Many of us are working hard to earn enough money to stay afloat while we try to save every month so that we can be financially free one day. The idea of financial freedom is captivating. However, very few people know what to do to achieve this. In short, do you know how much is enough for you?
Financial freedom is not the same as wealth
I believe it is possible for nearly everyone to be financially free but very few people will be wealthy. This might seem like semantics but there are big differences between the two.
Financial freedom is when you have enough income from your investments to cover your lifestyle costs every month without depleting your capital.
Being wealthy is usually linked to a specific size of assets. For example, someone who is worth R14 million or US$1 million would be considered wealthy in any country. However, if you are worth R14 million and spend R100 000 per month on your lifestyle, you are wealthy but not financially free. This is because you are going to erode the value of your capital within 10 or 12 years. Someone who is worth R7 million and spends R26 000 per month is financially free because the amount required from the capital is not too high and therefore the capital will probably be maintained over the person’s lifetime.
I believe there are three steps to financial freedom.
1. Be debt-free
You should not owe money on credit cards or for personal loans or overdrafts. In fact, it would be ideal if you had no debt at all. The only acceptable debt would be for ownership of assets where your income and capital are likely to increase in value faster than inflation. In most instances, this would be debt on a rental property or business.
2. Have an emergency fund
You should have a cash account or money market fund where you hold enough money to cover your monthly lifestyle costs for a minimum period of three to six months. In other words, if you spend R20 000 per month, your emergency fund should be between R60 000 to R120 000 in value.
3. Use income from assets to cover your expenses
It is important to know how much you spend in an average month on your lifestyle. This amount should include your regular monthly expenses (groceries, data, entertainment, clothes, transport and so on) as well as irregular expenses like holidays and replacing vehicles. If you spend R200 000 every five years on a replacement vehicle, you should add R3 334 to your monthly lifestyle costs to cover this.
Once you have identified what your average monthly lifestyle costs are, multiply this by 300 to determine how much capital you will need to be financially free. Let’s consider the example of someone who spends R20 000 a month on their average lifestyle costs. If we multiply this by 300, we get to an amount of R6 million.
If the person was to invest this R6 million in a typical balanced unit trust, they would get an average return of 10% a year, after costs. If inflation is 6% per year, that means they can still draw 4% a year to cover lifestyle costs. A withdrawal rate of 4% is R240 000 a year or R20 000 per month. I’m sure many people will point out that balanced unit trusts have not delivered 10% over the last few years, but over the last 10 years the average balanced unit trust has generated 10.45% per year.
The real secret to financial independence is to limit your monthly lifestyle costs as much as possible. If you keep your monthly costs really low, you will need a very limited amount of capital to fund your lifestyle in future.
There is an entire movement called FIRE (Financial Independence, Retire Early) that has gained popularity over the last few years. This lifestyle movement is about achieving financial independence and being able to retire early should one choose to do so. If you like the sound of this, there is a huge amount of information on the internet about how to limit your lifestyle costs.
Warren Ingram is executive director of Galileo Capital.
The views and opinions shared in this article belong to their author, cannot be construed as financial advice, and do not necessarily mirror the views and opinions of Moneyweb.