How to become financially independent

Reading time: 14-19 minutes (3.661 words)

If you are reading this you are probably not financially independent. You are stuck in the so called "rat race": 

1. Working for someone else and get income.
2. Spend this income on things you don’t need.
3. Work harder, more income, spend more.
4. Repeat till you retire and totally depend on the government and pension funds.

You're not the only one. In fact, almost all people are running (working) harder and harder to keep up with their spending. After all, we live in a consumer society. We always want to live in a bigger house, drive a more luxurious car and we spend way too much money on stuff we don't actually need.

Becoming financially independent is easier than you think. You don't have to make a lot of money, anyone can become financially independent. Becoming financially independent is a recipe and when you apply a recipe you know what the end result will be. There are only two reasons why you would not become financially independent:

Are you curious what this recipe consists of and how to apply this recipe in real life? 

How do all the people you know live their lives? About 99% of all people work for someone else. When you work for someone else, becoming financially independent depends on only one factor:

The higher percentage you can (and want to) invest per month, the sooner you can become financially independent. It doesn't really matter how much money you earn. Earning more money does not mean you can save and invest more. Simply because most people live by what they earn. It all depends on what you do with the money you earn. Are you spending your money on things you don’t actually need or do you let the saved money work for you? 

Let the saved money work for you

To become financially independent you need to earn money without working for it. You are going to make the money work for you. Think of it as a machine. You put $100 in the machine and after one year you get $107 back. To receive $7 in return you don't have to do anything. We call the machine an investment and the $7 is the return of investment. In this case, the return on investment is 7% ($100 * 7% = $7).

It is important to leave $107 in the machine. The result after the second year is not $114 (2*107$) but $114.49 (7% from $100 + 7% from $107).  In this case you made $7 in the first year. The next year, you'll earn 7% over the $7 interest you made the first year + initial balance. When you earn interest and leave it in the machine, you'll receive interest over that interest the next year. We call this compound interest.

When you leave your initial investment+interest in the machine it will make more money over time. We call this the compounded return.

In this case, the compounded interest was 49 cents after the second year. You made 7% over $7 = $0.49. $0.49 does not seem much, but this principle is your path to financial independence. The longer we leave the money in the machine, the higher the compounded returns become:

After 30 years, the $100 you deposited in the machine has become $761.23 without doing anything. This can be broken down into

As you can see, the effect of compounded return rapidly increases as the years go by. Not only that, the compound return grows exponentially. This is just the result if you throw $100 into the machine once! Imagine if you put $100 into the machine every month… in that case you would have $114,114.17 at the end of year thirty.

Why should you use 7% interest in your calculations?

In the example above, our machine used a 7% annual return (also known as gain). That is because the inflation adjusted return of the stock market over the last twenty years (2002 - 2021) is about 7%. The last thirty years (1992 - 2021) the average return was 8% and the last five years (2017-2021) a whopping 15%.

These numbers are no secret and everybody can use this machine to generate more money using compound interest. One key part the machine relies on is inflation. 

Right now (july 2022), inflation went over 9%. So even if our machine produces 7% gains, you still lose 2%. Development of inflation rates for consumer goods in the United States in the last few decades:

Source: worlddata.info

As you can see, inflation in 2022 is the highest in the last forty years. But we’re only half way (july 2022) and inflation might drop near the end of the year. Nothing to worry about yet but just to remind you that any investment returns should always be inflation adjusted. 

Inflation can create a mindfuck. For example, when you work for someone else you get a paycheck each month. One time a year you get a pay raise of about 1% or 2% (sometimes more). But if inflation in that year went up to 2,5% your money was actually devalued by 0,5% - 1,5%. In other words, you get more money in your bank account versus last year but you can buy less products and services with it! Your paycheck is certainly not inflation adjusted each year. And the raise you get has nothing to do with inflation rates. But keep in mind that your annual increase in wage can also be higher than the inflation rate.

You simply can’t assume that you make more money when you get a small pay raise. You always have to deduct the current inflation rates and then you can calculate your real gains or losses. This is important to understand because every investing related product must always be adjusted for inflation. Otherwise you’ll calculate yourself rich while in reality you’re losing money.

How does this principle work in practice?

In order to become financially independent, we are going to deposit money in the machine. The goal is that the automatic income from the machine will eventually exceed your monthly expenses.

How is this possible while both earn the exact same amount of money?

Pete buys a big house and a luxury car based on his income of $30,000 and has nothing left over. Karen buys a smaller house and chooses to live close to work so he can use a bike. This way Karen saves $15,000 a year (lower mortgage, no car/gasoline and only buys what she needs). Pete is spending all his money, he lives by what he earns. Karen lives below her means.

