Financial independence for the masses – Financial Shenanigans #4
Why the concept of financial independence is widely misunderstood.
Over the years, I have consistently encountered the perception that financial independence is not really possible for most people. That you need a substantial amount of capital to pull it off. That it's something you can aim for in retirement.
In my experience, that perception has many flaws. To make things worse, it prices most people out of ever achieving financial independence. Partially, it’s a financial literacy problem. At the end of the day, financial independence is highly subjective and thus achievable for many and not the few. What exactly does it mean though, and how do we measure it?
Let's talk about it. The point of any financial independence strategy or movement is to generate enough passive income to feel financially self-sufficient. Passive income is the income you don't have to work for, like dividend and interest income, or rental income, for example. That's an easy part. But what we perceive as being financially independent is not just different from person to person, it can also be different for the same person, based on their age or family situation.
To use an analogy, we can look at financial independence as an elevator ride. Each level corresponds to a certain degree of passive income. People get on and get off at different levels. Perhaps penthouse is the ultimate financial independence destination. But even the lower levels offer some degree of independence and financial safety. It is a simple equation of time and passive income. The longer you stay on the elevator, the higher you go. At the same time, the higher you go, the less time you have to enjoy the view. And that's the fundamental trade-off that very few people talk about.
So what are some of the levels on the financial independence elevator? It is common to think of passive income in terms of the percentage of your active income (salary for most people). Ideally, most of us would like to replace 100% of our active income with passive income. It would be nice to never work again and just maintain the same lifestyle. To illustrate the point, let's assume that we can generate a 5% income from our savings. And if we are trying to replace $100,000 of income, then we need $2 million in savings. That's the penthouse.
But we can think about alternative scenarios. Perhaps, not having to work again is worth a lot for me in terms of non-monetary, emotional value. And to achieve that, I might be willing to sacrifice certain aspects of my lifestyle. In that case, maybe 70% of my active income would be enough, which gets us down to $1.4 million in savings - still a little steep.
Most people I know, who have achieved some level of financial independence, continue to work. But instead of working for money, they work because they enjoy what they do. Even Marx thought that a job is a "genuine activity where man develops himself, becomes himself; work is not only a means to an end — the product — but an end in itself, the meaningful expression of human energy". Wait, so if you are going to continue to work, do you really need 70% of your active income replaced with passive one? It might take a bit of time, but eventually, your hobby will bring in some financial rewards. Then maybe we just need 50%, which still means $1 million in savings.
At this point, things become even more subjective. If you have kids or need to care for parents or grandparents, cutting down expenses might not be a smart choice. But for single folks or young couples, is $70,000 of annual income really necessary? Even in Sydney, often on the list of the most expensive places in the world, $40,000 per year could be just fine, depending on the lifestyle of course. But then again, this is part of the equation. Does your lifestyle matter more than having full control and ownership of your time and mental capacity? Highly subjective.
To take this even further, we do have control over the cost of living. This is what gets us to the lower levels of the financial independence elevator. Whether you are in the US or Europe, there are areas in each country that are more or less expensive. We can also look beyond our countries' borders. According to the World Bank, there are more than 100 developing countries in the world, where the Gross National Income (GNI) per capita is below $12,536 per year. These include countries like Chile and Colombia, Croatia and Hungary, Malaysia and Thailand, and many others that provide a comfortable standard of living.
The point of running through these different scenarios is to show that financial independence, at some level, is possible much earlier than most of us believe. The whole concept is simply the equation between the amount of passive income someone wants and time. In my opinion, achieving some level of financial independence sooner rather than later is a preferred outcome for two main reasons:
It allows more time for experimentation. Few of us really know what we want to do. Figuring it out is a trial and error process, it takes time.
It is easier to take risks, financial or otherwise, earlier in life. Specifically, because there's plenty of time to recover. As an example, losing 25% in the stock market is easier to recover from if it happens in your 30s instead of your 50s.
In the end, each one of us has different priorities. If financial independence as soon as possible is one of yours, getting there might be easier than you think.