What is Financial Independence?
Financial Independence (FI) is the point where investment cashflows cover your basic essential and non-essential expenses.
The term independence is well placed. You are no longer dependent on an employer to cover your essential and non-essential expenses. This is a nice place to be. It increases your freedom.
But I warn you that our work provides a strong sense of meaning, structure and belongingness that brings fulfillment to our lives. I write about the problem with Financial Independence Retire Early here. So “retiring” early should be thought about with care.
Your FI point is not based on your age. Rather, it is a portfolio value that can provide sustainable investment income through dividends, realized capital gains, rental income and/or bond yields.
How Do I Find My Financial Independence Number?
The Trinity Study examined the sustainable withdrawal rate for a portfolio of bonds and stocks. An agreed-upon safe withdrawal rate, accounting for inflation, was 4% for a 30-year time horizon, based on historical U.S. data.
This article provides a detailed overview of the Trinity Study and tests it’s effectiveness up to 2020. It also provides a breakdown of various portfolio asset allocations between stocks and bonds, while assessing time horizons of up to 50 years.
It would be terrible if you run out of money in the FI stage. To prevent this, income from investments must be sustained for a time horizon equal to your remaining life expectancy after retirement.
Early retirement, combined with longer life expectancy, and low interest rates, are reasons for a conservative rate of withdrawal such as 3%.
Alright, enough about defining FI and the mechanics, let’s dig into four ways to accelerate the journey to reach the FI number.
1. Increase Savings to Invest
Aggressive investing (especially early on) is the best way to accelerate the journey to financial independence. The more money that you can put to work, the better. Eventually, your money can work harder and longer than you can.
For example, a 10% annual return on $10,000 is only $1,000. But a 10% return on $100,000 is $10,000, and on $500,000 it is $50,000.
That’s why your savings rate is the most important factor. It drives the magnitude of compounding and directly drives the speed at which you will reach FI.
Someone with high income and high non-essential spending would focus on expense cutting. While someone with low income and essential spending would be more effective if they were focused on increasing income. A hybrid between expense cutting and increasing income is ideal.
2. Invest Early
I wish I understood the power of time when I was younger. I was building fast cars instead of investing during the longest bull market in history. No longer do I have fast cars, but I do carry the lessons learned.
Time is your friend when investing, it allows you to put compound interest to work in your favor.
Let’s say you invest $10,000 today and achieve a 10% return. Your $10,000 will grow to:
- $11,000 in 1 year;
- $26,000 in 10 years;
- $67,000 in 20 years; and
- $452,000 in 40 years.
Another example is the fact that 99% of Warren Buffett’s net worth was built after his 50th birthday.
Ronald Read offers more support. He had a low-earning career and surprised the world with a net worth of over $8,000,000 when he died at age 92.
Compound returns are why you don’t need a huge income to grow wealth. There are plenty of everyday millionaires who got to where they are by making $50,000/year.
The graph below shows how investing $2k per month will grow over time. The earlier you start this process, the sooner compound growth will take you to your FI portfolio value.
3. Reduce Lifestyle Expenses
You will need $1.2M to fund a $40,000 lifestyle in the FI stage, based on the 4% rule. But a nest egg of $2.4M will be required to fund $80,000 of expenses in the FI stage. A lower FI number is needed to fund a less expensive lifestyle.
Frugal lifestyle habits are forged as you save to invest during your journey to financial Independence. These habits don’t suddenly disappear when you enter the FI stage. You will naturally become comfortable with a low expense lifestyle and you will find fulfillment that is independent of spending. Sustaining a frugal lifestyle after FI will be natural, not difficult.
4. Achieve Higher Returns
Compounding investment returns are what build your nest egg over the decades to reach your FI number. Your savings rate influences how much money you provide to undergo compound growth.
The rate of return determines how quickly these investments grow. Your path to FI will be accelerated with a higher rate of return.
Your long-term expected returns can be tailored by the amount of risk you are able and willing to take. You can read more about investment risk in this post.
Returns From Savings Accounts and Bonds
A high-interest savings accounts return around 0.5% annually. That will get slightly farther than nowhere.
Bond returns are slightly better, but they barely keep up with inflation with today’s low-interest rates.
Returns From Stocks
This leaves businesses (stocks) and real estate as your source of long-term returns. I won’t discuss real estate here. It is not my area of competence. For example, the S&P500 index has achieved a 10.2% annual return since 1923, including all crashes.
Stocks are not for everyone. You require a long time horizon of 10+ years where you don’t need the money. Plus you need to be able to stomach the ups and downs of the stock market. Your ability to handle volatility depends on your unique risk tolerance. If you don’t have the stomach for the volatility with a 100% stock portfolio, you may need to pad your portfolio with some bonds.
Most investors will have a difficult time beating long-term returns provided by low-cost index funds. The reason is that markets are efficient, and most available information is already priced into stock prices. This makes it difficult to beat the market on the basis of skill.
What about mutual funds? Actively managed funds (mutual funds or actively managed ETFs) fail to beat indexed funds over a long-time horizon. Fees are the reason for underperformance. And picking winning funds doesn’t work because past performance does not predict future performance. Fund outperformance is mostly luck, rather than fund manager skill.
5. Optimize Investment Tax Efficiency
Tax efficiency occurs when you locate your investments in a way that reduces the tax owed on investment income. With tax efficiency, you can reduce tax drag and make the most out of tax-sheltered accounts.
Tax efficiency is the least influential on this list when it comes to accelerating your path to financial independence. Plus, the extra involvement with your portfolio can result in emotional decision-making that can hurt your returns.
So, how do you achieve tax efficiency? There are two main areas where you require knowledge:
- Understanding tax-sheltered accounts; and
- Understanding how taxes apply to investment income.
Boring. I know. Time spent learning about taxes will have huge payoffs over the long haul. Boredom is the price to be paid.
Tax Sheltered Accounts
How you allocate investments across these accounts is called asset location. This is a great guide on asset location for Canadians. Asset location can be used to maximize your after tax wealth. Tax-sheltered accounts will allow you to maximize after-tax wealth and to make the most out of the compound effect by minimizing tax drag.
The various tax-sheltered accounts have difference but they generally all allow investments to grow tax-free. For example, dividends can be reinvestment without paying taxes, and you can sell securities for a capital gain to re-balance the account without paying capital gains tax.
Taxes on Investment Income
You can only allocate investments across various accounts properly once you understand how dividend and capital gains income are taxed. I built this guide to help Canadian’s learn how taxes apply to investment income.
There are huge tax advantages on investment income relative to regular income. For example, domestic dividends and long-term capital gains are taxed at far lower rates than regular income in the U.S. and Canada. And dividends from foreign stocks and interest are taxed as regular income – they receive no tax benefits.