The Why & How of Financial Independence

19 Nov / James Eastham

Wealth is, as far as I see it, pretty commonly misunderstood. A lot of people seem to believe that ‘wealth’ in a typical sense is only there if you are driving a £100k+ car and live in a house with at least 3 bathrooms. Wealth is commonly seen as who has the fanciest or biggest material possessions and the common man thinks that is just a pipe dream simply because of the outlay required to be ‘rich’. I was one of these people for many years! “I’ll never be rich because I’ll never be able to afford a Ferrari” etc etc. I had my aha moment  that I think everybody on the road to financial independence has whilst away travelling in South America last year. I had started to garner a bit of an interest in personal finance and how best to manage my money before reading the book How to own the world by Andrew Craig which is also backed up by the blog Plain English Finance (https://plainenglishfinance.co.uk/). This book opened by eyes to the idea of index funds, investing, compound interest and how with really little relative effort you could become a different kind of wealthy.

Why

Before I go a little bit more into my own re-definition of wealth, as it’s quite important for the point of the article, I’d just like to talk about my own ‘why’. I think the most important of any journey to financial independence has to start with why. What is that makes you want to be independent of a traditional 9-5 and out of the rat race. For me, the goals are simple! I want more of this:

Laguna Paron, Peru

Looking out over Laguna Paron, Peru

I love travelling and I love visiting new places! The kind of trips I want to go on aren’t the kind that can be done with a traditional 20 days + bank holidays annual leave. It’s the 3 months spent hiking around South America, it’s the 6 week long trip across Russia on the Trans Siberian Express, it’s the month-long scuba diving trip working on Manta Ray conservation in the Maldives. This is my financial independence, being able to do these things without the need to worry about getting back after 2 weeks and be back at work. Be unapologetic about your why let it be whatever you want it to be. If your goals in life are to have the giant mansion and fancy car that’s great, but incredibly more difficult to achieve.

How

The ‘how’ is next on the list, and things will get a little more mathematical here so apologies in advance for that. The one and only place to start after having the internal debate of what your ‘why’ is, is to figure out how much your why is going to cost you. There is actually a really simple and pretty full proof way of doing the maths to work this out and it all starts with your annual expenses. This was the game-changing moment for me when it comes to FIRE, financial independence is as much about lowering your monthly expenses as it is about earning and investing lots of money. Here is a simple example taking the UK average salary for 2017 as an example.

Yearly expenses – £27,200
Multiplied by – 25
FIRE Number -27,200 x 25 = £680,000

That’s right if you had £680,000 averaging a 5% annualised return you could spend £27,5000 per year for the rest of your days and never run out of money. I’ll run into the finer details of that in just a second, but first, let’s just revisit these sums with a slightly changed set of numbers.

Yearly expenses – £20,000
Multiplied by – 25
FIRE Number -20,000 x 25 = £500,000

So if you could reduce your yearly expenditures by just £7,200 (which when you add things up isn’t actually that crazy) you’d be financially independent with a massive £180,000 less value. Just let that sink in for a second…

But why 25x expenses?

The 25x expenses comes from a study done by three professors of finance at Trinity Universtiy to work out a ‘safe withdrawal rate’ that would guarantee you never ran out of money. You can read more about the study itself here. The simple version is if you stick to a 4% withdrawal rate over a 30 year period you have a 95% chance of not needing to switch to the dog food diet regardless if the stock market is crashing or rising. A 95% of success, I’d take them odds. If you wanted to be extra sure using a 3% withdrawal rate is also a commonly used practice to be 100% sure that your money makes it. That does change the maths ever so slightly but is still very attainable. The below table (taken from the wonderful book ‘A Simple Path to Wealth’ by JL Collins) just outlines the various permutations of portfolio breakdown (stocks vs bonds), withdrawal rate and the success rate of that breakdown. I still take the 100% success rates with a pinch of salt as nobody can predict the future, but this should give you a visual breakdown of how powerful your money can actually be if you put it to work.

Withdrawal rate table

Table is taken from the book ‘A Simple Path to Wealth’ by JL Collins

The other point to consider as part of the ‘how’ is that some people (me included) won’t actually stop working once reaching FI. I really enjoy my work (software development if you’re interested). Now assuming I can take in around 12k per year working freelance in software development that again would have a great effect on my FIRE number. Let’s run the numbers one last time

Yearly expenses – £20,000
Income – £12,000
Shortfall – £8,000
Multiplied by – 25
FIRE Number -8,000 x 25 = £200,000

Obviously, the yearly income is a variable that could change dramatically based on the amount of freelance work available. I wouldn’t stick to this as a salary, instead I would use the first 2 calculations as my goal and any extra income would just get pumped back into my portfolio or used to fund any extra activities I discovered whilst on my travels.

The Short Version

To summarise; getting starting on the road to financial independence is a simple one

Find your WHY
Calculate your HOW
Start on the road to FIRE

I’ll go into more detail on the in’s and out’s of achieving FIRE in a later post, but for now. Get out that notepad, pull up a spreadsheet and get some maths done!

 

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