Consider the following statements from the famous Atlantic article, The Secret Shame of Middle-Class Americans:
- Nearly half of Americans would have trouble finding $400 to pay for an emergency
- 47 percent of respondents said that either they would cover the expense by borrowing or selling something, or they would not be able to come up with the $400 at all
Or these statements from the opening lines of the Netflix original Ozark:
- Half of all American adults have more credit card debt than savings
- 25% of all American adults have no-savings at all
- Only 15% of the population is on track to fund even one year of retirement
Both these scenarios are remarkably bleak. The middle-class is evaporating, pushing people into the lower class.
What if there was an alternate reality? What if you could build a life based on patience, frugality, and sacrifice? That is the life we at Frugal Hackers HQ have chosen for ourselves. Ultimately, money is not peace of mind, money is not happiness, money is at its essence a measure of a man's (or woman's) choices.
When I used to learn Karate as a kid, I thought reaching black belt was the goal. I plowed my way through the various color belts, starting with white, then yellow, green, blue, purple, brown 4, brown 3, brown 2, brown 1. When I got really close to getting my black belt after 10 arduous, aching years, I painfully realized that black belt was merely the beginning of Karate. What I had done so far for the last 10 years was merely initiation to be accepted as a student of my Karate Dojo. There were 10 more black belts (dans in Japanese) to go through before I could become a grandmaster. Most people rarely get there.
Financial independence is just like that. People struggle just to get to black belt, but that's because they don't know that a black belt is just the beginning. Reaching financial independence is a prerequisite. It's isn't the final goal, although most people work so hard their entire lives just trying to get there. Once you become financially independent, you can finally live life the way you want to live it, rather than the way you have to live it. You then spend the rest of your live pursuing Black 2, Black 3, Black 4 and try to get as close as possible to Black 10.
What exactly is financial independence?
Financial independence is the precise state in your financial life when your total passive income equals or exceeds your annual expenses for the year.
What is passive income?
Passive income is money attained through passive sources, without you having to actually work for that money actively. Perhaps you might have to do some upfront work to setup your passive income source, but after a while, it shouldn't require any additional work beyond very basic housekeeping and management. This is in contrast to job income, which is very active income: you need to show up to work everyday and perform work for your employer in order to get paid.
Popular examples of passive income include: stock market appreciation (assume 4-5% after-inflation returns in the US), dividends (assume 2-3% pre-inflation returns in the US), blog income, rental income from vacation and rental homes using AirBnB and such, and affiliate marketing of credit cards, hosting companies (e.g. BlueHost), linking to Amazon products, etc.
What's the problem with today's retirement model?
Many people think financial independence is only for the rich. That's not true. Even ordinary high-school teachers can become financially independent in just 13 years if they live ordinary, frugal lives, spend below their means, and invest the rest of their money in the stock market via unexciting index funds.
What do most people do after having worked for 40-45 years? They retire. People can retire if they have enough money saved up such that their retirement fund plus its annual growth covers for all expenses in retirement. Most people do not have enough money saved up by then, so their retirement fund will gradually drop in value once they retire, until one day it hits $0 if you're lucky enough to live longer than what your original retirement fund provided for. With continuing scientific advancements, people are only living longer as time progresses.
What are the 2 biggest issues with living your life under this model?
- It seems like the whole point of working for most people, often for 40-45 years, is to simply retire. When you retire at 65, your health and physical fitness are usually past their prime years and so, you choose to live a normal, boring life after retirement. What if you could retire at 35 instead? What would you do with those extra 30 years of freedom?
- If you don't have enough money saved up, the retirement fund doesn't extend indefinitely, perhaps only for 10-15 years after retirement. If you happen to live longer, you might be in a pickle.
Flash news: Human beings were not meant to work their entire lives! We've just historically done that so we can stretch out the arduous task of building out our retirement fund for as long as humanely possible. Also, the longer people are willing to work, the less employers have to pay their employees per hour.
If you don't work towards financial independence every day of your life, you're going to have a bleak future, much like 25-50% of all Americans in this country. You may not be able to retire at all. Imagine working at a job when you're 75!! Could you even get a job?
How do I achieve financial independence quickly?
