Originally published 2020, updated September 2022
In personal finance, The Good Old Days were actually The Bad Old Days.
In the Bad Old Days, before people knew about financial independence, there were financial advisers who acted as The Gatekeepers to investing.
People did not know how to invest themselves (sadly, many still don’t) and you had to speak to The Man in a suit if you wanted to invest and build wealth via the stockmarket.
The Essential Innovation of Financial Independence
The Financial Independence movement taught people that they could invest their own money (without gatekeepers) using a low cost global equities tracker fund. That was a good thing (and still is).
But the essential innovation of the Financial Independence movement was to join the dots between the amount you saved and invested (rather than spent) and the time it would take you to get to financial freedom.
At a 10% savings rate, it takes ~50 years to get to financial independence. But if you could dial up your savings rate to 50%, you could reach financial independence in ~17 years.
Here’s the graph that showed me how powerful your % savings rate is:
On the y axis we have the time until the person reaches retirement. Or more accurately financial independence, the position where work is voluntary.
On the x axis we have the % savings rate, the proportion of post tax salary that a person is able to save and invest. As we go from left to right, the savings rate goes from 5% of post-tax income (68 years to financial independence) up to 50% (where it takes 17 years to get to financial independence) and beyond.
Financial independence showed us the trade-offs that were possible. Knowledge is power and this knowledge gave us new and maybe better choices.
It also gave us the 25x rule of thumb which says that you are financially free (and work is now optional) when you have invested net worth of 25x your annual spending.
In other words, if you cut your annual spending by £1,000…either on fund management fees or on groceries or whatever… you bring the finish line for “enough” closer by £25,000. That’s quite the multiplier effect.
On it’s own, frugality won’t get you all the way to financial independence but it’s sure as hell a good place to start.
Money is The Power to Control Your Own Life
Without a freedom fund, your boss owns you. Having a six month freedom fund means being able to quit on your own schedule or at least wait for a good job to come around after you get laid off, rather than having to take the first one that comes along. That can be life changing. The bigger the freedom fund, the more time, options and runway you have.
This is not just a financial thing. But money is a big part of it. You can’t be truly fearless without some degree of financial security. Especially if you are providing for a family and people depend on you.
The importance of saving
I sometimes think that saving has a PR problem. It needs a makeover.
Saving is often seen as something that’s a bit boring. But its the foundation not just of your financial security but your freedom and life choices.
When you have a secure financial base, you can go on the offensive and take the fight to the enemy. You can afford to take more risk in 2 key areas of life:
1.Investing risk. You can afford to take more risk in terms of your allocation to risk assets such as equities, property etc. Remember: first things first…clear that expensive debt and get a cash emergency fund in place. But after that, you can afford to be braver with your money, take more equity risk and buy into the stockmarket.
2. Career risk. Saving for financial security also frees you to take more (intelligent) career risks. CEOs and investment bankers don’t have secure jobs, they have well paid jobs. People with their own small business don’t have secure jobs but, if they get it right, there is no cap on their earnings. If you are doing it right, more career risk should mean higher expected rewards.
Your % saving rate is the most important number in personal finance. It’s the most important metric for you to track.
How do you calculate your savings rate? If you move half of your salary (after tax has been deducted) to your investment account (aka your compounding machine) each month, that’s a 50% savings rate. Yes, you can make it more complicated than that (depending on how you treat pension contributions and so on) but it’s better to be roughly right than precisely wrong.
Remember that debt repayment (e.g. the capital element of mortgage payments) counts as savings. You can increase your net worth either by reducing debt or by increasing your assets. In my book, capital investments (e.g. loft conversions and extensions) in a house that you are planning to sell at some point and get a return on your investment also count as saving (rather than consumption).
Isn’t it strange how your % saving rate is far more important than your % investment returns?…and yet % returns are what people focus on and obsess about (actively encouraged by the financial services industry).
