What does it mean to be financially independent?
We can define financial independence as being able to live the life you wish to have without having to work. Depending on your lifestyle, it can cover very different realities. If you like to have a spartan life, not spending your money on superfluous things, and living in an area where the cost of living is cheap, then the amount you need to save will be way lower than if you are living the jet-set lifestyle, and living in an area where the cost of living is very high.
There are different flavors of financial independence. Do you want or not take the risk to outlive your capital, or do you want to take the chance to have your money lose its purchasing power? Or hopefully, financial independence without the risk of outliving your cash nor the risk of inflation eroding your lifestyle!
I am afraid that the most given advice on how to save for retirement combine the two pitfalls.
By the way, I use retirement and financial independence interchangeably.
How much do you need to retire?
If you want to retire at 40 by being smart in your investments, good for you, you can also become financially independent by 40, able to retire if you want, but still, decide to continue to work and invest to be even more wealthy when you reach 60 or 65. If you prefer that, then good for you too!
First, let’s talk about how much do you need to save before retirement. It is not a very hard question, with the help of a financial calculator or excel.
Let’s say you need $10,000 per month, for 40 years. And let’s assume you can get a conservative 3% return per year. The formula in Excel is :
=PV(3%/12, 40*12,10000,0,0)3%/12 is the monthly interest rate
40*12 is the number of months
10000 is the amount you need per month
You get nearly $2.8 million. Do not pay attention to the negative sign excel gives you.
If you need only $5,000 per month, you go down to “only” $1.4 million.
You can quickly calculate how much do you have to save, just like that.
I did not take into account your Social Security benefit. I am only talking about what you need to have above it. I discount the Social Security benefit hugely since we always hear about entitlement reforms. So, for myself, I am focused on the numbers we calculated before.
The two big issues!
To come back to the figures we calculated earlier; I am afraid it is not enough. Why? Because first of all there is a real chance you outlive your money.
The life expectancy issue
Life expectancy in the US is currently around 78.7 years on average. More if you are a woman, less if you are a man. However, this is life expectancy at birth, not your actual life expectancy. What I mean, since you are reading this blog, I can suppose you are an adult. You have passed all childhood sicknesses, and all stupid, risky things teenagers do. So, your actual life expectancy is higher than the life expectancy at birth. It is like the older you are, the older you can expect to live. Which is nice to hear, I suppose.
What is also great is that you can expect to live older and healthier than previous generations. We have new drugs, new treatments, and the future looks pretty bright.
So, guys, you should consider the outliving issue. In our hypothesis, we supposed you would need to get money for 40 years. But what will happen if you live 41 years after retirement, or 50, or 60? Will you go back to work at 95?
The inflation issue
The second issue with our computation is that money loses its purchasing power. Ten thousand dollars today will allow you to buy more than the same $10,000 in 10 years. With a hypothesis of 2% inflation year-on-year, $10,000 in 10 years is like $8,200 today. And in 40 years $10,000 will have the same purchasing power as $4,230 today.
Hence, even if you live only 39 years after your retirement, not depleting your money, you can end up with financial difficulties, which is not a great perspective.
I am not talking about those issues to scare you. On the contrary, view it as a challenge to be overcome. And you can avoid those pitfalls, with the right approach.
The classical approach focuses on savings. You need to save for your retirement; there is no argument here. The real question is how and where.
Handling the effects of inflation
We have to handle the effects of inflation on your money. Do you know guys that the answer is straightforward? You need to have assets that grow with the overall growth of the economy. What rises when the economy improves? I see two kinds of assets: stocks and real estate.
Then what about bonds? Don’t all the experts say you need to switch to bonds as you approach retirement?
One common rule of thumb is that you invest your age in bonds and money market. If you are 40, 40% of your portfolio should be in bonds. If you are 60, 60% of your portfolio should be in bonds. Simple. But probably too simple!
My opinion is: it does not help you to keep your purchasing power! Why? Because the principal of bonds does not grow. Your money loses its value every year. Moreover, coupons are lower than the average growth of stocks plus dividends. When you invest more and more of your portfolio in bonds, good luck to reach the capital you need.
Handling the outliving your money issue
Now to tackle the question of outliving your money, the answer is also simple: you need to save even more money, to live only from the cash flow it provides.
I know some will say: “Wow, wow! Hold your horses! I cannot save $1.4 million, how can I save even more? Are you insane?”
And I will answer: “Think about real estate!”
With only a fraction of the price of a house, you can control a significant asset. You are using someone else money to build your wealth. And another person is paying the rent, paying your mortgage for you. In time, your mortgages on all your properties will be paid off, and you will have a significant net worth.
With a real estate investment, you will be able to raise rents as the economy grows — no need to worry about the erosion of the purchasing power of your money.
In my opinion, the best way to be financially independent is to invest in real estate and stocks. And when I say stocks, I do not mean necessarily of picking shares, I mean an ETF on a broad index is enough. With enough real estate, there is no need to worry about the up and down of the stock market.
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Questions of the day:
what do you think about my investment philosophy? Please comment below; I am eager to read your thoughts.