Here's a better model that we at Frugal Hackers HQ are planning to follow:
- Work for the employer that provides the highest cost-of-living adjusted income. This may require moving cities. For us, this was San Francisco.
- Live frugally while working for 10 years so we end up saving most of our income, often as much as 70% of our after-tax net income.
- Retire at 33 and 30 respectively, after just ~10 years of working. By this time, we should've amassed 25-27 times our annual expenses in net worth.
- Move to a cheaper cost of living area (that's Vancouver for us) as soon as we retire so we can make our retirement fund last longer, or allow us to retire earlier.
- Make our retirement fund extend indefinitely. This is possible if the growth and dividends inside the retirement fund (i.e. passive income) equals or exceeds your annual expenses. By definition, this mean you are financially independent and do not need to actively work for money anymore, forever. This is possible if you withdraw only 4% (or less) of your retirement fund every year.
This is our ultimate formula for achieving financial independence early.
What's the catch?
Of course, not everything with early retirement is going to be so cozy. This great post outlines some of the risks/perils of early retirement in much detail. However, if you're anything like us, you should be caring more about financial independence, rather than early retirement. Financial independence allows you to retire early, but retiring early isn't a must. Once you reach financial independence, early retirement should only be pursued if nothing else in your life pans out, you get sick or handicapped, or you just want to volunteer your time for the rest of your life, and that is where you see the best use for your time.
However for us, financial independence means a few basic things (no early retirement unfortunately):
- The ability to sleep tight at night knowing your financial situation is fairly secure and does not rely on a single job that could vaporize anytime. This provides us with happiness, and more importantly, peace of mind. We can both rest easy knowing that even without any investment returns on your portfolio, a 4% withdrawal will last you 25 years. Your diversified index portfolio also invests in thousands of companies across the globe, so you are not tied to any one single company, CEO, industry, country, natural resource, or geography: problems that make your single job as your main source of income extremely risky.
- The ability to take insane risks with your time. You can now pursue passion projects that have way too much of an initial outlay of time before you see any returns, possibly even years.
You have a ton of free time to actually sit down, read, meditate, and live life properly, the way you've always imagined to live it, without having to worry about getting to a job on time, answering your manager's questions everyday, or attending meetings you don't care about.
Why is financial independence not optional?
In our opinion, financial independence is just the beginning of life. It's merely table stakes to play the real game. There's the "fake" life where you work and go to a job only to collect your savings. This provides a lot of value, but its value starts depreciating rapidly after 10-12 years. It teaches you how the world works, it helps you build your savings and your portfolio of assets, it gives you some real life experiences, and it provides you with evening + weekend time to read up on how you want to live your life, interact with family, friends, etc.
But then there's the "real" life once you hit financial independence (FI) which is when things get majorly exciting and rewarding. Unfortunately, most people rarely get to play this game. They never arrive at this point, or they play the first game for so long that they're tired and old by the time they reach FI. You want to plan to reach FI within 10-15 years of working, so you can have a more enjoyable and youthful 2nd Act.
For those who voluntarily choose to not play the 2nd Act, you're probably missing out on a huge part of life. If even elementary and high school teachers on $40-50k of annual income can experience the 2nd Act within just 15 years of working, so can almost everyone else.
The exciting part of life where you no longer have to worry about making money only begins when you become financially independent. It's like getting your first black belt. The journey to becoming financial independent is merely a prerequisite to start living your life enjoyably. Even if you enjoy your job thoroughly today, it's important to prioritize becoming financially independent. This is because the job you love today may not exist tomorrow. More importantly, you may very well stop enjoying that same job within the next 10 years. Because boredom can strike at any time for any person.During your early working years, you should be focusing on saving money, so you can get to financial independence as quickly as possible. Ideally you'd get there by the time you reach 40. But if not, you should definitely get there by 50. Remember, financial independence isn't optional, it's a prerequisite if you want to see the other side of life beyond a 9-5 job. The sooner you get there, the longer you can enjoy life without worrying about money or a job.
Once you're financial independent (FI), you don't have to quit your job right away. You can still continue working if you choose. Reaching FI is merely a state in your life; whether you choose to capitalize on it or not is entirely up to you. But if things change in your life or go south, at least you're heavily insulated and protected, and your life wouldn't have to change one bit.