In my last blog, I talked about how easy it is to become a millionaire through compounding. If you believe that wealth is an end unto itself, then that is a perfectly worthwhile goal. Most people make money by selling stuff to other people, so almost all advertising is focused on telling the audience that they don’t have enough, that they need to keep accumulating and buying. The “become a millionaire” idea fits nicely into that high-consuming lifestyle.
However, studies seem to indicate that in itself, wealth doesn’t provide that much happiness. That’s not to say that a rich person isn’t on average happier than someone living in a cockroach-infested apartment, but rather than the difference in their degree of happiness usually isn’t that large.
We also know that happiness tends to result from experiences and friends rather than a big house or a nice car. Thus, a smart strategy, if you want to lead a happy life, might be to focus less on accumulating stuff, and more on creating experiences with friends. The problem with that idea, however, is that work takes up so much time every week, getting in the way of vacationing and playing with friends. Darn.
One possible answer
One solution to this conundrum is, instead of focusing on building wealth, focus on becoming financially independent. One the surface, these two things seem similar, but they really aren’t.
Having wealth means you have a lot of money relative to other people. Financial independence means that you can live the lifestyle you want without working.
This distinction has some interesting implications. If you’re wealthy, but spend a huge amount every year, you might not actually be financially independent. In contrast, if you have modest savings, but don’t spend much at all, you might be financially independent. Thus, for financial independence, spending matters as much as savings.
This has some interesting implications when you combine it with the observations that happiness is derived from experiences and work is getting in the way of having those experiences. It means that many people may increase their happiness by cutting expenses and increasing savings to reach financial independence early, so as to have time to collect experiences.
Financial independence through extreme savings
In another blog, I discussed the idea of “safe withdrawal rates”, the amount of money you have in order to be financially independent today. Research says that, if you can survive on about 4% of your savings, you are financially independent—you can retire today, and your savings will almost certainly last you the rest of your life (even taking into account inflation). Personally, I prefer a number between 2.5%-3.5% just to be conservative, but 4% is what the experts say.
This leads to some interesting savings math. Like, let’s assume you start with nothing, but you’re going to invest part of your salary at a return of 10%. How many years do you have to work before you are financially independent, assuming a 3.5% safe withdrawal rate?
The answer depends only on how much of your salary you are saving. If you do the traditional 10% rate that I mentioned in my previous blog, it’ll take you 34 years. But if you double your savings rate to 20%, it’ll take you only 26 years.
But suppose you get extreme with your savings. Then you can become financially independent really quickly. In my last blog, I talked about how, in university, I was spending about $9,000 a year, but then I got a job where I was making $57,000 a year, or about $47,000 after tax. Suppose I had kept up the same expenses I had in university, and saved the rest, about 80% of my income. My time to financial independence? Roughly six years.
Time until financial independence
The key is that when you increase your savings rate, you aren’t only increasing the amount you’re investing. You’re also decreasing your spending rate, which means your nest egg doesn’t needed to be nearly as large for you to be financially independent.
In other words, if I were saving 80% of my $57,000 salary, I would only need an income of $9,000 a year to be financially independent. At a 3.5% safe withdrawal rate, I’d only need $257K in assets to generate that income. If I were saving 10%, that would mean I was spending about $50,000. I’d need $1.4M in assets to generate that $50,000 income.
With these assumptions, you can create a pretty table that shows how many years you have to work before you reach financial independence at different savings rates, assuming a 3.5% safe withdrawal rate.
|
Savings Rate |
7% Rate of Return | 10% Rate of Return |
|
10% |
43 years |
34 years |
|
20% |
32 years | 26 years |
|
30% |
25 years | 21 years |
|
40% |
20 years | 17 years |
| 50% | 16 years |
14 years |
| 60% | 12 years |
11 years |
| 70% | 9 years |
8 years |
| 80% | 6 years |
6 years |
The bottom line
This approach certainly isn’t for everyone, but, if you value your time far more than you’d value a nice car or a huge house, then it might be a good option for you. If the happiness studies are correct, I suspect most people could live a happier life by taking this sort of approach instead of working for long hours for years in order to maximize their ability to spend.
Deconstruction 