Financial independence is when you have enough savings and investments to cover your cost of living. When you are financially independent, you no longer have to work to earn an income.
Unless you get very lucky, the road to financial independence is full of peril. Back when we had limited investment options, most people didn’t even dream of financial independence before retirement.
These days you can plan when you’d like to achieve financial independence, but it requires discipline and a firm understanding of the forces at play on your money.
Like short-term savings, you’ll need a goal amount and a deadline for long-term savings. In saving for financial independence, however, the amount you’ll need at the end is much larger than the sum of your monthly savings.
When it comes to long-term financial goals, the money you’ve set aside has to work too.
Inflation is the worst. Without inflation, setting some cash aside for a long period of time would be enough to ensure your eventual financial independence. Unfortunately we can buy less with the same amount of money over time.
If inflation is 5% over 20 years, you’ll need R265 to buy what R100 can buy you today. If you only saved R100, you’ll only be able to buy 37% of what you need. What is 37% of a bread? Not enough bread.
For that reason, the money you put towards financial independence needs to work while you work. You also need to leave enough time for compounding to work.
Financial independence is all about how money you need to get through the month. If you spend every cent of your income, that will be your base amount.
If you’re very smart (which you clearly are, because you’re reading this), you’ll keep your monthly lifestyle expenses as low as possible so you don’t have to work as hard to achieve financial independence.
There are a number of different theories about how much you’ll need to be financially independent. The 4% rule is generally a good starting point.
The theory is if you have enough money saved that 4% of your savings covers your expenses every year, you have enough money to support yourself for the rest of your life. Much has been written about this and we discuss it in this podcast.
The easiest way to work out how much you need to be financially independent is to multiply your monthly expenses by 300. Make sure you’re sitting down when you do this.
The amount will be huge. This amount is a rule of thumb and a starting point. You might want to consult an advisor to help you work out your future needs.
This amount might scare you, but before you resign yourself to working until you drop dead, take heart! With the right investment strategy, you don’t need to work for every cent.
Since you need more money than you can put away, you need to find a way for your money to work.
This is where your financial life can get complicated very quickly. You already understand the difference between saving and investing. That’s a really good start, but it doesn’t help you much if you don’t know where to invest your money.
As we’ve discussed before, the answer to that question depends very much on when you need the money. The more time you have, the harder your money can work. If you have more time, you can afford to take more chances by investing in assets that carry more risk.
Where should I put my money?
For most of us, a retirement annuity or similar product is a great place to start. Government encourages us to use these vehicles by providing tax incentives and regulating how this money is to be invested.
We can’t access the money we put in these products until we reach retirement age, protecting it from our bad spending habits and giving it time to work.
However, if you want to retire before you reach retirement age, you need to put the money in the market.
We explain what that means here. An online advice service or a financial advisor would also be able to help you decide the best course of action for your investment.
A combination of traditional retirement savings, tax-free investments and discretionary investments will likely help you get to where you need to be.
Next week we’ll discuss the four obstacles that could prevent you from reaching financial independence.
There are four obstacles to reaching financial independence.
- You don’t have enough time.
- Your monthly cost of living is too high.
- You don’t save enough.
- The money you invested isn’t growing enough.