Here’s another sample lesson from Financial Freedom 1. Got questions about how the course is structured and why it’s different from other financial courses? Check out the FAQ here.
1.4 savings rate - when do you want financial freedom?
Question: who earns more money, someone who makes $30,000 or someone who makes $100,000?
It’s a trick question. It depends on how much they’re spending. If someone who makes $30,000 a year spends $20,000, they’re earning $10,000 a year. If someone making $100,000 spends $100,000 a year, they’re earning nothing.
This is such an important point to understanding financial freedom: profit matters more than income. Take a look at corporations. Do their shareholders care about revenue? No, profit is income after expenses. When Apple Computer reports it earned $84 billion in 2016, do you think they are reporting their sales or their profit? It’s their profit that matters. It’s called the bottom line for a reason.
So why doesn’t it matter for us as individuals? Run yourself as a business and make a yearly profit. I made a video about it. It’s one minute!
Read this blog post by Go Curry Cracker about personal savings rate, i.e. your profit that earns you financial freedom. It has the math and assumptions behind the chart we’ll be working on for this lesson. Here’s the key part:
A 50% savings rate would enable you to own every hour of your life after 16 years, and a 65% savings rate would get you out the door in just over 10 years.
On the other extreme, a person saving 5% of their income will likely be working their entire life, i.e. they will not retire at 65, live on restricted income, or depend on their children for income. This is the alternative if you don’t do something. (This is what not having enough to retire looks like.)
The savings rate is a core concept of the course. It drives everything you have to do to reach financial freedom. There are only two things you have to worry about:
How much you make (income)
How much money you spend (consumption)
The spread between those two is, in CFO of your life terms, your profit margin. It’s the fuel for your freedom. The point of financial freedom is to escape the system. The most important thing in the spread between how much you make and how much you spend. And here’s a crazy little secret: the less you spend, the less “nest egg” you need to retire. In the example above, the person earning $30k and spending $20k a year retires in 25 years and the person earning $100k and spending $95k never retires.
At this point, some of you may want to know your Number, i.e. how much money do you need in your nest egg to retire. Here are two ways to look at your Number:
The standard (and very general) measure for healthy retirement is the 25x Rule. You need to save 25 times your annual consumption in order to reach financial independence. There you can withdraw 4% of your retirement savings every year and have your investments meet that withdrawal rate. If you spend $20k a year, you need $600k in assets and investments. If you spend $100k a year, you need $2.5 million. (For nerds, this is the math under the 4% withdrawal rate. You could look up the Trinity Study as well.)
A modern way is to find enough passive income to match your annual expenses. Rental income, royalties, and stock dividends are all forms of passive income, i.e. money you earn without having to put extra labor in. We talk more about how to create passive income in FF2, but you can easily Google it as well.
Note that the 25x rule is the [passive income = annual consumption] rule. Note there are only two ways to accelerate your path to 25x: (1) cut down on your annual consumption and (2) make your hourly labor as valuable as possible. You should probably do both.
Want to know your current net worth? Money Boss JD Roth created a Google spreadsheet. Make a copy and put in your numbers. An earlier FF1 student posted another good one. If you have a nest egg already, find a compound interest calculator on the internet and input your numbers to hit 25x.
OK, it’s time to make a goal. Scary, I know. Because making a goal means you have to work towards it. There’s a saying: the best time to plant a tree was twenty years ago. Well, we’re about to plant the seed right now. Here’s the question I want you to answer: when do you want financial independence and to start owning every hour of your life? When do you want to never have to stress about money again? And with that, what’s the savings rate or profit margin you’ll need to achieve that? Answer these questions and your feelings about them below. It’s time to plant a tree.
P.S. Note that the chart uses a 6% real return on investment, which means returns after inflation. Inflation is historically 3% (right now 2% due to low interest rates), so your investments will have earn about 8%-9% a year in “nominal returns.” To earn 8%-9%, you’ll have to invest in the stock market or something equivalent; you can’t just stock it away under your mattress or in a savings account. If you do, your money will erode at 2%-3% a year to inflation.
P.P.S. Don’t think you can do it? JL Collins calls bullshit.
P.P.P.S. Still don’t think you can do it? Here’s the metaphor of The Two Managers. In your head, you have two managers, the Manager of Yes and the Manager of No. If you give a task to the Manager of No, your brain will use logic and find reasons why you can’t do the job. If you give the task to the Manager of Yes, your brain will think expansively and creatively on how to get it done. For these two months, give this course to the Manager of Yes.
P.P.P.P.S “But what if I run out of money?” “But what if the stock market crashes?” and those sorts of worries. All valid. Here’s a perspective. If you retire early and anything bad happens, the worse case scenario is to return to everyone else’s normal life.