Moxie asks:

I’m a fairly new reader and may have missed it somewhere, but can you clarify your definition of “Financial Independence”? Thanks!

Financial independence is defined as being able to meet all current and future cash outflows with passive cash inflows. I define passive fairly conservative (for instance, I do not consider blogging income passive under the presumption that if you stop writing, the money eventually stops as well), but I’ll let that be up to the individual to decide.

I think I do not need to go into much detail about what a cash outflow is. It is when you put money in someone else’s hands. Cash inflow is when someone puts money in your hands.

Some observations:
For FI, Net worth is not the holy grail that people seem to think it is. For instance, most I know, at least the home owners, include their house as part of their net worth. However, for FI purposes, you need to ask yourself. Does the house put money in your hands? Maybe it does if you rent out a room, but most likely it doesn’t. It may however prevent your money from leaving your pocket (or pockets if you have so much of it that it does not fit in a single one) in that you do not pay rent. You will still be paying property taxes.

More importantly, is your money cordoned off in retirement accounts or unvested? In that case, the only money that count for FI is the money you can actually access, it is like having a gun with the wrong ammo.

Then there is the difference between theory and practice. In theory, based on history, if you have all your money in stocks and you withdraw 3% of your portfolio annually, it will last for the rest of your life. The 4% rate should be good for a few decades, at least. If your expenses are 4% of your portfolio at a market low, you are much more likely to survive than if it held during a market peak but statistically, both should hold.

If you have other investments than a market index or use another method than total return, other percentages may apply. Different types of investments seem to be arbitraged according to risk/reward (Sharpe ratio), but if you have significant assets relative to your expenses, you are not likely to be like most other market participants. In particular, you can ride out rough patches and volatility does not hurt you as much. This means you can get higher returns by NOT investing with the institutions which mostly focus on large cap and fixed income, but I digress.

Sometimes people talk of a crossover point. Make a graph by plotting your monthly expenses as well as your monthly passive income. Once these two lines meet, you will be financially independent and that’s the crossover. If you are still working and reinvesting all your gains, you can use either 3% or 4% of your portfolio (or whatever rate you deem realistic) and divide that amount by twelve months and plot that instead. That’s what I did.

In retrospect I would have invested closer to what I’m currently doing so I would not have to rearrange my portfolio towards dividend income when I “retired”.

Originally posted 2009-05-05 10:20:46.