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What is the 4% rule?
What’s your financial freedom number? How much money do you need to have to be considered financially free? You can use the 4% rule to help you determine just how much you may need.
The 4% rule is a rule of thumb that calculates how much money you have to have saved to be considered financially independent and able to live off that wealth indefinitely. Most people seeking financial independence will use the 4% rule as a goal amount for how much they need to have in their portfolio.
For more info: The 9 Best Books on Financial Independence
Calculating your Financial Freedom Number: How does it work?
The 4% rule makes the following assumptions:
- Your wealth is invested and receives on average 8% returns annually
- You can live off of 4% of your total wealth – to calculate what your wealth should be take your average monthly expenses and multiply by 25
- Inflation is ~2% annually
With these assumptions, after you have saved up 25 times your average yearly expenses you can live off those savings indefinitely by investing those savings and living off of 4% of the total wealth. Assuming inflation is on average ~2% annually and you find a return on investment ~8% annually, you will have about 2% of wiggle room should inflation or rate of return be abnormally high or low.
Let’s take a look at an example:
If Kelsey and her family spend on average $50,000 per year, then she will need to have 25 times that, or $1,250,000 in wealth to consider herself financially independent. In other words, her financial freedom number is $1.25MM. See below for a snapshot of her wealth over time- assuming constant returns and inflation percentages every year (which is not realistic).
Over the 25-year period, Kelsey’s portfolio exhibits increasing gains over time.
According to these assumptions, Kelsey should never run out of money… but how does this rule stand up to actual data.
The 4% rule vs real data.
Pulling yearly inflation data and the historical S&P 500 returns over a 25-year period from 1990 to 2014 and applying those to an annual spend of $50,000 with a starting portfolio of $1,250,000, you can see the 4% rule play out in real time below.
While the actual portfolio is a lot more volatile over the 25-year period then the idealistic 4% rule, it still achieves the same desired effect of being able to live off of your portfolio indefinitely.
When does it not work?
So, if this is such a sure-fire way to never have to work, why isn’t everyone doing this? The 4% is a general rule of thumb for people to gauge their overall journey towards being ready for retirement or being financially independent. There plenty of scenarios in which the 4% rule will fail. Below are a few:
- If the market falls significantly at the beginning of your journey, you may never be able to recover from the losses.
- Assuming your average yearly expenses will never change is a long shot. While we can do our best to budget, we cannot plan for everything including sickness or the need to take care of a family member unexpectedly.
- While 7 to 8% is a decent estimate for average stock market returns, most people are not comfortable with having all of their money in stocks due to the volatility of the market. Therefore, when diversifying your portfolio, you may have to settle on a lower rate of return if you want to curb some of the risk.
Achieving your financial freedom number using the 4% rule.
The 4% rule is a valuable tool in determining where you should begin setting your benchmark portfolio goal. It also helps demonstrate how cutting down on spending can dramatically alter the amount of money you need to have in order to be considered financially independent. A couple that spends $100,000 per year has to have $2,500,000 in their portfolio versus a couple that spends $50,000 and only needs $,125,000.
How far are you from your financial freedom number?
Use this 4% rule calculator to determine how far you are away to achieving financial independence.