Not only have you earned interest, but you've earned interest on your interest. And all you had to do was invest your first pay cheque.

That said, let's be honest: $37,691 ain't what it used to be. So let's make one small revision and invest $1,200 every year. Behold compound interest in a mildly caffeinated state…

A more compelling table than the previous one

Now we can see a path to almost half a million bucks. Not bad, right? Still, you should be able to top it. In fact, it's not a massive stretch to get near that magical $1 million milestone.

Just save $2,500 a year (a mere $208 a month), and at 9% you've got a million dollars in 40 years. Or stick with the $1,200 annual contribution but improve your rate of return. If you are able to earn a 12% rate of return, the $1 million prize is yours.

And the best part about compound interest is that it works the same for everyone, whether you have $20 to invest or $200,000. If you don't believe you can become a millionaire with just the resources you have right now, keep reading.

The amazing tale of the Mississippi washer woman

Oseola McCarty was born in Mississippi in 1908. For nearly 75 years, she lived in the same simple house, washing other people's clothes for a living and putting whatever money she could into savings accounts at local banks.

In the summer of 1995, Oseola made local and then national headlines when she donated $150,000 to the University of Southern Mississippi to establish a scholarship fund. "I just figured the money would do [scholarship recipients] a lot more good than it would me," she said. It soon came out that this washer woman had managed to amass nearly one quarter of a million dollars over her lifetime.

Time — a key part of the compounding equation — helped turn her meager early investments into hundreds of thousands of dollars.

We like this ending better

As remarkable as the Oseola McCarty story is, the ending could have been a blockbuster. After she died in 1999, one of her bankers wrote to us saying: "Time was able to turn even the modest returns of her early investments into hundreds of thousands of dollars. If we had been able to introduce her to equities earlier, she would have left millions instead of thousands."

Remember, the amount you save and your time horizon — how long you have until you need the money you've invested — are only two-thirds of the compounding equation. Oseola excelled in both. But she did pay a price for ignoring the rate of return on her investments.

This might cost you hundreds of thousands of dollars

Typically, the more risk you are willing to take on (by, say, investing in shares rather than a savings account), the higher your potential return. But risk is a four-letter word to a lot of folks: They're happy to settle for lesser returns to avoid it.

But the avoidance of any sort of risk might end up costing you hundreds of thousands of dollars over a lifetime of saving and investing. Safer investments, like term deposits, not only return less than the share market, they barely keep up with the rate of inflation, and that means your retirement dollar is not going to go as far as you think.

As you'll find out over the course of these 13 Steps To Financial Independence, we Fools believe the best place for your long-term savings is the share market.

Your golden ticket to financial independence

There you have it: Financial independence is just three variables away. So start saving now (as much as you can), and invest it well. Because the sooner you get the wonder of compounding returns working for you, the sooner you'll reach your financial dreams. And that's exactly what this series will help you do.

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2. Trade wisdom for Foolishness

When you're plying your trade in the investment world, calling yourself Foolish (note the capital "F") is normally inadvisable. As you've probably surmised, we think quite the opposite.

The short version of where we got our name is this: We nicked it from Shakespeare.

The slightly more detailed back story is this: Our company name is in homage to the one character in Shakespearean literature — the court jester — who could speak the truth to the king and queen without having his head lopped off. ("A fool, a fool, I met a fool i' the forest, a motley fool," says Jacques in Act II, scene VII of As You Like It.)

The Fools of yore weren't simply stand-up comics sporting belled jester caps — they entertained the court with humour that instructed as it amused. More importantly, the Fool was never afraid to question conventional wisdom, particularly when popular thought was detrimental to the kingdom's people.

See where we're going with this?

Back in 1993, when the Fool debuted in the USA ("Fool US") — first as a print newsletter which later moved online — The Motley Fool looked around and saw all the conventional financial advisor "wisdom" in the financial world and we wondered why no one was crying foul.

So blatantly ripping off Billy Shakespeare (after consulting a few lawyer friends), donning the jester caps (a job requirement), The Motley Fool set out to expose what was wrong with the establishment and counter it with a healthy dose of honest, commonsense Foolishness.

Our mission has always been and continues with Fool Australia to be to educate, amuse, and enrich. We've taken the liberty of scribing a mission statement just for you, too: Get smart(er), make money, and have fun.

But first, you may be wondering exactly what we get out of all this feel-good-empowerment-join-our-team stuff. We're glad you asked …

What's in it for us?

Navel-gazing warning: The following section may seem rather self-indulgent. That's because it is. For those who are curious about our company, our business model, and the main difference between us and the rest of the financial trade, read on. If that's not you, skip ahead to the next section. No hard feelings, honest.

In all seriousness, The Motley Fool truly is a place with a passion and a purpose. We are dedicated to educating, amusing, and enriching every single person who visits Fool.com.au, happens to catch us quoted in the press or even sees one of us on TV (in full Fool regalia, if there isn't a dress code).

Fool US' workplace has won awards and been highlighted as one of America's great places of employment, and debates are settled at the table tennis table. Here in Australia, although we are only new to the investment scene, we have a team deep in experience, with deep Foolish values.

In short, we are serious about the business of financial education and advice. After all, your money is on the line, and so is ours.

The Motley Fool is a commercial enterprise, we have investors, a board of directors, and goals — just like any other company.

Over in the USA and UK, The Motley Fool has services that it is proud to sell – primarily a suite of premium stock-picking services. Here in Australia, we have a similar service,  Motley Fool Share Advisor.

