PATH TO FINANCIAL FREEDOM
Achieving financial freedom means passively generating enough income so that you may spend your time as you wish rather than to support your lifestyle by working, which is really trading your time for money. If the goal is to produce passive income, you will need assets, which Robert Kiyosaki described so well in his famous book “Rich Dad, Poor Dad”. He defined an asset as anything that puts money in your pocket and a liability as anything that takes money out of your pocket. You want to accumulate assets that can eventually fund all your expenses from the income produced by those assets. This post is about the math behind accumulating assets.
ACCUMULATING ASSETS
When most people begin their journey as independent adults, they don’t have many assets. In fact, they may have only liabilities such as student loan debt or credit card debt. So, they go get jobs to generate income (i.e. money). Now, a person who works for money is the asset because this person is generating money through his active participation (i.e. work). Assets accumulate when someone lives below his means. On the other hand, if you spend every dime that you make, then you remain as your only asset and you will be forced to perpetually work for money…unless you happen to find a sugar daddy or sugar mama! But this post isn’t about sugar mamas and gold diggers.
Let’s look at an example to illustrate what’s going on. Young Rico, who is 22 and has no assets and no liabilities, starts his career earning $100,000 per year. After carefully assessing his annual expenses, he calculates that he needs $90,000 a year for all his living expenses, which leaves $10,000/year excess. To make things simple, we’ll assume no raises and no inflation.
| AGE | INCOME | SAVINGS | NEST EGG |
|---|---|---|---|
| 22 | $100,000 | $10,000 | |
| 23 | $100,000 | $10,000 | $10,000 |
| 24 | $100,000 | $10,000 | $20,000 |
| 25 | $100,000 | $10,000 | $30,000 |
| 26 | $100,000 | $10,000 | $40,000 |
| 27 | $100,000 | $10,000 | $50,000 |
| 28 | $100,000 | $10,000 | $60,000 |
| 29 | $100,000 | $10,000 | $70,000 |
| 30 | $100,000 | $10,000 | $80,000 |
| 31 | $100,000 | $10,000 | $90,000 |
| 32 | $100,000 | $10,000 | $100,000 |
| 33 | $100,000 | $10,000 | $110,000 |
| 34 | $100,000 | $10,000 | $120,000 |
| 35 | $100,000 | $10,000 | $130,000 |
| 36 | $100,000 | $10,000 | $140,000 |
| 37 | $100,000 | $10,000 | $150,000 |
| 38 | $100,000 | $10,000 | $160,000 |
| 39 | $100,000 | $10,000 | $170,000 |
| 40 | $100,000 | $45,950 | $180,000 |
| 41 | $100,000 | $10,000 | $190,000 |
| 42 | $100,000 | $10,000 | $200,000 |
| 43 | $100,000 | $10,000 | $210,000 |
| 44 | $100,000 | $10,000 | $220,000 |
| 45 | $100,000 | $10,000 | $230,000 |
| 46 | $100,000 | $10,000 | $240,000 |
| 47 | $100,000 | $10,000 | $250,000 |
| 48 | $100,000 | $10,000 | $260,000 |
| 49 | $100,000 | $10,000 | $270,000 |
| 50 | $100,000 | $10,000 | $280,000 |
| 51 | $100,000 | $10,000 | $290,000 |
| 52 | $100,000 | $10,000 | $300,000 |
| 53 | $100,000 | $10,000 | $310,000 |
| 54 | $100,000 | $10,000 | $320,000 |
| 55 | $100,000 | $10,000 | $330,000 |
| 56 | $100,000 | $10,000 | $340,000 |
| 57 | $100,000 | $10,000 | $350,000 |
| 58 | $100,000 | $10,000 | $360,000 |
| 59 | $100,000 | $10,000 | $370,000 |
| 60 | $100,000 | $10,000 | $380,000 |
| 61 | $100,000 | $10,000 | $390,000 |
| 62 | $100,000 | $10,000 | $400,000 |
| 63 | $100,000 | $10,000 | $410,000 |
| 64 | $100,000 | $10,000 | $420,000 |
| 65 | $100,000 | $10,000 | $430,000 |
| 66 | $100,000 | $10,000 | $440,000 |
| 67 | $100,000 | $10,000 | $450,000 |
The table shows Rico’s age, his gross income, his savings each year, and the cumulative assets that Rico has amassed. Assuming that Rico will continue to need $90,000/year for all his living expenses, he will have saved a year’s worth of living expenses after 9 years. After 45 years of working, at age 67, Rico will have earning himself a five-year “retirement” only to need to return back to work at age 73. The point of this example is not to depress you but to point out that while savings are essential to build up assets, those savings will usually not be enough for permanent financial freedom. This is where investing comes in, and, as you will see, this is where the magic can happen.
