So you want to be financially independent (FI)? I don’t blame you. And I know you can do it! I got there in under seven years on a mid-five figure salary. But first, you need a plan. I’ll walk you through how to create your own financial independence plan in the steps below.

I know this plan delivers – because it’s the one I used. 

You only need to work out a few figures, and the only one that takes much time to fathom is your required annual income. That is, how much will you need to live on? 

To set the stage, here’s a fast-forward preview of what’s to come:

1. Annual income / withdrawal rate = FI target
2. Take FI target
3. + monthly saving figure
4. + real return rate assumption
5. Feed numbers into calculator
6. = Years until you are FI

Okay, let’s get on with it. Freedom awaits!

 

Annual income required

1. How much do you live on now? The ideal way to laser this number is by tracking your current monthly expenses on a spreadsheet for a year or so. By that point you’ll have captured most of the annual expenses that parachute into our lives like enemy commandos behind the lines.

If that’s all too much of a drag – or a traumatising journey into your own heart of darkness – then try an online budget planner. You’ll rustle up a workable number in no time.

Now for the fun bit. Let’s imagine how that number might look once you no longer answer to The Man.

2. Subtract expenses that will no longer apply. For starters you can gleefully strike out all your work-related costs – commuting, work clothes, professional fees, expensive lunches, the lot.

Also eliminate expenses that won’t apply once you’re FI. Mortgage payments (hopefully), saving to be FI and the like can all go.

3. Add new lifestyle expenses. Most people find they live on much less once FI. But it’s worth considering a range of categories that begin with ‘H’: holidays, hobbies, heating, health, and helium (or is that just me?).

The number you’ll be left with is a rough gauge of the net income you’ll need. Obviously it’s not the real number – you’ll only know that once you arrive in the future – but it will do for now.

Also, don’t worry about inflation. Later we’ll use calculators that take inflation into account, so we can keep working in today’s figures. Praise be!

4. Don’t forget tax. As if you would. To turn net income into gross income, just dial up your favourite tax calculator. For sheer simplicity I like the UK Tax Calculator.

Pop in your net income figure as your salary (into the calculator) and you’ll see what you’re left with once your tax bill is chopped off. Play around with the salary figure until you can take home the net income you need. Et voila! The salary figure is the gross income you need to work with.

Remember to cancel out the effect of National Insurance Contributions. You won’t be paying any if you’re not employed.

Bear in mind that income drawn from an ISA is not subject to income tax, but you do pay tax on pension monies over and above your personal allowance.

This is our best post on the eternal SIPPs vs ISAs question. Most people should probably use both, so we wrote this series on how to maximise your tax shelters to achieve FI. 

5. Deduct other sources of income. Expect to have money coming in from elsewhere? Then you won’t need to amass quite as big a mountain of assets to pay your bills with. Obviously these other income sources only count if they can be relied upon, and if they’re on stream by the time you achieve FI.

Common conduits of regular cash include:

• State pension

• Defined benefit pension

• State benefits

• Part-time work

• Other passive income – trust payments, royalties, and so on.

Still with us? Having dashed through those five steps you’ll have a good enough idea of the gross income you will need to live on from your investments. Once your assets can support that income then you can declare yourself FI.

Cut a ribbon, run a flag up a pole, fire AK-47s into the air – whatever floats your boat.

Your target asset pile

To generate your desired income from your investments, you’ll need to accumulate a large heap of capital.

How big should it be?

To find out, all you need do is divide your income by your sustainable withdrawal rate (SWR). 

Your withdrawal rate is the set percentage that you cream off from your hoard as income.

• If your required annual income = £20,000
• And your withdrawal rate = 4%
• Then your target to achieve FI = £20,000/0.04 = £500,000

You’ll need to accumulate £500,000 to earn an annual income of £20,000 at a 4% withdrawal rate in this scenario.

£500,000 = Financial independence in this scenario

A few things to know:

• The withdrawal rate is the amount you take in year one of your financial independence. You adjust your income in line with inflation every year after that.

• The 4% rule assumes you have a judiciously diversified portfolio of assets, as discussed elsewhere. Shares, bonds, and so on. It doesn’t work with cash in the bank!

• If you withdraw too much then you’ll shrink your hoard faster than it can replenish itself with interest, dividends, and capital gains. Live like a Roman emperor for a few years and you’ll be running on empty with bills to pay.

• 4% is a commonly used sustainable withdrawal rate. According to widely accepted practice, you can set your withdrawal rate at 4% a year and have very little chance of running down your entire hoard to zero.

