Summary: Building wealth and making progress toward financial freedom boils down to a single, simple formula that applies to everyone:
Your progress toward financial freedom is the inescapable mathematical result of how much your income exceeds your expenses and what you do with the surplus. Income, Expenses, Tax, Time, Debt and your average Investment Return Rate are the only factors that matter.
Details:
The financial freedom formula is so universal it can actually be written mathematically:
W = P * (1 + R)Y + (I - E - T )[ ((1 + R)Y - 1) / R ] ± D
W = Financial Wealth
P = Principal (Initial sum of money)
R = Investment Return Rate after all fees (Weighted average of different investments and rates)
Y = Number of Years
I = Annual Income
E = Annual Expenses
T = Income Tax
±D = Aggregate impact of Debt. (Obviously consumption debt has a negative impact but so can much supposed wealth-creating debt like property mortgages. Each debt needs to be calculated separately and properly as to its effect on your wealth. Don't take on debt if you can't accurately ballpark its wealth impact.)
Most people don't have the immediate inclination to apply this formula manually in a spreadsheet (if doing so precisely, you'll want to separate different types of investments and their return rates and calculate the separate effect of each debt). The main purpose is simply to introduce all of the critical variables: Income, Expenses, Tax, Investment Return Rates, Time (Years), Debt and be able to estimate the outcome of changes to them.
Simply use your preferred Compound interest calculator that allows regular contributions to plug in values for P, R, Y and the Annual Contribution (I - E - T).
Note: The aggregate impact of Debt has to be ignored from compund interest calculators but you can work out the outcome of each debt over time using debt calculators.
MoneySmart's Compound interest calculator produces a wealth tally (excluding tax) of $819,910 with P = $0, R = 7%, Y = 20 years and the Annual Contribution = $20,000.
Importantly, your total contributions amounted to only $400,000. The other $419,910 are purely investment returns and as the graph shows they increasingly outweigh your own contributions over time.
Once people realise that compounding investment returns increase exponentially unlike wage or business income it becomes inevitable to question for how long one should slave away full-time exchanging time for money when simply investing money wisely can do the job more efficiently.
If we run the same calculation over 50 years (excluding tax) you end up with over $8 million, of which over $7 million comes from investment returns. However, the marginal value of extra money is limited once you've satisfied your needs and most worthwhile wants. Also, tax becomes a bigger and bigger disincentive once your yearly income is over a certain level. In Australia each dollar in taxable income over $180,000/yr is taxed at almost 50%.
It turns out there is a sweet spot for most people's quality of life when annual investment returns start climbing over $25,000 (which requires $360,000 at 7%). It makes sense to work less or more selectively, avoid your marginal tax rate getting too high, focus more on non-financial life enhancement (health, leisure, relationships, meaningful activities), and eliminate unnecessary living costs (costs relating to work, being time-poor, or that don't really improve quality of life).
For example, after getting to $360,000 let's say you downshifted work such that your wage income after tax only just covered your living expenses and left you no extra investment contributions. Your $360,000 would still grow to $708,174 after 10 more years.
At this level of wealth you could quit regular work entirely and, if you received a 7% return, obtain over $49,000 per year in pre-tax investment returns indefinitely. This is more than enough to live comfortably on. Indeed, there's sufficient headroom to weather volatility in investment returns or invest more safely at lower rates.
Most people who achieve financial freedom don't quit work forever though. They may take extended breaks from work but ultimately use their financial freedom to choose part-time work that is more satisfying and on their terms not an employers. They develop more varied skills and interests and pursue hobbies. Some insource tasks like cooking or maintenance they previously would have paid for.
Is this feasible for most Australians?
- Average annual wages are $1,191/week ($61,958/year). The median wage is around $55,000/year. The average full-time wage is $81,000/year. (All before tax).
- A couple (or single person house-sharing) can afford all necessities and enjoy life with annual expenses of less than $25,000/year each (more expensive cities also have higher wages so this evens out).
- So even if earning only $55,000/year this is about $47,000 after tax. Minus $25,000 if you live like a student and that leaves $22,000/year to invest. For each person!