But we also never, ever forget that our measure of success is whether we have enriched people's lives in a direct way. We do this every day with the free content and information we provide right here on Fool.com.au

But enough about us. Perhaps you're wondering what's in it for you? What exactly will you get by trading wisdom for Foolishness?

Get smart(er)

We know that most people have never formally been taught much about finance or investing.

Obviously, we think that's ridiculous. The harsh reality is that only one person has your best interests at heart — you. Our job is to show you how to take control of your own financial life so you can make confident, well-informed decisions about every dollar that passes through your hands, whether you're saving it, spending it, paying it back or making it grow.

Make money

Most everything in Fooldom is here to fulfil this part of your mission. And you've found the exact right place to start: The next steps of our 13 Steps to Financial Freedom will help you along the way.

In this series of articles, we lay out a systematic approach to investing that should benefit novice and seasoned investors alike. We cover almost every money situation you can imagine – paying off debt, finding no-brainer ways to save, smart asset allocation, finding the right investing strategy for you, and even the pitfalls you should avoid.

But, of course, our job is not complete unless you have some fun along the way.

Have fun

In the USA, back in 1994, Fool US hyped a fictional penny share called Zeigletics on one of the Internet's first "chat rooms". "Zeigletics" manufactured "linked sewerage disposal systems for the central African nation of Chad." Literally, it shovelled excrement.

The aim was to "out" the penny share hype-sters that were abusing the chat rooms. Their electronic pyramid scheme — pumping tiny, thinly traded shares to get other investors to load up so they could dump shares at the first sign of an uptick — was not just harmful to investors, but it also degraded the real conversations people were having.

So the Fool fought them the only way we know how: by trying to kill them with humour.

A few posts was all it took to get investors excitedly looking to buy shares on the Halifax Stock Exchange (which doesn't exist). Many of the hype-sters were duped, and they were furious at our little joke.

The weekend project — the Fool's first April Fool's Day prank — landed Fool US a spot in the Wall Street Journal and introduced Foolishness to Wall Street. But the real triumph wasn't the press attention or the prank — it was the amazing thing that we witnessed during the weekend of the Zeigletics gag: People started playing along with the joke.

We're all Fools

Members of the Fool's online community joined the gag, hyping Zeigletics, hinting at their "inside information," and bragging about their "amazing returns" investing in the fictional sewage disposal outfit in Chad.

Zeigletics showed us what a group of like-minded individual investors could accomplish by banding together. Even better, it created a bonafide Foolish community where honesty, optimism, teamwork, and innovation thrived. That's right, pretty soon we noticed that people were identifying themselves as Fools — just like us.

A movement had begun, and now, years later, that movement has made it all the way to Australia. Let the fun begin.

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3. Get control of your money

It might sound incredibly basic, but getting control of your money is about spending less than you earn.

Boring, hey? Wouldn't it be fun to buy a new car, a new flat screen TV, the latest and greatest smartphone, to take a 3-month European holiday, and to get that brand new kitchen you've always wanted?

Of course it would. But if you consistently spend more than you earn, it doesn't take a rocket scientist or indeed a Fool to work out you'll more than likely end up in the Poor Farm. You may have lots of material possessions, a few memories, but ultimately nothing to show from it.

It sounds boring, we know, but let us show you how saving, and not just spending, can be a whole lotta FUN.

Remember we introduced you to the miracle of compound returns in Step 1? Well, miracle of all miracles, if you used the money you saved each week or month to fund savings and investments, you can get the miracle of compound returns working for you. From modest beginnings, you too could accumulate serious wealth.

Now you're talking, Fool.

You should aim to spend less than you earn each and every month. If you already do this, you're well on your way to gaining control of your money – you just need to get the money you're not spending to start earning interest.

Do this by paying yourself first: set up a regular direct debit or BPAY® into a savings account just after pay day and put that money to work right away so you don't get tempted to spend it elsewhere.

If you don't spend less than you earn, don't worry. Most of us need a little help getting control of our money. In fact, those of us who barely make it from one pay day to the next need to start with basics: budgeting.

Budgeting – the key to a healthy bank balance

Budgeting is neither as scary nor onerous as it sounds. To start, make a list of your regular bills and how much they cost you each month. This should give you a good idea of your main areas of expenditure. If you're not sure where your money's going, keep a spending diary: for one month, make a note of everything you spend, even if it's $2 for a chocolate bar. At the end of the month, tot it all up to see how much you spend and where you spend it.

Once you know your outgoings, it's time to start trimming them. Often there's no need to cut back on the things you enjoy, but rather to get better value for money for the stuff you have to get anyway. If you're spending far in excess of your income, you will need to take more drastic steps, but for most of people, a trim should do it.

Trimming the fat – the same products for less money

Start trimming your outgoings by reducing one major bill each month, prioritising the bills you pay on a regular basis, as with these, one phone call could lead to sustained savings. Most people can save hundreds of dollars, if not more, just by making a couple of switches. You shouldn't have to look too hard, either…

Financial products
Changing your mortgage, savings account or credit card is often one of the easiest ways to generate some surplus cash.

Getting connected
These days, you're likely to have at least one mobile phone bill, a landline bill and an internet bill. Together, they can easily add up to $300 per month, making communication your second biggest bill, after your mortgage. Shop around for a better deal. Compare plans on the internet. Haggle with your existing providers. There is big money to be saved.

Getting around
If you're a driver, you can probably save a packet on car insurance by switching to a cheaper provider. Women drivers and drivers with clean records can stand to save the most here.

