financial independence

Piggy Bank
Piggy Bank by pictures of money licensed under CC BY 2.0

Happy new year to everyone I wish you all a healthy and succesful 2016! In my previous post I mentioned that I would explain more about my path to becoming financially independent.

What is financial independence

According to wikipedia financial independence means:

Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities. For financially independent people, their assets generate income that is greater than their expenses

How does it work

There are many blogs that explain how to get financial independent. Let me try to give a quick summary.

As stated the main goal is to let my assets generate enough income to cover for my expenses. The question is then how much assets do I need. This question is not easy to answer and it depends on your personal situation. There many ways to generate income with money, e.g. becoming a landlord/landlady. In my example however I’m going to use the stock market to generate income as this is the most common scenario.

As we all know stock markets go up and down and nobody can predict it correctly. Given that there is this much of uncertainty, how much assets do we need to have to make sure we won’t have to work again. Or in other words how much can I withdraw from my assets without depleting the assets too quickly. The Trinity study tries to answer this question. Basically they used historical data to check if withdrawing X% of the initial portfolio each year, this was possible for at least 30 years without being out of money. Within this study a safe withdrawal rate is determined at 3 to 4% of the initial total portfolio value. As we all know results in the past are no guarantee for the future, but we have to work with something.

To be conservative let’s take 3%. That means I need about 33 times my yearly expenses in assets to be able to call myself financially independent. Next step is then how to get there. I don’t think you have this amount of money lying around, at least I don’t. To become financially independent I need to save this amount of money. As said before I’m using the stock market to earn money with money. How much do I need to invest each month?

There is a metric that is often used to answer this question: Savings rate. This is easy to calculate: savings divided by income (after taxes) * 100%. E.g. assume I have an income of €2500 and save €1000 each month. My savings rate would be: 1000 / 2500 * 100% = 40%. Using the savings rate anyone can determine in how many years one would be financially independent.

Savings rate Years left Savings rate Years left
5% 102 55% 21
10% 78 60% 18
15% 65 65% 15
20% 55 70% 13
25% 47 75% 10
30% 41 80% 8
35% 36 85% 6
40% 31 90% 4
45% 28 95% 2
50% 24 100% immediate

Assumptions used in calculations above: There are no current savings, a conservative ROI of 3% per year, the expenses are just as high as they are now, income will not grow or decline and finally there is no inflation. Sure there will be inflation and probably you will get a raise. But let’s keep that stable for simplicity and probably they will offset anyway. Historically the ROI of the stock market is higher than the 3% I used here, that should compensate for inflation as well.

My road to financial independence

For my path to financial independence I calculated how much money I needed after I paid off my mortgage using current expenses. Using a safe withdrawal rate of 3%, multiplying these expenses by 33, I got my target amount. I don’t use any future ROI of my current savings, because that is used to compensate for inflation.

Given these assumptions the numbers for December are:

Savings rate last 12 months 30,6%
Savings rate year to date 30,6%
savings as percentage of financial independence goal 12,1%
years till financial independence using total amount of savings of last 12 months 32

As you can see it takes me longer than the expected 25 years I was speaking about in pervious post. That is mainly because I don’t take any ROI into account for these calculations.

Financial goals 2016

Savings rate 25%
Savings as percentage of financial independence goal 13.8%

For 2016 I have a goal to save 25% of my income. This is much lower than the savings of last year. Main factor to this drop is that I’m going to marry this year. Taking these new savings and adding these to my current stash (ignoring any market changes) I would be at 13.8% of my end goal at the end of 2016.

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