After twenty years, both Karen and Pete still earn $30,000. What is the balance? Pete still lives in a big house. In addition, Pete has to buy a new car every few years. Karen - compared to Pete - has been able to save $15,000 each year and has saved $300,000 in the past twenty years. 

Karen has not only saved $300,000, she also put this money into the machine from the beginning (invested in shares with an average 7% return). The $300,000 has now become almost $450,000 due to compound interest and is growing faster and faster. Karen could stop working after seventeen years (at age 42), while Pete still has to work for his money to pay all the expenses.

Karen can stop working many years before she reaches her retirement age because her automatic income from the machine eventually exceeds her monthly expenses. Pete will be behind for the rest of his life because he lives (spends) based on what he earns. But Karen can’t just take any amount of money out of her investments. Otherwise she would not be able to pay her monthly expenses anymore. There is a specific amount of money she can safely withdraw from her investment which is called the withdrawal ratio.

What is a safe withdrawal ratio?

There are two variables at play:

You can't just run a calculation on this. You don't know what will happen in the future. Maybe money won't exist in thirty years or everything will become ten times more expensive. Those are pretty realistic thoughts right now in 2022. Inflation reached all time highs of almost 10%. Governments all around the world are working on digital forms of the dollar, euro and other currencies. This might change how money is handled forever. And you should not take this lightly. With a digital currency they can control everything. They can decide what you can buy with that money or travel to with a single automated system. Maybe the dollar and euro we know today won’t exist anymore in just ten years from now.

Anyway, although it is never certain what will happen in the future, you can study the past. There is a study that looked at investments over a larger amount of time (30 years) and looked at how much % of the portfolio you can safely withdraw without jeopardising your investment. In other words, how much % of your investment can be safely withdrawn (to pay for your monthly expenses) without running out of money. This study is called the Trinity Study.

Thepoorswiss looked at the Trinity Study results and updated it with all data up to 2021. I would recommend reading the entire study yourself. The bottom line is:

The safe withdrawal ratio is 3,5% - 4%. 

What exactly does this mean? It means that you can safely withdraw 3,5% of your investment without depleting your investment for many decades. In addition, the Trinity Study assumes, among other things, that you:

The consumer price index measures changes in price through a predefined list of consumer products and services. While you may initially compare this to inflation, the CPI is not quite the same. The CPI is an index, a number used to measure change. Inflation causes the CPI to grow and deflation causes it to fall. To calculate inflation, you need the dates of the beginning and ending points of the CPI. For example, the CPI for the U.S. in July 2000 = 178.8 and the CPI in July 2008 is 219.964. The formula for calculating inflation is:

The original Trinity Study assumes a 4% withdrawal in the first year and subsequent years increased by the CPI. So the withdrawal rate is already adjusted for inflation gains.

The Trinity Study also assumes that you earn nothing extra at all in addition to your assets. This is of course to your advantage because in practice you will always get money from something. If it's not from working (pay raises over the years), you still get a little pension. These things reinforce the results of this study. Of course, there are some question marks that we don't have an immediate answer to. 

Crunching the numbers, a 4% withdrawal ratio means you need 25x your annual expenses to become financially independent. Suppose you spend $1,250 per month (just like Karen) on all expenses:

4% of $375,000 = $15,000. This is exactly the amount Karen spends on fixed costs per year (12 * $1,250). Although the poor Swiss did some calculation and a withdrawal rate of 3,5% seems best. Also, a portfolio with 100% stocks performs best in terms of returns but also has the highest amount of risk. If you increase withdrawal rates above 3,5% there is a chance that you’ll not be able to sustain the withdrawal rates. So it would be best to:

The average return (investing in the U.S. stockmarket) in the last twenty years (2001-2021) is about 7% adjusted for inflation. The last five years the returns were much higher (15%). But you have to take into account that markets can also drop for longer periods of time. There are some other things you should be aware of:

For example, you can save a lot of money buying low quality foods. But this will affect your health sooner or later. Depending on your current job you might have a higher risk for injury so you need good insurance. 

When does the automatic income from the machine exceed your expenses?

The breaking point (the point when her investment yields more than her expenses of $15,000 per year) is about seventeen years. Within seventeen years, Karen will earn more money from her investment than she has to pay for monthly expenses.

The most important part of this story is that it’s not about the amount of money you earn, it’s about what percentage of your income you can save and invest. If Karen earns $10,000 per year and can save $5,000 (50%) she will still be financially independent within seventeen years. If she saves more than 50% she can even stop working sooner. 

