How To Plan For Your Financial Independence

How To Plan For Your Financial Independence

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The path to Financial Independence and Early Retirement (FIRE) seems to be really simple. The steps are really easy to understand:

  1. Understand why you are seeking FIRE
  2. Determine your current financial situation
  3. Increase your income
  4. Decrease your expenses
  5. Create passive income by investing your net income (income – expenses)
  6. You will reach FIRE when your passive income is equal to or greater than your expenses

In theory, everybody should be able to understand the above steps and follow them, in order to become financially independent and retire early. But in practice, very few do.

In this blog post I will create the outline for a plan that will allow you to achieve this goal.

Work to me has become kind of a hobby. I was a part of something that gave me financial independence and the rent is paid. Now it’s just about projects that turn me on.

Matt LeBlanc

1. Understand why you are seeking FIRE

In order for you to be focused on FIRE, you need to understand what is driving you towards it. During your journey there will be several times when you’ll be thinking about giving up. That’s why you need to have a clear understanding of your expectations and your motivations behind seeking FIRE.

Important questions to ask yourself about your goal

  1. Am I interested in Financial Independence (FI) only or do I also want to Retire Early (RE)?
  2. What would I gain by reaching FI/FIRE?
  3. Is there a specific timeframe by when I want to reach FI/FIRE?
  4. What would I change in my life, after I reach FI/FIRE?

My thoughts for the above questions

  1. My goal is to have the option to stop work anytime I want. I actually love my work right now, but I can’t predict if this will be true N years in the future as well. So, I am more interested in Financial Independence (FI) than to Retire Early (RE).
  2. In order to get an idea about the power that FI has, you can read the real experiences from hundreds of people, who already had F-you Money, and were facing issues at work. There is a great (very long) forum thread at the Mr Money Mustache forum.
  3. My goal is to be FI within the next 10 years, i.e. within my late 40s.
  4. I don’t currently think that I’d change something if I reached FI. At this point, I just want to have the option to be free from work. I haven’t decided what I’d do with this option yet.
    • I enjoy reading about the experiences from other people, who already reached FIRE. The Mad Fientist has blogged about his during the 1st, 2nd and 3rd anniversary after after reaching FIRE.

2. Determine your current financial situation

During my first few years as a software engineer I thought that most important financial number to track was my income. This is the number that I used to compare different job offers, performance bonuses (which are a % of the income), etc. And this is a very simple number to track, as everybody is (or should be) aware of how much money they are earning every year.

I still remember one day, when I was creating my new 401k account at Fidelity and one of the questions that I was asked is “How much is your net worth”? I literally had to Google what the term “net worth” means. It turned out that even though I had a quite good job that provided a relatively high salary, my net worth was still quite low 🙁

Net worth is the difference between what you have (assets) minus what you owe (liabilities).

The 5 financial numbers to monitor

The journey to FIRE is all about maximizing your net worth. In addition, you also need to monitor how much your net worth changes as time passes, e.g. because your increased your assets (by earning more income) or decreased your assets (by spending money).

  1. Assets: Everything that you own, including 401k, IRA, HSA, taxable accounts, bank accounts, house, cars, etc
  2. Liabilities: Everything that you owe, including mortgage(s), car loans, student loans, any other type of loans, etc
  3. Net worth: This is equal to assets minus liabilities
  4. Income: Everything that increases your net worth, e.g. salary, pension, SSA, interest, dividends, revenues from stock sales, etc
  5. Expenses: Everything that you pay for, e.g. groceries, buying gas, mortgage payments, shopping , daycare, taxes.

Recommended tools to monitor your finances

  1. DIY using Excel or Google Sheets: This is the cheapest, but also more time consuming method
  2. Mint
  3. Personal Capital

After tracking your expenses for a few months, you’ll have a good idea where you are spending your money. Remember that you should not only tracking monthly expenses, but also the ad hoc expenses (i.e. expenses like travel that occur only once in a while) and periodic expenses that reoccur every few months (e.g. home insurance is paid once every year).

3. Increase your income

A simple Google search shows that there are lots of articles with ideas about how people can increase their income. For example, Forbes has an article titled “44 ways to make more money“. Most of the available ideas can be implemented by anyone, e.g. become a driver, clean houses, walk dogs, etc.

