Here’s the million-dollar question: How the heck can I write a guide to achieving financial independence if I haven’t even achieved it myself yet?
A fair question, and one I should probably answer immediately before I lose your attention.
My own journey to financial independence is an ongoing education. It started in earnest in 2018 and has gathered pace over the last couple of years. During this time, it’s not an exaggeration to say I’ve read hundreds of articles on financial independence.
That number, I’m sure you’ll agree, is too many. There are far better ways for human beings to invest their time.
And so we get to the point: We must spare as many FI newbies as we can from the same destiny.
This article is therefore my attempt to consolidate some of the central principles of what I’ve learnt in one, easy-to-understand article.
If you’re new to the idea of early financial independence, I think you’ll find it a helpful introduction. If you’ve been around the FI block a few times, the chances are you’ve seen it all before. To you I say, no problem. There’s plenty more on the website that you might not have seen. You may be excused.
This article, then, is for the self-professed laypeople of personal finance. It’s for anyone unfamiliar with the personal finance world, but keen to put pay to the routine early. It’s for anyone who values independence over the relentless chase for more, but doesn’t know where to begin. And it’s for anyone who has heard about the growing financial independence movement, but doesn’t want to indefinitely trawl the web looking for answers.
You get the picture. New to the concept of financial independence? This article is for you.
And with that, let’s get to it.
What Is Financial Independence?
We should start, of course, by setting the scene.
Put simply, financial independence (FI) is a state in which we have enough income to pay our living expenses for the rest of our life, without being employed by or dependant on others.
Movements like the FIRE movement (that’s Financial Independence, Retire Early) have narrowed this definition somewhat. Although self-employment fits the broader definition, FIRE and many of its variants define financial independence as having enough passive income to cover living expenses – in other words, where our assets or work continue to produce income, long after we’ve stopped working.
It’s this definition which is the focus of my attention in this article.
Why Pursue Early Financial Independence?
We’re all already pursuing financial independence. We work until we receive a pension, at which point we can retire and fully enjoy our financial independence. This is the standard, template approach.
Thing is, there are few problems with it.
#1: Moving goal posts
As we live longer, retirement ages are rising. But just because we’re living slightly longer, it doesn’t mean our latter years are healthier years.
Early financial independence creates the opportunity to enjoy the fruits of our freedom before our age starts to take its toll on that enjoyment.
#2: Financial dependency is a risk
When we depend on employment or on others to cover our living expenses, we run the risk of financial meltdown if that flow of income suddenly stops.
Financial independence negates the risk of redundancy or sudden changes in dependent income.
#3: Flexibility beats inflexibility
When we are dependent, it’s harder to say no. We have a mortgage to repay, bills to cover, mouths to feed. And most of us have just one source of income to cover all these things. That makes it incredibly difficult to turn down work that leaves us unfulfilled, miserable or burnt out. After all, we turn it down at our potential financial peril.
Financial independence makes rejection easier. You call the shots, because you don’t need that source of income; you choose it. Independence creates options.
#4: The rat race
A creativity-draining routine, keeping up with the Joneses, a relentless pursuit of more. Sound familiar? You’re not alone. While we are in many ways fortunate to have it, modern knowledge work also has the capacity to expend our energy and time away from the things we really value.
The 9-5, often draining and unfulfilling while we’re in it, is almost always not the 9-5. We commute, we prepare, we work extra. Early financial independence is a path to rejecting this route.
#5: Your time is everything
Ultimately, when we look back and assess our lives in the cold objectivity of the deathbed test, we will assess how we used our time. If we chose a stable 9-5 to provide for our families, there should be no regrets. But if we forced ourselves down that road, year after year, decade after decade, knowing we’d reject it if we felt we had the flexibility to do so, then that is a cause for concern.
At the heart of independence is how we use our time. Sometimes a state like financial independence is the security we need to make better use of it.
Key Principle: The Miracle of Compounding Returns
Before we get to the important question of how we can achieve early financial independence, I want us to begin with a gentle illustrative example.
Imagine you are going to retire at 60 (don’t worry, we will get to earlier ages shortly). You decide to invest £500 per month for every month until you retire into an equity index fund, which for the sake of argument, we assume returns 5% on average per year over the time you invest. As the rate of inflation is 2%, you also decide to increase your investment by that percentage each year. In other words, in Year 2, you invest £510 per month, in Year 3, £520.20 per month, and so on.
Annualising these assumptions, if you started this process at age 55, investing for just 5 years, you’d end up with £36,000 to your name, with growth of £5,000. As the below table shows, however, the earlier you start this process, the larger the proportional gains become. If you started at age 40, you’d wind up with £245,000 and almost £100,000 in growth. And if you wisely started this investment at age 20, you’d invest £362,412 and finish up a millionaire.
