“If you don’t find a way to make money while you sleep, you will work until you die.” – Warren Buffet

I’ve talked a lot about being a millionaire.  And achieving that threshold is great, if you are able get there.  But in many ways it is a pretty arbitrary number.  For some, having a million or more can be more than enough money to live on for the rest of their lives.  For others, it can be a pretty insignificant amount.

The better metric is what I like to call the Magic Number.  That is how much a person needs to accumulate before they no longer need earned income.  Having this amount of money allows a person to simply harvest the interest, dividends or capital gains produced by their investments to cover their living expenses for the remainder of her or her life.  So achieving that number, in my humble opinion, is the holy grail.  The promised land.  Financial Independence.  Much more meaningful than simply striving to be a millionaire. 

But how do you calculate that number?  Do you need to hire a fancy (expensive) financial planner to figure it out?  Actually it is pretty straightforward.  The rule of thumb that most in the FIRE (Financial Independence, Retire Early) community use is called the 4% rule.  The 4% rule is based on a study done by 3 professors at the Trinity University in the 1990’s to determine what the safe rate of withdrawal is that a retiree can take from their portfolio so that he or she would not exhaust their portfolio for at least 30 years. 

Using this rule, you can calculate how much you must have in your portfolio such you will be able to withdrawal 4% of the portfolio’s starting balance, and increase that amount by inflation each year thereafter.  In doing so, with 95% certainty, the trinity study concludes that your portfolio will last at least 30 years.  The study assumes a certain mix of stocks and bonds (and in a future post we will discuss the right type and mix of investments you should have). 

Interestingly, if you go to a financial planner or use one of the retirement tools online, they might use a similar calculation.  But their calculation would solve for an amount of money that covers your current earned income.  This logic relies on the ignorant assumption that you spend very close to everything you earn. 

Now if you are the average American that has not adopted the principals advocated by the Average Joe Millionaire, you very well may spend close to everything you make.  But for those enlightened folks that control their spending and make sure they have a juicy margin between their earned income and their expenses, they should apply the 4% rule to their living expenses.

So let’s consider an example.  Say a young man named Bob makes $70k per year, and has annual living expenses of about $37k.  To figure out Bob’s magic number, all we need to do is take Bob’s expenses of $37k and divide it by 4% (0.04).  That equals $925k.  So once Bob accumulates $925k, he becomes financially independent.  He can quit his job, and let his money do all the work.

This math works because each year that $925k, plus the interest, dividends or capital gains it produces is enough to cover Bob’s $37k of expenses, plus slightly more.  The little extra will help Bob’s portfolio to keep up with inflation, which is that slow increase in the prices of everything we buy that erodes our purchasing power over time.  Now the analysis does not assume that your portfolio increases steadily overtime.  We know that the market goes both up and down.  But the 4% rule takes that volatility into account based on actual market results over a 70 year period.

Pretty awesome, huh?  Just for fun, let’s analyze this example a little more closely to see how realistic it is that someone like Bob making $70k can become financially independent (and darn close to a millionaire in this example).  And if it is possible….., how long would it take?

Assuming that Bob keeps his $70k per year job, and gets only 2% rate-of-inflation raises each year, and that his expenses increase at that same rate of 2%, then it would take Bob less than 23 years to become financially free.  By the end of his 23^rd year earning and savings, Bob would have $950k.

But that simple calculation does not even consider that Bob is investing all his savings.  If Bob dutifully invests all his savings each and every year, and those savings earn even an 8% rate of return, it knocks Bob’s number of years to get to his magic number to only 15 years!  Congratulations Bob!  Get your middle finger ready for your boss, because you don’t need to put up his/her shit anymore.  Bob can now sit on a beach and sip pina coladas for the rest of his days.

So hopefully you can see the power of getting to the magic number.  Reaching this level of financial independence opens up a life of freedom and opportunities.

So where should most people start who want to make this journey?  Well, as I mentioned in my most recent post, measuring your situation is a great place to start.  You need to know where you are before you can get where you want to be.  So calculate your own personal balance sheet as soon as possible.

The other critical piece of information is your expenses.  This can be more challenging to calculate, but still very do-able.  What I do is start with my bank account balance and a starting date.  Let’s use January 1 of any given year.  Then I track where every dollar goes over the course of whatever period I am looking at.  Certainly a year is a good period to calculate, though that can be a lot of activity to track.  I tend to calculate my expenses every quarter.  There are several good tools available such as an app called mint, or you can even find software to help you.  But the point is that you want to understand where each dollar goes or comes from your bank account during the period.

Once you know how much you are spending, you can calculate your Magic number by dividing it by 4%.  Another way to think of dividing by 4% is to multiply by 25 (which gets you to the same answer).  So your magic number is really just 25 times whatever your required spending needs are.

What I like about this math is that it illustrates the power of managing your spending level.  In other words, finding a way to cut $1 from your periodic spending saves you $25 in your magic number.  Think about that for a minute.  As I have argued many times, when most people think about improving their financial situation, they primarily think about how much money they make, or how to find the best investments to put their money.  Very few focus on the most impactful, and might I add simplistic element, which is how much you spend.

Let’s take our good friend Bob from our earlier example.  He had expense of $37k and needed a $925 thousand portfolio to attain financial independence.  But what if Bob tracks his expenses and identifies that he had some unnecessary fat in his spending that he could easy trim out of $5k.  Well…. all of a sudden Bob’s magic number drops to only $800,000.  A savings of $125,000!  Or 25 times our $5 savings.  So again, it illustrates just how powerful it is to focus and minimize our spending.  Because every $1.00 of our annual living expenses we can reduce, our ticket to financial independence gets $25 cheaper.

So if you are serious about attaining your financial independence, there are 4 critical numbers you should calculate and track over time.  1) your net worth, 2) your spending rate 3) your savings rate and 4) your Magic Number.

By knowing these amounts, a whole new world opens to you.  You now have a very clear roadmap that shows you where you are (net worth), where you want to be (Magic Number), and how to get there (savings rate).  You also have visibility to the various levers you can pull to get you to your goal faster.  For example, you can:

1. Make more money (and thereby boost your savings rate). 
2. Cut your expenses and boost your savings rate. 
3. Adjust your investment rate, thereby boosting how much your portfolio (net worth) is growing by.

Improving any one of these factors decreases your time to achieve FI.

One side note here.  As I just mentioned, you have two tools available to increase your savings rate; increase your earned income and decrease your spending.  Both are very powerful.  And you should focus intently on both of them.  However, not to sound like a broken record, but I find that most people fixate on the make more money side of the equation, and put less emphasis on their spending.

Now that you know the math of calculating your magic number, you should now see the double benefit you get from cutting your spending.  As you cut your spending, your savings rate increases, so you increase the size of your investment portfolio (net worth).  Which moves you closer to your magic number.  PLUS…. every dollar you cut from your required living expenses, reduces your magic number target!  So your Magic number declines.  Therefore, you are both accelerating your climb to the magic number and decreasing it.  Which is a very powerful strategy to achieve your financial independence. For me, once I learned these concepts it was like a lightbulb went off in my head.  Hopefully the same will be true for you.  Good luck on your journey.