INVESTING THE ASSETS
Investing can be defined as purchasing an asset with the expectation that the asset will produce an income stream and/or appreciate in value. We can express the return on the investment as a percentage. For example, $10,000 invested at a return of 10% will be worth $11,000 after one year or, alternatively, will generate $1000 per year of income. Rather than socking his excess into a savings account, Rico can invest his savings at the end of each year. If Rico can earn 10% per year, he will attain financial independence. To cover Rico’s living expenses of $90,000/year, Rico will need a nest egg of $900,000 earning 10% per year. At this point, Rico can ditch the job and live off of the investment gains each year. Let’s look at the table below. Each year, Rico saves $10,000, and, at the beginning of the next year, he invests the money at 10%. Each year’s savings is shown in a column. Although I’ve only shown the first five years (due to space constraints), Rico keeps investing $10,000 in year six and thereafter (more columns are added but not shown in the table). The sum of all the years’ savings and their investment gains are shown in the far right column that’s labeled ‘NEST EGG’.
| AGE | YR1 SAVINGS | YR2 SAVINGS | YR3 SAVINGS | YR4 SAVINGS | YR5 SAVINGS | NEST EGG |
|---|---|---|---|---|---|---|
| 22 | ||||||
| 23 | $10,000 | $10,000 | ||||
| 24 | $11,000 | $10,000 | $21,000 | |||
| 25 | $12,100 | $11,000 | $10,000 | $33,100 | ||
| 26 | $13,310 | $12,100 | $11,000 | $10,000 | $46,410 | |
| 27 | $14,641 | $13,310 | $12,100 | $11,000 | $10,000 | $61,051 |
| 28 | $16,105 | $14,641 | $13,310 | $12,100 | $11,000 | $77,156 |
| 29 | $17,716 | $16,105 | $14,641 | $13,310 | $12,100 | $93,772 |
| 30 | $19,487 | $17,716 | $16,105 | $14,641 | $13,310 | $113,149 |
| 31 | $21,436 | $19,487 | $17,716 | $16,105 | $14,641 | $132,154 |
| 32 | $23,579 | $21,436 | $19,487 | $17,716 | $16,105 | $155,369 |
| 33 | $25,937 | $23,579 | $21,436 | $19,487 | $17,716 | $180,906 |
| 34 | $28,531 | $25,937 | $23,579 | $21,436 | $19,487 | $208,997 |
| 35 | $31,384 | $28,531 | $25,937 | $23,579 | $21,436 | $239,896 |
| 36 | $34,523 | $31,384 | $28,531 | $25,937 | $23,579 | $273,886 |
| 37 | $37,975 | $34,523 | $31,384 | $28,531 | $25,937 | $311,275 |
| 38 | $41,772 | $37,975 | $34,523 | $31,384 | $28,531 | $352,402 |
| 39 | $45,950 | $41,772 | $37,975 | $34,523 | $31,384 | $397,642 |
| 40 | $50,545 | $45,950 | $41,772 | $37,975 | $34,523 | $447,406 |
| 41 | $55,599 | $50,545 | $45,950 | $41,772 | $37,975 | $502,147 |
| 42 | $61,159 | $55,599 | $50,545 | $45,950 | $41,772 | $562,362 |
| 43 | $67,275 | $61,159 | $55,599 | $50,545 | $45,950 | $628,598 |
| 44 | $74,002 | $67,275 | $61,159 | $55,599 | $50,545 | $701,458 |
| 45 | $81,403 | $74,002 | $67,275 | $61,159 | $55,599 | $781,604 |
| 46 | $89,543 | $81,403 | $74,002 | $67,275 | $61,159 | $869,764 |
| 47 | $98,497 | $89,543 | $81,403 | $74,002 | $67,275 | $966,740 |
The table shows that Rico’s nest egg will cross $900,000 before the end of his 47th year (26th year of working). Contrary to saving for 45 years to earn a five-year sabbatical at age 67, investing at 10% for 25 years achieves a permanent retirement at age 47.
Looking at the table closely will reveal that the savings from the earliest years grow the most and increasingly so each year. This demonstrates the effect of compounded investment returns (i.e. earnings return on top of the previous year’s gain) and the importance of starting to save and invest early. Starting early gives a huge advantage.
THE RATE OF RETURN MATTERS
We’ve established that saving to build assets is vital; you need money to make money (or else you’re the asset working for the man). We’ve also demonstrated that saving without also investing will likely lead to a very long working career that perhaps has no end. The next item to cover is the importance of the rate of return. It’s best shown by comparing a year’s worth of Rico’s savings invested at different rates of return. The table below shows the value of $10,000 at each year if invested at 5%, 10%, 15%, 20%, and 25% compounded annually.
