How Much Money Do You Need?

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Now that we have discussed the three levers of financial independence, you understand the basic concepts behind them and know what action plans you can implement to use each of them effectively. The one remaining question is: How much money do you need to never have to work again?

Net Worth: Assets minus Liabilities

The first thing you need to do is: 

Track your net worth. 

Tracking this number is as key to financial independence as it is to track your expenses. In short, what you do is add up all your assets (e.g. cash at the bank, investments, real estate property value) and deduct from it any kind of liabilities (e.g. debt, car loans, credit card balance, mortgage). 

The resulting figure is your net worth and is key for determining whether you are financially independent or not. 

The Trinity Study and the 4% Rule

So how much net worth do you need to be financially independent?

In 1998, three professors at TrinityUniversity in Texas, USA, asked themselves the following question: Historically, how much money could a person withdraw from his or her portfolio every year and survive 15, 20, 25 and 30 years, without ever going below USD 0 (i.e. without running out of money). The assumption is that all a person’s money is invested in stocks and bonds, and that the annual withdrawal rate remains constant except for inflation.

Let me give you an illustrative example. Let us assume that you have saved up CHF 1 mio and invested it 100% in stocks. You are 65 and expect to live until 95, so you have a retirement period of 30 years ahead of you. 

You expect to spend CHF 40’000 every year, which is 4% of the initial CHF 1 mio. The only adjustment you make to the CHF 40’000 is  based on inflation. You never take out more than these CHF 40’000 and never less than these CHF 40’000, no matter how big or small your portfolio becomes during the 30 years of retirement. 

The ultimate question: Historically, how often would you have gone bankrupt and how often would you have survived?

The researchers used data from 1926 to 1997 and simulated different scenarios for 15, 20, 25 and 30 years with different portfolio compositions:  

  • 100% stocks / 0% bonds
  • 75% stocks / 25% bonds
  • 50% stocks / 50% bonds
  • 25% stocks / 75% bonds
  • 0% stocks / 100% bonds

Because we are interested in financial independence in the long run (at least 30 years), let me only show you the results of being able to survive for 30 years.

The way to read this table is as follows: if you have all your investments invested in stocks and withdraw 4% of your initial investment every year, then you would have survived 98% of the time assuming a 30-year retirement period. Had you taken out 8% of your initial investment every year, then you would have only survived 44% of the time.

From these results, people infer the so-called “4% Rule”. It basically states: 

The moment your annual expenses represent 4% of your total investments, you are financially independent.

Or, your investments need to be 25 times as high as your annual expenses for you to be financially independent.

Yes, the data does not show that you will survive 100% of the time if you withdraw exactly 4% of your initial income every year. However, if you have at least 50% of your investments in stocks, then you will survive 95% of the time. 

In general, this is considered sufficient enough. The model is quite inflexible in that it assumes that you will never decide to go back working in case of an economic crisis and that you will never have the possibility to reduce your spending to a level below 4%. In reality, you would most probably spend less than 4% in times of economic crises. 

Whenever you meet someone in the FIRE community, the 4% rule is the basis of any calculation for early retirement. Some people retire the moment their investments hit 25 times their annual expenses. I even read of a girl who retired at age 29 with savings of USD 0.5 mio, because her annual expenses were somewhere at USD 18’000 per year.

I would be more cautious and consider the “4% rule” a general rule of thumb and not a hard rule, because of the following reasons:

  1. The study only covers a retirement period of maximum 30 years. However, if you retire at age 45, you might be looking at a retirement of 50 years, maybe even longer.
  2. The study only covers a period from 1926 to 1997. 
  3. As discussed, the study makes many assumptions which are not necessarily representative of real life. For example, pensions and social security are not included; withdrawal rates are completely fixed and not flexible; you will never earn another cent.

The Trinity Study – Extended Version

One of the financial gurus within the FIRE community, called Big ERN (blogger at earlyretirementnow.com), redid the simulation for a period from 1871 to 2016 and looked at retirement horizons of 30, 40, 50 and 60 years. 

There are two main conclusions when looking at the data-set:

  • The success rate drops significantly when you consider a longer time horizon, especially when moving from a 30-year time horizon to a 60-year time horizon. How much money you need to be financially independent should be therefore based more on a “3.25% Rule”, rather than a “4% Rule”.
  • When you consider long time horizons such as 50 and 60 years, you fare a lot better with a 75%-100% stock portfolio than any other combination. This would indicate that even during the “Wealth Preservation Phase”, you should consider having a stock ratio of 60-100%.

Big ERN has a whole “safe withdrawal rate” series with about 30 articles on his blog. It is definitely worth a read if you are interested in understanding this topic in all its nuances. For example, he looks at the impact of social security, of going back to work, of having passive income and of having a flexible withdrawal rate. 

Overall, there has been a lot of research on this topic and many, many different variations of the trinity study have been conducted since its original publication, not just by Big ERN. 

As I am interested in describing a simple strategy to reach financial independence, I want to give you a simple definition of what level you must achieve to be financially independent. For this reason, I will not go into all the details and scenarios possible. In the end, there is not one right way to do it.

My takeaways are the following and this is what I would urge you to remember:  

  • Apply a 3.25% rule. That means when your annual expenses represent 3.25% of your total net worth, then you are financially independent (so multiply your annual expenses by 30 to make it simple).
  • If you plan to retire and stop working before 55, keep 80-100% of your portfolio in stocks.

One part which I think is important to consider is that as of age 65 you will receive social security and this will form a major part of your income as of this age. In Switzerland, if you have a pension fund and a third pillar, then this amount will be further increased. 

If this is the case, then 3.25% is most likely too conservative and you could go more for something towards 4%. 

My approach and philosophy is the following: I do not know how the pension system in Switzerland will change in the future, especially considering a long-time period of the next 30 to 40 years. To be on the safe side, I will take a 3.25% approach and everything which I get extra from social security and pensions is an added benefit.

Just for the sake of completeness, let’s look at some simple calculations to see how much money you would need to be financially independent with both 3.25% and 4%:

To reach these numbers you need to use the three levers described in the previous three letters. Have a high savings rate, invest in low-cost index funds to make use of compound interest and be proactive in increasing your income.

Conclusion

As mentioned at the beginning of these letters, I do not have a solution for making you rich over night or even within 3 years. But using these three levers will allow you to reach financial independence within a reasonable timeframe and much faster than having no plan at all.

After having gone through the mathematical way of determining when you are financially independent, I only have one more letter waiting for you. You now have the basic structure and understanding (I hope) to tackle financial independence. The last topic I want to discuss with you are the benefits of being financially independent and what to do once you reach this level of financially independence.

I hope you are enjoying the ride down the financial independence hole and that your head is not smoking after this mathematically heavy letter.

Cheers

Mr C&M

Actionable Items


  • Calculate your financial independence numbers
  • Calculate how far on the path of financial independence you are
  • Compare the figure against your estimates from Letter 1 – An Intro To Financial Independence

Do you have any questions, concerns, feedback or constructive criticism? Let me know in the comments or send me an e-mail at info@chocolateandmoney.com. Anything is highly appreciated.

Continue with Letter 6 of the Basics: Why Should You Seek FI

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