Getting away
Fancy a break? However and wherever you're making tracks, you can save at least the price of a meal by shopping around before you buy. With dozens of online resources dedicated to finding the cheapest fare, accommodation, excursions, and breaks, there's just no excuse for paying too much for your holiday fun.

A final note on getting control of your money

Getting control and keeping control are different things, and there's no guarantee you won't fall off the straight and narrow at least once. When this happens, just take stock of why you fell – so you can learn from your tumble – and calmly and proudly climb back on the horse.

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4. Dump your debts

These days, being in debt is almost considered normal. The average adult has non-mortgage debts of several thousand dollars, and pays interest rates well in excess of 18% on what they owe. While the miracle of compound returns can be a fantastic thing when you're saving, it works in reverse when you're borrowing, which explains why debts often spiral out of control.

Credit cards are a major culprit here. While it's useful for borrowing money, if your card has a high interest rate and you can't afford to pay off much each month, then the credit card company is getting the benefit of compound returns – and who wants that?

Savings vs. debt: the knockout round

A common mistake for well-meaning but misguided savers is to carry debt on the credit card while accumulating savings in the bank. Sure, these are good intentions, but bad maths: with savings earning, say, 5%, but debts costing 18%, there's a shortfall of 13%. It makes far better sense to use the savings to pay off the debt and start again from scratch with savings that are earning real returns.

Beware the lifelong debt!

It's impossible to overemphasise the dangers of debt. Even small, seemingly harmless debts can quickly grow out of control. Take a credit card debt of $1,500. If you're charged 1.5% a month and only ever pay the minimum monthly requirement of 2% of your outstanding balance, this bill will take an astounding 37 years to clear, and at the cost of thousands of dollars of interest!

In almost every scenario, there is no better use for your first freed-up dollars than paying off high-priced debt, which, for most, means credit card debt. We'll prove it.

Consider the difference between setting aside $200 a month and coming up $200 short and covering it with a credit card. After five years of that — assuming you simply stuff your $10s and $20s into a shoe box, your credit card charges 18% interest, and you pay a minimum $15 a month toward the balance — here's where you'd be:

Years	$200 in Monthly Savings Amounts to …	Putting $200 per Month on a Credit Card Amounts to …
1	$2,400	($2,652)
2	$4,800	($5,583)
3	$7,200	($9,088)
4	$9,600	($13,278)
5	$12,000	($18,288)

Stashing your cash in a savings account earning nearly 20 times less in interest than you're paying on those lingering credit card balances leaves you $6,288 in the hole after five years, and you've paid nearly $7,000 in cumulative interest charges alone.

The bottom line: If you have credit card debt, invest in its destruction. Only once this is done can you really start building up your finances for the future.

Amass a cash cushion. Stuff happens — stuff that requires money to fix, such as a job loss, car transmission issues, and a really bad haircut before your high-school reunion. If you don't have the money on hand, you'll have to make a crash financial landing, which could mean patching over the problem with a credit card.

Your emergency fund needs to be readily accessible in a simple savings account. Don't expect to make a killing on this investment. The interest you can get on most savings accounts won't even keep up with inflation.

How big should this essential investment be? Here are some basic guidelines:

If you …	Then your emergency fund should cover living expenses for …
Have no dependants relying on your income	3 to 6 months
Are the sole breadwinner or work in an unstable industry	6 to 12 months
Are retired and living on a fixed income	5 years

Sweat the big stuff and the 80/20 rule

One other thing we want to make clear: Not every "investment" has a dollars-and-cents return. Or, in more practical terms: Go ahead and enjoy your daily latte or cappuccino. At The Motley Fool, we're hardly advocates of excruciating denial and extreme penny-pinching in the name of "investing."

We'd much rather you spend your energy on the big stuff that really pays off — the 20% of line items on your budget that counts for 80% or more of your spending — things like your mortgage, cars, travel, energy, communications, insurance, and any four-figure line items in your budget.

Pinpoint your 20%, and earmark a few hours to cut those costs. Then take that savings and put it to work in bonafide investments — in the traditional sense, that is.

Not coincidentally, making those first share market investments is the topic of the next step.

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5. Prepare for investing take off

Pardon us for interrupting your illustrious investing career for this very important public service announcement: Any money you need in the next month, five months, or five years does not belong in the share market.*

Go ahead and read that sentence again. It is the key to avoiding heartache, headache, and a lifetime of Quick-Eze addiction.

Got it? If so, please continue reading. For those into footnotes, we've provided this one:

*The last place for your short-term savings is any place where it is at risk of being worth less when you need it most. That rules out the share market, which is prone to roller-coaster-like ups and downs, as is evident on any chart that tracks its month-to-month performance. Now, we don't want to scare you away from shares. Over most five- and 10-year periods, the squiggly line on the chart that resembles a ride on the Great Share Market Scream Machine morphs into a gently rising upward slope. The key is time — giving your money time to ride through the stock market's bumps and tumbles and reap the rewards of long-term investing.

With that important bit of business out of the way, we're ready to find proper accommodations for all of your savings needs and devise a strategy for funding your long-term financial goals.

The best places for your short- and mid-term savings

There's a vast array of appropriate places to stash the money you may need to access soon, including basic bank accounts, high-interest savings accounts, term deposits, cash management trusts and even government bonds.

These types of accounts are safe harbours: They won't provide killer rates of return (and may not even keep up with inflation), but they do provide a virtual guarantee that the money you deposit will all be there when you need it.

Keep in mind that one type of account may not best serve all of your short-term savings needs. For example, cash earmarked for a deposit on a house you plan to make in a few years is ideal for a term deposit. The kid's summer camp is better off in an instant access high-interest savings account.

