The math behind financial independence is surprisingly simple. I sometimes wonder why more people don’t realize they can be financially independent, but it probably boils down to either a misconception about investing, or being trapped in a consumerist cycle (or both). I’ll leave the more difficult problem of being caught in the consumerist trap to some future posts, but once you see how rewarding the path to financial independence can be, I think the motivation to spend money more intelligently will come somewhat naturally.
For now, I want to try to dispel some of the myths you may have about investing, and provide a very simple investment strategy (the one I use) to help you reach financial independence.
“Investing? But the stock market is scary and I don’t know what stocks to buy!”
It is scary! And you’re also right that you don’t know what stocks to buy, and neither does anyone else. Please don’t trust people who try to tell you what stocks to pick—especially a financial advisor who makes money by convincing you to invest money with her, not by making you returns.
It’s important to realize that no one can consistently “beat” the stock market, and you certainly shouldn’t pay someone to try. This is one of the hardest things for new and veteran investors alike to realize, because it sometimes seems that investment gains are irrelevantly small (and certainly not enough to ever live on!). So people usually try to beat the system by investing in some company that their brother’s neighbor’s uncle said is going to be the next Apple, or by giving their money to a financial “professional” to take care of.
I’m warning you now that the temptation to beat the market is real, and most of us have probably fallen into this trap at some point (I know I have). So be disciplined! Figure out your strategy and follow it no matter what, and through the near-mystical power of compound interest, you’ll reach your goals way sooner than you thought possible.
“Well, since no one knows which stocks to buy, I guess I’ll just work forever…”
Wait! What if instead of trying to pick the best stocks, you just bought them all? Impossible? Not at all—it’s actually very simple.
You can easily invest in hundreds or even thousands of companies by buying a fund that tracks a large portion of the stock market. Because your exposure to the market is so huge, you have an equally huge margin of safety. You’re basically betting on the United States (‘Merica!) or even the entire world to succeed. Sure there will be some companies that go out of business or do poorly, but there will also be some that do spectacularly well. By investing in so many companies, you have much more diversification than you could otherwise, and diversification is the gold standard in solid and predictable investment gains.
I cover my specific investment strategy in more detail here, but for now just know that the magic of passive investing is that it almost always performs better over time than a hedge fund or financial manager who tries to time the market, pick hot stocks, or use other risky investment strategies. The worst part about having someone manage your money is that you have to pay them to do it! The management fees can take a huge cut from your earnings, and to prove to you that they’re worth paying, the financial planner (or active fund manager) will fiddle with your investments, which loses you even more money over the long term. On the other hand, passive index funds generally have very low fees, which will snowball into a surprising level of future earnings.
So stop paying people to manage your money and do it yourself. It’s dead easy, and more effective.
“Got it. I’ll invest my own money in index funds. So how does that make me financially independent again?
Pretty easy so far, right? No picking stocks, no digging through piles of financial reports, and no ongoing demands of monitoring and selling stocks. But how does this lead to financial independence? Rather than just continuing to accumulate wealth forever, financially independent people actually use a portion of the earnings of their portfolio to live on. The size of the investment portfolio will vary wildly depending on the level of spending required. But you can easily accumulate enough to live on for the rest of your life in a matter of 7-10 years—less if you’re disciplined with your spending “needs.” This may seem like a long road, but it’s nothing compared to the 40-50+ years most people work before they can retire.
Put your portfolio to work for you!
Your money is actually much better at working than you are. The stock market (and the type of index investing I’m advocating for here) has consistently returned approximately 7% annualized per year, during its entire history. This means that despite all the ups-and-down, the highs and the lows, and everything in between, people who keep their money invested in the market make money. So if you’re financially independent, you can take advantage of that phenomenon, and use a portion of your investment portfolio each year to live on. During the “up” years, the earnings more than make up for what we take out, and cover what we need to withdraw during the “down” years.
How much can you withdraw? The simple answer is that a well-diversified portfolio can support a 4% yearly withdrawal rate, pretty much forever. Another way of thinking about this is that you need approximately 25-30 times your annul yearly spending needs to be financially independent. For example, if you spend $50,000 per year, you need approximately $1,250,000 in your portfolio to be financially independent for the rest of your life ($50,000 x 25 = $1,250,000). Not-so-coincidentally, 4% of $1,250,000 equals $50,000.
Wow, that seems like a lot…
It does, but by saving a proper amount of your current income, you should be able to reach your target in less than ten years. Your spending needs have the biggest influence on when you’ll reach FI. If you can lower your spending to say $30,000 per year, an amount that many in the FI world live on very comfortably, you only need $750,000 of investments. Taking control of your spending habits, and more importantly spending your money efficiently (I’m looking at you cable TV and unused gym memberships), have the dual effect of increasing your current savings rate, and decreasing the amount of spending you have to cover while living after FI.
Some other strategies that I’ll get into later in this blog include investing in real estate rentals, which can give you a much higher than 4% return, and taking on some work post-FI to help pay the bills. Most people in the FI community that I’m aware of don’t want to simply sit on the couch and do nothing, but the risks of pursuing a part time or lower-stress, lower-paying job simply aren’t feasible without supplemental income. Fortunately, those pursuits, and even most hobbies, generally have some monetary return, which can significantly reduce the necessary size of your portfolio, and allow you to spend more than $30,000-50,000 per year. Additionally, if you have a cushion of cash savings, you can avoid selling part of your investments when your portfolio is “down,” which allows you to safely withdraw more than 4% when the market does well.
For now, the goal is to invest approximately 25-30 times your yearly spending in a well-diversified portfolio. Once you reach that, you’re done! You are financially independent and can quit your job at any time, and generally make any life-decisions you want without thinking about money.
Pretty exciting, right?!