• What’s less well known is that the 4% rule was derived from a specific set of assumptions that applied largely to the US, and to retirements lasting 30 years or fewer. It shouldn’t be used blindly by UK investors. We’ve previously explained why. 

• A 3% SWR is a far safer yet still achievable withdrawal rate, although research is ongoing. But you might be able to increase your withdrawal rate with a few smart investing techniques.  

Savings rate

Hitting your target comes down to how much you can save and the returns you earn on your investments.

Your savings rate is absolutely critical. This is the master string that makes the rest of your financial puppet dance.

It doesn’t matter how big your salary is or how much you live on, your savings rate dictates how long you will spend working. The following table – sampled from Mr Money Mustache’s excellent post that underlines this point in red pen – shows you how quickly you can go from zero to ‘cheerio’1:

Savings rate	Years to FI
85%	4
75%	7
50%	17
20%	37
10%	51

It’s a beautiful relationship. If you can save more now, then you have proved you can live on less. Which in turn means your income target is smaller and you will reach it sooner.

So what’s your savings rate?

For the purposes of our calculation, we’re interested in the actual amount you can tuck away monthly.

You probably know this number already, but just to make sure you’re getting as full a figure as possible:

• Take your annual net income.

• Subtract your annual expenses.

• Add all your other income streams including rentals and bank interest.

• Add pension contributions and employer matches if pensions are a factor in your plan. Gross them up to account for tax relief.

• Don’t add investment income and gains. These are accounted for in the return assumptions that follow.

The number you’re left with is how much you should be saving a year. Now take your total savings and perform the following calculation as provided by UK early retirement blogger The Firestarter:

Total Savings2 / ( Total Savings + Expenses ) x 100 = Your savings rate

Once you know your savings rate you know how long it will be until you retire.

Ratchet up the rate if you want out quicker.

Picking an investment return rate

This is the final piece of the puzzle – the return that swells your investments into your own financial life support system.

However you calculate it, this number will be wrong. If I (or anybody else) knew what the market will deliver over the next couple of decades then I wouldn’t be writing this post. I’d be flicking through What Tropical Island? magazine.

You could just use whatever rate is inserted by default into an online calculator, but be aware that these numbers are usually pretty generous. Companies know you’re more likely to use their products if they deliver good news.

A 4% real rate of return3 is a common gambit. That comes from a 5% historical real rate of return for UK equities and 2% for government bonds. It also assumes you’ll plump for a 60:40 equity-bonds portfolio.

A more sophisticated approach (although not necessarily more accurate) is to use an expected return calculation. 

Again, even Brian Blessed couldn’t over-emphasise what a shot in the dark these numbers are. You also need to dilute to taste. If your portfolio is more like 40:60 equities-bonds then your expected returns rate will be lower. But you can nudge the rate up to historical norms if your time horizon lengthens and your tilt towards equities becomes more daring.

Your best bet is to run a few different scenarios using nightmare and conservative assumptions, especially if your timescale is fewer than 20 years.

I personally wouldn’t run a dream scenario for fear that I’d anchor myself to an unrealistic number. If the future turns out to be a garden of roses then I’ll enjoy that when the time comes.

Don’t get your nominal and real returns mixed up. If your calculator includes an assumption for inflation, then feed in a nominal return which incorporates that inflation number along with your expected real return. For example, the calculator assumes inflation will be 3% and your expected real return is 4%, so your nominal expected return would be 7%. If you feed in a real return without adding something for inflation and the calculator also backs out inflation, then your future will effectively be whacked by inflation twice! (And the calculator will tell you that you’ll never be able to retire…)

It’s a numbers game

Right, let’s spin the wheel of fortune and see when you’re gonna be FI.

• Feed all your numbers into an investment calculator like this one.

• The annual charge is the total cost of your portfolio, with platform fees.4

• Strip out the inflation figure from the calculator if you’re feeding in a real expected return. If you want an inflation guesstimate then 3% p.a. is around the UK long-term average. 

• The lump sum figure is money you already have. It can include the value of any rental property (minus attached mortgage debt), pension assets, savings accounts, and current investments.

• Don’t include your home, wine cellar, fleet of Vauxhall Corsas and so on.

• Check out this post for our ultimate, belt-and-braces financial independence calculation. This one includes how to factor in a boost for the State Pension or any defined benefit pensions that begin long after you FIRE. 

The result of all this number-crunching is your answer, in years, to the question:

When will I be financially independent?

