Welcome!
In my earlier post, I talked about why you should start investing?. Naturally, the next question is how long should you keep investing. Or in a way I like to put it, “when can you attain financial independence (FI)?”
In this post, I talk about it.
Financial Independence (FI)
So, to the ones unfamiliar with the concept of financial independence (FI), here is a short primer. Financial independence is a stage at which you can stop working for money. Your investments/assets make enough money to cover your day-to-day bills.
Income from investments = Expense of everyday life
Before I talk about when you can achieve FI, I want to talk about why one has to achieve FI. If you are rather interested only in the “when”, click here to directly jump to that point.
Why achieve Financial Independence (FI)?
A bad deal: 5 to 2
For most of us, our primary source of income is from a traditional 9 to 5 job. In a traditional job, you often trade 5 days in a week for 2 days of freedom. It is like someone saying:
“We have a fantastic deal. Give us 5 dollars and in return we will give you 2 dollars?”
Will you keep accepting such a deal for the rest of your life?
Well, definitely not me! FI will free you from a 5-2 deal.
Freedom
Some might protest what I wrote above. Maybe you love your wonderful job. Maybe with that job you are adding value to the world. But, still the fact is that you are constrained. You are not free. For better or worse, everyday you have bills to pay and so you feel obliged to work.
Would it not be wonderful if somehow the bills could be taken care of?
Maybe then, you can stop working and start travelling the world.
Or maybe then, you can do that “THING” you always wanted to do, but never had time for.
Or you can continue to work, but only because you want to, not because you have to.
Financial independence will give you the freedom to choose what you want to do.
My point is we all love the freedom to choose. FI will give you that freedom and it is up to the individual to decide how to use this freedom. FI will give you power to do something because you want to do it, not because you have to do it.
When can you achieve Financial Independence (FI)?
The formula
Well, I am going to cut to the chase and directly present the formula that tells you when you can achieve FI. These are very realistic figures, derived from historical long-term data. If you are interested in the proof/reasoning behind the formula, check the end of the blog.
You can stop working for money or you have achieved FI, when
Your saved up money = 25 x annual living expenses
Even 25 is too high a number in my opinion. I prefer 20. Consider 25 as a safe number and 20 as the practical number. Better to be safe than sorry. For reasons, see here.
Annual living expense is all the money you need for your day-to-day expenses in a year: vacation, rent, food, gadgets, basically everything. So, if you spend about 250,000 in your bank account.
But you say –
“Hey wait! But, this still does not tell exactly WHEN can I achieve FI? How many years will it exactly take?”
Yes, you are right! Then, let’s do some more math to find out.
Assuming that you are not inheriting money, most of your “saved up” money is going to come from your paycheck. So let us assume, you save x% of your paycheck and spend the rest on your living expenses.
Then, let us also assume you are going to deposit this saved money in an account that gives 5% real rate of return. Real rate of return means the interest that is being paid on your money post inflation. For example, if inflation is 3% and rate of return of your investment is 8%, then your real rate of return is 5%. 5% is a very easily achievable figure for a long-term investment. Through the years, this account will grow and when it has hit the goal, i.e.
25 x Annual living expense,
where Annual living expense = (1-x/100) x Annual paycheck
then you can retire. I also depict this whole process in a flowchart below, that makes it easier to understand.
The road to financial freedom.
The magic number, years needed to retire!
So as you see, the number of years needed to achieve FI depends upon your savings rate (x%). The more you save, the faster you retire. But what is the exact number?
To save you from more mind pain, I crunched some complex numbers (for the inquiring minds in you, check this page. Basically, you compute when the compound interest account hits the target. The formula is messy. If interested, just ask me.) and plotted (savings rate) vs (the years needed to reach FI). This graph tells when can you retire.
Number of years needed to reach financial independence depends upon your savings rate. 30% savings rate needs 28 years. 60% savings rate needs 12.5 years.