I believe that out of all these ideas, there are 5 main themes that have the potential to really boost the income of an engineer:

  1. Working for a company that provides high compensation for Software Engineers, such as FAANGM (Facebook, Amazon, Apple, Netflix, Google, Microsoft). I’ve written additional details in the following posts:
  2. Investing in the stock/bond markets. I’ve written additional details in the following posts:
  3. Creating your own side project. For more details, please take a look at
  4. Freelancing in websites, such as upwork.com
  5. Buying rental properties

4. Decrease your expenses

In step #2 I discussed about the importance of calculating your expenses. Now that you have a good idea about where your money is flowing, the next step is to find ways to reduce those expenses.

You can find detailed information in the following posts:

7 steps to minimize expenses

My advice is to be smart and methodical in how you prioritize your expense cutting. For example, one very popular advice is to stop paying for $5 lattes. This might or might not be good advice for you. You should do the math and determine if it makes sense.

This is my advice about how to minimize your expenses:

  1. Monitor your expenses for a few months
  2. Write all your expenses down (on a piece of paper, in Notepad, in Excel, etc). Order them from the highest total expense to the lowest expense
  3. Go down the list one by one and find ways to reduce each item as much as possible. You can brainstorm, search the internet, ask friends, etc)
  4. Create expense targets for each category, based on your findings
  5. Use these expense targets as the basis of your first budget
  6. Try to follow your budget as much as possible within the next few months
  7. Go to step #1

Each $1 saved is important

One thing that I learned from Dollars and Sense: How We Misthink Money and How to Spend Smarter by Dan Ariely is that $1 always counts as $1, even though our minds might not consider it as such. He gave the following example (paraphrased below):

Let’s say that you are buying shoes. You pick a pair that costs $60 and you are about the pay. The cashier informs you that the same pair is available in another store 5 minutes away for $40. What do you do? Most people would drive to the other store and buy the shoes there, in order to get the $20 discount.

Now, let’s say that instead of shoes you are buying furniture that costs $1060. You reach the cashier and they inform you that that the same piece of furniture is available in a store 5 minutes away for $1040. What do you do? Most people would just ignore the $20 discount and not drive to the second store.

Dan Ariely (paraphrased) – Dollars and Sense: How We Misthink Money and How to Spend Smarter

My advice is not to make the same mistake. Go through the whole list in order to minimize each expense. The reason that the list is sorted is because it is typically easier and more effective to reduce the big expenses, however remember that $1 is always $1.

Recommended tools for budgeting

There are 2 main tools that I recommend for budgets:

  1. DIY using Excel or Google Sheets: This is the cheapest, but also more time consuming method
  2. You Need a Budget (YNAB): YNAB will teach you how to prioritize and plan, so you have money for the things that are most important to you—whatever they are.

5. Create passive income by investing your net income (income – expenses)

The first time that I was introduced to the idea of Financial Independence and passive income was in 2008 when I read Rich Dad Poor Dad: What the Rich Teach Their Kids About Money That the Poor and Middle Class Do Not! by Robert Kiyoshaki. The book focused on real estate investing. I found the concept fascinating, but since I had a full-time job, it was not possible for me to spend the appropriate amount of time on buying houses, so I ignored the idea for many years. Fortunately, things changed in 2015, when I started reading about personal finance.

I have written two detailed blog post about investing:

Jim Collins (https://jlcollinsnh.com)

In 2015 I was introduced to Jim Collins’ blog and especially his Stock Series. Jim has done an amazing job in taking very complicated concepts and making them easy and fun to read. He has also written The Simple Path to Wealth: Your road map to financial independence and a rich, free life, which is a better organized version of the Stock Series blog posts.

