The Simple Math of Financial Independence

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The Simple Math of Financial Independence

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Financial independence is the state in which one’s income from passive sources exceeds expenses.

Financial slavery is the state in which one’s income from passive sources cannot cover expenses.

A financially enslaved person must work in order to cover their expenses.

A financially independent person can still work, but does not have to. That is the key, the person has a choice of whether to work or not. Independence is freedom of choice.

The amount of money needed for an individual to achieve financial independence is directly proportional to his or her annual expenditures:
30*(Annual Expenditures)=(Total Amount Invested)
Understanding the implications of this 30:1 ratio is the key to achieving financial independence.

An example:
A person living on $20,000 per year will need to invest $600,000 in order to be financially independent.

Why is the ratio 30:1?
The 30:1 ratio is based on dividend growth investing. It is predicated on a few assumptions:

  • Portfolio is comprised entirely of dividend growth stocks
  • Stock market gains on average will atleast match inflation
    Historically it has: the 1950-2009 average inflation adjusted capital appreciation was 3.3% per year for the S&P. This means stocks grew an average of 3.3% more than inflation per year!
  • Average dividend yield of portfolio ≥ 3.33%

The key here is that the dividend portfolio gives a total annual yield of 3.33%. A portfolio of $30 will annually yield $30*(3.33%) = $1
$30 invested : $1 annually

How long will it take to reach financial independence?
It depends on your expenses and income. Say you are living on $20,000 per year. By the 30:1 ratio, you will need to invest $600k before being financially independent. $600k is a lot of money. Even if you had a high paying job that allowed to you save $50k a year, it would still take you $12 years ($600k/50k = 12 years). Capital appreciation, dividend growth, and dividend reinvestment would slightly reduce this time to 11.15 years based on my model [more to come on my dividend model in another post].

Achieving financial Independence faster
There are two-ultra-secret techniques to achieving financial independence faster; use at your own risk.
1. Reduce annual expenses
2. Save more money

These are two sides of the same coin.

1. Reducing expenses is the most effective way to cut down the time to achieve FI. Every $1000 you reduce annually will reduce the amount of money you need to invest by $30,000.
From the previous example: If the person were to cut $5,000 annually from their $20,000 in expenses, they would reduce the total amount they need to invest by $150,000. Thus, $600,000-$150,000 = $450k. Assuming they still save $50,000/year, they will achieve financial independence in just 9 years. Why would they only save $50,000/year though? Didn’t they just cut $5,000 from their expenses? Enter saving more money.

2. Saving more money can be broken down into two sub categories

  • Reducing expenses and investing the difference: Building on the previous example, the person who reduced their expenses from $20k to $15k, can now invest the $5k each year. Investing $55k per year will allow this person to save $450k in just 8.18 years. Including capital appreciation, dividend growth, and dividend reinvesting, the total time is realistically 7.75 years.
  • Earning more money and keeping expenses the same. Nuff said

Calculate How Many Years It Will Take You to Reach FI
Step 1: Determine your annual expenses
Step 2: Apply the 30:1 ratio to find your Total Amount Invested
Step 3: Determine your annual income after tax
Step 4: Subtract your expenses from your income, and determine how much you can save per year.
Step 5: Divide (Total Amount Invested) by (Amount Saved Yearly)

Financial Growth


1 Comment

Paul

August 13, 2014 at 1:31 pm

Very in-depth assessment. I am sure the consumerist mind frame will struggle with the cut expenses portion.

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