It all starts with a change
You’ve thought about it for so many years, but you’ve never done anything about it. The corporate world you hate, the long work hours, the meaningless work routine and of course commutes. Hopefully someone will save you, you think for yourself while sitting in the cubicle. You hope in vain that there will be a change, but how can a change occur, if you don’t change anything about your own routines?
Or maybe you actually like your job, but you’re working way too much. Maybe you don’t even have time to visit your family, spend quality time with your wife or see your children grow up?
In this post I will show you how to reach financial independence (FI), so you can take your most important asset back; time. Warning! This is not a get-rich-quick-guide, but rather a step-by-step-guide to reach these goals in 5 – 20 years. You decide how many years you will spend to reach FI! Are you ready?
How to achieve financial independence?
Financial independence is a term used to describe a person who doesn’t have to participate in labor (which provides income), to cover their expenses. Route 2 FI’s definition: “When your income from other sources than your normal day job exceeds all your life costs”. This is also called passive income.
Passive income is money that even if you sleep, are on a vacation or write a blog post goes in to your bank account, in other words; income you don’t have to work for. There are several ways to achieve this; including stocks, real estate, starting your own business etc. In this blog I will focus on index funds because I think that’s the best way to achieve financial independence. You can read more about index funds here.
But how can you achieve financial independence (FI)? In theory it is simple:
1. Increase your income
2. Cut all unnecessary costs
3. Invest the profit in index funds!
1. Increase your income
It is really important to have a focus on your income if you’re trying to achieve FI. One will more easily achieve the dream with an high income, but at the same time it doesn’t matter if you earn 10.000 $/month if you spend it all. It must therefore be seen in connection with your spending rate.
-A person who earns 2000 $/month and who is able to save 1000 $/month, will gain financial independence faster than the person who earns 10.000 $/month, but only managed to save 500 $/month. Perhaps an extreme example, but it’s only for illustrating a point. It does not help to earn a lot if you spend everything!
So how can you increase your income? Here are some suggestions:
-Negotiate with the boss about higher salary
-Start a side-hustle, such as online product sales, blog advertising revenue/sales revenue
-Rent out the apartment/a room on AirBnb
-Write an E-book
-Work part-time for Foodora (food delivery by bicycle) in addition to regular work, and get free exercise on the purchase.
There are several possibilities, and it’s just imagination that limits how to increase your own income.
2. Cut all unnecessary costs
As I mentioned in the example above, it does not help to earn much as long as the consumption is high. In the United States, they got an expression called “Keeping up with the Joneses”, which refers to comparing with the neighbor in terms of material goods.
That’s usually why you buy the coolest car, the best sporting equipment or the freshest watch. Failing to keep up with the neighbors can give a strong sense of understatement. In the movie Fight Club, Tyler Durden couldn’t say it any better:
We buy things we don’t need, to impress people we don’t like
We buy things we don’t need, to impress people we don’t like
So how can you break this? Ie. stop buying things you don’t need to impress people. I think the most important thing is to stop comparing yourself with others, appreciate what you already have and focus on your own goals. I will dedicate a later post for this, so now let’s just focus on how to cut unnecssary costs.
Get an overview over your financial situation
In order to cut costs, one should form a picture of their own financial situation. I would recommend you to set up a detailed budget so that you can see all your earnings/expenses monthly. Right now I want you to take action and sit down with pen and paper. Write down how much money you spend each month at:
-Leisure activities (sports/cinema/theater etc.)
Once you’ve created your budget, the next step is to go through each post. Is it possible to cut costs on anything? I would recommend you to cut brutally down on all items that do not change your quality of life.
Do you have the lowest mortgage rate? All right, then switch to the bank that gives you that. The same with electricity/cell phone/gym membership, etc. Switch to the supplier that gives you the best offer.
Are you enjoying your fitness center where you already workout, even if there are cheaper alternatives? Then I recommend you to stay there. Why? Because this may reduce your life quality, which in turn may lead to that you skip the workouts completely. My opinion is that it’s better to pay some extra dollars a month to actually complete the sessions.
Anyway: go through the entire budget and cut costs like a ninja!
I think most people have the opportunity to cut a lot of their costs. When you’re done cutting costs in every area, you should make a revised budget.