| YEAR | 5% | 10% | 15% | 20% | 25% |
|---|---|---|---|---|---|
| 0 | $10,000 | $10,000 | $10,000 | $10,000 | $10,000 |
| 1 | $10,500 | $11,000 | $11,500 | $12,000 | $12,500 |
| 2 | $11,025 | $12,100 | $13,225 | $14,400 | $15,625 |
| 3 | $11,576 | $13,310 | $15,209 | $17,280 | $19,531 |
| 4 | $12,155 | $14,641 | $17,490 | $20,736 | $24,414 |
| 5 | $12,763 | $16,105 | $20,114 | $24,883 | $30,518 |
| 6 | $13,401 | $17,716 | $23,131 | $29,860 | $38,147 |
| 7 | $14,071 | $19,487 | $26,660 | $35,832 | $47,684 |
| 8 | $14,775 | $21,436 | $30,590 | $42,998 | $59,605 |
| 9 | $15,513 | $23,579 | $34,179 | $51,598 | $74,506 |
| 10 | $16,289 | $25,937 | $40,456 | $61,917 | $93,132 |
| 11 | $17,103 | $28,531 | $46,524 | $74,301 | $116,415 |
| 12 | $17,959 | $31,384 | $53,503 | $89,161 | $145,519 |
| 13 | $18,856 | $34,523 | $61,528 | $106,993 | $181,899 |
| 14 | $19,799 | $37,975 | $70,757 | $128,392 | $227,374 |
| 15 | $20,789 | $41,772 | $81,371 | $154,070 | $284,217 |
| 16 | $21,829 | $45,950 | $93,576 | $184,884 | $355,271 |
| 17 | $22,920 | $50,545 | $107,613 | $221,861 | $444,089 |
| 18 | $24,066 | $55,599 | $123,755 | $266,233 | $555,112 |
| 19 | $25,270 | $61,159 | $142,318 | $319,480 | $693,889 |
| 20 | $26,533 | $67,275 | $163,665 | $383,376 | $867,362 |
| 21 | $27,860 | $74,002 | $188,215 | $460,051 | $1,084,202 |
| 22 | $29,253 | $81,403 | $216,447 | $552,061 | $1,355,253 |
| 23 | $30,715 | $89,543 | $248,915 | $662,474 | $1,694,066 |
| 24 | $32,251 | $98,497 | $286,252 | $794,968 | $2,117,582 |
| 25 | $33,864 | $108,347 | $329,190 | $953,962 | $2,646,978 |
| 26 | $35,557 | $119,182 | $378,568 | $1,144,755 | $3,308,722 |
| 27 | $37,335 | $131,100 | $435,353 | $1,373,706 | $4,135,903 |
| 28 | $39,201 | $144,210 | $500,656 | $1,648,447 | $5,169,879 |
| 29 | $41,161 | $158,631 | $575,755 | $1,978,136 | $6,462,349 |
| 30 | $43,219 | $174,494 | $662,118 | $2,373763 | $8,077,936 |
It’s almost mind blowing to see how much of a difference the rate of return makes after compounding for many years. To drive the point home, consider that $1 growing at 10% for 25 years increases to $10.83, $1 growing at 20% increases to $95.40 in 25 years, and $1 growing at 30% grows to $705.64 in 25 years!!!
Let’s look at Rico’s retirement age with difference rates of return on his invested savings. If you recall, Rico could retire at age 47 with a nest egg of >$900,000 after saving $10,000/year invested at 10%. The next table shows Rico’s retirement age with various rates of return. We’re still assuming that he needs $900,000 to retire and will earn 10% investment returns after retirement.
| RETURN | RICO’S AGE (years of work) |
|---|---|
| 5% | age 58 (36 years) |
| 10% | age 47 (25 years) |
| 15% | age 42 (20 years) |
| 20% | age 39 (17 years) |
| 25% | age 37 (15 years) |
If the rate of return is so important, then why do the years to retirement show diminishing benefit (e.g. 11 years sooner from 5% to 10% yet only two years sooner from 20% to 25%) from further increases in the rate of return? The answer is because retiring sooner also means that saving that $10,000 per year also stops sooner. As a general rule, saving more early on is important while the rate of return on the nest egg becomes increasingly relevant as the nest egg gets bigger.
PUTTING IT ALL TOGETHER
Here are a couple of tips:
- Begin saving as much as possible as soon as possible
- Learn how to invest early to maximize returns and minimize mistakes when the nest egg is larger
Achieving financial freedom is easily doable if one is committed to consistently saving and then investing those savings. The former is achieved by figuring out how to live below one’s means and having the discipline to practice that. Savings can be increased by spending less, earning more, or both. Investing is a skill that can be easily learned. People have been successful in buying income producing real estate or investing in stocks. These are not the only ways to invest, but they’re probably the most common. Historically, the stock market has returned about 10-11%, but after subtracting inflation, which eats into purchasing power, the annual returns have averaged about 8%. Investing in the average or the whole stock market is completely passive because you could just invest in a S&P 500 index fund. Higher returns are achievable if one is willing to put in the work. The best investors in the world like Warren Buffett, Peter Lynch and Stanley Druckenmiller achieved average annual returns well in excess of 20% for many years. Saul Rosenthal is just a regular guy, but he’s anything but ordinary. His returns for the past 30 years have exceeded an average 25% per year. Some of my friends and I have learned and adopted his methods, and we’ve had amazing success. Getting to financial freedom is not a get rich quick scheme, but it’s easily achievable for those who have the will to make it a priority and the discipline to stick with it.
A final note: the amount that a person needs to retire depends on many factors. The example of $900,000 that Rico needed to retire is just a made up number.
The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.