You see the more you save up, the faster you retire. Saving up more has two benefits:
- You put more money into your compound interest account. This will enable you to reach the goal faster.
- You cut your living expense, thereby making your goal easier to meet.
But I guess most of you knew this fact before. But what you didn’t know probably was that, by increasing your savings rate you could EXPONENTIALLY decrease the number of years to reach your freedom. By just increasing your savings rate from 30% to 60%, you potentially gain 16 years of your life. 16 years of freedom. Isn’t that mind-blowing?
Also, what you probably didn’t know was that it doesn’t matter how much you earn. It is how much you save (x%) and how much you can live on.
Preach mode: ON
Although, I am not very fond of telling others how to live their life, bear with me while I preach for a second.
We humans have a bad tendency. Once we get used to a luxury long enough, then it often becomes a necessity. Much of what we consider necessities are often luxuries. So closely look at your life. See which luxuries you can cut down on. By cutting down luxuries and keeping only the necessities, you will find that attaining a saving rate of 60% or more is very easy.
We humans also have a good tendency. Once we set a tangible goal that can be achieved, we will always find ways to do it. So, decide a savings rate for yourself. Decide that you will start travelling towards the road of financial freedom. This mental tangible clear goal will trigger actions.
Maybe, now you can cut down on the coffee that you buy everyday at the office.
Or you will start packing food some-days. Or you will start biking to work.
Clear goals will automatically motivate you towards attainable actions.
Okay, I hear you and I will stop preaching now.
Understand the light side and dark side of the force. Use them on your journey for financial freedom. May the force be with you.
What is the most ideal savings rate? You decide.
You decide how long you want to keep making a 5-to-2 deal.
You decide how quickly/badly you want the freedom to do what you want to do.
Personally, from now, I am going to set a goal of saving 60-65% of my paycheck.
Conclusion
A quick recap:
- Stop making the 5-to-2 deal
- Financial independence enables you to do something because you want to do it, not because you have to do it.
- Your saving rate determines when you can retire.
- Saving helps in two ways:
- It helps you to grow your nest egg faster.
- It reduces your living expense goal, so that it can be attained easily.
- Do not let luxuries become necessities.
- Set a clear financial goal. Decide what is your savings rate today and work towards it.
Click here to see the math or the proof behind the earlier result.
Maybe, you were curious earlier on how I attained this formula:
Your saved up money = 25 x Annual living expenses
Let me explain. Basically, once you have stashed up enough cash, you want your living expenses to come from the interest that is generated by the stashed cash. So, once you know how much interest is being generated from the money, then you can keep withdrawing the same money from your account. So your withdrawal rate depends upon the interest generated by your investment.
While, for now I am going to skip the details on what the best investments are that give the best interest. That is for a future blog post. Just know that, you usually invest in a well diversified stock portfolio that gives decent returns. These returns vary depending upon the market. On good years, it could give 12% rate of return and on bad years it could give 2% rate of return. But on average it will give you steady returns, somewhere close to 9-10% pre-inflation.
So, given that the interest generally varies, how do I select the safest withdrawal rate?
Luckily for us, this is already done by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz (all professors at Trinity University in Texas). Their now famous study, known as “Trinity study”, examines what is the sustainable withdrawal rate over long periods of time. The following is the graph they came up with.
As you see, if you withdraw 5% of your investment account for living expense, then you will be safe most of the time (>90%). Hence, from this figure 5%, we deduce that your investment account should have 20 x living expense.
Some people even consider, 4% withdrawal rate as the safest, because that considers the worst-case scenario. In such a case, your investment account should have 25 x living expense. But, I personally feel it’s an overkill. So, I stick with 5% figure and hence I target 20 x living expense.
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With my first two posts, I introduced you to the start and the end of the financial journey. But there are several check-posts that have to be crossed successfully to complete the journey.
In this blog, I hope to write more about these check-posts and how to get there as easily as possible. So please SUBSCRIBE if you would like to be notified when such posts come out.
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Thanks folks.
Until the next time, Ciao!
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