If you follow along at this blog, perhaps you’ve noticed a trend. As the months have passed, I have slowly but surely reduced the rate at which I write about personal finance.
This didn’t happen by accident. Truth is, if I wrote about personal finance every week, this blog wouldn’t have lasted more than a few months. I simply don’t have enough to say about it. And I think with good reason.
Solid personal finance is simple, automated, and frankly, boring. It’s meant to be that way. Because away from the glamour stories, simplicity and long-term consistency are the principles that steadily build wealth.
Bottom line: we needn’t make personal finance complicated. In fact, for the people who would benefit the most from better managing their personal finances, complexifying these concepts is the ultimate turn off.
With that simplicity in mind, this blog post is dedicated to one of the most important personal finance charts. It is a simple visualisation of two lines. And I believe that anybody that likes the sound of financial independence (which is surely everybody) should be maintaining this chart for themselves.
The Financial Independence Chart
Now, I’m sure there are plenty of names for the graph that follows, but let’s call it the financial independence (FI) chart.
The FI chart is a simple monthly plot of two items: (1) living expenses and (2) independent income.
This isn’t rocket science, but let’s briefly recap on what these two items mean in practice:
- Living expenses: Quite simply, your total monthly cost of living. This includes housing costs, food, travel costs, subscriptions, etc. You get the picture.
- Independent income: This is income not made through your regular job but generated “independently”. It’s also income that has a strong likelihood of being sustained over time. I’ve deliberately not referred to this type of income as “passive” because often some of these sources of income require considerable ongoing effort. Examples of independent income include dividend and interest income, rental income, drawdown income (the personal finance community generally punts for 4% as a safe rate for 30 years), eBook income, blog income, “flipping” income, and any other side hustle income achieved by independent means.
The rewards of this simple visualisation don’t happen by magic. Getting to these two monthly figures clearly requires some basic understanding and tracking of your finances.
But once you have set up your tracking, the end result is two lines that over time provide a clear sense of how far away financial independence might be.
Basic: Understanding Your FI Cover
Let’s plot some hypothetical figures to illustrate this point.
As you can see from the below FI chart, Joe Bloggs has made considerable progress over the last few years. While his living expenses have remained relatively flat (except for early 2020, where he couldn’t leave his house), his independent income has grown strongly over the same period.
Put another way, what I call Joe’s “FI cover” has gone from significantly negative to positive in 2.5 years.
FI cover is the difference between your monthly independent income and your monthly living expenses – hence Joe’s FI cover of £800 in June 2020. The FI cover ratio is your monthly independent income divided by your monthly living expenses. In this case, Joe’s FI cover ratio is 1.5 in June 2020 (i.e. £2,500 / £1,700). Lucky him.
Of course, most of us won’t be as lucky as Joe. It’s unlikely that we can turn a significantly negative FI cover to a positive FI cover in the short matter of a few years.
But once we’ve achieved a positive FI cover like Joe, that’s it, right? We’ve done it. Financial independence is in the bank.
Intermediate: Averaging Your FI Chart
Well, not quite. There would be significant risks to throwing in the towel with your main job after just a couple of months with a positive FI cover. What’s more, we have no context on how Joe is generating this money and whether this independent income is truly sustainable.
This, of course, is a judgement call for Joe as he tracks his income. If he knows a source of income is unlikely to be sustained, it would be unwise for him to include it in his independent income in the first place.
Ignoring these contextual questions, one useful way of smoothing our FI cover is to use rolling averages. In other words, instead of just plotting whatever he spent each month, Joe might use an average of the last 12 months instead.
As you can see below, when we apply a 12-month average, Joe’s situation looks rather different.
While we know his current monthly situation shows a positive FI cover, on a 12-month rolling average basis, he is still lagging behind.
The average basis gives a clearer indication of the overall direction of travel, which is still excellent, but Joe might think twice before taking the plunge away from his main job just yet.
Advanced: Forecasting Your FI Chart
While this view is useful for understanding the impact over a complete year, averages can also skew the view the other way. It’s perhaps therefore worth maintaining the basic and intermediate view in parallel.
The other problem with both views is that they don’t tell us much about the future. To make the most use of the FI chart, we need to have a sense of how our spending and earning might evolve once we hit financial freedom, or simply in future months while still financially dependent.
This again requires some honest judgement calls from Mr Bloggs.
Let us suppose that he plans to travel much more once financially independent, and that as he takes his foot off the gas a little with his side hustles, he will be left with independent income that requires less day-to-day work.
The inevitable result is a division of the two lines and a much lower FI cover. In this example, by the end of 2021, Joe has an FI cover of -£1,100 and an FI ratio of 0.6 – a long way from the FI ratio of 1.5 that he had achieved in June 2020. In other words, financial freedom is further away than Joe thought, primarily because of his desired change in lifestyle once he gets there.
Modelling the future in this way is an imperfect exercise, but it’s nonetheless a useful way of establishing how much FI cover we might really need from month to month. And then it’s an invitation to explore the solutions in more depth.
The Power of Tracking
All of this, of course, is a huge simplification for the purposes of illustration.
I accept personal finance is a bit more nuanced than this. These lines don’t encapsulate your net worth or the size of your investment portfolio. They don’t clearly tell you how much to draw down from your investments. They don’t even tell you what your cash flow situation is from month to month.
But if you are doing what is required to arrive at this chart, you should in turn be answering all these questions.
If you are serious about achieving financial independence, whichever way you try to dress it up, these two lines are the ones that matter most in that equation. It would be absurd not to track them.
Like me, many of you will already be tracking these lines. But if you haven’t done it already, why not take these 5 simple steps?
- Set up a simple spreadsheet to track your personal finances.
- Calculate your monthly independent income and living expenses each month.
- Plot them on a line graph.
- Work out your FI cover and FI cover ratio.
- Set some targets and watch these lines evolve.