This is just a starting point. In practice, the more enlightened you become about focusing on quality of life and not quantity of consumption or ownership, the more enjoyably you can live on $25-35k/year while your wages and investment earnings grow far in excess of this level.
As for the 7% average investment return, this is the most challenging. I will discuss this in more detail but the most passive options include:
- Your progress toward financial freedom is the inescapable mathematical result of how much your income exceeds your spending and what you do with the surplus. Income, Expenses, Tax, Time, Debt and your average Investment Return Rate are the only factors that matter.
- Some people don't become wealthy because as their income increases they increase their spending so no significant surplus between Income and Expenses is ever created. Sometimes this is "lifestyle inflation" like expensive homes, cars and holidays but it can also be optional expenses like various types of insurance, private alternatives to public services (e.g. health, education), and using professional services like accountants, financial planners and lawyers.
- Some people don't become wealthy because they don't understand that most riches are built slowly by leveraging time, not suddenly in the future by leveraging some opportunity or luck. The length of time you have the formula working gradually for you is critical.
- Many people progress very slowly or don't bother for long periods because they save but don't invest optimally and their Investment Return Rate is very low. However, the best, simple, passive investing opportunities can simply be copied from the wisest investors without understanding them.
- Most Australians dedicate their surplus income toward paying a mortgage for a home to live in or a property investment. But directly owning property is almost always a terrible investment. Once you have significant wealth, buying a long-term home can be worthwhile for non-financial reasons. But it is always a mistake to devote most of one's surplus income to direct property ownership too early.
- Avoid carrying any debt with the only exceptions being: (a) a mortgage only when it makese sense (Price to Rent ratio not too high, settled and won't move for at least 10 years, spending a lot of time at home and will benefit a lot from stability); (b) worthwhile education costs at low interest rates.
- Avoid or eliminate all supposedly wealth-building debt unless you can demonstrate it actually is the best way to build wealth and is necessary.
- Don't buy property when the Price to Rent ratio exceeds 20 and learn how to get the most out of renting and saving on accommodation through various life stages (sharehousing, housesitting, living with less rooms, etc)
- Avoid major wealth leaks like spending on gambling, smoking, alcohol, drugs, sex and similar habits. Avoid other pitfalls like ending up paying child support, or being a victim of theft or scams.
- Invest in your education and skills to obtain well-paid work you can continue to develop expertise in. Maximise opportunities like moving to a better location, demonstrating capability through your own projects and involvement in groups (even if unpaid), or engaging in part-time work while studying. Become invaluable to your employer/clients, give yourself options, and then ensure your rate of pay increases with your value.
- Consolidate all of your superannuation into the balanced option of a large, highly-rated, low-fee industry fund and make salary-sacrificed contributions in years where your income (and thus tax) is particularly high.
- Use your high savings rate to start building your savings early via compounding. Focus on conservative investing first (term deposits, RateSetter Australia) while you learn about higher return/volatility investing so that you never suffer large losses through scams or unjustified risks. But start actively building your knowledge and then use of the full range of investment opportunities I recommend.
Spend less than you earn and invest the difference wisely. Also, minimise debt and unnecessary tax.
Your progress toward financial freedom is the inescapable mathematical result of how much your income exceeds your expenses and what you do with the surplus. Income, Expenses, Tax, Time, Debt and your average Investment Return Rate are the only factors that matter.
Details:
The financial freedom formula is so universal it can actually be written mathematically:
W = P * (1 + R)Y + (I - E - T )[ ((1 + R)Y - 1) / R ] ± D
W = Financial Wealth
P = Principal (Initial sum of money)
R = Investment Return Rate after all fees (Weighted average of different investments and rates)
Y = Number of Years
I = Annual Income
E = Annual Expenses
T = Income Tax
±D = Aggregate impact of Debt. (Obviously consumption debt has a negative impact but so can much supposed wealth-creating debt like property mortgages. Each debt needs to be calculated separately and properly as to its effect on your wealth. Don't take on debt if you can't accurately ballpark its wealth impact.)
