What is Financial Independence

In my previous post I described why I think Life is backwards and how I first came to think about this topic. With time I discovered all this has a name. So what is Financial Independence?

Financial Independence is the concept of having enough passive income to sustain your standard of living, indefinitely.

The topic can then further be broken down in two large subjects: Passive Income & Standard of Living. In future posts we will be able to discuss those in all the detail they deserve, but for now let’s stick to the basics!

The basics

Let’s suppose your household’s (even if it’s just yourself) yearly expenses are 20.000€. If you can earn 20.000€ in passive income every year, congratulations, you have achieved Financial Independence! In effect, you can then spend your time as you wish, and can focus on maximizing happiness instead of maximizing money. That can be through volunteering, travelling the world, spending more time with your kids, working on your dream job or turning your hobbies into your full time job.

There are many ways to make money passively, but the most simple one is through investing the money you already have. You are surely aware of what the stock market is, and also about real estate investments. These are probably the two most common ways of investing money and seeing a consistent return.

Investment paths

The great majority of the blogs and other resources on Financial Independence are focused on making passive income through the stock market. Investing in the stock market is much more usual in the United States than in Europe (and quite uncommon in Portugal). Those resources point to the stock market since average yearly returns have historically been around 10% gross per year. Coincidentally, a study I read last year shows real estate investments to be competitive with the stock market, on average, sometimes even better depending on factors like location. Some will say real estate investing is a lot of work and not really passive investing, and I tend to agree. In any case those debates I will leave for future posts.

So, if we take the most common path to Financial Independence, we will have to save enough to consistently make our yearly ammount. In our example this was 20.000€.

Considering we invest the money in the stock market, to be able to use the money to pay for our yearly expenses we will need to sell a certain percentage of our investment every year. This is the definition of Safe Withdrawal Rate (SWR). It has the word “safe” in the name because it needs to be small enough that the investment portfolio keeps growing on the long term, accounting for inflation and market fluctuations.

While it is not the purpose of this post, a SWR of between 3% and 4% is usually considered acceptable, based on historical returns and the often quoted Trinity Study.

For real estate investments, in Portugal it is conidered a decent return to get 5% of the value of the property yearly in rent. I believe many other countries can show similar returns. This is before taxes, maintenance and other expenses which will easily bring that number to around 3%.

An example

If you want to get a quick idea of how much you would need invested, just divide your yearly expenses by the return of your investments. As per our example, to cover a yearly spend of 20.000€, with a 4% investment return we would need:

20.000 / 0.04 = 500.000€

As you might remember if you read my previous post, this is the amount I estimated I would need even before I discovered there were other people working towards the same goal!
Now, feel free to replace the values by your own… Hopefully you will realize it is an achievable goal without having to win the Lottery!

João

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