Now you’ll know!

Take it steady,

The Accumulator

Note: This article on creating your own financial independence plan was rewritten in August 2023. Comments below might refer to the 2013 incarnation, so double-check the dates if confused! 

1. See Mr Money Mustache’s post for the assumptions. []
2. Include all grossed up savings into pension funds along with employer matches []
3. The real return is the return you’ll get after stripping out inflation. []
4. If you don’t know that number then you can safely plump for 0.5% if you’ve got a nicely diversified portfolio of index trackers. []

What caught my eye this week.

Perhaps the most fanciful of the many ultimately costly reasons I found for not buying my own place in London for decades – missing the entire boom, before finally doing the deed after it ended – was self-driving cars.

Yes really.

My thinking was that when AI can drive us about everywhere, there will be less of a premium on living near the action.

Instead you could fall asleep drunk in a cheap robot taxi that drives you back to your home anywhere. You could live up a mountain, miles from public transport. You could commute in a bed-car.

Location would still be important, but that would be re-calibrated. Maybe views would be at a premium, or peace and quiet, or being a drive away from several social hubs rather than being at the heart of any one of them.

I didn’t know exactly how London’s pricey postcodes would be affected. But I was wary of placing a bet.

Needless to say, while we now have chatbots that can bluster as convincingly as any sixth-former who didn’t do their homework, we’re still waiting to be ignored by a passing autonomous black cab.

So much for that great reckoning!

More recently the pandemic – and working from home  – was touted as doing something similar.

Remember the countless stories about people moving out from the cities in 2020?

Yeah, well lots of them moved back. Or perhaps found they couldn’t afford to do so, because others had rushed in to fill the spaces they’d left behind.

Bonnie’n Inverclyde

And so the UK remains a country divided by house price to average earnings ratios as much as by absolute house prices. Higher-earning bidders pay relatively higher prices for already pricey property.

Indeed this week we learned that the most affordable place to live on the basis of such ratios is Inverclyde.

No, me neither. According to The Guardian:

Inverclyde, which boasts a saltwater Lido looking out over estuary, has an income ratio score of just 2.9, compared with central London’s score of 16, the research shows.

It is closely followed for affordability by Dumfries and Galloway (3.2) and East Ayrshire (3.3).

And here’s a comparison in table form, again from The Guardian:

The salaries behind the ratios are regional. Which means that while they don’t have the granularity of the local authority house price data, we’re at least not seeing those Scottish house prices made comparatively cheaper by being set off against bankers’ bonuses in Canary Wharf.

Of course it has been like this to some extent forever. But the ratios really do look extreme now.

If you live in Hull and I live in Islington, can we even have a mutually intelligible conversation about the price of a first-time home?

How does it end? More of the same?

Perhaps tribes of highly-skilled tech workers who can work remotely could get together to set themselves up in luxury in Scotland – creating a critical mass to bring sufficient baristas and craft beer breweries in their wake.

Perhaps not. As one blogger put it during the pandemic:

The more people can be anywhere, the more they will want to be somewhere.

And with no offence to those living far from the madding crowd – hey, it’ll be me someday – I expect that for most such bright young people, London will continue to be the UK’s centre of gravity.

Whatever the ratios say.

Another membership housekeeping note

Last week’s site housekeeping note flushed out a new issue, which is that a tiny handful of Monevator members hadn’t been getting any premium emails at all.

Which is distressing. Because we’re grateful for the support of every one of our members!

The issue seems to be that if you’ve ever unsubscribed from Monevator emails, then when you sign-up for membership the system assumes you still don’t want them.

Blame GDPR and all that malarkey.

The solution is to resubscribe to our free emails. This should ensure that as a member you get all our emails – including your special member content.

I know there are some people who are better than me who like to keep pristine inboxes. If that’s you, I suggest reading the Mavens and Moguls articles by logging in on the Monevator website.

(Remember you must allow third-party cookies to log-in. But there are no ads as a member, at least).

Have a great weekend all!

[continue reading…]

There is something that fluctuates even more than the stock market in investing – and that’s investor sentiment.

Indeed once you’ve been around the investment block a few times, it’s hard to take old-fashioned textbook economics – with their purely rational Vulcan investors and perfect pricing – very seriously.

I’ve observed that just as there’s a business cycle, there’s an investment sentiment cycle. This cycle sees the emotions of investors wax and wane as they lurch from fear to greed and back again.

That’s not to say the old textbooks – or the various forms of the efficient market hypothesis – are entirely wrong.

