This year, I learned a lot about money. I think the biggest breakthrough I had in 2013 was to connect the ideas of personal and financial freedom. I spent a week in Ecuador talking with folks about this subject, and then I spent a couple of months putting my thoughts onto paper. I've done a lot of writing and thinking and speaking on this topic.
But you know what? I've come to realize that the essentials of financial independence can be boiled down to just a single page.
What is financial freedom?
Financial Independence occurs when you've saved enough to support you for the rest of your life without needing to work for money. You might choose to work for other purposes — such as passion and purpose — but you no longer need an income to meet your expenses.
To achieve Financial Independence as quickly as possible, follow the basic rule of personal finance: To build wealth, you must spend less than you earn. But instead of heeding the standard advice to save 10 percent or 20 percent of your income, practice extreme saving. Your goal should be to save at least 50 percent of your income — and 70 percent is better.
How to achieve financial freedom
To do this, conduct a three-pronged attack.
To begin, minimize your spending. Because a handful of expenses consume most of your budget, pursue these first (and with the greatest vigor).
- Choose a home in an area with a low cost of living. Reject the advice to “buy as much home as you can afford.” Buy as little as you need. Take out a small mortgage at a low interest rate. Repay it as quickly as possible. Don't be afraid to rent.
- Reduce your use of motor vehicles. Walk, bike, or take the bus.
- Prefer used instead of new.
- If you can, do home projects or grow food yourself.
- Self-insure whenever possible.
- Spend purposefully.
- Avoid debt.
Next, maximize your income. It's great to cut expenses and develop thrifty habits, but there's only so much fat you can trim. In theory, there's no limit to how much you can earn.
Finally, funnel your savings into investment accounts. Take advantage of employer- and government-sponsored plans first. Then put your money into regular investment accounts. Don't get fancy. Invest your money into low-cost diversified mutual funds. Ideally, choose a total-market index fund. Ignore financial news. Ignore the fluctuations of the market. Ignore everyone. Keep investing in good times and bad.
If you follow these three steps, you will become rich.
Staying financially independent
As you work and earn and save, keep score. Track your spending. Each January, conduct a review. How much did you spend during the previous year? How much are your investments worth? Have you saved enough to retire?
To determine whether you can retire, use the following assumptions:
- You'll spend as much in the future as you do now. (In reality, most people spend less. But go with this.)
- You can safely withdraw about 4 percent of your savings each year and your portfolio will maintain its value against inflation. During market downturns, you may have to withdraw as little as 3 percent. During flush times, you might allow yourself 5 percent. But 4 percent is generally safe.
Based on these assumptions, there's a quick way to check whether retirement is within reach.
Multiply your current expenses by 25. If the product is greater than your savings, you still have work to do. If the result is less than your savings, you've achieved Financial Independence. (If you're conservative and/or have low risk tolerance, multiply your expenses by 33 before comparing the product to your savings.)
That's it. That's all you need to know. That's the sum total of everything I've learned about early retirement over the past decade.