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Monday, July 16, 2012

Wealth vs. Financial Independence (part 3)

In this three part series I have been discussing the factors that you need to consider when trying to figure out what financial independence is for you. In the first part I asked you to figure out how much income you need to live the life you want. In the second part you needed to choose what strategy is going to help you get there. 

In this part I am going to ask that you figure out what is your number...what net worth you need to achieve to reach financial independence...

Choosing a Net Worth Target

Another way of expressing how you are going to achieve financial independence and get on the road to wealth would be by setting a net worth target.

Your net worth is basically the result of all your assets minus your liabilities. Our main site goes into a lot of detail on the importance of net worth, calculating it and tracking it I recommend you review those articles.

Having a net worth target allows you to keep track of how you are getting closer and closer to financial independence. With net worth tracking you want to make it your goal to increase assets and reduce if not eliminate liabilities.

If you track your net worth the way I recommend, you will have no doubt if you are making progress or not. Because you are keeping a close watch on the assets that you are accumulating this in turn helps you make decisions
 since you should be choosing those actions, investments and financial moves that are going to increase your net worth. 

A big factor in choosing a net worth target is based on the amount of income you want to have when you reach financial independence. If you have determined for example that you want to have an income of $100,000 per year then you multiply that by a factor between 12-15 (more on that below). This gives you a net worth target of $1.2 to $1.5 million.

The bottom line here is that if you create a net worth in that range you should be able to reach financial independence. Because such an amount of assets if allocated in stocks, savings, real estate or a combination of all of these should give you an annual return of anywhere from 5% to 10%. This return should provide the $100k in annual income you are looking for while maintaining your principal (the $1.2M) untouched.

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Determining Your Net Worth Target

To find your net worth target you multiply your target annual income by a factor between 12 and 15. Why?...
Because you want to assume that your money will be invested in fairly safe vehicles that distribute regular income. It’s reasonable to expect a 5% yield from bonds or other low-risk money instruments and a 10% return from rental real estate and/or a well selected portfolio of stock investments.
If your funds are divided fifty-fifty, this will give you an average return of 7.5%. And the inverse of that, in percentage terms, is 13. Therefore 12 would be a more aggressive number if you expect better returns than this and 15 a more conservative one. I personally chose 13.

So for example if you determine you need $100,000 annually to cover all your expenses and have some to play with then you would multiply $100,000 by 13 which equals $1.3M. This means that you would want to build your nest egg to $1.3M at which point you would have enough income coming from your savings/investments to produce the $100k annually that will give you financial independence.
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Keeping Your Eye on the Ball


By this point you should have pen, paper and calculator in hand and be crunching some numbers!

Sit yourself down and crunch these numbers today. Knowing them can be the start or your whole financial plan. You will then be able to figure out how much you need to make, save and invest in order to achieve your goal and how long it will take to get there.

But most importantly you will now be able to see that financial independence is not a catch phrase to sell books but an actual, achievable goal for YOU.

Can you see the steps you need to take now?
Can this help you to create a plan to get where you want to go financially?

Share your comments or questions below and let me know how you are taking action...

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…thanks, my friends.




2 comments:

  1. Good article but I am not sure that I agree or understand why you say that achieving $x net worth will allow you to reach financial independence. After all, it really depends on what you do with that net worth and what is that net worth composed off. For example, if you have a $500,000 house that is paid off that's great and is part of your net worth but it does not help pay the bills. See my point?

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    Replies
    1. You are right Nate...a million bucks sitting in a savings account making 0.5% interest will not make you financially independent.

      What I was trying to say with the entire series is that you need to consider all of these factors; your net worth, other sources of income, how much money you need to live on, etc.

      Your net worth provides a marker and a goal but you are right that it really matters what your net worth is composed of. Because if you create whatever net worth you determine is sufficient for you it will make a big difference how that net worth is structured.

      What I want you more than anything is thinking about questions like this (which 99% of the people out there don't)to see what it is that you want financially and what kind of life you want to create with your money. In the end you will have to come up with your own definitions and goals.

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