This is the miracle of compounding returns in action. Our gains from one year to the next compound as our return is calculated on the total balance each year.
As I’ll show shortly, if you’re to take the conventional route to financial independence, the principle of compounding returns will be the star of the show. Keep that in mind as we move forward.
How Much Money Do You Need to Be Financially Independent?
The short answer to this question is it depends. Specifically, it depends on your expected living expenses and your chosen FI strategy.
Step 1: Set an Annual Living Expenses Target
Let’s be a bit more specific.
To understand how much money you’ll need in total, you first need to calculate how much money you will need per year in the future. Obviously.
If you’re planning to live the rock star lifestyle, your annual living expenses are going to rocket. If you’re planning to live a relatively simple life, on the other hand, your living expenses are clearly going to be lower.
Don’t kid yourself when estimating these costs. Bills aren’t going to disappear when you achieve financial independence, but it’s possible that other liabilities such as mortgage repayments may be cleared by that point.
Make a detailed calculation of all your costs, factoring in known changes in the future and including any additional costs you expect to incur when you reach financial independence, such as travel.
Step 2: Time-Value Adjust Your Target
Once you’ve got a living expenses target, you need to adjust it to reflect inflation. Why? Because the figure you’ve calculated at this point is in today’s money. A bottle of milk won’t cost you £1 in 20 years’ time.
Inflation in the UK typically sits around 2% and similar rates are observed in developed economies across the world. For the sake of a working example, we’ll use a consistent rate of 2%.
Example: Caroline calculates expected living expenses of £25,000 per year when she stops working. She thinks that will provide ample funds to cover her core costs and give her the freedom to travel several times per year. She would like to call it a day with her job within 20 years.
To get an adjusted living expense target, her calculation would be as follows:
Target LE = £25,000 x (1 + 2%) ^ 20 years = £37,148
Rounding down, the end result is that Caroline expects to spend £37,000 per annum in 20 years’ time.
This target living expenses number, as I’ll explain shortly, is the centre point of a financial independence plan. If you don’t have the passive income or drawdown to provide it, you’re not financially independent. Simple as that.
Step 3: How much do I need to invest?
One of the most popular approaches to financial independence is based on the four-percent rule. This suggests that when we withdraw 4% per year from an investment portfolio predominantly invested in the stock market, this should be a ‘safe withdrawal rate’ over three decades – and possibly more.
In other words, the balance of the investment should be sustained, so long as we only take 4% from it per year and so long as the stock market behaves the way it has for many decades. The latter, of course is never guaranteed.
The useful thing about the four-percent rule is it can be inverted to give us our target total investment. We do this by multiplying our target annual living expenses by 25.
So in the case of our example, Caroline would multiply her future target living expenses as follows:
Investment Target = £37,000 (Time-Value Adjusted Living Expenses) x 25 = £925,000
Caroline would need £925,000 invested predominantly in equities in 20 years’ time, in order to allow her to safely withdraw 4% per annum for 3 decades. As this money will not endure in perpetuity, she’d ideally also need to supplement this with a private pension to provide income when she reaches retirement age.
How Long Will It Take?
“Yikes! That’s a lot of money. It would take me a century to pull together that sort of cash!” I hear you say.
Well, you might be pleasantly surprised – or you might not be.
Let’s take a few conservative assumptions. First, let’s assume inflation is 2% and any fixed investment amount that you decide to invest increases by that percentage each year. Second, let’s assume you invest primarily into a well-diversified range of stocks and achieve a growth of 5% per annum on average.
The below table takes these conditions and projects the number of years it would take you to get to 25 times your living expenses. As our future living expenses are in part dependant on the number of years in the future, the living expenses in the red section on the left of the table are in today’s money. They are then adjusted in the calculation depending on the number of years.
As an example of how to read this table, let’s return to Caroline.
Caroline will be financially independent once she can independently cover £25,000 of living expenses in today’s money. With that in mind, she’d find the £25,000 living expenses in the table and then scroll across to find 20 years.
As you can see, under these assumptions, 20 years would require an annual investment between £20,000 and £25,000, increasing at 2% per annum (highlighted in the table in red).
If we restricted ourselves to the 4% approach to financial independence, it’s easy to see how average earners could spend an eternity trying to get to their target. Not many of us are earning enough to comfortably put aside some of the sizeable annual investments in this table, and maybe we never will be.
In the realms of the 4% rule, if we can’t increase our investment, that means we have two options: (1) find a way to reduce our future living expenses target, perhaps at the expense of our future standard of living, or (2) accept more years of financial dependency, with the highlighted rectangle in the table shifting towards the left.