Most people don't have the immediate inclination to apply this formula manually in a spreadsheet (if doing so precisely, you'll want to separate different types of investments and their return rates and calculate the separate effect of each debt). The main purpose is simply to introduce all of the critical variables: Income, Expenses, Tax, Investment Return Rates, Time (Years), Debt and be able to estimate the outcome of changes to them.
Simply use your preferred Compound interest calculator that allows regular contributions to plug in values for P, R, Y and the Annual Contribution (I - E - T).
Note: The aggregate impact of Debt has to be ignored from compund interest calculators but you can work out the outcome of each debt over time using debt calculators.
MoneySmart's Compound interest calculator produces a wealth tally (excluding tax) of $819,910 with P = $0, R = 7%, Y = 20 years and the Annual Contribution = $20,000.
Importantly, your total contributions amounted to only $400,000. The other $419,910 are purely investment returns and as the graph shows they increasingly outweigh your own contributions over time.
Once people realise that compounding investment returns increase exponentially unlike wage or business income it becomes inevitable to question for how long one should slave away full-time exchanging time for money when simply investing money wisely can do the job more efficiently.
If we run the same calculation over 50 years (excluding tax) you end up with over $8 million, of which over $7 million comes from investment returns. However, the marginal value of extra money is limited once you've satisfied your needs and most worthwhile wants. Also, tax becomes a bigger and bigger disincentive once your yearly income is over a certain level. In Australia each dollar in taxable income over $180,000/yr is taxed at almost 50%.
It turns out there is a sweet spot for most people's quality of life when annual investment returns start climbing over $25,000 (which requires $360,000 at 7%). It makes sense to work less or more selectively, avoid your marginal tax rate getting too high, focus more on non-financial life enhancement (health, leisure, relationships, meaningful activities), and eliminate unnecessary living costs (costs relating to work, being time-poor, or that don't really improve quality of life).
For example, after getting to $360,000 let's say you downshifted work such that your wage income after tax only just covered your living expenses and left you no extra investment contributions. Your $360,000 would still grow to $708,174 after 10 more years.
At this level of wealth you could quit regular work entirely and, if you received a 7% return, obtain over $49,000 per year in pre-tax investment returns indefinitely. This is more than enough to live comfortably on. Indeed, there's sufficient headroom to weather volatility in investment returns or invest more safely at lower rates.
Most people who achieve financial freedom don't quit work forever though. They may take extended breaks from work but ultimately use their financial freedom to choose part-time work that is more satisfying and on their terms not an employers. They develop more varied skills and interests and pursue hobbies. Some insource tasks like cooking or maintenance they previously would have paid for.
Is this feasible for most Australians?
- Average annual wages are $1,191/week ($61,958/year). The median wage is around $55,000/year. The average full-time wage is $81,000/year. (All before tax).
- A couple (or single person house-sharing) can afford all necessities and enjoy life with annual expenses of less than $25,000/year each (more expensive cities also have higher wages so this evens out).
- So even if earning only $55,000/year this is about $47,000 after tax. Minus $25,000 if you live like a student and that leaves $22,000/year to invest. For each person!
This is just a starting point. In practice, the more enlightened you become about focusing on quality of life and not quantity of consumption or ownership, the more enjoyably you can live on $25-35k/year while your wages and investment earnings grow far in excess of this level.
As for the 7% average investment return, this is the most challenging. I will discuss this in more detail but the most passive options include:
- investing long-term in the lowest-fee, diversified passive index ETFs like VDHG
- salary sacrificing into the Balanced option of the best industry super funds or managing investments in ETFs and LICs/LITs via BT Super Invest
- using the best term deposit and online saving rates (e.g. UBank)
- when bank rates are very low shifting bank savings to Plenti's 5 year market (as long as the rate is at least a few percent above the 5yr term deposit rate)
Things to know:
- Your progress toward financial freedom is the inescapable mathematical result of how much your income exceeds your spending and what you do with the surplus. Income, Expenses, Tax, Time, Debt and your average Investment Return Rate are the only factors that matter.
