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EARLY RETIREMENT isn’t a common goal among my friends. When I talk about my semi-retirement, many assume I either made a quick buck in the stock market or benefitted from some sort of financial windfall. I counter this misconception by narrating the magic formula: Financial freedom is frugality, multiplied by simplicity, compounded by patience.
My response often seems mysterious until I explain the two basic math concepts behind it. We learn them in school, but rarely internalize them. One is simple subtraction and the other is compounding.
Subtraction tells us that savings equals income minus spending. The more we save, the faster our nest egg piles up. But looking at it from a savings perspective tells only half the story. If we let our lifestyle grow ever more lavish, even regular salary increases won’t get us to financial freedom any sooner.
Indeed, keeping our spending in check has a double benefit. First, a reduction in spending increases our regular savings by the same amount. We can sock away more money and reach our target sooner. Second, lower spending means that we need less to cover our living expenses and that shrinks our target nest egg proportionately. In other words, if we hold down spending, we not only go faster, but also we have less distance to cover.
Consider a 25-year-old man and woman, both earning $75,000 a year. To them, financial freedom is about having enough money so that a conservative 3% annual withdrawal rate can cover half of their spending. The man saves 10% of pretax income, while the woman socks away 25%. Let’s assume their savings earn 6% a year. The two charts below track their progress toward financial freedom, with the green bars showing their nest egg’s current value and the peach-colored area indicating the sum that still needs to be amassed.
The bottom line: Our 25-year-old man takes 60% longer to reach his goal than his more frugal, female counterpart. This is because he not only saves less, but also his higher spending pushes up his target nest egg by 20%. This illustrates the crucial role of frugality in achieving financial freedom. Lower spending equates to both a higher savings rate and a smaller target nest egg.
But frugality alone isn’t enough. The money saved doesn’t go far on its own. It needs to be invested with an eye to growth. The saver must become an investor. This is where the second math concept—compounding—comes into play.
For illustrative purposes, let’s assume a 10%-a-year portfolio growth rate, even though that’s likely unrealistic, given today’s stock market valuations. At 10% a year, a dollar saved at age 25 becomes $45 at age 65. What if we could save even more at age 25? Two dollars would potentially become $90 and $20 would grow to $900.
But making a bigger investment isn’t the only way to speed our financial progress. Both the growth rate and the years of growth also have a big impact on the outcome. If we trim the growth rate by a tenth, so the money we invest at age 25 compounds at 9% a year instead of 10%, that slashes the final amount amassed by almost 31%. Likewise, making our investment four years earlier, at age 21 instead of 25, boosts the final sum by more than 46%. It’s a no-brainer that we can reach our target much sooner with a higher growth rate and a longer period of compounding. But how do we do that?
The two other virtues of the freedom seeker—simplicity and patience—can do the trick. True, we can’t control or predict the investment growth rate. But with a few simple steps, we can improve our odds of getting a higher return. First, we need to start with a realistic list of financial goals.
The next step is asset allocation—how we divide our money between stocks and more conservative investments—which is the surest predictor of our long-term rate of investment growth. Time until our financial goals should play the biggest role in driving our investment mix. Another important factor is risk tolerance. Once we have our financial plan, we can implement it using low-cost, diversified investments that are simple to understand and easy to maintain. Convoluted or expensive investment products usually hinder success. Simplicity is the key.
With our plan in place, the final ingredient is patience. Financial freedom doesn’t come overnight, so patience is essential. The lure of instant gratification is always there to distract us, but a laser-like focus on our long-term goals can act as a shield. With frugality, simplicity and patience joining forces, financial freedom is all but inevitable.
A software engineer by profession, Sanjib Saha is transitioning to early retirement. His previous articles include Feelin’ Groovy, Ready or Not and Spring Cleaning. Self-taught in investments, Sanjib passed the Series 65 licensing exam as a non-industry candidate. He’s passionate about raising financial literacy and enjoys helping others with their finances.
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As a retired accountant and auditor I can relate to your methodical analysis. Often the facts of life often interfere with such arithmetical precision that we all aspire to live by. Such as our future health issues, the health of our children and parents, divorce, personal tragedy, intermittent employment, lack of needed insurance and the list could go on. You are right that it does take patience but luck helps a lot too. I was lucky enough to have steady employment, be healthy and earn consistent 10% plus returns for at least 15 years using long term treasury bills during that terrible time when mortgage interest rates were over 10%. Luck helps a lot too.
Working a few more years creates margin to manage sequencing risk! 😉
In your example, lower spending/higher savings accounts for the vast majority of the difference between the man and the woman in the time to reach their goals. In fact, it appears that it takes him 50% longer to reach his goal than it does for her to accumulate the same nest egg.
Thanks, parkslope.
The important thing here is the amount of saving, relative to the amount of spending. Each person’s target is a function of their own spending – not a fixed dollar amount. The man has a smaller annual saving amount ($7,500) compared to the woman. This also means that the man has a larger target too compared to the woman. The man takes 39 years as opposed to 23 for the woman to reach their individual financial goal.
Now consider another man, who also saves only $7,500 – the same dollar amount as the example. But this other man spends only $42,5000 per year. Due to the lower spending, his target is also much smaller – only $700,000. He will reach the financial independence goal in 32 years, much sooner than the person in the example. Stated differently, though both persons are saving the same exact dollar amounts per year, the first man (in the article) reaches financial independence at age 64 and the second man at age 57. This is because the second man spends less. Even with a lower income compared to the first man, the second man clearly comes out ahead.