Later behavioural economists were surely correct that investors often act irrationally and take prices out of whack.

But that doesn’t make it simple to profit from such extremes. The woeful record of most active funds that try to beat the market is proof of that.

A share’s price may well reflect everything that’s publicly known about the asset. This may even include the knowledge that half the people buying it are doing so irrationally.

Yet the price can go even more irrationally higher.

Just think of tech and meme stocks in 2021.

Hunting for highs and lows

So far so straightforward. Avoid getting swept up in a mania, invest with your head not your heart, and sidestep the dangers oscillating investor sentiment, right?

If only it were that simple.

For starters it’s only in retrospect that you can clearly read back a cycle of fear and greed – even when you understand that bull and bear markets are at least partly emotional, and you’re alert to all the signs.

You’ll often see exuberance and reckless trading years before a given market tops out. Get out too soon and you’ll miss years of gains while you wait for a crash that might never come. (Miss enough gains and it might not have been worth abstaining overall, even if and when the market does crash.)

Betting against the market is always risky, both financially and emotionally. The great economist John Maynard Keynes said “the market can remain irrational long after you can remain solvent”. But what Keynes didn’t mention was that even if you avoid betting against a crazy market, you can still feel pretty lousy in your haughty solvency for as long as everyone else is making out like bandits.

I’ve been there many times.

For instance, in the previous version of this article published in 2010 I wrote:

I’ve avoided gold miners for years, despite their popularity, because gold has long seemed detached from reality. More fool me.

The gold price looked very stretched back then. Yet powerful undercurrents of fear that followed in the wake of the financial crisis kept its price bobbing along.

My patience was even more stretched. Sitting out this market while investor bulletin boards were full of my stock-picking peers doubling or tripling their money in a year was not easy.

It wasn’t until 2013 that my avoiding gold miners was at all rewarded, as the boom ended in a bust.

Who knows what money I failed to make before then?

The real zombie investments

I’ve been through similar cycles with everything from oil companies to tech shares to bonds to Bitcoin.

This is one reason I never say never again about any asset class or investment opportunity. I’ve seen too many supposedly surefire investments flounder. Even as others rise from the dead again when, eventually, both their fundamentals and investor appetite recovers.

If you leave entire sectors or asset classes behind every time you get your fingers burnt, you’ll soon end up with nothing left to invest in. Because they will all burn you from time to time.

Better to learn your lesson and leave only your emotions behind if you can.

Peak bullshit

One of the best things about updating very old Monevator articles is that since-proven illustrations are often just sitting there on the page.

Again from the previous version of this post from 2010, I wrote:

It seems like every private investor I meet nowadays owns a portfolio of oil companies, variously prospecting in the Mongolian steppes or trying to snake a pipe under the Arctic.

These people (maybe you’re one?) will tell you earnestly that oil shares are the only game in town, and peak oil makes all other investments irrelevant.

Indeed as far as I can tell, every 50-year old man who dabbles in shares (and they’re always men and over 50 these days, which says something in itself) thinks humanity’s future is to transport bundles of copper and gold back and forth between China and India in gas-guzzling trucks at great profit to themselves, while the rest of the world burns its old Tesco share certificates and 50 pound notes for warmth.

No place for media companies. No point in buying shares in breweries or builders. No future for whoever makes those fancy leggings that all the girls in London are wearing.

These peak oil investors have endless technical arguments as to why they’re not the last punters to turn up before midnight. They are supremely confident, and they grow more confident by the day.

We’ll see, but history is not on their side – all one-way bets hit the wall eventually.

Well this mania did indeed prove a tell.

Most oil and gas producers – and other commodity producers – started a decade-long slide down soon after.

You may recall the oil price briefly went negative in March 2020? By then, the iShares basket of oil and gas producers (Ticker: SPOG) was down 75%:

And as the graph shows, prices going negative – and every oil bull checking into the slaughterhouse – turned out to be a historically good time to buy.

(Do I sound smug? I shouldn’t – because buy I did not!)

Dot come again

If you think that’s an impressive bit of Mystic Meg action, you’re going to love what I wrote about tech stocks in the 2010 edition:

For a contrasting unloved sector, consider technology companies.

It’s hard to remember a time when half the office owned shares in nonsense companies like Baltimore, Webvan, and NTX. Yet it was only a brief decade ago that the Dotcom stocks were doubling in a month on a good press release and a name change.

Today roughly nobody except institutional investors bothers with individual technology shares – yet the Nasdaq tech market in the US has been quietly beating the Dow and the S&P 500 for months.

