How Much Money Do I Need to Reach Financial Independence?

FIRE stands for Financial Independence Retire Early. The FIRE movement advocates for achieving a position of financial strength where we no longer depend on a paycheck to pay for basic needs. Since we’ll spend time creating additional income streams outside of a W-2, we can then decide to stop working. Now, remember that you don’t HAVE to retire. The retire early part of FIRE is completely up to you. Because the RE part of FIRE is optional I typically use the term Financial Independence (FI). It was amazing to discover that I could use my current income,  frugality, and intentional spending to buy my freedom. But how does it all work? How much money do I need to reach Financial Independence?

Step 1: Track your Expenses

The 4% Rule is commonly used to estimate how much money you’ll need to retire based on your expenses. Therefore the first step to calculate your FI Number is to track your expenses. We started tracking our expenses much more closely which in turn enabled us to continue cutting non-value added expenses. I highly recommend you go ahead and set an account with one of the multiple expense trackers available. There is plenty of options such as Mint, HoneyDue, or Personal Capital. We use both HoneyDue and Personal Capital. HoneyDue is great because it allows us to link our accounts which is helpful when keeping separate finances. We use Personal Capital to track our net worth and investment performance. Check out our post on Expense Tracking to learn more!

Step 2: Extrapolating your Expenses

Now that you are tracking your expenses we can extrapolate your annual expenses by multiplying your monthly expenses by 12. Keep in mind that there are some expenses like travel, which will be higher in the months where you are taking vacations vs other months. We typically average those expenses out throughout the year. To calculate our FI-Number we took our yearly expenses and multiplied them by 25. Let’s say for example that a person spends $40,000/year, their FI-Number would be $40,000 x 25= $1,000,000. At this point, you might be wondering why are we using 25, and not another random number. The answer can be found in a famous study known as the Trinity Study or the 4% Rule (of Thumb).

The Trinity Study

Published in the 1990s by three professors from Trinity University in San Antonio, Texas the study attempted to identify a safe withdrawal rate for various portfolios that had different stock/bond allocations. The portfolios were tested for periods of up to 30 years.  For an inflation-adjusted portfolio with an asset allocation of 50:50 stocks to bonds, if the investor were to withdraw 4% of the total value of the portfolio every year, the investor would have a 5% chance of running out of money. That means that there is a 95% chance that you could live off that investment portfolio. And that is not even considering you could go back to worth it things went south!

 I just introduced a couple of new concepts so I’ll define those before we move on :

Safe Withdrawal Rate: How much money you can withdraw without running the risk of depleting your portfolio. The SFR is typically expressed as a percentage of your portfolio’s value.

Asset Allocation: Percentage of stocks, bonds, and other assets that comprise your portfolio. You can establish your asset allocation based on your investment goals.

Step 3: Be Flexible

The number 25 comes from 1/4%=1/0.04=25 which means that assuming that your annual expenses won’t change when multiplying by 25, you are calculating the value of the portfolio you’ll need in order to fund your current lifestyle. Since we are calculating against your current lifestyle, the neat thing is that you can always adjust your lifestyle down using frugality if the time comes.

The 4% Rule is also referred to as the 4% Rule of Thumb because the reality is that our future income streams are not stagnant. The study did not consider that the investor is able to go back and work for a year as an English Teacher in Thailand, or that we can create passive income by creating travel videos. It’s pretty awesome that we can utilize the 4% Rule to give us an approximation of how much we need to save in order to retire but we have the ability to weather any storms by adjusting along the way. Maybe the market crashes and we go back to work part-time for a bit until the market recovers, or maybe we implement the frugality habits that we learned to get to FI and decrease our spending for a bit. The opportunities are endless, especially when you are not tied to a single location!

Geographic Arbitrage

Geographic Arbitrage is a strategy that allows you to leverage the difference in lifestyle costs across different geographical regions (countries, states, etc.). In their journey to Financial Independence, some people decide to move to a lower (or higher) cost of living area in accordance with their FI plan. You could decide to move to a state with lower or no income tax, or you can decide to move to another country entirely! We’ll be able to decide where we want to spend our time. Utilizing that flexibility and making work to our advantage is what geographic arbitrage is all about. We could move to a cheaper state, or even a cheaper country to allow our portfolio to heal after a rough year by decreasing our expenses. I won’t go into much detail into geographic arbitrage in this post, just know that this is another lever to pull if you face a couple of rough market years during Early Retirement.

But What If (Insert Catastrophe Here)?

To add even more to the array of things we can do to protect your portfolio, you can add even more money to your emergency savings to protect your portfolio from sequence of return risks. From what I’ve gathered so far there are certain time periods where your portfolio is the most susceptible to fail to in produce enough money during your entire retirement long term if it does not receive additional income. I won’t go into details about Sequence of Return Risks but I’m currently reading a great blog post series (Safe Withdrawal Rates Series) on the topic by Early Retirement Now. Go check that out for more details! If anyone has a good simple definition, please share it in the comments below! 

The 4% Rule provides scientific evidence that living of an investment portfolio is possible regardless of the dips and crashes from the market, but as with anything built with historical data, there will be speculation and plenty of what-ifs. We don’t truly know what the future holds but what we do know is that…the market always goes up (eventually). And if one day that changes, we’ll have more important things to worry about than our portfolio’s performance. 

Mr. DMD and I chose to do everything possible to achieve Financial Independence because we are optimistic that the world will be available for us to explore when we are ready.

Ms. DMD 🙂

Have you started tracking your finances yet? What app or website has worked for you? Do you know your FI-Number? See you in the comments!

*The content posted on this website does not constitute professional financial advice. Please consult a certified financial planner or investment advisor for professional financial advice*

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