Stacking Money, Part 1

Obtaining financial freedom through savings & investment

A few years before coming to Rotman, I had taken an interest in investing and wealth-building. I’d made financial freedom my life’s goal – i.e., accumulating wealth to the point where my investment income is greater than my reasonable and foreseeable expenses. Building wealth and/or attaining financial freedom are a lot simpler than most people make these things out to be. It starts with the right mindset, and ends with creating and maintaining good habits. Apologies in advance, but there will be math. Investing is a numbers game, and so a bit of math will be unavoidable. Let’s look at what it might take to become financially independent…

A Framework for Building Wealth

Looking back, this was probably something I had thought about since I was kid, when I’d kept a drawer in my room to store the weekly $10 allowance my parents would give me. Every now and then, I’d ask to come along to the bank, and I’d pull out a few hundred bucks to deposit, and mom would stare at me, surprised, and ask, “Who gave you all that money?” and I’d answer, “You did.” I’ve always been a lot better at saving money than spending it. Maybe I’m just too lazy to spend it. I’d like to share here the framework of how I’ve come to think about how personal wealth can be created. I like to view myself as being a corporation. In reality, I am not a heartless, soul-sucking corporation (I’m totally a good person, I swear), but for this exercise, I must be. Therefore, my only goal is to maximize present and future profit. I can do this through two very simple means. I can: a) Increase revenue; or b) Decrease costs   These two variables can further be broken down to their fundamental components. Personal revenue is sourced from two broad streams: a) Salary income; and b) Investment income   Whereas costs are derived from: a) “Necessary” living expenses; and b) Discretionary spending I’m no career/life coach, so I can’t speak to constraints each of us may have (such as how much time we’d like to spend with our family, rather than out there “earning revenue”). However, I will state two obvious facts from which clear conclusions can be drawn. First, the “profit” I can make is simply the difference between my revenue and my costs. There are a variety of means to increase revenue, and there are often several options available to anyone at any time. For example, we could increase revenue simply looking for another job which would require the same skills, and is just as satisfying, but pays more. For example, some companies are known to pay more than others, even within the same job category. Second, there is unlimited upside in the revenue one can earn. Conversely, there is only limited upside that can be achieved from decreasing our living expenses, and our living expenses can be decreased only to the point where we simply incur the minimum “necessary” living expenses to sustain ourselves. This probably isn’t the most entertaining lifestyle for most of us. However, it is important to note that increasing our costs when our revenue goes up – which is something many of us do when we splurge after getting a raise – is a poor recipe for building wealth. Spending more when we make more negates the effect of making more, and basically means we’re on a treadmill – running hard, but not going anywhere. Remember, our investable income (our “profit”) is the difference between revenue and costs. With this in mind, let’s look at whether financial freedom is possible, and if so, for whom, and how quickly.

Will I Be Wealthy?

I define “wealthy” broadly as the point at which your total expenses are less than your investment income after tax. That is, you could get fired from your job tomorrow, and really not be too upset about it. This question can then be broken into two parts: 1) How much do I need? 2) How fast can I accumulate that much? Is it even possible?!

How much do I need?

To answer this, I’ve built a model, and I’ve done this in real dollars. What this means is that if you retired now, this is how much in investments you would need today in order to subsist in perpetuity, given your reasonable expenses. Adjusting these numbers by what you expect inflation to be would yield the amounts needed in some future year (see note at the bottom). The reason thinking of this in real dollars is more useful is that your expenses and income will scale with inflation over time. Though you will need more money in the future, and your expenses will be higher, your income will be higher as well, and these should all increase similarly with inflation. The proportions will be roughly the same, and thus we can ignore what inflation may be in the future for the purposes of understanding. So, assuming your total costs (both “necessary” and “discretionary” spending) are $30,000 per year today, the following graph illustrates how much in investments you would need to have in order to be financially free. The x-axis is the real return you believe your portfolio will earn (the total return above inflation), the y-axis is the required value of your investment portfolio, and the three curves illustrate how this value changes with the amount the tax man might claim. The blue line shows a 20% tax rate, while the red and green lines show 35% and 50% tax rates, respectively. PerpetualPortfolio If you expect, in the long-run, that your portfolio will earn 2% real returns (roughly 4-6% including inflation), and that your tax rate will be 35%, you would thus require a portfolio of $2.3 million in order to subsist forever (i.e., the principal on your portfolio will never be drawn down). However, if you don’t plan on living forever or leaving much for your heirs (hey, no one’s judging), you can instead purchase an annuity from an institution such as your bank or an insurance company. Or you can achieve the same effect yourself by simply selling off a portion of your portfolio each year, rather than just living off of the investment income (interest/dividends) it generates. How much you have and how fast the principal is drawn down essentially dictate how long this “annuity” will last. The graph below shows the amount you would need to construct a portfolio that acts like an annuity. Each curve represents the life expectancy you project from the point at which you decide to retire. LifeAnnuity At a 2% real return, a tax rate of 35% on your investments, and total expenses the same as above ($30,000), you would need to have an investment portfolio of about $1 million if you expect to live another 30 years from the date of your retirement. The earlier you try to retire (i.e., the longer you expect to live), the more you would need at that point in time. Obviously, having more money sooner in your life is difficult. However, remember that if you tried to buy an annuity, for example, you would be charged a higher amount than you project. The institution you purchase the annuity from is inevitably trying to remain profitable, and is also assuming the risk that you continue living for a much longer time than they expect. Not to mention, they invest the sum you have given them, and these investments inherently carry their own risks. So, in order to be truly financially free, you would need an investment portfolio of perhaps $2.3 million. If you were to cheat a bit, and draw down some of the principal value of the portfolio (instead of just living off the income), or buy an annuity, you would need something around $1 million. This sounds like a lot, so is it even possible to retire comfortably? Part 2 of this topic will address our second question: whether or not it is even possible for everyone to become financially independent, and if so, how fast. Note: to compute the value of the portfolio you would need in the future, simply adjust the portfolio values above to their future value according to the formula: FV = PV * (1 + i)^n Where FV is the future dollar amount needed, PV is the value of the portfolio in today’s dollars (charted above), n is the number of years between now and when you want to be financially free, and i is your expectation of future inflation (say, 2-4%).

 

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