It’s really easy to get decent investment returns with a global equities tracker. I’ve always invested a big chunk of my portfolio actively but my pension savings were 100% global equities tracker funds. Why take unnecessary risks with your long term capital? Your primary focus should be on earning and saving more rather than risky or complicated investing.
I still remember the lightbulb moment when I realised that there’s no point in earning a higher income if that doesn’t lead to higher % savings rate. Your income (expressed as £/$/€) doesn’t directly affect when you can retire. Higher income just allows you to save a higher % of your income whilst still enjoying life…and that’s the key.
To show you how these numbers are built up, here’s the maths for the 50% savings rate (~17 years to financial independence). The numbers in this old example are too low but they scale: it’s the percentages that matter. A 50% savings rate means it takes 17 years to get to financial independence regardless of the actual amount you earn.
In the example above, our investor reaches financial independence in year 17 when their invested net worth exceeds 25x their annual spending and their withdrawal rate is below 4%.
This means that you can bring the finish line closer either by saving more or spending less. These two approaches work hand in hand. You are gonna need to work both sides of this equation.
If you are just starting out, don’t let the high percentage savings rates put you off. I accept that for many people these figures will not be achievable (or at least not yet and not without a crazy level of frugality). I’m sharing them because they illustrate powerful concepts.
What’s interesting about the shape of the graph is that it’s non-linear (i.e. curved) so that the time taken to get to financial independence falls rapidly as the % savings rate is increased. You get a BIG improvement (in speed to FI) when going from a savings rate of 10% to 20%.
Less so when going from 50% to 60%. If that marginal increase in savings rate makes your life miserable, then it would be a mistake for you. Everyone has to figure out their own “sweet spot”. This is a very personal consideration for everyone so I’m not saying what is right or wrong, I’m just illustrating the trade offs.
Whenever you mention 50+% savings rate, you trigger a bunch of people. But bear with me and over time you might just be amazed at what is possible for you.
2020 provided a fascinating illustration of what is possible in terms of increasing your savings rate. The total savings rate across the UK shot up from less than 5% to ~30% during lockdown as many more people discovered Monk Mode.
What seems impossible for you right now may be possible for you in a few years time. Where attention goes, energy flows. Or something like that.
What are your assumptions?
Models are simplified versions of reality that illustrate important concepts. The assumptions that sit behind these illustrations are:
- you never do any more paid work;
- you never get any state pension or other benefits;
- 5% real (excluding inflation) investment returns; and
- a safe withdrawal rate of 4%.
These calculations are all based on the idea of a safe withdrawal rate. In most scenarios in the past, this has meant that the retiree actually end up dying with a large pot: there is no de-accumulation where investment returns are 5% and you are only spending / withdrawing 4% per annum. For people who want / expect to run down their pot during retirement, these calculations may be too conservative.
This is not deprivation
When people see graphs like the one above, a common reaction is: I don’t want to give up all the fun in my life!
The implicit assumption is that everyone is spending efficiently, consciously and mindfully. That’s just not true. I could give you a million examples but here is just one. I recently bought a navy blue cap for £2.99. Price is what you pay, value is what you get. I could have spent £45 on an almost identical cap. You choose the price.
I hope you can see that buying the £2.99 version is not deprivation.
It’s the sum total of thousands of decisions like this over the years that leads to results so good that it almost seems like magic. This is The Aggregation of Marginal Gains.
Don’t get me wrong
Saving is a wonderful thing. But even the best ideas can be taken too far. It has to be sustainable and you have to enjoy the journey or else you won’t stay stick to The Path.
Plugging the leaks in your spending bucket and saving money is super-important but don’t be penny-wise, pound-foolish. The problem for extreme frugalistas is that they won’t spend any money on health, self-development or education. Example: if you are saving money by not buying books that could change your life, that’s a rookie mistake. Invest in yourself.
Not everyone can be a high earner or reach financial independence by 40 or whenever. But everyone can learn to get better with money.
Amazing things are possible over time once you get started on The Path.
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