This is my first post concerning personal finance, so I’m horribly tempted to spew a whole bunch of financial terms at you. The struggle is real. Seriously, though, everyone needs to know how to handle their own money. Money is like life. No one can do it better than you – you are the only person living your life. And the only person spending your money is you. You can get help or advice about what to do with your money, but in the end you buy things and experiences that you value.
Now that that little tidbit is out there, let’s get started. I want to start out with a slightly more advanced topic than you might expect. The reason I want to do this is to give you something to strive for. In fact, I believe everyone should strive for this as much as they can. Why? Because there is no downside. I’d go so far as to say if you’re not pursuing this, then you’re wasting your money!
What am I talking about? I’m talking about financial independence. To be clear, this is not about becoming or being financially independent; I’m simply discussing pursuing financial independence. Being financially independent is wonderful and a worthy goal, but as with life, it is a journey, not just a destination.
FI vs FIRE
I’ll be using the term FI, pronounced like a word (fye) or letters (eff eye). However, there is another acronym used in the FI community: FIRE, which stands for Financial Independence, Retire Early. There are arguments every day around the word Retire, both inside and outside the community. I don’t care to get into the mud with that discussion, so I will only address FI here.
The first tenet of FI
The first tenet of FI (and one may argue the only tenet of FI) is to save as much of your income as possible. Your typical financial advisor might encourage your typical worker to save 5%, or if they’re ambitious 10%, of gross income. A person pursuing FI laughs at that number. For FI, it is common to see savings rates such as 30%, 40%, 50%, even 75% (and more!). People brag in forums about their high savings rates.
Why So High?
What’s the point of having a high savings rate? You’d rather use your money now! Not have it wasting away in a savings account! Life is short! Enjoy it while you can!
The point is like this. Let’s say you are a typical ambitious worker so you save 10% of your income. This means you live on 90% of your income. Ergo, in order to be financially independent (or have passive income to cover your annual expenses), you need your passive income to cover 90% of your current income. At 10% savings rate, it will take you 9 years (with 0% investment returns) to save 1 year of expenses. Multiply that 9 by the number of years you want to live after you become FI and that is a very rough estimation of the time you will be dependent on a paycheck to live. It’s not just about retirement either. What if you lose your job before you’re FI? You’ll need another one quickly and around the same pay in order to continue your lifestyle and savings.
If you save 50% of your income, you live on 50% of your income and only need enough passive income to cover 50% of your current income. It will take you 1 year (with 0% returns) to save 1 year of expenses. Sounds a lot better than 9 years, doesn’t it? Plus, if you lose your job unexpectedly, you’ll have a lot more time to look for a job you love because you’ll have plenty of savings to fall back on.
Given these two scenarios, or these two people, A and B, which one do you think will reach financial independence first? Assuming of course person A’s income is the same as person B’s.
We all know that person B, the person who saves 50% of their income, will reach financial independence earlier than person A. Great. Now what? Now, B has become financially independent (we say reached FI), and can do whatever they want, while A must continue working – not only because they haven’t saved as much as B, but also because they need more money to reach FI!
How much longer will it take A? Before I answer this, there are two things we need to discuss:
- Return on investment, or ROI
While you save your money, you need to put it somewhere. The place you put it – no matter where that is – will have a return on investment associated with it. A return can be negative or positive or zero. This is the money that your money makes without you having to do anything (or the money your money loses if return is negative). If you stash cash under your mattress, your return will be negative of the inflation rate. If you stash your money in a savings account, your return will be the interest rate the bank offers you. (Current high yield savings accounts offer 2% rate with no minimums.) If you buy a low cost index fund that mirrors the S&P, your return will arguably average 7% per year.
A caveat for returns is:
The higher the potential return on investment, the higher the risk you will lose money.
That “average 7% return per year” above of the S&P index fund is just that: an average. Some years, it may be 2%. Some years, it may be 10%. Some years, it may be -15%. Because of this caveat, you need to know thyself. As in, know how much you can handle risk when it comes to money. Will you pull out all your money if your index fund loses 10% of its value? (Hint: it happens). So, why invest? Because in the long term, the stock market always goes up.* And when you are saving for financial independence or retirement, you are in it for the long haul.
*Past returns do not guarantee future results.
In the previous section, I mentioned inflation. This is the increase in costs for consumer prices as time goes on. This is your grandfather complaining about the price of milk now because when he was a boy it only cost 50 cents for a gallon. The current annual inflation rate in the U.S., as of November 2018 (prior to the current government shutdown) is 2.18%.