Once you've deployed your funds for near-term needs, it's time to find the right spot for the money you'll need to cover Saturday date nights … in the year 2041.

Long-term parking

Much of your long-term cash stash (specifically, money designated for your retirement years) will likely belong in an account set up solely for that purpose — we're talking superannuation.

For reasons far too complex to go into here, we can't get into any detail about super, so instead we'll point you to the excellent Australian Tax Office site and its section on super funds. If you are an employee, you'll likely have a super fund – we urge you to get to know it as if you were married to it.

For all the benefits of superannuation, we'd suggest you'll also want to build a large nest-egg outside your retirement fund. You know, for all the extravaganzas in your later life, like a round-the-world cruise, a new car or the latest and greatest zimmer frame (only joking!).

Get yourself a broker account

If you want to buy shares, you're going to need a broker. And in this modern day and age of the internet, why not choose an online share broker account?

You can buy and sell shares with the click of a button – no more phone calls, no talking to bespectacled gentlemen wearing bowler hats and braces, and commissions far cheaper than the offline variety.

Most of the big banks offer execution-only brokerage accounts. Commissions start from around $15 per trade for trades up to $10,000.

The sooner you get your short- and long-term savings accounts set up, the sooner you can get to the fun stuff — investing.

Which brings us nicely onto our next step…

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6. Share market investing… seriously, it's simple!

What would you do if we said you were missing out on an investing strategy that, in the long run, has produced returns that far outweigh those offered by a bank? One that outperforms cash in a term deposit or savings account? Well, meet the share market.

Internet bubble and global financial crisis (GFC) included, according to 2019 research by Credit Suisse, Australia has had the best performing share market in the world from 1900 to 2018. Australia posted 6.5% after-inflation returns per year in USD terms during that time, making those returns the highest (with volatility the second-lowest) of the 23 major markets the researchers studied.

The global financial crisis shook many people's belief in shares. It's likely that the recent COVID-19 bear market will have had the same effect. Some people, battered and bruised by the experience, have sworn off the share market for life. Sure, they made some mistakes and some poor investments, but that's part and parcel of investing. As the old saying goes, if at first you don't succeed, try, try again.

Plus, having a long-term investment horizon can help you ride out the inevitable volatility, all the while letting the miracle of compound interest do its thing.

Shares vs property

We're not about to get into a debate here about the relative merits of shares versus property. Since we're all about shares, we hope you don't mind if we just stick to the share market for now.

The bottom line is we think investing in the share market can be financially smart, simple, inexpensive, and over time, help you generate life-changing wealth.

Think back to those tables from Step 1. There are no guarantees in life, but if you invested $1,200 per year for 40 years and you generated 9% returns every year, as is possible by investing in the share market, you could be half a millionaire.

Enough said?

Investing in the share market: funds vs. shares

You can invest in the share market by buying shares in an individual company, or by investing in a fund, which consists of a variety of shares in different companies – sort of like a basket of shares. With shares, as the value of the share itself (a publicly traded company) goes up or down, the value of your investment does the same.

With funds, the value of your investment is tied to the value of the fund, which is reflective of the value of the shares the fund is comprised of. It follows that one share's movement has a smaller impact on the fund as a whole, and thus on you, than it would if you had all your money tied up in that share alone. You do pay a price for the relative stability of funds, and that's the fund management fee – all funds have these. We have more on the specific type of fund we like in our next step.

With shares, perhaps the biggest challenge with investing is knowing what to buy, when to buy it and when to sell it. It is a challenge, but if you get it right, and buy shares in a company like Woolworths Group Ltd (ASX: WOW) when it floated at $2.45 per share, the rewards can be truly remarkable.

As you'll see, we like the challenge of picking the next Woolworths, or the next Fortescue Metals Group Limited (ASX: FMG).  These are the types of investment successes that can make a massive difference to you, potentially setting you up for a long and very financially comfortable retirement.

But we believe funds have their place in your portfolio too. Not every fund, mind you. We're talking about funds with certain characteristics. But first, we'll have to introduce you to the dirty little secret "the industry" doesn't want you to know about.

Summing up…

As a rule, the longer you invest for, the greater the chance that you'll do well. Investing for the short term, which we would describe as less than five years, is certainly risky. But when you're investing for your retirement you can afford to be a bit more patient.

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7. The dirty little secret of managed funds

Active fund managers get paid to beat the market. Funny thing, though, is that most fail. What is not funny is why they fail.

Standard & Poor's found that almost nine out of 10 actively managed funds underperformed the S&P/ASX 200 Index (ASX: XJO) after fees in 2018. Ouch.

But why do most active managers underperform? After all, they're well trained and with Bloomberg terminals and swarms of research analysts at their disposal.

The most straight-forward reason is many fund managers are closet indexers. No one gets fired for buying IBM (or BHP, or Woolworths), as the old saying goes, and there's comfort in owning the same shares as your peers. Predictably, such unoriginal thinkers struggle to compete: Morningstar found that only 22% of closet indexers outperform their benchmarks.

Managers also struggle to invest in the least picked-over part of the market: small-caps. Like a whale in a bathtub, many managers have gathered too much money to deftly invest in small-caps. Their loss: S&P Capital IQ finds the median member of the S&P/ASX 100 is followed by almost 4 times as many analysts than the S&P/ASX Emerging Companies Index. When it comes to stock picking, it's better to be a minnow than a whale.

