Saturday, April 9, 2016

Money Crashers: How to Become Financially Independent

It's been a few years now since Brian and I, having paid off our mortgage, decided to set our sights on Financial Independence (FI) as our new long-term goal. At that time, I did what I considered some extremely rough back-of-the-envelope calculations to figure out how long it might take us to reach this goal, based on our present rates of spending and saving. I made a guess, based on the historical averages for the federal funds rate, that we could count on our investments to bring in a return of 4 percent each year. True, this doesn't look like such a safe assumption now, when the federal funds rate has been stuck at close to zero for over five years—but then, back in the late '70s and early '80s, it was at over 10 percent for nearly the same period, and often above 15 percent. So my theory was that it all balances out.

Since then, I've discovered that my wild guess is actually a well-established rule of thumb, generally known as the 4 percent rule. It's based on a 1998 study called the Trinity Study, which found that as long as you have about half your retirement funds invested in stocks, you can safely withdraw 4 percent of the total each year without depleting your reserves. Over the long term, this rule holds through all the ups and downs of the market. Numerous financial bloggers, from Trent Hamm of The Simple Dollar (whom I don't always consider reliable) to J.D. Roth of Get Rich Slowly and Mr. Money Mustache (both of whom I generally trust), rely on the 4 percent rule. And while many sources, from CNBC to the New York Times, have questioned whether the rule still applies in today's economy, a 2015 study found that for households with "considerable wealth"—enough to ride out a market downturn—it's still a reasonable guideline.

The main thing that struck me back then, as I fiddled with the numbers, was how much more benefit you get from cutting your expenses than you do from increasing your income by the same amount. Every dollar you add to your income (after taxes) helps you once: you can add it to your savings. But every dollar you cut from your expenses helps you twice: it increases your savings, and it decreases the total amount you need to save, because you now need less to live on. According to my calculations, a hypothetical saver who trimmed $5,000 a year from his expenses would shorten his time to FI by more than twice as much as he would be getting a $5,000 raise.

All this struck me as so interesting and useful that I decided to turn it into a post for Money Crashers, so I could share it with a wider audience. In the first part of the article, I outline the formula I used (which, I acknowledge, is still a very rough approximation) for calculating how long it will take you to reach FI at your present rates of spending and saving. Then I go into ways to reach FI faster by saving more, and I go into specific strategies for earning more and spending less (with an explanation of why the second approach helps you more). And finally, I outline a simple approach to investing for financial independence, known as a lazy portfolio. Investing this way means:
  1. Pick out two or three funds with low fees—either ETFs or index funds that cover the whole market as broadly as possible;
  2. Invest a fixed amount in each of these funds every month (automatically, if possible, so you don't even have to think about it); and then
  3. Just hold the funds until you're ready to start withdrawing. Don't try to adjust based on performance or market conditions; that's a good way to guess wrong and withdraw your money at exactly the wrong time. Just sit tight, and let it work out in the long run.
I first learned about this strategy from Andrew Tobias, one of my personal household gods, and it's worked out well for me—especially the part about not having to think about it. The term "lazy portfolio" was new to me until I started working on this article, but now that I know it, I'm going to use it often in casual conversation.

So if you want the complete scoop on everything you need to know to become financially independent, you can check out the complete article here: How to Become Financially Independent Quickly Using the FI Formula. However, I would ask you to please disregard that word "quickly" in the title, which was added by the editor. I do not, anywhere in the article, promise that this strategy will help you reach FI quickly; I only help you figure out how quickly you can do it, and then suggest some tips for getting there a little faster. But it is not, in any way, a get-rich-quick scheme, and if you click on the article looking for one, you will surely be disappointed.
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