=Intro bookend=

Hi. 

In this lesson, we will discuss some more aspects of the interaction between spending, saving and investments, and talk about financial independence. 

=Learning objectives=

After this lesson, I hope you will be able to do the following:

* Define financial independence
* Describe spending and saving ratios
* Model path to financial independence
* Distinguish between needs and wants

and finally

* Describe benefits of financial independence

=Money flows=

Remember our earlier discussion of money flows. Unless we managed to get really lucky, we all start out trading our time and skills for money, and using that money to get stuff, like food, shelter, and other niceties. 
If we spend more than we make, we borrow money, and have to give up part of our future income to other people.
If we make more than we spend, we can invest the extra money into assets, and get more income in the future from asset returns. 

This is how money flows look like for most people. Even if they manage to avoid debt and build some savings, most people continue to have to trade time and skills for money in order to provide for their basic needs. 

But what if I told you that it is possible for ordinary people to build up enough assets, that the asset returns alone are sufficient to cover your spending needs? So that trading your time for money becomes discretionary, rather than mandatory?

Blows your mind, doesn't it? 
We will call this state of things "financial independence", because you are not dependent on working for income to sustain yourself.

The good news is - we are about to model income, spending, and asset building to observe the path toward financial independence.
The bad news is that there's no magic. It takes discipline, restraint, and planning over a relatively long period of time.

=Money flows over time=

So, let's do some modeling, with the help of our old trustworthy friend, the spreadsheet. I hope by now you are appreciating the usefulness and versatility of this tool. 

We'll only need two variables here, the rate of return, and the savings rate. We'll do everything in terms of percentage of income, whatever that may be. 

This is an important point, your absolute level of income is not as important as the amount of your spending relative to your income. Someone who makes 100 thousand a year but spends 110, is going to be feeling a lot more financial stress and anxiety than someone who makes 50 thousand but spends 30. 

Let's start by creating a timeline, maybe take it out to 50 years, and hope that's sufficient.
Now, in the next column, we have our income, after tax. So we don't have to make up specific income figures, let's just do everything in relative terms. So we get 100%, or 1, of income every year. This assumes the same inflation-adjusted income throughout, which is a good conservative baseline. If it grows, so much the better.
Now, let's set up some important constants - our investment return, which we'll initially set to 5%, and our savings rate, which is the percentage of income that we save, as opposed to consume, every year, which we'll start at 15%. 

In the next columns, let's put annual spending and saving, invested assets, and asset return.

So after the first year, we spend 85% of our income, save 15%, and our invested assets grow from 0 to 0.15. 

Our initial assets are 0, so our first year's investment return is also 0. 
Our end of year assets are the previous asset amount, the savings that we are putting in, and the returns that we accumulated throughout the year.

Let's lock in the references to return and savings rate before we fill down. Let's fill down one and see what happens.

In the next year, we again spend .85, we save .15. Now, our previously invested assets get a return, and our total invested assets is the sum of previous amount, plus investment return, plus our new contribution.

And we keep going from here, and fill down for 50 years.

=Quiz 1=

Under these conditions, how many years does it take to reach financial independence? Namely, when are our investment returns sufficient to cover our spending?
Take a minute to examine our spreadsheet model.

If you scroll down and examine investment returns, you can see that they overtake spending, which is .85, all the way down here in year 40. This isn't too bad, but if 40 years seems like a long time to you - you're right, it is. What can we do to get there faster?

=Control variables=

One tempting approach is to just increase the investment return. Try it! This will certainly make things easier. The problem is, investment return is not actually under your control. You can /try/ to make investments with higher expected returns, but the actual returns you get are subject to a lot of external factors. So just assuming a higher return doesn't actually help us in real life.

There is only one other variable here, that of the savings rate. The savings rate, after a certain minimum threshold of required spending, actually is under your control.

After you take care of expenses like shelter, food, healthcare, et cetera, everything else is pretty discretionary. Spending 5 bucks on a coffee? Optional. Blowing some money on a bigger house, bigger car, fancy watch, all discretionary. So maybe you can save a bit more than 15% of your after-tax income. How about 20%? Let's try that.

Let's put in 20% as our savings rate. Note that this means our expense ratio is 80%, so we only need to get to 0.8 as our investment return to reach our goal.
Well look at that, if we do that, we reach financial independence in year 34, a full 6 years earlier. By saving a little more each year, we have just saved ourselves 6 years of having to work for money. 

Can we do even better?

=Needs vs wants=

Before we answer this question, Let's discuss the distinction between needs and wants. 
While often talked about as a clear dichotomy, needs and wants actually lie on a continuum of options. For example, let's take a look at shelter.
There are many things you can do for shelter. One is to do nothing and just hang out outside. Depending on the climate in your area, that might be pleasant enough, and there actually are people who do this by choice. But you'd have nowhere to cook your food, or safely stash your stuff, so a vast majority of people would agree that having no home base is undesirable.