You got a monthly income of $ 3000, and after you made yourself a budget, you’ve found that the consumption is $ 2500/month. The $ 500 you got left, you’ve saved.
After revising your budget, you’ve found that you can reduce your consumption down to $ 1500/month by quiting your daily restaurant meal and getting rid of the car. Both parts are really hard, but you are motivated by the opportunity to save $ 1000 extra/month and to use you bicycle more often.
I could use another example, because there are countless ways to reduce costs. The point is that it is worth to take a review, and I’m absolutely sure you’ll be surprised by all the expenses you have each month. Anyway, I know how boring it is to live with a budget each month. It makes you feel stingy and that you have to turn every penny around.
Therefore, I use a method called anti-budgeting. Anti-budgeting means that you first make a budget (as you’ve just done), then set up regular monthly payments from your account. In the example above, you managed to cut costs and increase your savings from $ 500/month to $ 1500/month.
By setting up a fixed payment every month, you never see anything of the $ 1500, because this goes straight into the index fund account. The $ 1500 you’ve got left goes to other expenses you may have in your budget. This means you do not need to keep track of your account every day, because the savings were already deducted on payday! Choose anti-budgeting and enter vacation mode!
3. Invest the profit in index funds!
You’ve already understood what’s coming next. After the costs is broken down to a level you’re comfortable with, the next step is to invest the rest of your paycheck.
My recommendation is to put it into an index fund that has low management costs. The return in index funds follows the market and depends on how each stock performs. KLP Global Index V (MSCI World Index), for example, contains 1600 of the largest companies in the Western world, and the return on the fund depends on how these 1600 companies perform.
In the short term, there may be large fluctuations in the stock market, but in the long run the market will always point upwards. Another reason why index funds are so brilliant, is that you get to enjoy the compound interest (that’s interest rate on your interest rate!). You may wonder why the market always points upwards in the long run, and why compound interest in brilliant? I will save it for the next post.
Below, I will give you some examples of how your invested capital may grow in 10, 20 and 30 years, depending on whether you invested 500 $/month vs. 1500 $/month. For simplicity, I have omitted tax in the examples.
It will nevertheless take many years before you at all need to think about tax when you invest in index funds in a stock savings account (Norway). You only pay taxes on your profits (ie. the amount that exceeds the amount invested). Management fees of approx. 0.1 – 0.3% annual for index funds is also omitted. This will be discussed in more detail in the next post.
Example 1: 1500 $ invested every month for 10 years
Let me introduce an example. You have 0 $ as your initial capital, but now you want to invest 1500 $ every month, ie 18000 $/ year, see figure 1. If you assume 7% return you will have 259.000 $ after 10 years.
Of the 259.000 $, 80000 $ is return on capital.
Figure 1: 1500 $ invested every month for 10 years.
Example 2: 1500 $ invested every month for 20 years
What if you had let the money grow for 20 years? I assume the same return (7%) and the same savings amount (1500 $), see figure 2. The invested amount has now grown to 781.000 $. As a thank you for keeping the money in index funds, you have now received a staggering 421.000 $ in return!
Figure 2: 1500 $ invested every month for 20 years.
Example 3: 1500 $ invested every month for 30 years
And then, imagine if you had left the money in index funds for 30 years with the same savings invested and returns as in the previous two examples. Then you would have had a total of 1.82 million $ ! Of this insane amount, 1.29 million $ is pure return on investment!
Figure 3: 1500 $ invested every month for 30 years.
Example 4: 500 $ invested every month for 10 years
To illustrate a point, I would like to show the same examples as above, with investing periods of 10, 20 and 30 years, and 7% return every year. The difference in these examples is that you only invest 500 $/month. I hope this example can make you more aware of cutting costs, but also more motivated to increase your income!
Figure 4: 500 $ invested every month for 10 years.
In the figure above you clearly see the difference between how much less you got in your investing account after 10 years by only saving 500 $/month. After 10 years you will be left with approx. 86.000 $.
If you instead cutted your costs or/either increased your income and saved 1500 $/month you would have had 259.000 $! Quite a significant difference! If this doesn’t motivate you, then what will?
Example 5: 500 $ invested every month for 20 years
Figure 5: 500 $ invested every month for 20 years.