- Some people don't become wealthy because as their income increases they increase their spending so no significant surplus between Income and Expenses is ever created. Sometimes this is "lifestyle inflation" like expensive homes, cars and holidays but it can also be optional expenses like various types of insurance, private alternatives to public services (e.g. health, education), and using professional services like accountants, financial planners and lawyers.
- Some people don't become wealthy because they don't understand that most riches are built slowly by leveraging time, not suddenly in the future by leveraging some opportunity or luck. The length of time you have the formula working gradually for you is critical.
- Many people progress very slowly or don't bother for long periods because they save but don't invest optimally and their Investment Return Rate is very low. However, the best, simple, passive investing opportunities can simply be copied from the wisest investors without understanding them.
- Most Australians dedicate their surplus income toward paying a mortgage for a home to live in or a property investment. But directly owning property is almost always a terrible investment. Once you have significant wealth, buying a long-term home can be worthwhile for non-financial reasons. But it is always a mistake to devote most of one's surplus income to direct property ownership too early.
Things to stop doing or avoid:
- Avoid carrying any debt with the only exceptions being: (a) a mortgage only when it makese sense (Price to Rent ratio not too high, settled and won't move for at least 10 years, spending a lot of time at home and will benefit a lot from stability); (b) worthwhile education costs at low interest rates.
- Avoid or eliminate all supposedly wealth-building debt unless you can demonstrate it actually is the best way to build wealth and is necessary.
- Don't buy property when the Price to Rent ratio exceeds 20 and learn how to get the most out of renting and saving on accommodation through various life stages (sharehousing, housesitting, living with less rooms, etc)
- Avoid major wealth leaks like spending on gambling, smoking, alcohol, drugs, sex and similar habits. Avoid other pitfalls like ending up paying child support, or being a victim of theft or scams.
Things to start doing:
- Invest in your education and skills to obtain well-paid work you can continue to develop expertise in. Maximise opportunities like moving to a better location, demonstrating capability through your own projects and involvement in groups (even if unpaid), or engaging in part-time work while studying. Become invaluable to your employer/clients, give yourself options, and then ensure your rate of pay increases with your value.
- Time is critical. Start saving AND investing as early as possible. Don't put off investing till you understand it. Piggyback off the best advice. Switch from seeing money's sole purpose as consumption to seeing money's greater potential as a way to make more money and buy your freedom from wage slavery.
- Live close to work without a car in an area you can do your regular trips by walking, cycling or transit. Buy as few cars as possible and only second-hand, reliable ones.
- Invest the time and effort to minimise all required expenditures like energy, water, internet, phone, healthcare costs and tax.
- Minimise discretionary spending to boost your savings rate by spending purposefully only on things that genuinely best contribute to your happiness.
- Prefer used to new and repair to replace. Wherever worthwhile, work toward efficient self-sufficiency rather than paying others (child care, personal services, cleaning, transport, etc).
- Self-insure wherever possible and eliminate all unnecessary fees and charges from financial services.
- Invest the time and effort to minimise all required expenditures like energy, water, internet, phone, healthcare costs and tax.
- Minimise discretionary spending to boost your savings rate by spending purposefully only on things that genuinely best contribute to your happiness.
- Prefer used to new and repair to replace. Wherever worthwhile, work toward efficient self-sufficiency rather than paying others (child care, personal services, cleaning, transport, etc).
- Self-insure wherever possible and eliminate all unnecessary fees and charges from financial services.
- Consolidate all of your superannuation into the balanced option of a large, highly-rated, low-fee industry fund and make salary-sacrificed contributions in years where your income (and thus tax) is particularly high.
- Use your high savings rate to start building your savings early via compounding. Focus on conservative investing first (term deposits, RateSetter Australia) while you learn about higher return/volatility investing so that you never suffer large losses through scams or unjustified risks. But start actively building your knowledge and then use of the full range of investment opportunities I recommend.
Further Info:
- Of course, there will be differences between people in circumstances and opportunities. But everyone who has to make decisions about their income (e.g. work), spending and any potential surplus (i.e. saving and investing) has some control over their wealth and financial freedom. And that control is fully expressed by the formula.