The 4% Rule: How you know you can finally stop working
One of the most common questions I hear from people first learning about Financial Independence is, "When do I know that I have enough money to retire?" And this is a great question for several reasons:
Having a goal to aim at is critical. Without the destination in mind, you won't really care if you're making progress, but if you know what you're aiming at, you can see if your steps are paying off.
You'll also have more motivation if you know that there's a light at the end of the tunnel.
For a lot of people, they don't know that there's actually any answer to this question, because greed and marketing (and Instagram) have us chasing a never ending amount of increasingly expensive things and experiences. If you just think of money as a way to buy stuff, and there's an infinite amount of things to buy, you might need infinite money to retire "in style".
There are two parts to the answer to the question of when you have enough money to quit your job and sip fruity drinks in photogenic locations forever. The first part comes from knowing yourself, particularly, how much you spend in a year, or want to spend in a year of retirement. The first step to knowing this is by tracking your spending. Modern technology makes this incredibly easy with apps on your phone like "Spending Tracker" (it's free on iOS and Android and can be set to AED). It takes about 10 seconds after you make a purchase to log it into the app and select which category like rent, clothes, cell phone, etc that the purchase belongs to. Pretty much every financial expert I've ever listened to recommends this as the first step towards taking charge of your economic life, and for good reasons! Without this information, you can't really know how much you spend or what you spend it on. And you can't figure out how much you need per year to live on after you stop working.
There is a lot of debate as to how much of your spending per year that you'll need after your retirement. Some people say 70% of what you spend now, as you'll have more time to do things that save you money like cook at home. Others say you'll need more than you currently spend, because you'll have to find ways to entertain yourself or else you'll get bored. Only you can really answer that question, but for me, a good estimate is just to say how much you spend currently at leave it at that, it's just easier.
Now that you know the amount you spend per year, multiply that by 25. This number is the amount you need in investible assets like stocks, bonds, or preferably low cost index funds. "Wait!" you're probably saying right now, "Why 25? Why not 20 or 40?" And the answer, as is so often the case, is MATH! In 1998 three Finance professors at Trinity University published a study that showed that if you withdraw 4% of your assets per year, you have a 98% chance of having your money outlive you over the course of a 30 year retirement. This changes a little depending on what percentage of stocks vs what percentage of bonds you have, but if you have a good asset allocation of around 80% stocks /20% bonds to around 60% stocks / 40% bonds, odds are, you are good to go!
If you need $40,000 USD per year, you would need a portfolio of $1,000,000 to retire, if you had no other pensions or sources of income. If you were going to get a pension of $20,000 per year, you would only need $500,000 in your portfolio to provide you with the other $20,000.
So, if you already have a portfolio of $1,000,000 and you feel like you can live off $40,000, CONGRATULATIONS! You can quit right now and go live a relaxing life away from office politics, alarm clocks, and rush hour commutes. You've made it!
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