This one will make you squirm: many managers don't even invest in their own fund! A 2016 Morningstar study found that a staggering half of American equity fund managers had $0 of their own money in the funds they managed — not exactly a ringing endorsement.

Lo and behold, Morningstar also found that the average fund manager who has skin in the game outperformed the average one who does not, and that a manager's odds of outperformance went up alongside the money they invested in their own fund.

The last reason is simple: fees. Like most of us, active managers expect to get paid for their effort. However, like a midget running the 110 metre hurdles, funds with middling performance struggle to overcome their fees. Making matters worse is the high commissions funds end up paying to brokers when managers try (and usually fail) to day trade their way to success.

A better way

So the bad news is that most actively managed funds underperform. The good news is that investors can invert the problems above to increase their odds of outperformance.

• Seek out managers with long track records of outperformance.
• Tilt towards reasonable, aligned, straightforward fee structures.
• Avoid closet indexers, who are basically charging an active fee for a passive strategy.
• Look for managers with skin in the game — the more the better!
• Low turnover, which means fewer commissions and is correlated to improved performance.

Meanwhile, you can always go in another direction…

The humble yet extraordinarily efficient index tracker

Welcome to "the index".

An index tracker is a fund that copies one of the main stock market indexes (like the S&P/ASX 200, for example) so that by buying into an index tracker, you can buy the overall market without having to pick individual shares.

The S&P/ASX 200 contains two hundred of the largest companies on the Australian share market, with each company weighted according to its market value. This means movements in large, usually more stable companies like BHP Group Ltd (ASX: BHP), Commonwealth Bank of Australia (ASX: CBA), Woolworths Group Ltd (ASX: WOW) and Telstra Corporation Ltd (ASX: TLS) affect the S&P/ASX 200 index much more than smaller companies.

Index investing is perfect for investors who just want the benefits of share ownership without either the hassle or the risks that are inherent in picking your own shares. Index investors won't beat the market, but they'll only underperform by a small amount (thanks to the — low — fees).

Index-tracking exchange-traded funds (ETFs)

The best way for most investors to buy index tracking fund is right on the ASX, via something called an exchange-traded fund (ETF). As ETFs are traded on the share market, you can buy and sell just as you would with a regular stock, using an online discount broker.

The bottom line: buy the haystack

The Motley Fool is all about encouraging you to take control of your own money and make better financial decisions.

The evidence is clear when it comes to investing in actively managed funds: Most underperform, and the average investor is better off placing their money into a low-cost index fund.

Then again, some managed funds do consistently outperform. And for some people, who don't want to put in the time and effort of stock picking, those funds might be best. Or, if you're Fools like us, you'll now want to find some great individual shares to add to your stack. As well as potentially helping you beat the returns of the index, the holy grail of investing, it's also fun.

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8. The great dividend tax advantage

The old saying goes there are two things certain in life – taxes and death.

Because you're reading this, we presume you're alive and breathing. But as you're alive and breathing, the taxman will also have his beady eye on you, looking to get his fair share of your income and capital gains.

It's natural to want to optimise your after-tax returns. For that reason, you should have a basic understanding of the tax treatment of different types of share investments. As ever, if you are unsure about anything tax related, seek advice from the tax office or your friendly accountant.

The joy of dividends

We love dividend payments, whether they be in the form of a cheque in the post, a direct debit into you bank account, or are reinvested via a dividend reinvestment plan. To long-term investors, dividends in high quality companies are the gifts that just keep on giving.

On the flip side, resident individual taxpayers are liable to pay tax on their dividend receipts. Trust the taxman to spoil the party!

But there is some good news. Unlike most other countries, dividends from Australian listed companies are often paid with franking credits attached. Called dividend imputation, prior to their 1987 introduction a company would pay company tax on its profits and if it then paid a dividend, that dividend was taxed again as income for the shareholder, a form of double taxation.

As far as the taxman is concerned, you are entitled to a franking tax offset equal to the amounts included in your income. In essence, the franking tax offset will cover, or partly cover, the tax payable on the dividends. If the tax offset is more than the tax payable on the dividends, the excess tax offset will be applied to cover, or partly cover, any tax payable on other taxable income you received.

Here's an example of franking credits in action.

Cash Dividend Received (Franked amount)	$700
Franking Credit (at the tax rate of 30%)	$300
Gross Dividend	$1,000

For a 45% taxpayer…

Tax payable (45% * $1,000)	$450
Less Franking Credit Offset	$300
Net tax payable	$150
Net after-tax dividend received ($700 – $150)	$550

So, instead of paying tax of $450, as you would in many other countries, Australians only pay tax of $150. Happy days.

The other thing to note is, when you take franking credits into consideration, the dividend yield on your investments is effectively higher. You might see the terms "gross yield" or "grossed-up yield" when quoting the dividend yield on a share.

Using the example above, if you owned $15,000 worth of shares in the company…

Cash dividend yield ($700/$$15,000)                                    4.67%

Gross yield ($1000/$15,000)                                                  6.67%

Net after-tax yield ($550/$15,000)                                          3.67%

By way of comparison, if you'd received $700 interest from a $15,000 investment in a term deposit or savings account, the after-tax return would only be 2.57%.

Capital gains tax (CGT)

Investors are also liable for capital gains tax (CGT) on any net capital gains realised by selling their investments.

If the shares were acquired on or after 20 September 1985, the capital gain is subject to CGT at the rate in the year in which you sold the shares.

For shares bought on or after 21 September 1999 and sold 12 months or more after the date of purchase, only half (50%) of any capital gain is included in your taxable income.

