An Approximation for Financial Independence
Simple math behind breaking free
Motivation
I just had a conversation with a friend who is looking to get a hold of her own finances but doesn’t know where to start. I couldn’t find an article that presents the subject as accessible as I’d like (MMM comes close)... so I just decided to write my own piece.
Financial Independence
Financial independence is the idea that you’re investments “passively” generate enough money so that you aren’t beholden to working for pay anymore. The basic principle is that you leave the original investment untouched and simply shave the excess off every year. If that investment generates enough for you to pay your bills, CONGRATULATIONS!! You’re financially independent.
This is the basic framework for how to “buy your way out” of the system. It allows for your house, groceries, bills, etc to be paid for passively and sustainably. Of course, you can still work and stay busy but it’s on your terms. You’re free to pursue your passion projects that the work-grind never left you with enough time/energy to do.
But how much money do you need?
Well, that’s where finance people like to get complicated and scare people away. They write about different “asset classes,” “market cycles,” “balanced portfolios,” etc. It is so fantastically complex that folks decide: “I’ll just pay someone else to do this for me.” Or worse, I will just do the whole “save 20% thing” and call it good enough.
However, not everyone can afford a financial planner and simply not thinking about it is a great way to never retire.
The good news is that we simplify things if we stop trying to “beat” the system.
The market grows every year right? We’d have problems if it didn’t… What if there was a single “stock” that simply followed the market’s inherent growth? If you chose to simply put ALL your excess money into that stock… maybe that could be enough?
Introducing the 4% rule
TL;DR: It’s one formula
The basic assumption is that, on average, the market grows 7% every year and that the S&P 500 follows that growth. So if you put $100 into that “stock” this year, you can expect to have $107 next year. But, of course, inflation decreases the value of that by about 3% every year (yes, your money is basically on fire if you leave it in cash).
Thus, we have the 4% rule. This simply says that you can expect 4% growth of your investment every year assuming the market grows 7% and you lose 3% of that to inflation.
It’s crude. It’s reductionist. But it turns out to be good enough to get started. There are many arguments that can be made against this “rule of thumb” but I think MMM handles them well so I won’t list them here.
Applying the 4% rule
Remember, we want to keep our initial investment “untouched” when we “retire” so we can just shave the cream off the top every year. If that “cream,” is enough to live on, then we have achieved financial independence. So we need our “nest egg” to be large enough such that 4% of it matches our standard of living (how much we spend).
Well, if we use the 4% rule above, it turns out to be 25 times the amount that you spend every year. So if you spend $100,000 a year then you’d need keep working until you save $2.5 million. That seems like a lot right? So…what if you can live off $40,000? Well now it reduces to only $1 million. Still a lot maybe… but you got time.
Again, the formula is…
To make it visual, I plotted your nest-egg size (in millions) vs your annual spending budget (in thousands). So if you can collect your bills and figure out how much you spend every year, you can use the plot (or the formula above) to determine how much you need to save.
Lower your Living Standard — > Break Free Faster
As I looked for articles for my friend, I kept finding things that said “well just make sure you save 10 to 20% and you’ll be fine.”
Contrary to this theory, it’s not how much you earn but how much you can save. Of course earning a lot helps, but the rate that you save is heavily influenced by how much you spend too.
As you spend more,
- you save less of your income
- your retirement “target” gets larger and thus harder to reach (again see plot above)
Spend less, save faster. Spend more, make it reallllly difficult to retire.
But Life Costs Money…
Exactly. I realized I needed to start thinking about how much things cost and how much each costs me in terms of my “time.” I trade time for money when I work. Thus, when I buy something, I’m indirectly trading my time for it.
Remember this is about breaking free so it doesn’t make sense to sacrifice unnecessarily the things that bring me true joy. Living only for the future is a great way to completely miss out on life as it comes.
However, it still makes sense to ask myself value questions about spending habits. For starters, it might be to simply start documenting them.
How much of a difference is it to eat-in vs eat-out? How much of my income goes towards rent or house payments? We all need to unwind so how much do my “nights out” cost? How often do I impulse buy from Amazon? All of these things fall under “cost of living.”
A great way to stay stuck in the work-for-someone-else lifestyle, is to act like these things are unnecessary to think about. Spreadsheets make things easier … I just started playing around and it grew from there.
How much do I need to retire given the above calculation? Can I cut costs anywhere to make it easier to hit that mark?
Good luck and stay tuned. I plan to write a piece that demonstrates why the “20% savings” rule makes no sense.
