Financial Independence Model


I’m interested in financial independence, as I think it is very responsible thing to do, as well as the most sustainable way to live life.  I remember first learning this from Rich Dad, Poor Dad.  A lot of people do not like that book.  I think the major reason is that the thought of passively making income is so overwhelming that one’s “fight” reaction takes over.  It’s just my guess, though.

Essentially, passive income is earnings where your efforts are not actively needed.  It is much easier to define active income: a job (where time and skill and traded for $bling).  In financial terms, passive income is generally investment capital traded for $bling.  Examples of passive income are dividends, apartment rent (if you own an apartment complex), and the part of the pyramid scheme where you profit from others’ efforts.

Passive income can also be viewed as potential.  As ERE’s post describes, the 25 and 33 scalars, applied to one’s annual budget, are commonly used for estimating this potential.

  • If you need your money to last 30 years and you invest it 100% in index funds and you withdraw your annual expenses every year, you need 25 times as much money in index funds as your annual expenses (including taxes).
  • If you need your money to last 60 years instead and follow the same procedure, you need 33 times as much money.

(If I remember correctly) this concept of potential is defined in Work Less, Live More.  The book, as well as firecalc, describe how those numbers take into account risk, so that one will be financially independent.

The time to generate these amounts are below,

http://adventuresinmissingthepoint.files.wordpress.com/2010/06/sustainable-fi-equation-1.gif?w=470

in general terms, and

http://adventuresinmissingthepoint.files.wordpress.com/2010/06/sustainable-fi-equation-2.gif?w=470

in a more applied form.

Applying the equation above in terms of the percentage of your pay that you save, you’ll come up with a pretty graph.  I have two versions, out of respect for the scale.  The first is in a scale for Joe American.  The second is for the whacky nut job ladies that plan to leave millions of dollars to their cats.

http://adventuresinmissingthepoint.files.wordpress.com/2010/06/american-sustainable-retirement1.png?w=450&h=320

http://adventuresinmissingthepoint.files.wordpress.com/2010/06/ere-sustainable-retirement1.png?w=450&h=320

It’s interesting to see that saving extremely, in terms of one’s earnings, provides a nearly inversely proportional relationship in time for retirement.  These are not revolutionary ideas.  I just like visualizing numbers.

It’s interesting to note that spending less, as opposed to making more, has a greater impact to achieving financial independence, faster.  This is logical, if you look back to the equation.  The accumulation denominator is a function of earning and spending, yet the state of the system in the numerator is a function of spending scaled by a factor of 25.

Work Less, Live More

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2 Responses so far »

  1. 1

    Rooster said,

    I generally agree; however, passive income is not always that passive. For example, the admin duties of buying/selling stock, keeping updated on stock performance, paying taxes on capital gains, etc take time and work. Upkeep of an apartment, finding new (and good) tenants, etc also take time and effort.

    There are entire companies devoted to making money “passively.” How’s it passive if you need so many people to spend time and effort doing it? Just sayin’.

  2. 2

    Pete said,

    You raise a good counterpoint. Perhaps work could be thought as % Passive, which is 1 – % Active. It depends on what you like more, labor engagement (40+ hours a week) with less anxiety and management of capital or an alternative: less labor engagement with more responsibility in managing capital.

    Corporate retirement is drastically reducing it’s efforts, % Active if you will, by moving to 401k plans and similar options for its employees, in lieu of pensions. The new option I see emerging now is retirement “insurance.” Essentially it is like a mutual fund but it will provide a cash flow for the investors, once retirement is “achieved.” Either way, I think it is beneficial to learn these skills, or at least realize you are going to pay for these types of risk services.

    Another option is living off the land or in a commune, and avoiding money altogether by using and possibly exchanging skills directly. I think these options are cool if you have a community to support you in old age or during sickness. The benefit of money is that you can trade it for support. Without money, it’s all good until it’s too late.


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