For example, 1,000 shares purchased in January 2008 for $5 each are sold in February 2009 $7 each, giving you a capital gain of $2,000. This gain is discounted by 50%, so only $1,000 is subject to CGT.

If you make a loss (and losses are an inevitable part of share market investing), there are rules regarding the treatment of capital losses. In short, in many cases, you should be able to offset at least some losses against any capital gains. Again, seek advice.

Summing up

There is an old saying that you shouldn't let the tax tail wag the investment dog. In other words, make an investing decision based on its own merits, and not on any tax advantages or disadvantages.

Believe it or not, paying taxes on your dividends and on any capital gains is a good thing. It means you're generating income and/or making a profit, which is a far better outcome than paying punitive rates of interest on your credit card debt!

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9. Asset allocation

As fun as finding winning shares is (and trust us, it really is fun), your allocation to shares (equities) is only one slice in your total investing pie. Asset allocation basically comes down to how much you should have in cash and how much in shares. The Fool's three rules for asset allocation will help you slice up your portfolio into these important pieces.

Rule 1: If you need the money in the next one to five years, it should be in cash. Choose a term deposit or a high interest savings account.

You don't want the deposit for your European adventure, or your kid's school fees to evaporate in a share market crash.

Keep it in a term deposit or a high interest savings account. As with any product, shop around for the best rates.

Job done.

Rule 2: Any money you don't need within the next five years is a candidate for the share market.

We Fools are fans of the share market. Over the long-term, shares have consistently outperformed the returns on cash and most other forms of investment, the only possible exception being property.

Of course, in the short run, no one knows what shares will do. But make no mistake: Even if you're in or near retirement, a portion of your money should be invested for the long term. That's because, a 65-year-old can expect to live another 20 or more years. A 110-year-old, however, should sell everything and get to Vegas while he still c

an. (We're kidding… mostly.)

So unless you're a 95-year-old skydiver who drinks and smokes, expect your retirement to last two to three decades. To make sure your portfolio lasts that long, you should…

Rule 3: Always own shares.

Over the long term, shares are the best way to ensure that your portfolio withstands inflation and your retirement spending.

In the US, according to Jeremy Siegel's Stocks for the Long Run, since 1802 US shares outperformed US bonds in 69% of rolling five-year investing periods (1802-1807, 1803-1808, etc.). The percentage of the time that shares wallop bonds only improves as you look over a longer horizon.

Data from Stocks for the Long Run, by Jeremy Siegel.

In the US at least, for holding periods of 17 years or more, shares have always beaten inflation, a claim bonds can't make.

The bottom line is that when you need your money will partially dictate where you put it. What else determines your asset allocation? That favourite term among financial gurus: your tolerance for risk.

Risk drives return

Most people base their investment strategies on the returns they want, but they have it back to front. Instead, focus on managing risk and accept the returns that go along with your tolerance for it. It'd be great if we could get wonderful returns with no risk at all. But to achieve returns beyond a minimal level, we have to invest in things that involve some possibility that we'll lose money.

So ask yourself: What would you do if your portfolio dropped 10%, 20%, or 40% from its current level? Would it change your lifestyle? If you're retired, can you rely on other resources such as your superannuation or the Age pension, or would you have to go back to work or downsize your living arrangements (and how would you feel about that)?

Your answers to those questions will lead you to your risk tolerance. The lower your tolerance for portfolio ups and downs, the more cash you should hold.

As an extra aid in determining your mix of shares and cash, consider the following table, from William Bernstein's The Intelligent Asset Allocator:

So, according to Bernstein, if you can't stand seeing your portfolio drop 20% in value, then no more than 50% of your money should be in shares. Sounds like a very good guideline to us.

OK, you now know how much you should have in shares. But what kind of shares — large caps, small caps, value, growth, international? And how much?

Over in the US, we use these charts as a guideline for basic allocations, based on where you stand on your lifelong investing journey.

Note that bonds aren't nearly as popular or widespread here in Australia as they are in the US. In fact, according to Deloitte's 2018 Corporate Bond Report, Australian private investors' direct participation in the bond market is less than 1% of all Australian corporate bonds on issue. Over in the US, this figure is nearly 20%.

We'd suggest using ETFs to get access to the bond market.

Action: Determine how much you should invest in shares. Just use Bernstein's table above. And remember that our appetite for risk changes depending on current market and personal circumstances. So err on the conservative side if you're taking this quiz during a bull market (and vice versa).

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10. Avoid the biggest mistake investors make

We're about to share with you the secret to avoiding a $10 billion investing mistake. It's not more money, a higher IQ, or superb market timing.

It's mind control.

The way we're wired — our natural inclinations to seek more information, look for patterns, compare options, and even flee to safety — is great at keeping us out of harm's way. But these same emotional tendencies are also our biggest liability when we're in investing mode. In other words, your brain is to blame for all those boneheaded money mistakes.

Just ask super-investor Warren Buffett. The man widely acknowledged to be the world's greatest investor openly admits that a short in his analytical circuitry — his "thumb-sucking" reluctance (Buffett's words) in the 1980s to pick up more shares of US supermarket giant Walmart because of a small uptick in the share price — cost him $10 billion in potential profits over time.

And this is from a guy who has famously said, "Success in investing doesn't correlate with IQ … what you need is the temperament to control the urges that get other people into trouble in investing."

In other words, Warren Buffett made a $10 billion investing blunder because his emotional brain got in the way.

2 traits you must have to be great

And now, the information you've been waiting for: the secret ingredients to investing success, regardless of education, investing styles, or golf handicaps: timeline and temperament.

