Whenever I'm considering a new purchase, I try to figure out a way to make the cost more tangible so I can determine whether or not it’s worth it. In high school and college I used to think of the opportunity cost in terms of the other things I would likely buy with the money instead.
It was usually food that resonated the most with my primordial brain. When I was really young it was candy bars, then it was Hot and Spicky McChickens1 from McDonalds and most recently, Chipotle burritos. For instance, how many Chipotle burritos is this diamond ring going to cost me? 125? That’s a lot of burritos... maybe I’d rather have the burritos instead of getting married. It was a good system.
After I graduated and started a higher paying job, I started investing any money that I didn’t spend each month.
Pretty great, huh? Sure… but this completely ruined my previous opportunity cost strategy. Making a purchase didn’t equate to losing X burritos; instead, it just came out of the money that I would have invested at the end of the month. Having X less shares of an S&P 500 index fund just doesn't have the same ring; it's not nearly as visceral.
In actuality, forgoing investment for consumption is a much bigger deal. If invested money grows steadily over time and I have a fairly long time horizon, I could be losing out on way more than a few burritos just by buying this thing.
But how much? Are we talking fancy cars or mansions or college savings for my kid(s)? Could that slice of pizza really be worth a private jet later on? Hyperbole, sure, (unless that's a really expensive slice of pizza) but without a better way to conceptualize the cost, how can we know how hyperbolic it is?
Time for a new strategy. Instead of things, let's focus on something else that's easy to conceptualize: time. Time to financial independence, to be specific. We'll define "financial independence" as the point at which one can live indefinitely off of passive investment income only. It won’t matter if you live for 6 more years or 600 more years.
So that’s the big question: if instead of buying this thing, I invest the money, how much earlier, on average, will I reach financial independence?
Here is a rough set of financial attributes for an average U.S. household (data from 2016):
- Average Annual Expenses: $57,311
- Median Savings: $60,000 (among families with retirement savings)
- Yearly Savings: Savings Rate * Median Household Income = 7.6% * $57,617 = $4,378
Here's how some popular expenditures can delay this household's financial independence:
|New Car||$34,0772||5 years, 262 days, 22 hours, and 44 seconds|
|Trip to Europe||$5,000||238 days, 7 hours, 3 minutes, and 22 seconds|
|Lunch||$15||16 hours, 49 minutes, and 49 seconds|
|Guac on your burrito||$1.95||2 hours, 11 minutes, and 16 seconds|
This will help you conceptualize how much you are giving up when making a purchase, in terms of time until financial independence (FI). Then you can decide if it's worth it!
How much money do you need to reach financial independence? Here is one common way to think about it: the 4% rule. To calculate how much wealth you need to accumulate, with some assumptions that we'll detail in a moment, it only takes two steps:
- Determine your annual expenses (food, rent/mortgage, fun things, child care, etc.). One assumption is that you will continue to spend this much every year.
- Multiply the number you calculated in (1) by 25. This is a guideline for how much you need.
That’s it. If you spend $40,000 per year, you'll need to save and invest $1,000,000 before you are financially independent.
Where did that "25" number come from? That corresponds to a safe withdrawal rate (SWR) of 4% (1/4% = 25). SWR is a retirement philosophy, but it can be applied to financial independence as well. The idea behind SWR is that because you have investment income (growth, dividends, interest, etc.), you can withdraw a fixed (but inflation adjusted) amount from your investments every year, and be confident your money will outlive you.
Over the long term, a portfolio of 100% stocks (before taxes and fees) has historically returned a real annualized inflation adjusted return of 6-7%. Therefore, if you only withdraw 4% of those earnings per year, your portfolio should increase 3% each year. So why not a 6-7% SWR?
The issue is that those returns don't come in gradually and consistently, they come in spurts with a lot volatility in between. Poor returns in early phases of financial independence are particularly bad. There is a chance that the day you reach your financial independence wealth goal the market crashes 20% or more. A nest egg 20% smaller will grow significantly slower than the original amount, which puts the whole account at risk of being drained if the withdrawal rate is too high. This is referred to as sequence of return risk.
A SWR of 4% was determined by researchers evaluating the optimal SWR that would keep a portfolio balance above 0 after a 30 year period even after weathering the worst possible historical sequence of returns.
A quick Google search will show plenty of detractors from the 4% rule. They argue it should be lower for a variety or reasons (slower economic growth, lower interest rates, etc..).
One of the key themes here is that it's very difficult to be 100% certain of anything. In this case, the additional wealth needed to gain a marginal point of certainty is high. The good news is that, depending on your philosophy and situation, being 100% certain isn't necessary.
If you happen to get very unlucky and reach financial independence at the beginning of one of the worst historical periods for growth, you likely have options. The 4% rule is very rigid and assumes constant withdrawals of a fixed (but inflation-adjusted) amount each year from your portfolio regardless of market conditions. A little flexibility to decrease spending or a willingness generate even just a little income before or during periods of slow growth can go a long way to ensuring portfolio longevity.
This tool uses a SWR of 4% by default. You can make it higher or lower under the 'assumptions' accordion. Here are some other interesting takes on SWR:
|The Trinity Study||4%||Study that popularized the '4% rule' originally proposed by William Bengen.|
|Retirement Researcher||3.94% (US)||Historical SWR by investment allocation and country.|
|Mad Fientist||3.5% - 5.5%||Adaptive SWR for early retirees (longer than 30 years), depending on market valuations.|
|Financial Samurai||0.5%||Government bond only portfolio in a low interest rate environment.|
The default return assumption for this calculator is 6.11%. This is based off the inflation-adjusted historic return of the S&P 500 index adjusted downward by a 15% capital gains tax rate and a 0.03% expense ratio.
Feel free to adjust the sliders in the assumptions accordion.
- Changing the SWR slider changes how much wealth you'll need to accumulate to reach financial independence.
- Changing the ROI slider affects the how much every dollar you spend increases the amount of time required to reach that wealth goal.
Clearly, many things are worth their cost. That's for you to decide. You may or may not be tempted by the 40 seconds of financial independence you gain by picking up a penny off the ground and investing it, or from the 16 minutes and 50 seconds you get from doing the same with a quarter. Either way, hopefully now when you decide to part with your hard-earned money, you'll have a better idea of what you're giving up!
Late one night in New Hampshire I just got off of a flight from Denver and was starving. I busted into the closest McDonald's I could find and boldly declared "Two Hot 'n Spicys, please!". The very Bostonian man behind the counter looked up at me, perplexed, and said "Two what?". "Hot n Spicys?" I said, much less confidently. I looked up at the menu and to my horror, in the place of the Hot n' Spicy on the Dollar Menu was just the word "McChicken". "Ummm... two McChickens". So I ate the two bland chicken sandwiches.. meh. I learned later that the Hot n’ Spicy McChicken is a regional delicacy those who don't live in certain parts of the south and southwestern United States will have to travel to appreciate. This is what you're missing out on.↩