Thankfully, the financial independence path doesn’t have to be so black and white.
How to Accelerate Your Financial Independence
The four-percent rule is just one way of visualising the route to financial independence. While it’s a useful tool for quantifying the financial hurdles, the reality is it’s not without its limitations and caveats (more on that here).
Its central question, however, is fundamental: How can we ensure we have enough income to cover living expenses?
If we’re seeking to accelerate our financial independence, we need to find quicker ways to answer this question.
#1: Double down on the three wealth levers
Whatever route you take, the answer inexorably involves one or all of three levers: earning, saving and investing. A heightened focus on each is the key to accelerating this process.
How to earn more. My advice: focus on big wins. Core salary growth will be critical for medium-term wealth accumulation. Regular salary negotiation and job switching every 2-3 years offer huge comparative gains versus sticking around in the same job.
Your active income will – initially at least – be the cornerstone of your wealth. Shortly, though, I’ll explain why the pursuit of earnings shouldn’t be limited to your job.
How to save more. Take a measured look at where you’re spending money. Start with cutting pure waste: subscriptions you don’t use, spending habits that bring you no value. We’ve all got them.
Then shift your focus to asking questions about how other costs can be approached differently. Can you shop smarter? Can you make better coffee from the comfort of your home? Do you get a better workout outdoors for free?
These types of questions focus on doing things cheaper and better. A focus on cutting costs that feels like you’re losing value can feel counterproductive. The journey needn’t feel reductive, but for regular earners, it must ask important questions about what we value.
How to invest more. This one is simple: do more earning and saving. Focus the gains you make here on well-diversified investing.
For the everyday investor, don’t underestimate the importance of diversification. In this respect, the beauty of modern finance is its accessibility. Everyday investors can readily invest in index funds through sites like Vanguard or directly via Exchange-Traded Funds (ETFs). Think, however, about diversifying beyond electronically-traded investments, too.
#2: Passive mindset, active pursuit
Our diversification should not be limited to our investments. Let us not lose sight of the prize: income that covers living expenses. Diversification of income streams can be an incredibly important tool for early financial independence. Specifically, a focus on passive income can change the complexion of our FI pursuit.
Suppose, for example, that in our earlier case of Caroline, she decides to start producing eBooks. She puts in the hard, active yards. But slowly, surely, the books start to trickle through an income of £5,000 per year. Suddenly the target living expenses she’ll need to cover by other means has shifted from £25,000 to £20,000. If she wanted to produce this income under the 4% rule, under our earlier example it would knock about 5 years off her investment path.
The opportunities to make additional income have never been so abundant. Many of these things, including investing, require active work, but will produce subsequent passive returns. And as our income sources become more diversified, we begin to feel the flexibility that fully-fledged financial independence can bring.
#3: Track your progress
If you’re serious about your FI pursuit, the chances are you’ll set some targets. It follows, of course, that you should not underestimate the importance of tracking these targets. Maintain a spreadsheet or use a tracking tool to keep tabs on your net worth, investments and expenditure. Use your tracking to provoke actions: identify and eliminate waste, optimise investments, manage debt, and so on.
#4: Automate your finances
One of the most powerful psychological tools of personal finance is making a sensible decision once and then letting a machine repeat that decision for you, over and over again. Automation plays into the power of default choices. When we make a decision to automate that £1,000 investment every month, we’re less likely to change it. Defaults breed consistency, and consistency breeds results. Think about where you can automate transfers of money – investments, savings, debt repayments – to take advantage of this effect.
#5: Attack your debts
The miracle of compounding returns unfortunately also applies in reverse. Debts can therefore quickly spiral out of control. It’s essential, then, that we eliminate expensive debts that create a drag on our wealth accumulation. I recommend using the debt-avalanche method, paying down debts with the highest interest rate first.
It’s also important to consider the good side of debt. Your leverage, if cheap, can offer a mathematical advantage. That’s something worth due consideration before racing to pay down a low-rate mortgage (more on that here).
I’m in! What Now?
Welcome to a boundless world of possibility: one where you officially own your time. To get there may take some time, but I hope I’ve demonstrated that it needn’t require great sacrifice.
Consistency will be the key that unlocks the door to this world. Consistent investing, consistent growth in income, consistent focus on passive income, consistent effort.
But it must be enjoyable – or else what’s the point?
Do not labour through years of misery to get there. Find a happy path to financial independence: one that is effective for your money and your state of mind.
My hope is that this article has stimulated thoughts about where to begin on this path, and how to tread along it. But everybody’s path is different. Take the principles from this article that apply holistically and think about how they apply to your world – and how they can be put into action.
The sooner you start, the sooner you’ll be financially free.