After 20 years, the capital has grown to 260.000 $, of which 140.000 is a pure return (see figure 5). This is by all means a decent sum, but imagine if instead you had invested 1500 $/month. Then you would have had 781.000 $ !
Also notice that if you invested 1500 $ for 10 years you would have 259.000 $. This is the same amount as in this example, but the difference is that you could work 10 years less to reach the same dollar amount! First time I saw this I was blown away! This is so amazing and it makes me all FIRE’d up!
Example 6: 500 $ invested every month for 30 years
Figure 6: 500 $ invested every month for 30 years.
In the figure above you see the result of investing 500 $/month for 30 years. In total there will be 609.000 $, of which 430.000 $ is return on capital. Had you instead invested 1000 $ more every month, you would have 1.83 million $.
A total of 1.22 million $ more! 609.000 $ is absolutely an insane amount of money, but what if you could give up 1000 $ each month if that meant you could realise your dreams more quickly? Would you?
Do you want to test the calculator yourself and plan your own FI-date? See here: Savings Interest Calculator
Conclusion for the 6 examples
Is it possible to conclude with something after looking at these six figures? One conclusion is, at least, that it pays off to start saving as early as possible. The longer you save, the longer the compound interest effect will work. An even higher monthly savings amount leads to a higher return.
But how much do you really need to save before you are financially independent? It depends on your needs and wants. Do you have a low consumption rate you will be financially independent far faster. In the next section we will look at the 4% rule, a rule you can use to calculate how much money you need in order to say that you are financially independent.
The almighty 4 %-rule
How much money do you need to say you are FI? Well, it depends on your needs. As a rule of thumb you can use “Rule of 25”. If you want to have a passive income of 40.000 $/year, then you need: 40.000 $ x 25 = 1 million $.
This leads us to the 4% rule, also called “Safe Withdrawal Rate”. The 4% rule definition is: “The percentage of money you can withdraw of your invested funds every year, without losing any money from your funds for the rest of your life.”
Well, you can lose money from the funds in line with the market fluctations, but the money will always come back in the long run if you follow the 4 %-rule.
Let’s say you have a stock savings account of 1 million $. By using the 4% rule, this means that you can withdraw (1 million $ x 0.04) = 40.000 $ each year without losing money. Genius, right? Yes! But is it true? Yes, it really is! Still not convinced? Let me give you some facts:
-The 4% rule or “Safe Withdrawal Rate” is based on a study conducted by three professors in finance at Trinity University, Texas, USA. The assumption in the study is that you have a stock portfolio that rises/decreases in line with the market, but on average in the long run you have a return of 7%. It is also assumed that inflation can reach 3%, thus remaining with the 4% rule (7-3 = 4).
–Another assumption of the study is that the portfolio lasts for 30 years, ie that you should be able to withdraw 4% of the funds each year in all 30 years. In the example above, where you had 1 million $ and made a $ 40.000 withdrawal yearly, this means that in year 1 you will withdrawt $ 40.000. The following year, you will withdraw $ 40,000 x 1.03 = $ 41.200 (inflation-adjusted). In year 3 the withdrawal is 40.000 $ x 1.03 x 1.03 = 42.436 $ … etc.
-The study was conducted with variable combinations of stocks/bonds. A portfolio composition of 50% stocks and 50% bonds had 96% probability for success in the study. In our example, this means we got 96% probability that after 30 years you will have 1 million $ or more (even if you have withdrawn 4% of the funds each year!).
–In 67% of all the scenarios in a 30-year period, you will have more than twice as much money as you started with, even with withdrawal of 4% annually. The median is 2.8 times as much money as you started with, in our example, 2.8 million $. With this in mind, one can argue that you might be able to more, for example withdraw 5% annually.
–An attempt has also been made with withdrawal rates of 7% annually. Simulations over 30 years showed that the starting portfolio of 1 million $ had only 43% chance of surviving such an aggressive withdrawal rate. If you are flexible and have the opportunity to go back to work again if your portfolio fails, I do not see anything negative by withdrawing more than 4%. This depends on your goals of course.
Calculate when you will be financially independent
Numerous Early Retirement calculators have been made, ie spreadsheets/calculators that calculate when you can retire financially independent.