Timeline: As we mentioned previously, investing in shares requires a minimum five-year time horizon. Think of it like sending some of your money on holiday while your other money takes care of the more immediate chores, like paying for car repairs, a house, or a kid's private education.

But, at the risk of sounding like a country and western song, it can be hard to be a long-term investor in a short-term world — which brings us to the second secret ingredient for investing greatness.

Temperament: Successful investors have the ability to remain calm and level-headed when everyone around them is freaking out. That mindset makes the difference between investors who consistently outperform the market and investors who get lucky for a while. Walmart foible aside, Warren Buffett says this is the key to his success. When a group of business-school students asked Buffett why so few have been able to replicate his investing success, his reply was simple: "The reason gets down to temperament."

Money, IQ points, and lucky charms are no help when your investment is down 50%. But if you can keep your emotions in check and ignore the noise, you'll be able to hang on (even back up the truck and load up) rather than selling out at the worst times. If you look back at history and study how investing fortunes were made, you'll find it wasn't by jumping in and out of shares based on fear and greed, but by buying great businesses and investing in them over the long haul.

Hop off the emotional roller coaster

To cultivate a good temperament — one that focuses on the long-term, not the short term, and ignores the crowd in favour of a well-thought-out strategy – you need to build resistance to the emotional triggers that lead to bad investment decisions. Here are a few exercises we regularly do to keep our cool:

Memorise this affirmation: "I am an investor; I am not a speculator." All together now: "I am an investor; I am not a speculator." As investors, we:

Buy shares in solid businesses. We expect to be rewarded over time largely through share price appreciation and dividends.

Don't time the market. And we certainly don't speculate when we buy shares. Speculation is what traders and gamblers do.

Focus on the value of the businesses we invest in. We try not to fixate on the day-to-day movements in share prices.

Buy to hold. We buy shares with the intention of holding them for long haul. (That said, we are willing to sell for reasons we outline in step 12.)

We recognise that believing your affirmation is sometimes easier than living it. To avoid behaving like a speculator …

Tune out the noise: Put down the newspaper, stop reading emails from speculators pumping the merits of some dubious mining outfit in outback WA, and stop looking at your portfolio at every 'spare' moment. None of it is doing you any good.

Fixating on the market's minute-to-minute news won't help you make your next brilliant financial move. At best, all the hours, days, and weeks spent soaking in sensational stories might help you impress some members of the opposite sex at the next office happy hour, but mostly it's all noise, and it's costing you a serious amount of sound sleep — and maybe even some actual money.

Spread out your risk: In order to get some quality Zs, you need a solid asset-allocation plan — meaning a portfolio with a load of investments that don't always move in the same direction. You need to diversify. For more details on diversification, go back one step.

Putting an assortment of eggs in various baskets isn't the only way to spread your risk. You can also avoid the risk of investing in a company at exactly the wrong time. Say you're interested in buying shares of Scruffy's Chicken Shack, but you just don't know when to pull the trigger. The answer? Use the shotgun approach.

Practically speaking, you do this through dollar-cost averaging — accumulating shares in a company over time by investing a certain dollar amount regularly, through up and down periods. So every month for three months you purchase $500 of Scruffy shares regardless of the share price. The beauty of this system is that when the shares slump, you're buying more, and when it's pricier, you're buying less.

"Buying in thirds" is another way to average in to an investment: Simply divide the total dollar amount you want to devote to a particular investment by three, and pick three different points in time to add to your position.

Stay strong, think long! For Fools, investing success is not measured in minutes, months, or even a year or two: We pick our investments for their long-term potential. So resist the urge to act all the time. Make decisions with a cool head after letting new information sink in. Sometimes the best action to take is no action at all.

Distract yourself with something useful: If you're going to obsess about your investments, use your time productively and review your investment philosophy and process. For example, pick any investment that's interrupting your sleep. Write down why you bought the business in the first place. Ask yourself: Has any of that fundamentally changed? This exercise underscores that short-term ups and downs in the share market have little relevance to winning long-term investments and wealth generation.

If you don't already have one, start a watch list so you can keep up with the companies that pique your interest. And add your list to a portfolio tracker so that all the company news will be in one place.

When preparation meets opportunity, that's when great investments are made.

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11. Buy your first shares

When you buy a share, you're purchasing a stake in a living, breathing business. Buy shares of your favourite electrical store and you own the place. Literally. Every time someone picks up a new iPhone or DVD, a tiny bit of cash drops to your company's bottom line. High five, shareholder!

Finding great share ideas is as simple as opening your eyes. Your fridge, medicine cabinet, wallet, computer: all hotbeds of investment ideas. Behind virtually every successful product or service lies a publicly traded company that's cashing in on that success — and that you can join as a business partner.

Better know a better business

But a great service or product does not a great investment make — just ask anyone who invested in One-Tel during the dot-com era. Again, think of buying shares of a company just like buying a stake in a local small business. Does the business have staying power? How much cash flows in and out? Do you trust the management and employees to do right by you as an outside investor? Hardly questions you'd need a Harvard MBA to spell out for you, right?

Fools take the same commonsense approach to investing. We're interested in the strength of a business. Not past performance, charts, or whether the shares trade at 10 cents or $50.

Specifically, here are a few things we look for:

1. A sustainable competitive advantage: Some businesses have unique, lasting competitive advantages that allow them to earn outsized profits. The more durable a company's competitive advantage, the larger the "moat" that surrounds its financial fortress. Think about Woolworths' and BHP's pure scale, Seek's network effects, and CSL's intellectual property. They are all classic examples of sustainable competitive advantages.