But at which exact point along this continuum would you say that you have adequately satisfied the need for shelter and moved onto a want of better shelter? Different people would give you different answers depending on their preferences. 
For instance, many people deliberately and by choice abandon fixed dwellings and spend their time on the road in a mobile home, enjoying the nomadic lifestyle. Others, trade their perfectly good houses for even bigger and more expensive houses.
I can't tell you where needs stop and wants begin, that is something you have to discover for yourself. I can only offer some general suggestions for keeping your saving rate up and your spending in check.


One great trick for increasing your saving rate is to avoid what is called "lifestyle inflation" - letting your spending increase as your income increases. For instance, when you graduate from college and get a job paying you that average of 45 thousand per year, keep living like a student on 15K per year, rather than rushing to "upgrade" all the stuff in your life. Suddenly, your saving rate is 50% per year of after-tax income. If you are in a higher-paying field, your savings rate can be even greater.
Got a raise? Invest it rather than blowing it on a new wardrobe. Got a bonus? Save it instead of spending it in vegas. You get the idea.

Another good rule of thumb is called "pay yourself first". This is the idea that rather than spending first, and saving whatever is left, you set a savings target and set aside and invest the money as it comes in, and only spend whatever is left. This approach makes it much easier to meet your savings goals. Spending has a creepy tendency to expand to eat up all available cash before you notice it. Removing the cash from within easy reach is a time-tested trick to nip this in the bud.

=Quiz 4=

So let's see, how many years does it take to reach financial independence if you have a 50% savings rate?
Tweak the spreadsheet, and observe. If you haven't been following along and creating your own spreadsheet model, you can download a copy from the website, available for download right next to the videos.

Let's change the savings rate to 0.5, and scroll. Note that now our spending is also only 0.5.
Looks like 16 years is it. 16 years is still a long time, but being financially independent at 35 if you are starting at 20, sure beats having to work for income until you're in your 60s.

=Model caveats=

The model we developed is a good start, but there are some caveats we need to mention.
Some are things that are likely to increase the time required for financial independence.
First, it is advisable to keep some money in cash for short term needs, maybe 6 months or a year worth of spending, as an 'emergency fund', which generally wouldn't earn a good return.
Second, we have only mentioned in passing the various tax-advantaged savings vehicles currently available, but it is generally a good idea to use them for some of your money in order to reduce your current or future tax burden. However, these accounts usually have limitations on withdrawing money until you reach the age of 60.
Finally, while we assumed that the rate of return is fixed, rates of return in the market are variable, and can be sometimes higher and sometimes lower. Thus, you probably want to have a comfortable cushion on top of the minimum.

Others are actually likely to improve our standing. 
First, your income is likely to grow overtime, thus allowing you to increase your savings rate.
Second, we used a relatively conservative rate of return estimate, and you are likely to do a little better than that on average in the long run.


=Benefits of financial independence=

So why all this talk about financial independence? It has many benefits, so is in my opinion worth aiming for.

Having your expenses taken care of insulates you from the ups and downs of the job market. If you are laid off or fired, you can just take your time and find something else to do, without having to worry about how you'll survive. 
You can go a long way toward helping yourself in this regard even with a relatively small emergency fund, covering maybe 6 months or a year of expenses. If you do nothing else, you should at least build up that emergency fund.

Relatedly, it reduces or eliminates many sources of financial anxiety. Financial stress is a common source of stress in people's lives, as people worry about possible job loss, health issues, and various unexpected expenses. According to the American Psychological Association, nearly 3 quarters of americans experience financial stress in a given year, which in itself has significant negative health connotations. Building an asset base goes a long way to alleviating this issue.

If you know you have your assets to fall back on, you have a much easier time remaining ethical in the face of pressures to do otherwise under threat of financial costs. What do I mean by this? If you are an engineer and your boss tells you to fudge some safety test numbers; or if you're a working in construction and are pressured to use poor quality materials on a job; or you are a car mechanic and are told to charge customers for unnecessary repairs because hey, they won't know; or you work in any company and notice some financial improprieties and are told to keep your mouth shut; the list goes on and on. 
If you are reliant on your job to provide for your expenses, the financial hit you would take from losing your job if you refuse to go along with shady behavior is often enough to override people's ethical concerns. A financially independent person would have a much easier time standing up for what is right.

Additionally, having financial independence opens you to various very rewarding, but not very remunerative, occupations. Whereas under normal conditions you might think twice before going into a career like early childhood education, social work, or theater, for example, since they don't pay very well generally speaking, if you are financially independent, compensation can take a back seat.

Finally, many people have great ideas for a new business, but are afraid to take the plunge because how are they going to pay for food and shelter if they quit the paying job to do it? Once you are financially independent, you can take on the risk of promising new ventures without worrying about the lack of income while you give it your best shot.


=Additional reading=

So, financial independence has a lot of benefits, but it takes some years of discipline on the spending side to reach it.
At the end of the day, it is up to you how frugal you decide to be and how high of a priority you make of financial independence. 
The point of this is not to tell you how to prioritize your life, but to give you information so that the decisions you make are not made blindly, following along with whatever seems natural at the time, but are well considered decisions that are informed by long term thinking.

For our recommended reading in this video, I suggest The Millionaire Next Door, by Thomas Stanley.

Thank you for your attention.

=Attributions=