One of the calculators I particularly like is called FIRECalc. We all know that the stock market can fluctuate very much. If you were unlucky and invested just before the financial crisis in 2008 or before the dot.com bubble in the early 2000s, you were probably also one of those who pulled out of the stock market when the market fell like a stone.
This calculator takes into account all possible start years for a portfolio since 1871, ie 118 possible scenarios. Other assumptions in the calculator are that the portfolio must last for at least 30 years, that 75% is invested in index funds and 25% in bonds.
What the calculator tries to point out is that if your portfolio has survived all possible scenarios since 1871, it will most likely survive the future stock market too (although of course no one can predict this). In the calculator you enter how much you plan to spend yearly, and how much money your portfolio contains in the start year when you begin to withdraw from the portfolio.
Example: 40k withdrawal per year, 800 k portfolio
Withdrawal of 40.000 $ annually and with a portfolio value of 800.000 $. The portfolio should last for at least 30 years. Figure 7 below shows the graph for this scenario. The result: “FIRECalc found that 32 out of 118 cycles failed, for a success rate of 72.6% (see figure 7). Note that the numbers I entered into the calculator here do not meet the 4% rule: 40.000 $/800.000 $ = 5%.
The red horizontal line below (figure 7) is the 0 line, the line indicates that you are out of capital. In figure 7 below, each line (118pcs) represents how your portfolio would have done it depending on whether you started investing in 1871, 1872, 1873 … or any year until 1988. 1988 is the last 30 year-period the calculator can create 30-year historical data for (1988-2018).
Figure 7: Withdrawal of 40.000 $ annually. The start portfolio is 800.000 $.
Example: 40k withdrawal per year, 1 mill $ portfolio
If you instead choose to follow the 4% rule and want a withdrawal of 40.000 $/ year, the starting portfolio would be 1.000.000 $. By plotting these numbers into “FIRECalc” you get the result: “FIRECalc found that 6 out of 118 cycles failed, for a success rate of 94.9%. See Figure 8 below. Not surprisingly, the result is close to 96% success rate such as the Trinity study concluded with.
Figure 8: Withdrawal of 40.000 $ annually. The start portfolio is 1.000.000 $.
Try the calculator for yourself here: FIRECalc
Another calculator I like is called “NetWorthify”. The assumptions the calculator is based on is that when the return on your investments exceeds your expenses (the annual withdrawals), you are financially independent. This calculator focuses more on how many years it takes to get FI.
Example: 60 k income, 50 % savings, 5 % withdrawal rate
You have an income of $ 60,000. Of that you can save 50%, ie $ 30,000. Here I assume an annual withdrawal rate of 5%. From the figure below you can see that it will take 14.2 years for you to be FI. This is such a long time! By increasing your income, your savings rate and investing what’s left in index funds, you can cut this time significantly.
Figure 9: Networthy calculator – Assumptions: 60K income, 50% savings rate, 5% withdrawal rate
Example: 72 k income, 66 % savings, 5 % withdrawal rate
Let’s say you’ve managed to increase your income, cut your costs and thus increase your savings. The income is increased from 60.000 $ to 72.000 $. The savings rate has increased from 50% to 66%. This allows you to retire financially independent after 8 1/2 years (see figure 10 below). By raising your income and increase your savings rate you will be able to retire 5 1/2 years earlier. This is so sick! You just want to increase your savings rate even more, so you will be able to retire as soon as possible!
Figure 10: Networthy calculator – Assumptions: 72K income, 66 % savings rate, 5% withdrawal rate
Try Networthify here: Networthify
-Increase your income by eg. negotiate an higher salary at your day-job, rent out a room in your apartment or start a side-hustle.
-Cut costs -> Make a budget and go through all the posts where you can reduce your spending. Then use anti-budgeting to set up fixed transactions from your bank account at pay-day to your index funds. Then it will be impossible for you to spend those money on other things!
-Invest the surplus in index funds every single month and let the money grow over time! While the money grows at their vacation and meanwhile you’re waiting, you can make your own plan with the calculators and spreadsheets I recommend. Hopefully this will motivate you to save even more!
Hopefully I’ve given you some thoughts on how you can become financially independent. There are many ways to the goal of FI, and I will appreciate if you share your opinion in the comments section below.
What is your plan for financial independence? In the next post I will tell you about my plan! I hope you will follow my journey further.