Blimey! This is how someone gets themselves a big head. (Or a permanent place on rotation on CNBC.)

I went on to speculate that the seeds were being planted for a new boom in technology shares:

• The first shoots will be obscure magazine articles on the Nasdaq’s recovery.

• Then you’ll discover a friend or a bulletin board poster who has tripled his money betting on cloud computing micro-caps.

• Perhaps Facebook or Twitter will float for what will seem a crazy valuation, but will look positively modest a few years later.

• Some new kind of fusion or computer or website will emerge and capture everyone’s attention.

• Whereas today there’s less than half a dozen surviving UK funds focused on technology, by then there’ll be dozens. You can’t miss them – they’ll be advertised in all the Sunday papers.

• The last lemon will ripen in 2020, when even you and I will buy shares in a Korean software company that’s a rumor we heard from an old boss who’s confused it with gadget in a movie he saw on the first commercial space flight to the moon.

And then the bubble will burst. We’ll all wonder again what we were thinking, and put our savings into ‘risk-free’ Chinese government bonds and middle-class apartment blocks in New Dehli.

Okay, so I lost the plot a bit at the end there – the dangers of long-range speculation.

But I think these examples – which you’re welcome to check back on using the Internet Wayback Machine – show that it’s possible to judge what’s in and out of fashion at the extremes.

Again though, don’t confuse ‘possible’ with ‘easy’.

A cycle for all seasons

To conclude this walk down memory lane, last time I finished by reminding readers how I’d suggested in 2009 that we might be on the cusp of a new bull market:

I don’t know how the next bull market will play out. Maybe it’s not the turn of technology shares again quite yet. Maybe investors will go mad for Chinese small caps or German widget makers instead.

Oh well, I was half right!

But the important point is not that you can predict what’s coming next. It’s not even that you can be sure that cycles are reaching a peak or about to burst.

Not gonna lie, after a rotten couple of years in the market revisiting this article has boosted my ego.

But still, in practice commodity shares did continue to run for at least another 18 months after I flagged the oil and gas mania. As for the new tech boom, I certainly benefited – it did most of the late-stage heavy-lifting that took me to FIRE – but by no means was my portfolio as full of them as it might have been.

More recently I’ve been cacking things up anyway, getting back into growth stocks too soon after the 2021 sell-off and ditching UK investment trusts I’d bought to ride out the turbulence before they rallied.

Active investing is hard and best left to masochists who are wired a certain way. We’ve argued that many times.

So what is the important point?

Just that thinking about the sentiment cycle can be helpful.

Investor sentiment 101

Try to step outside of the current tumult from time to time to consider the broader currents – whatever kind of investor you are.

• You should understand your own emotions – why we all feel fearful, brave, or even guilty at different times.
• If you’re an active investor, you can potentially profit by guessing how others are feeling, and placing your bets accordingly. Never bet the farm! Stay humble.
• If you’re a passive investor, the cycle explains why you should keep on investing through the market’s ups and downs. You’re not being reckless by seeing the cycles play out and yet perhaps doing nothing different. By staying on course you’re strategically taking advantage of the oscillating and unprofitable emotions of your fellow investors.
• You might also keep an eye on technicals like CNN’s Fear & Greed index.

Always remember: this too shall pass.

Not everything changes

Think this is all too obvious?

Okay, but – for example – have you been loading up on super-safe government bonds despite their recent rotten run?

Have you been salivating as real yields on index-linked gilts turned positive?

Or have you been one of those writing in the Monevator comments to say that you don’t see the point of bonds anymore and you will never invest in them again?

Sure there are valid reasons why you might reply “not for me” or at least “not yet”.

But that bond prices have gone down a lot and everybody hates them is as bad a reason to avoid them as exists if you’re any sort of long-term, diversified investor.

It will not always be this way.

The crying game

When I first wrote about investor sentiment and emotions back in 2010, the idea that investors’ emotions constantly shifted with narrative and price remained controversial.

Yet only a few years later Robert Shiller won the Nobel Prize in Economics alongside Eugene Fama – efficient market royalty – and Lars Hansen (who we’ll get to another day.)

For Shiller to take the 2013 award along with Fama was proof that behavioural economics – and ideas like investor sentiment – are now part of the framework of modern market theory.

So much so, in fact, that younger readers might now take it for granted.

Fair enough. But let’s see if that stops investors getting carried away again in the future.

Personally I will be betting against it.