This means, according to my limited knowledge, that $100 worth of goods (food, paper, toys, rollerblades, whatnot) in November 2017 would cost $102.18 in November 2018.
We always need to have inflation in mind because it’s the hidden killer when it comes to return on investment. When your returns don’t keep up with inflation, you are losing money because you are losing the ability to buy as much as you could before. The numbers may look higher in your account, but because you have to pay more for the things you buy, your money is worth less.
Also, as an aside, inflation is usually positive, but it could be negative as well. When inflation is negative it is called deflation. This may sound like a good thing, but it’s not. It usually follows a recession or depression and people end up not spending money, which hurts the economy further. Businesses lose money and start laying off workers. Not good.
How much longer does A need to work?
Now what happens to person A and person B? Let’s put some numbers to it. Let’s say they both have good jobs and make $70k a year. They both invest in low cost index funds that return a modest 5% annual return after inflation and expenses. Starting from $0 net worth, it takes B (saving 50% of income) 17 years to reach FI. Starting from the same $0 net worth, it takes A (saving 10% of income) a whopping 51 years to reach FI – exactly 3 times as long as B. That’s 34 more years A has to depend on a paycheck to live.
What if they make more money? Maybe if they have really high paying jobs, it won’t take them as long! Well, I said they saved a percentage of their income, so the amount of time they work is exactly the same. Which means, it doesn’t matter how much you make, it only matters what percentage of your income you save. The more you save, the sooner you reach financial independence!
What do I save my money in?
Where to save your money is a 2-pronged question, when it comes to investing. The first prong is the vehicle you save in, and the second prong is the securities you buy in that vehicle.
Maybe this will help.
An account that holds securities. Examples are 401(k), IRA, brokerage accounts, savings accounts.
A stock, bond, commodity or mutual fund invested in a vehicle.
The easiest, most effortless way to save money is to purchase low-cost index funds in a tax advantaged account like a 401(k) or IRA. Index funds are mutual funds that are specifically designed to follow a particular part of the stock market. Fund managers choose stocks to make up the index fund that can approximate, for example, the S&P 500 index. Other index funds are designed to follow bonds or commodities. Contrary to actively managed funds, which try to beat the market, index funds merely try to match the market. Actively managed funds are very expensive and there’s no guarantee they will beat the market.
I did not make up the numbers about how long it will take worker A and worker B (haha XD) to become financially independent. First, you need to understand the math behind how much total money you need to be FI, then you need to understand how you get to that total.
Simply put, you need enough money so that you don’t run out before you die. Correct? You just need to know your annual expenses and when exactly you’ll die. Simple, right?
When will you die? You don’t know? Well I guess you’re screwed then.
Okay, okay. There’s another way. You have your money invested, and those investments produce gains. So you want your annual expenses to be no more than the gains on your investments. If you never touch the pot of money invested and only live off the gains from your investments, you’ll be golden.
But, doesn’t the stock market go down? Yes. Yes it does. So, someone decided to research historical stock market data and test every single year to see what percentage of a portfolio that is a mix of stocks and bonds you could withdraw from and still have money left over after 30 years. The study looked at a variety of stock/bond allocations and a variety of safe withdrawal rates (SWRs) over a variety of time periods. This research was published and is the definitive study to determine how much it is safe to withdraw over a 30 year retirement, even if the stock market goes down. A lot. The years in the study include the Great Depression and the high inflationary period in the 70s. This study is called the Trinity study because it was done by professors at Trinity University.
What did the Trinity study find? It found that with a 4% initial withdrawal of a portfolio of 75% stocks, you have a 98% chance of your portfolio lasting 30 years.
How much do I need? With this 4% safe withdrawal rate, you can calculate how much you need to have saved. As long as you know your annual expenses, just divide by 0.04 (or multiply by 25!) to get your total number. This is the total amount of money you need to survive on your investment portfolio.
Annual expenses * 25 = Total Needed to be FI
Why am I congratulating you? Because you’ve just finished the TechDifferent course on being Financially Independent! Here is your certificate:
Where To Learn More
I’ve given you the what and the why, but not the how. How do you save so much money? Here are a few places you can start to learn more about pursuing financial independence.
Last but not least, the women of Financial Independence
Listen: Journey to Launch podcast
Real Estate: I did not mention it, but real estate is another path to FI besides index funds. Here are two resources for the real estate path to FI.
Paula Pant’s Afford Anything podcast