IS FINANCIAL FREEDOM ONLY A DREAM?
Discovering Magic Points In Your Journey
Do you ever ask yourself, “Am I saving enough to retire someday?” Does it ever seem like savings and investments grow very slowly? Like watching paint dry but slower?
Recent inflation has many people wondering if they have saved enough. Gas and housing prices have skyrocketed. Wages are rising, but they don’t seem to keep up with inflation. That means my portfolio will buy less. It will take a larger nest egg to fund my desired lifestyle.
Many people feel frustrated in their early years because the nest egg grows so slowly.
One of the basic principles to attain wealth is to Invest at least 10% of your earnings. Hopefully we started this at an early age. If not, it will take a higher savings rate to catch up.
The FIRE movement encourages significantly higher savings rates to attain financial freedom sooner. That stands for Financial Independence Retire Early. It does not mean that you have to eat beans and rice and retire early. The focus is on investing as much as you can in your early years so that you attain financial independence, or FI, sooner. Attaining FI gives you more choices, whether you want to keep working or not.
I realized early that I would be working for money until my money was working harder for me than what I was working for it. It is up to each of us to learn how to get our money working harder and grow our nest eggs.
Financial Independence means having enough passive income to cover your expenses. A common goal is to have assets that total 25 times our annual expenses. This amount can provide a 4-5 percent withdrawal rate and continue to grow, maintaining buying power with normal inflation.
That sounds like a huge number, especially in our early years. It can be downright discouraging. So let’s take a look at some key milestones. I like to call them Magic Points because they give you a really good feeling that you are making progress.
KNOW YOUR NUMBER
What really matters is the amount of passive income your nest egg can produce. If you are investing only in real estate, then it can be easy to add up the cash flow from each property and compare that to your total living expenses.
During our wealth-building years we may accumulate a combination of stocks and real estate. Many people have stocks in a 401(k) or other retirement plan. It is easy to obtain the market value of a stock portfolio. But how does that translate to passive income? Someday the assets must be sold, maybe a little bit at a time, to obtain cash that covers your expenses.
As we progress along our financial journey we want to know the destination. Why did I choose 25X, or 25 times annual expenses? I’m not a financial planner, but a 10-percent return on investment will allow a 5-percent withdrawal as cash flow and continue to grow a nest egg faster than normal inflation. For example, a $500,000 portfolio should produce a cash flow of $25,000 and allow another $25,000 to remain in the portfolio to compound the growth.
Real estate can provide a stream of cash but it is more difficult to value. Sure, you can check Zillow and get an estimate with a large margin of error. One of the main reasons for buying real estate is the cash flow. Over time I would expect real estate to produce cash flow at a rate exceeding 5% of your investment. And the property will continue to grow in value, providing a hedge against inflation.
There are other tax advantages that make real estate more powerful and increase your return on investment. We’ll ignore those benefits for now. We are seeking a simple number that we can use to measure our progress as we grow our portfolios.
I like to use the 25X as described above. Knowing the assumptions made, you can make adjustments based on your expected returns and projected expenses.
Block some time in the next day or so to “know your numbers”. Becoming aware of this number will make a huge difference as you go forward from here.
MAGIC POINTS OF PROGRESS
Some people have different ideas as to what Financial Independence and Financial Freedom mean. So I offer these descriptions.
Financial Independence. This is when your passive income exceeds your current expenses and provides growth exceeding inflation. So if you were to become unable to work, possibly due to injury or medical reasons, or lose your job or your company folds due to an unforeseen event, you would have enough passive income to maintain your current standard of living.
Financial Freedom. This is attained when your passive income allows you the financial ability to do the things you want to do with and for the people you want whenever you want.
Some of you have reached FI or FF already. Others are just getting started and may want some milestones to feel like they are making progress.
MAGIC POINT 1. The first Magic Point is when the annual earnings from your portfolio exceed your contributions. The earnings can be in the form of cash flow or appreciation. You know how hard you worked to make your investments that year. Many hours. And your nest egg produced the same results for you!
Wow! That calls for a celebration. It probably took a few years to get to this point. Maybe a special dinner is in order.
If you are not here yet, what can you do to achieve this first Magic Point on your way to where you want to be?
MAGIC POINT 2. The next Magic Point is when your portfolio’s earnings exceed your fixed expenses. These are non-discretionary expenses like housing, taxes, food and insurance. If you lose your source of income you can cut vacations. You still have to have a place to live and be able to buy groceries. You could maintain this reduced lifestyle indefinitely, if necessary.
Remember, this is the earnings from your portfolio, not the size of your portfolio. This is a different concept than is often taught.
MAGIC POINT 3. Financial Independence is the third Magic Point. Your portfolio is really gaining traction. Passive Income, or the ability to generate it, exceeds your expenses and continues to grow.
This is what might be called “getting out of the rat race”, when your income from your portfolio is enough to meet your financial needs each year. What would that number be if you had achieved it already?
MAGIC POINT 4. The fourth Magic Point is when your portfolio earns more than you do working. Your working earnings may be in the form of W-2 or self-employment income. Or commissions. Your nest egg is finally working harder for you than you do for money. This calls for a really nice celebration.
Set a goal now for the date this becomes a reality for you. What will you need to do to get there?
MAGIC POINT 5. Financial Freedom is the fifth Magic Point. It occurs when your portfolio can produce enough income to cover both fixed and discretionary expenses AND continue to grow and outpace inflation. This is Financial Freedom. Your nest egg can fund your desired lifestyle without you having to work.
This can also be the most elusive point in our journey. As we grow older our dreams and ambitions change. The more we have leads to the more we want to do, both for ourselves and others. It is completely reasonable to change our target and redefine it as we get closer.
MEASURE PROGRESS REGULARLY
It can take years to get from one magic point to another. Don’t be discouraged.
The journey is like growing an oak tree. Picture live oaks with their long branches stretching out. Some of these trees are over 200 years old and have outlived many pine trees that grew up fast and blew over in a storm. A solid portfolio is like the live oaks. It grows slowly at first, maintaining the ability to stand the test of time.
My wife and I update our personal financial statement on the first of every month. We see what has gone up and what has dropped. We see the total of our income producing assets. Real estate assets don’t have to be valued every month. We typically adjust those about once a quarter in the current market.
Some people are okay with evaluating their assets on an annual basis.
Choose what is right for you and track it.
When you reach a milestone or Magic Point, be sure to take time and celebrate it.
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Mike is a retired aerospace engineer with a passion for real estate investing and teaching financial literacy. He lives with his wife in Daytona Beach, Florida.