Jim’s investment advice is very easy to follow:

  1. Buy VTSAX (Vanguard Total Stock Market Index Fund). This is a basket that holds all the stocks in the US market. Its price will fluctuate together with the US Market. However, historically the US market has been going up by 6-7% per year on average.
    • Keep putting all your money in VTSAX until you retire.
    • If VTSAX is not available (e.g. in your 401k), then you can replace it with an S&P500 index fund, such as VFIAX (Vanguard 500 Index Fund Admiral Shares)
  2. When the stock market plunges, this is a great opportunity to buy even more VTSAX, because you buy it a discount. Don’t panic and sell.
  3. If you are afraid of big market declines and want to smoothen the ride, then buy VBTLX (Vanguard Total Bond Market Index Fund) for some part of your portfolio (e.g. 10-40%). This is a basket of all the US bonds.
    • Bonds are more stable than stocks and they go up, when the stocks go down, so the total value of your portfolio does not fluctuate as much.
    • After retiring, you want to minimize the risk of losing your capital, so VBTLX should become a big part of your portfolio (e.g. 40-50%), while the remaining should still remain in VTSAX.

Bogleheads (https://bogleheads.org)

Another great resource on this topic are the Bogleheads forums. They follow the investment methodology from John Bogle, who was the creator of the first index fund. The Boglehead’s investing methodology is summarized in the following 2 books:

  1. The Bogleheads’ Guide to Investing
  2. The Bogleheads’ Guide to the Three-Fund Portfolio: How a Simple Portfolio of Three Total Market Index Funds Outperforms Most Investors with Less Risk

The Boglehead’s investing focuses on 3 index funds (2 of which are the same as Jim Collins’):

  1. VTSAX (Vanguard Total Stock Market Index Fund)
  2. VBTLX (Vanguard Total Bond Market Index Fund)
  3. VTIAX (Vanguard Total International Stock Index Fund Admiral Shares): This is a basket of the major stocks of the international (non-US) stock markets.
    • A big % of the global economy is outside the US, that’s why if you are a believer in the global economy, then you should allocate some part of your portfolio to this fund (instead of focusing only on VTSAX to cover the stock portion of your portfolio).

I will write a follow-up post to get into more details about investment strategies, however my advice is to ignore stock picking and invest only in the 3 above index funds.

6. You will reach FIRE when your passive income is equal to or greater than your expenses

Passive income is defined as the income that you earn, when you are not working, e.g. income from real estate or investments. By definition, as soon as your passive income becomes equal to your expenses, you never have to work again and you become financially independent (i.e. you reach FI).

If you are investing on real estate, then your passive income is equal to the sum of the rents that you are collecting. However, it is not so easy to give the same definition in the case of stock/bond market investing.

Most of the FIRE bloggers rely on the 4% rule, which says that “you can withdraw 4% of your portfolio each year in retirement for a comfortable life”. This means that you are financially independence, when your investments become 25x your expenses.

They attribute this rule-of-thumb to the Trinity Study, which analysed  refer to an influential 1998 paper by three professors of finance at Trinity University. It is one of a category of studies that attempt to determine “safe withdrawal rates” from retirement portfolios that contain stocks and thus grow (or shrink) irregularly over time. It states that a person has sufficient savings in assets if 4% of his/her assets are sufficient to cover a year’s expenses.

Most FIRE bloggers are ignoring 2 important factors related to the 4% rule

  1. The Trinity Study verified the 4% rule for 30-year periods. So, somebody who becomes FI at 30 years old can safely withdraw 4% of the investment porfolio until they become 60 years old. However, the life expectancy of humans are much higher and increasing.
  2. The highest amount of risk (i.e. the cases where the 4% rule does not work) is when valuations are really high, as they are now (in 2019/2020). The problem is that in those cases, there will always be a correction that will reduce valuations to the expected average (this is called “reversion to the mean”) and will decrease the investment portfolios. Maybe this is not a problem for people, who have declared FI, but it is indeed a problem for the early retirees (i.e. people, who declared FIRE).

Suggestion: Replace the “4% Rule” with the “3% Rule”

The blogger Early Retirement Now has done a lengthy series of posts called “The Safe Withdrawal Rate Series“, which talks extensively about the shortcomings of the 4% rule and why it is very risky to retire based on this rule. He evaluates different withdrawal strategies and calculates multiple rates of success based on those strategies.

After going through the whole series, I believe that the simplest change would be to switch to the “3% rule“, i.e. consider somebody to be financially independent, when the investment portfolio is 33x the expenses (as opposed to 25x, which was the result of the 4% rule). That’s the target that I am using for my own investments.

You can do your own calculations about reaching FIRE by following the instructions in my post “How to Build Your Own Retirement Calculator“.

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