Do you have Financial Freedom?

December 1, 2010 — Leave a comment

Financial success is often measured in terms of high income or high net worth. This article offers an alternative measure that focuses on the freedom to choose what to do with your time, and is stated as a low withdrawal rate from a diversified stock portfolio.

High Income is a powerful tool for covering expenses. An individual making $1M per year is considered financially successful. While high income can allow you to live comfortably as well as prepare for substantial surprise expenses, it does not capture financial freedom:

  1. It ignores expenses. If you make $1M per year, and spend $1M in a normal year, you will be in trouble as soon as a surprise expense comes up. Considerably more modest income of $60k with expenses of $30k would leave you with a greater cushion for surprise expenses.
  2. It depends on willingness to work. Whether the income is from employment or self-employment, it depends on your willingness to work. A portion of your time has to be spent on work, and you are not free to do as you wish with your time.
  3. It depends on ability to work. Even if you love your job and cannot think of any other way to spend your working hours, you may not be able to work forever. Risks include disability, aging, business failure, and layoffs.

Note that guaranteed income that does not depend on work or on a company’s solvency can count as a contributor to financial freedom, but is still subject to your spending relative to the income amount.

Net Worth can be calculated by adding the value of your bank accounts, brokerage accounts, retirement accounts, real estate including your own home, art collection and anything else of monetary value (assets), and deducting all mortgages, business loans, student loans, car loans, and any other financial obligation (liabilities).

High net worth means you have plenty of money that you can potentially spend as you may choose, and may seem like a good measure of financial freedom. Anyone with $10M or even less can buy a private jet, but may not have financial freedom. The problems with net worth as a measure of financial freedom are:

  1. It ignores expenses. A person with a new worth of $10M would typically be considered wealthy, and would be expected to have financial freedom. If $5M is invested in a nice home, and supporting staff, maintenance and all other living expenses total $500k per year, the person is not financially free, given the spending of 10% ($500k of $5M) of the investable assets per year. This withdrawal rate cannot be sustained reliably at all times, no matter which investment you choose.
  2. It ignores the investment approach . Continuing the example above, say that expenses were cut down to $200k per year, limiting the withdrawal rate to 4%. This withdrawal rate could be sustained given the right portfolio. But if the entire portfolio is put into bonds or into a concentrated stock portfolio, the withdrawal rate cannot be sustained.

An alternative measure: very low withdrawal rate from a diversified stock portfolio . Limiting the withdrawal rate from a globally diversified stock portfolio provides a high probability of financial freedom – the ability to sustain life for as long as needed with no need to worry about work. With the right portfolio, a withdrawal rate of 2%-4% can be sustained through major declines. At 2%-3%, there isn’t much that can affect your financial stability and freedom. Specifically:

  1. A prolonged and deep decline in your portfolio is not likely to be a problem. At 2%-3% you should have been able to sustain the 2008 recession as well as the Great Depression without any problems. This still holds true if you never reduce your withdrawals (the withdrawal rate is measured from the peak value of the portfolio), and adjust them for inflation.
  2. Unexpected expenses can be supported to a large degree given that the entire investment is liquid, ready to be sold at any time with no notice.
  3. Inflation is not a problem given that companies’ earnings grow with inflation. It may not happen instantaneously, but over time stock prices grow well beyond inflation.
  4. Growing income beyond inflation is an extra bonus, given the high long-term growth of stocks. Whenever there is a growth spurt, you get a nice increase in your income, while maintaining the withdrawal rate.

Great news! Now you have two ways to achieve financial freedom – build up your savings, or reduce your spending.

Focus on the positive. You may feel constrained by limiting your spending, in the face of advertising and seeing others living more lavishly. The comfort of not being stuck in the rat-race and not depending on work can give you the strength to keep your expenses at a low percentage of your assets.

In addition, while most people spend most of their lives trying to keep up with their expenses, you can get handsome ‘raises’ to your income once you reach the low withdrawal rate for the first time. This is thanks to the growth of stock investments, combined with the fixed percent withdrawal.

A practical progression: While most 20-year-olds don’t have the assets to generate lifelong income, they can establish a certain standard of living, and raise it more slowly than their income. With every raise, they can save a greater portion of their pay. If they ever get to earn a substantial income, they can stop raising their standard of living until they reach financial freedom. This is in line with the idea that living off of $40,000 can make you much happier than $30,000, but going from $200,000 to $210,000 will not have nearly as much of an impact, and may not make you happier at all in the long run.

Assumption about investing: The financial security of a low withdrawal can be obtained only if the stock portfolio is highly diversified, and held with iron discipline through all declines, however deep or long, with no market timing or individual stock selection.

Summary

High income and high net worth do not guarantee financial freedom. Financial freedom can be obtained by maintaining a low spending rate (2%-4% annually) compared to your assets, if they are invested with discipline in a diversified stock portfolio, with no market timing or individual stock selection.

Disclosures Including Backtested Performance Data

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Gil Hanoch

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