This blog article will help you determine what to do with the money you have saved to invest by further explaining index funds and the 4 Percent Rule. It will help you get started utilizing Mechanism 4 – Invest your savings wisely!
In chapter 23 in First to a Million, I went over the index fund investing strategy, what an index fund is, and why they are the best way to invest in the stock market for the long term. I highly recommend you review that chapter before moving on.
One of the two main investment strategies you will want to use for early FI is index fund investing. (The other being real estate investing.) You should use this investment strategy with the 4 Percent Rule in mind. The FIRE community uses the 4 Percent Rule as a general guide in their path to early FI. I know these may be intimidating terms and ideas, but hold tight. I will walk you through everything you need to know as simply as possible, so it makes sense to you and your financial future. You are a Freak. You can handle this, I promise!
Before we dig into the 4 Percent Rule, you should know we will not consider inflation. This is because the 4 Percent Rule already accounts for it. So, we don’t need to adjust for the fact that the amount of money someone spends today will not buy that person the same amount of stuff in the future because the 4 Percent Rule factors that in for us.
Inflation – a general increase in prices and a fall in the purchasing value of money.
How Much Does Alex Need to Reach FI?
Let’s say Alex is 30 years old, and he spends $50,000 a year on living expenses. (Just a reminder that “living expenses” include everything Alex spends money on. They consist of necessities and wants such as entertainment, travel, and fun.) He’s hoping to live until he is 90 years old. So, Alex has 60 more years to live. And if he spends $50,000 a year, he needs $3,000,000 to live on for the rest of his life. (60 years x $50,000/year) So if he had $3,000,000 saved, he would no longer have to work and thus would be financially independent.
But Alex doesn’t really need to have $3,000,000 saved to reach FI. He can have less. That is because when he invests that money over the long-term (index funds), he can expect it to have some growth due to positive returns on his investment. So, if Alex invests the money wisely, he will need less than $3,000,000 to be FI because the investment will have some positive returns (growth) over those thirty years even while he is slowly taking money out.
Return – the money made or lost from an investment over time
This is true because when someone has money invested wisely in the stock market (index funds), they can expect a positive return over a long period of time. The stock market, in general, grows over time. So, therefore, money invested will increase in total value over time. If we go back decades and look at stock market performance, we can expect an average annual return of around 7%. Therefore, since Alex can expect whatever money is invested to have positive returns over the 60 years, he can start with less than $3,000,000 and still be okay. So, the total amount needed can be lowered based on the positive returns one expects to receive on the money they’ve invested.
So how much money does someone need to have invested to be financially independent when considering future positive returns and the amount of money they will spend each year? That is the question the Trinity Study answered with a simple mathematical formula.
The 4 Percent Rule
The Trinity Study answered this question with the 4 Percent Rule. And it says if someone takes 4% of the value of their initial investment amount out each year to pay their living expenses, then they can expect to have enough in investments to last until they die. The Trinity Study came to this conclusion using “worst-case scenario” numbers. In other words, the researchers wanted to be as sure as they reasonably could that the investment money would not run out. So, the 4 Percent Rule is considered a relatively safe and conservative rule for one to follow.
As we mentioned before, Alex has determined he will need to spend $50,000 a year on living expenses from now until he dies. (Remember, there is no need to account for inflation, as the Trinity Study already did that.) So, if he stopped working at age 30 and had no income source, he would need to take money out of his investments to pay for his $50,000 of living expenses each year. The 4 Percent Rule says Alex can take out only 4% of his investment’s initial value each year until he dies. So, the question is: $50,000 is 4% of how much in investments? The answer is:
$50,000 / .04 = $1,250,000
A much easier way to get the same answer is to take the yearly living expenses x 25. In this case:
$50,000 x 25 = $1,250,000
This is how much Alex would need to have wisely invested in the stock market to be financially independent. Alex would be relieved at this amount because it is far less than the $3,000,000 he would need if his investments were not growing at all.
Note: The amount of money Alex withdraws will only equal exactly 4% the very first year. After the first year, Alex has no idea how much his investments will be worth since it will have a positive or negative return each year, and he will be taking out $50,000 per year. The 4% calculation is only used in the first year to arrive at the amount Alex will withdraw every year going forward, no matter what the investment value is in the future. So, Alex will take out $50,000 each year (adjusted for inflation), regardless of whether the investment’s total value is more or less than the $1,250,000 it was worth when he started.
Note: The 4 Percent Rule does account for inflation, so each year Alex would take out 3% more than the previous year. For example, in Year 1, Alex would take out $50,000 to pay his living expenses. In Year 2, he would take out $51,500 ($50,000 x 1.03). And in Year 2, he would take out $53,045 ($51,500 x 1.03). And so on.
Alex’s Plan in “Retirement”
Once Alex reaches his FI Number, he will take out $50,000 from his investments each year (adjusted for inflation) to pay his living expenses. Even though he’s taking money out and not putting any additional money in, he can conservatively expect to have enough money to last the rest of his life. This is “sustainable asset withdrawal” in the FI equation.
Passive Income + Sustainable Asset Withdrawals > Living expenses
After reaching an investment value of $1,250,000, Alex can start withdrawing money from his asset (stock market investment) until he dies. Since it will last until he dies, it is sustainable.
Note: In this scenario, Alex could have zero passive income because his sustainable asset withdrawal alone exceeds his living expenses. However, most of you will choose to invest in real estate and index funds, so you would not need to do what Alex did and cover all your living expenses with only index fund investments.
Now keep in mind that this whole scenario assumes that Alex will make zero income for the last 60 years of his life. But I find it extremely difficult to believe that Alex, a proven FI Freak, would not be continuing to make money somehow even after reaching FI. It seems he would find an enjoyable way to make money while “retired,” whether that be working part-time at a fun company, starting his own business, or finding ways for his investments to earn more than the average return from the stock market. If Alex plans to make some income after reaching FI, then his FI number would actually be lower.
Since you are young, it’s important to note that you do not yet have a way to accurately determine your living expenses for 5 or 10 years down the road. But you do know how to track your expenses now and can practice that skill so you will be able to accurately determine your living expenses when the time is right.
You will need to track your expenses for at least two years after you are on your own to have a valid “living expenses” number. Until you know your living expenses, you won’t be able to calculate your FI Number. But that doesn’t matter. Just start hammering all four Mechanisms as soon as you can so your FI Number is easier to reach once you can calculate it.
The 4 Percent Rule is not bulletproof. There are never any guarantees for future stock market performance or any investment performance, for that matter. So, there is risk involved with using the 4 Percent Rule as a guide to determine when someone has reached FI.
There are opponents of the 4 Percent Rule who say it is flawed in one way or another or that it is not a safe tool to use for one’s financial future. There have been numerous follow-up studies, papers, articles, and discussions about the 4 Percent Rule, some for and some against it. Since it is not guaranteed to work, most people who employ the 4 Percent Rule as a measurement tool for FI also have other investments on which to rely after they stop working. Or they continue to work in some way to produce income even after they have enough money invested according to the 4 Percent Rule.