Achieving financial independence requires only two things, a high savings rate and a descent rate of return. But what constitutes a high savings rate? What if you just want the lowest possible savings rate that will still get you to a comfortable retirement? Can you really expect to achieve financial freedom faster if you load up on high yield stocks? Answers to all of these questions are revealed as we explore the magical worlds of compound interest and savings rate below.
You’ve probably heard some version of the apocryphal Einstein quote about there being no greater force in the universe than compound interest. Compound interest is indeed pretty powerful. In case you are unfamiliar, compound interest is interest that is applied not only to the principal, but to all the previously accrued interest as well. And compound interest is made even more powerful by adding regular contributions of principal.
For example, if you invest $1,000 ONCE and let it grow at 10% interest per year, it will become $2593.74 after 10 years.
If you invest $1,000 per year and let it grow at 10% interest per year, it will become $15,937.42 after 10 years.
Of course, it doesn’t have to be 10% per year. It could could grow at 5% or 1% per year. So how do different growth rates effect your net worth?
Effect of Rate of Return on Net Worth
I’ve put together the following example to illustrate just how powerful compounding can be at growing net worth so that you can achieve financial independence.
We’re going to assume someone pulling in $70,000 per year. He currently saves 20% ($14,000) of his income annually. He will consider himself financially independent as soon as his investment income fully replaces his current expenses, $56,000 per year ($70,000 gross minus $14,000 savings = $56,000). He can pick from a variety of different savings vehicles ranging from CDs earning a paltry 1% per year to a stock market index fund pulling in 10% per year.
For the purposes of this model we’ll assume that he lives in a very static world without inflation and that he never gets a raise.
The below graph shows how each of his different investment options will grow over time. The red line represents $1,400,000. The amount he needs in the bank in order to safely withdraw 4% per year. A more conservative 3% safe withdrawal rate would shift the red bar down a bit.
Notice how only three (the 8%, 9%, and 10% investments) of his possible investment choices will allow him to achieve financial independence within a 30 year time horizon. 26 years is the earliest that he’ll be able to achieve financial Independence with this strategy.
Effect of Savings Rate on Net Worth
Compound interest doesn’t look so great if you want to achieve early financial independence. It’s great, but a 26 year timeline is long for those of us who who with early financial independence in mind.
You might suggest that we start shooting for investments with a rate of return well past 10%. Remember that interest or yield can also be a measure of risk. So the higher the rate of return goes, the greater the chance that we might start losing money. To be an investor, one must embrace risk, but I’m not a gambler, so don’t expect me to start speculating in penny stock futures anytime soon.
So what can we do to get to financial independence faster? We can adjust our savings rate.
Your savings rate is simply how much of your disposable (after tax) income that you save. Americans are abysmal savers, which probably explains why working longer is becoming the new retirement.
One very simplistic way to think about savings rate is to assume that you are just working, spending some money, and then shoving the rest under the mattress. How long would you have to work in order to buy 1 year of freedom?
- 10% savings rate – Work 9 years for 1 year of freedom
- 20% savings rate – Work 4 years for 1 year of freedom
- 30% savings rate – Work ~2.33 years for 1 year of freedom
- 40% savings rate – Work 1.5 years for 1 year of freedom
- 50% savings rate – Work 1 year for 1 year of freedom
Savings Rate Plus Compound Interest Delivers Early Financial Independence
We can all be a bit more sophisticated than shoving money under a mattress. We can invest in the stock market and couple the power of compound interest with aggressive savings.
For this example, we’ll start with the same fellow above who earns $70,000 per year. He can either spend his money or invest it in the stock market for an 8% return. But how much money should he be investing per year? The graph below shows savings rates ranging from 5% ($3,500 per year) to 50% ($35,000 per year).
As savings rate increases, the crossover point decreases. The crossover point is the point where your annual investment income is the same as your annual expenses. Basically, the point where you’ve achieved financial independence.
The red lines on the graph below start at the crossover year and show continued portfolio growth should our example saver continue working and saving at his current rates.
You will notice that with a 50% savings rate and an 8% rate of return, financial independence is achieved in 15 years. 50% is kind of aggressive (I speak from experience on this), so how about 30%? That leads to financial independence in only 23 years.
Savings rate and rate of return are both very important components of your investing plan. Save aggressively and, at a minimum, get yourself into a low fee stock market index fund. You can win the early financial independence game with just an index fund or two. There is much more to the world of investing like valuation, rebalancing, and diversification. But if you aren’t saving money, adding all the investing bells and whistles to your portfolio isn’t going to amount to a hill of beans.
The other important piece of information to take away from this post is that if you are saving only saving 15% or less of his income, financial independence is basically an impossibility. Did I mention before that most of America is screwed because they refuse to save? Maybe you’ll be able to retire on time or a bit late with the help of Social Security and maybe a pension. But it’s not going to be a very enjoyable retirement, since your standard of living will be forced down. 20% is the minimum that you should be saving!
Readers: What’s your savings rate? Have you thought about it? Do you feel that you’re on track to financial independence or retirement?