Becoming financially independent is not dependent on how much you earn but how much percent of your income you can save and invest.

But be aware that with a higher saving rate your risk also increases. That’s because markets don’t only go up. They do go up in the long term, but there are always bear markets that might last for several years. If you invest 75% of your income you can become financially independent in just seven years. If you started investing in 2010 you would be financial independent in 2017. But that is because from 2010 - 2017 we had a bull market.

If you start investing in a bear market, it might take a few years longer to reach your goal.

Because we live in a consumer society there are not many people who can save and invest 50% of their income each month. Maybe 10% is already hard for you. And even if you can save and invest 50% of your income it still takes a whopping seventeen years to get there no matter how much money you earn. 

This might seem like a very daunting task. You need to have a very long breath to take advantage of compound interest this way. 

Is there a way to have the best of both worlds?

Besides saving 50%, which already is a huge amount for most people, you also have to give up your dreams. 

You can’t buy that dream car if you need to save 50% of your income each month. Unless your dream car costs you about $2,000. Can you pay for a big house, luxury car, multiple luxury vacations every year and save 50% of your income each month? Probably not.

Can you become financially independent and also buy whatever you want? Yes you can. But that does not involve saving and investing X percent of your income in index funds. 

This goal can only be reached when you start a business. A business can potentially not only have hundreds of times more income versus a regular job, it also has the leverage of time. Because a business can eventually run without you. That’s especially true for the most common businesses today: internet businesses.

The potential earnings from a business outperforms any day job. A website that is online 24/7 can earn money 24/7. While with a regular job you only get paid for exchanging your free time. And your free time is very limited. You can’t work 24/7. We’ll dive into the details in later chapters. 

In that case, the business becomes the machine. You build the machine by investing your free time instead of using money. Starting an internet business costs almost nothing. You only need to pay a few dollars each month for hosting and that’s it.

This machine does not rely on average gains. This machine relies on your marketing and product or service building skills. This machine can potentially earn you multiple millions within ten years. That is impossible if you use the other machine I mentioned before. 

But, you can also combine both machines when starting a business. Machine one is the business. And you use the earnings from the business to fund machine two (investing in stocks). Because the potential earnings from a business can grow very rapidly, you can increase the monthly payments made to machines by thousands of dollars each month.

And that is how rich people get rich. They are business owners and invest all their money in expanding their business and invest in other assets like stocks or real estate. I dive into the details and show a few examples in the next chapters. I also show you what it takes to become a millionaire.

Don’t get me wrong, starting a business is not an easy task. But as you’ll learn or already have learned, nothing comes easy in life. If you want to be financially independent and buy everything you want you need a large amount of money and invest a huge amount of your free time. Just like a surgeon does not become a surgeon in a few years. They need to study and practise for many years and sometimes even decades. Although saving and investing money is not hard to do at all. What makes it hard is that you have to change your consumer mindset and give up or adjust your materialistic dreams.

By all means, not everybody can start a business. And you don’t have to if you don’t want to. But then you have to adjust your goals. What do you want in life? If you don’t mind working for someone else and you really enjoy it why should you give that up? That’s why it’s crucially important to determine your goals before you start your journey to become financially independent.. You need to develop a new mindset that you need for the next few decades. Not some temporary mindset that changes all the time. That won’t bring you anything in the long term.

Maybe you don’t know what you want right now. The next chapters can help you with that. I’ll discuss the most important asset that any human being has and how you can get more of it. I’ll discuss what it takes and how to start thinking about starting a business. At the end of this guide you’ll have a pretty good idea how becoming financially independent works in practice.

You already have two machines up and running!

The good news is, you probably already have two machines up and running. Think about what you learned for a second. Can you come up with two machines that are already generating money for you right now without working for it?

The government already knows 99% of the people can’t handle money. Most people would spend all their money and leave nothing for their old days, causing huge economic problems. There is a reason why you never learned anything in school about the information you’ve just read on this page. They don’t want you to know. Because our economy is driven by debt and spending. And in order to keep things rolling, people need to spend money not save and invest it. If everyone would save and invest their money the economy would come to an halt and will never recover. 90% of all businesses would go bankrupt. 

There are more factors to consider

All of the above is just a general guideline. If you are already fifty five years old and are stuck in the rat race, you need a different plan versus someone who just turned eighteen and has decades to invest. Also, becoming financially independent in the way I described above means you need to give up your dreams of living in a big house and drive a luxurious car. Spending money and investing money at the same time does not work. We’ll dive into the specifics in the next chapters and how to make a plan for your future.

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