2. Cash aplenty: Cash is the lifeblood of any business. It pays the bills and covers the tab for new growth projects. Fools look for low-debt, cash-rich balance sheets and steady cash flows. Specifically, free cash flow — the cash left over after funding operations and growth — fuels share repurchases and those sweet, sweet dividends that show up in your bank account every six months.

3. Strong leadership: Is management invested alongside you? Do they have a history of creating value for shareholders? Do they have years and years of relevant experience? Do they treat outside shareholders (business partners) with respect?

If you stumble across a company that nails all of the above, odds are good that you're looking at a great candidate for your hard-earned cash.

Now you're ready to buy your first shares

You've paid off your credit cards. You've saved up an emergency fund. You've opened an online brokerage account. You've done your research and found the company of your dreams. Let the guns blaze!

Whoa there, tiger!

We're just as excited as you are that you're ready to be a shares owner. But before you go knocking on Mr. Market's door, bearing cash and gusto, let's keep some perspective.

First, this is just one of many investments you'll end up owning. That's to say, you want to invest in sips, not gulps. Your first purchase should be as petite in size as it is bold in spirit. Second, don't forget that your first investment is also a learning experience. As any craftsman will tell you, there's no better way to learn than by doing.

A journey of a thousand miles begins with a single step. And that's what we recommend to you: Buy $500 worth of your favourite company. Just one company. This one share will teach you more about life as an investor than we could ever hope to teach you here. Follow it. Get to know it. Read the news earnings releases, look at the company's presentations, and see how the share's daily fluctuations affect you. For future purchases, you should keep trading costs and commissions to less than 2% of your total purchase amount, but we'll let that slide on your first buy.

But there's something else we want you to pick up while you're making a stop at your friendly stockbroker: A stake in an index tracking ETF – those wonderfully efficient investment products we introduced to you in step 7.

Index tracking funds don't look to beat the market — they look to match it as closely as possible. That might not sound enticing at first blush, but consider that index funds offer:

1. Instant diversification: When you invest in an index fund, in one fell swoop you've spread your dollars across industries, markets, currencies, and countries, substantially lowering your risk in the process.

2. Low costs: Index funds have much lower expenses than actively managed funds. The average actively managed US fund charges its investors 1.4% for the privilege of owning shares. Vanguard Australian Shares Index ETF (VAS), meanwhile, carries an annual fee of just 0.10%.

3. Superior returns: Over in the US, according to Morningstar research, only 23% of actively managed funds beat the average of their passive rivals through the 10 years ending June 2019. Numerous studies both in the US and here in Australia show that you're likely to underperform the index by investing in a typical active fund. And as we just pointed out, you'll pay a lot more for that privilege.

Little wonder that we think index funds should be the foundation of your portfolio. But for now, we simply recommend that for every dollar you put into individual shares, you roll the same amount into an index tracking fund (the Vanguard ETF we mentioned above is a good choice).

But about that one share

Yes, we Fools love index funds, but we also believe everyone should own at least one share (and ultimately, at least 15 to reduce your risk and increase your odds for success). Why? Well, it's fun (really!). By owning a share, you have your own little piece of history, and you get to witness firsthand the power of capitalism and entrepreneurship at work.

But just as important, if you want to beat the market, you simply can't do that by investing only in index funds. In fact, your goal for every share you buy should be to outperform the index. So get out there and start having some fun on your way to market-beating returns.

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12. Five reasons to sell

When should I sell? This is one of the most frequent questions we hear. Our glib (yet truthy!) answer is: Almost never. We'll come back to that shortly, but in the meantime, here are five reasons we do sell shares.

Reason No. 1: Better opportunities

Sometimes, there's nothing wrong at all with a company or its share price: There are simply better opportunities elsewhere that will bring us more bang for our bucks. We will consider selling a less attractive share (even at a loss!) if we think we can get a better deal elsewhere.

Reason No. 2: Business changes

There's no way around it: Businesses change — sometimes significantly. We could be talking about a major acquisition, a change in management, or a shift in the competitive landscape. When this occurs, we incorporate the new information and re-evaluate to see if the reasons we bought the company in the first place still hold true. We will consider selling if:

* The company's ability to crank out profits is crippled or clearly fading.

* Management undergoes significant changes or makes questionable decisions.

* A new competitive threat emerges or competitors perform better than expected.

We'll also take into account unfavourable developments in a company's industry. Here, it's important to delineate between temporary and permanent changes. In a downturn, financial figures may suffer even for the best-run companies. What's important is how these businesses take advantage of the effects on their industry to improve their competitive position.

Reason No. 3: Valuation

We're all for the long-term here, but sometimes Mr. Market shows our shares too much love. We will consider selling if a share price has run up to a point where it no longer reflects the underlying value of the business.

Reason No. 4: Faulty investment thesis

Everyone makes mistakes. Sometimes, you'll just plain miss something. You should seriously consider selling if it turns out your rationale for buying the share was flawed, if your valuation was too optimistic, or if you underestimated the risks.

Reason No. 5: It keeps us up at night

It is tough to put a dollar value on peace of mind. If you have an investment whose fate has whirled such that it now causes you to lose sleep, that could be a great cue to move your dollars elsewhere. We save and invest to improve our quality of life, after all, not to develop ulcers. Adding insult to injury, stressing about a share might cause you to lose focus and make rash decisions elsewhere in your portfolio. Remember, there's no trophy or prize for taking on risk in investing. Stick with what you're comfy with.