FI 101: A Brief Recap of Basic FI Concepts

Key Takeaways

• You achieve financial independence (FI) if your passive income from investments, including capital gains and dividends, covers all your living expenses.

• Work on the three pillars of FI to accelerate your path to FI: 1) earn more, 2) spend less, and 3) invest smartly.

• Based on more than 90 years of historical U.S. stock market data, your investments in a mutual fund (e.g., SWPPX) or exchange-traded fund (e.g., VOO or SPY) tracking the overall market are expected to grow around 8% per year.

• Once you reach FI, you can safely withdraw around 4% of your investments per year to cover your living expenses, while allowing your investments to grow even further.

• Your FI number is equal to your annual expenses divided by 0.04 (4%). For example, if you spend $50,000 per year, your FI number is $50,000 / 0.04 = $1,250,000. In other words, you should be able to cover all your expenses by withdrawing only 4% of your $1.25 million investment and never run out of money.

Baby Steps

• This is an easy one. Finish reading this post, then move on to the next one. It will only take you a few minutes.

• Estimate your annual expenses and calculate your personal FI number. This is your initial FI number. You should be able to lower your FI number over time by spending less, as discussed in later posts.

• If you start to like the idea of FI and want to learn more, read The Simple Path to Wealth by J. L. Collins and Choose FI by C. Mamula, B. Barret, and J. Mendonsa.

The Whole Story

"The American dream used to be home ownership. The new American dream is financial freedom."

Many people in the US and worldwide live paycheck to paycheck. If they earn more, they start to spend more. They take on debt to finance their lifestyle: credit card debt, student loan debt, car loan debt, and home loan debt. That's a lot of debt. They work most of their adult life paying off debt and just barely make ends meet. If they are lucky, they are able to pay off their home loan before retirement - and then they are ready to go to assisted living or a retirement home. Dang it! For most people, this is normal, unfortunately. Many people do not actively plan their finances, probably because financial literacy including inflation, compound interest, and tax laws is not taught in school.

What if I told you that there is a better path? A path where you do not have to take on debt. A path where you carefully control your expenses and create several streams of income. If you follow this path, you will soon earn more money than you spend, and you will be able to invest the difference. Soon, your investments will start to earn compound interest. If you consistently follow this path, you might be able to achieve financial independence (FI) or financial freedom sooner than you can imagine. FI is the concept of generating enough passive income to cover all living expenses.

Passive income sources include capital gain, dividends, interest, and rental income, just to name a few. You realize capital gain if you sell an investment such as stocks of US companies at a higher price than what you bought it for a long time ago. You receive dividend payments several times per year if you hold stocks or financial products known as mutual funds or exchange-traded funds (ETF). Such mutual funds and ETFs simply hold stocks of many or most publicly listed US companies in order to offer you diversity, all in a single financial instrument. If you hold cash in a bank, you earn interest (even though interest rates have been low recently). Over time, you will also earn compound interest: this happens if your interest starts to earn interest. If you buy real estate such as a multi-family home and rent it out, you earn rental income.

In order to speed up your journey to financial independence or financial freedom, you will want to 1) earn more by developing multiple streams of income, 2) spend less by controlling your expenses and avoiding debt, and 3) invest smartly in the stock market and perhaps real estate. If you consistently adhere to these principles over the years, you will most likely become a millionaire and achieve financial freedom sooner than you would ever have imagined, even if you currently have low or moderate income. This post might open your eyes and encourage you.

The U.S. stock market is likely the best tool to generate wealth and create income. Companies "go public" by offering shares of common stock to investors. Investors thus give money to the companies to fuel their growth and in return participate in the potential future growth of the companies. In addition, most companies pay dividends to stockholders - typically three times per year. If you buy common stock of a company using your own money, you can potentially lose 100% of your money if the company doesn't make it. However, there is no limit to how much you can gain. In fact, the stock price of a company can appreciate by 100%, 200%, 500%, 1,000% or more. Statistically speaking, the odds are on your side. Since nobody, and I mean nobody, can predict the future of companies, it is important to diversify your investments. That means you want to own stock of many companies, maybe 500 or more companies. Some of them will fail. Most of them will perform reasonably well. A few of them will perform spectacularly well and multiply our investment by 10X or more! Just look at the stock price chart of Tesla or Amazon. Do not try to pick the stocks which you think will perform best. Most likely, you will fail. If someone tells you they know how to pick stocks, do not trust them. Instead, buy the "whole market" buy buying a low-cost mutual fund or exchange-traded fund (ETF) which tracks a broad market index such as the S&P 500.

