Updated: Oct 8
When I was just a few years out of university and trying to find my way in the world, I did a quick calculation of my expenses and tried to figure out how much I would need to save to ensure I had 30+ years worth of money for retirement. It was immediately evident to me that I would never be able to save enough to support myself for a prolonged period. I would never have full financial independence.
This was the mid 2000's, I was making just a little above US minimum wage. Paying my student loans, credit card debt, rent and car payment used up almost all of my income. I was barely able to make ends meet each month. Saving anything was a challenge. Saving enough to make a difference in my future looked impossible.
What I didn't know then was the power of compound interest.
Compound interest works against you if you're in debt. It's why it's so hard to get out of debt, because it grows exponentially.
But compound interest can work in your favor. Essentially, compound interest is earning interest on interest.
Oversimplified example: If you invest $1000 and earn 10% interest on it annually, after one year you will have $1100. The original $1000 plus $100 (the ten percent interest). If you reinvest that $100, the following year you earn 10% on that too. So your interest earnings will go up to $110 the second year, for a total of $1210 after the second year. Each year your interest earnings will increase because you're earning interest on more money.
Money grows faster the longer it's invested.
So, how does this change what's possible?
Because we know that on average, the total stock market has increased by about 10% per year over the past 100 years, we can make the assumption that it will, on average, continue to do so.
If we are able to invest in the entire stock market (diversification) then, over time, our investments will grow. (Note that this is not true in the short term due to volatility)
So we don't actually need 30+ years of expenses saved up, we only need about 25 times our annual expenses, and that should last forever.* This is known as the 4% rule. We use it to estimate our financial independence (FI) number (the amount of money you need invested in order to support yourself only from the interest earned in that investment). This is also a little oversimplified, but it's useful to know what's possible when you're first setting your financial goals.
The amount of money you need to save is lower than you might think, and your money can grow. So it's actually easier to get financial independence (aka retirement) than you might have guessed (if you were me at 26).
You can accelerate the time it takes to get to your FI number by increasing your earnings and/or decreasing your expenses. This is why expense tracking is so beneficial.
If you already know your annual income and annual expenses you can figure out how long it would take you to get to FI using Networthify's Retirement Calculator. (Assuming you invest your savings in the whole stock market.)
Mr Money Mustache wrote this excellent post about how quickly you can get to your FI number. The main idea is encapsulated in this image he adapted from Networthify's calculator.
This is enough information to make initial financial goals, but you need to know more specifics before you make an investment plan. Sign up for a free call, or continue reading up before you make any changes to your current investment strategy.
*Note that more recent research has come to the conclusion that 3.5% is the sure withdrawal rate for your money to last forever. But 4% is still a useful planning tool, and it still works for 30 years even in bad market conditions.