The S&P 500 index tracks the performance of the 500 largest companies in the U.S., i.e., the 500 companies with the highest market capitalization. You cannot directly buy the S&P 500 index, but you can buy mutual funds (e.g., SWPPX) or ETFs (e.g., SPY or VOO) which track the S&P 500 index. These funds and ETFs hold the same stocks as in the S&P 500 index, with the same weight as in the index. So, if you buy a share of VOO, you instantly become a co-owner of the 500 biggest and most powerful American companies. You will co-own Microsoft, Apple, Google, Amazon, Tesla, and many more companies. Mutual funds and ETFs tracking broad market indices can offer low management cost or low expense ratio since they are passively managed. As of 2021, typical expense ratios are 0.02% - 0.09% for these financial instruments. Fidelity even offers its ZERO Large Cap Index Fund (FNILX) at 0% expense ratio to attract new customers. Most of the time, you should avoid actively managed funds and ETFs which charge high fees of 1% or more while they most likely cannot outperform the market over extended periods of time. The beauty of passively-managed funds and ETFs which track the S&P 500 index is that they are self-cleansing. In fact, if a certain company is in the index but starts to struggle financially and loses market capitalization, it will most likely be dropped from the index before it goes bankrupt. On the other hand, spectacularly successful companies (such as Tesla in 2021) will automatically be added to the index (and thus to your mutual fund or ETF) as soon as they are among the 500 biggest companies in the US.

Now that you have some basic knowledge about stocks, stock market indices, mutual funds, and ETFs, let's have a look at the historical performance of the U.S. stock market over the last 93 years. Based on historical data from 1928 to 2020, the U.S. stock market, as measured by the S&P 500 index, can fall or rise by up to 50% per year. See bar chart below (data adopted from Macrotrends). However, for 62 out of 93 years, or 66.67% of the years, the market went up over the course of the year. For 29 out of 93 years, or 31.18% of the years, the market fell over the year. For 2 years, the market was flat. On average, the annual return of the market was 7.8%. In summary, there is a 2 out of 3 chance that the market goes up over the course of the year, at least based on 93 years of past history.

Now, let's have a look how the annualized returns of the U.S. stock market compounded over the last 93 years. The index started at 17.57 in 1928 and reached 3,756.07 at the end of 2020. This corresponds to an increase of 214X or 21,278%! This does not even include dividends. Typically, you would re-invest dividend payments into the same mutual fund or ETF to realize even more gains. Through many recessions, highlighted in gray in the graph below (from Macrotrends), the market went up by 214X over the last 93 years. Based on this, we can conclude that the market always goes up over extended periods of time. There can be bad years or bad decades. If you cannot tolerate a temporary 50% drop in the value of your investment, the stock market is not for you. Therefore, only invest the money you do not need in the next 20 or more years. You have to stay the course and hold your investment, even if you have unrealized losses of 50%. Remember that you still own the same shares of the same companies which will work hard to survive a recession. Eventually, the economy and stock market will recover and rise to new highs. If you are willing to stay invested in the U.S. stock market for 20 or more years, it is almost impossible to lose money. Maybe an alien invasion or a meteor hit will bring the U.S. economy and the stock market to a halt - but in this case, your investments will be the least of your worries. For more detailed information on the historical performance of the U.S. stock market I recommend reading The Simple Path to Wealth by JL Collins.

Now, the history of the U.S. stock market is all good and nice. But when can we start living off of our investments? A rule of thumb recommended by many retirement specialists and based on academic studies says that you can safely withdraw 4% of your investments in the U.S. stock market per year without ever running out of money. What is more, even if withdrawing 4% per year, your investment is expected to grow even further, which intuitively makes sense since the average annualized return is expected to be around 8%, or more if accounting for dividends.

To determine when you reach financial independence, first determine your annual expenses, including rent or mortgage payments, car payments, insurance, food, and entertainment. Then, take this number and divide it by 0.04 (4%), and you will get the minimum amount of investment required to enable financial independence. For example, if you spend $50,000 per year, you need to amass investments of $50,000 / 0.04 = $1,250,000 in order to be financially free. In this case, your FI number is $1,250,000. If this sounds like a big number, you might be surprise by how easily and feasible it is to amass a net worth of over $1 million. Read on to learn proven strategies to earn more, save less, and invest smartly.

If you are frugal or live in an area with low cost of living, you might have annual expenses as low as $25,000. In this case, your FI number would be $650,000. If you enjoy the good life and spend $100,000 per year, you need investments totaling $2.5 million before you can consider yourself financially free.

I hope I was able to get you interested in financial independence with this post. Check out the following great books for further detailed information on FI. I really enjoyed reading The Simple Path to Wealth - it is interesting, entertaining, and easy to understand. Choose FI is a bit less entertaining but contains tons of invaluable information regarding FI.