What is financial independence? It is a state where ones assets generate enough passive income to pay for the required expenses of life.
People also mention this state of independence as financial freedom.
In this state of independence, people need not work (do a job) to earn income. What they rely on is effortless automatic income (called passive income).
- A state of financial independence.
- The Process:
- Importance of other goals.
- Final words.
A State of Financial Independence
What is shown in the above flow chart is a state of financial independence.
- Asset Base: These are those assets which has been accumulated overtime in form of investing. These assets can be a house property, stocks, deposits, annuity etc. Read: about asset building.
- Return on Asset: The “Assets” accumulated above generates regular returns. These returns can be in form of cash (like rent, dividend, interest etc), or capital appreciation (profit booked). Let’s say, these returns are getting credited periodically in a bank account.
- Passive Income: These periodic returns, are available for consumption. It is a form of income. As the income so generated is happening automatically, it is called as passive income. Read: about passive income.
- Required Expense: These expense requirements are met by consuming passive income. The lower will be the “required expenses”, lesser will be the demand for passive income. Read: Plan expense for early retirement.
- Re-Investment: It is also an important ingredient to maintain the state of financial independence. Re-investment increases the size of asset base. The bigger will be the asset base, more will be the return from these assets. Increasing returns, is essential to negate the effect inflation. Read: How to invest after retirement.
To reach the state of financial independence, the first step is to start accumulating assets. These assets in turn must generate income (passive income). The passive income will take care of different needs of life.
Process: To Achieve Financial Independence
It is necessary to follow a process to achieve financial independence. Why?
Because it is tough goal to achieve, and following a process makes it easy and quantifiable. How?
- Preconditions: There are few things that needs to be done before one even attempts to attain financial independence. What are these things? These are such activities which improves ones financial health. These improvements in turn helps one to climb the peak of financial independence. Read more.
- Implementation: This is where the core idea of building financial independence (asset building & passive income generation) is implemented. Here we will discuss how one needs to map their minds to successfully implement the idea. Read more.
- Stages of Financial Independence: Financial independence is a dynamic goal. There are three stages of financial independence. In the first stage, people can independently afford “basic” necessities of life. Similarly in second and third stage, expenses of “comfort” and “luxury” in nature can be afforded. Read more.
To begin the journey of financial independence, one must start with the “preconditions”.
If these preconditions are implemented properly, it builds a solid foundation on which the infrastructure of “financial independence” can stand.
1. Preconditions: To Financial Freedom
Everyone must aspires to achieve financial freedom. But it also important to realise that this is not an ordinary goal. To achieve this goal, it is necessary to follow a process.
The process to achieve financial independence starts with the “preconditions”. Following these preconditions will strengthen one “financial health”. Read: Tips on money management.
There are three preconditions that one must take care:
- #1.1 Emergency Fund Creation: Prepare self for the worst. Start building emergency fund. This fund basically consists of cash and insurance. How much cash, life cover, and health cover should be enough? The bigger is the emergency fund the better. But essential is to first build the minimum balance and take the next step. Read: Where to keep emergency fund.
- #1.2 Becoming Debt Free: Debt is a financial burden. Best is to keep the debt burden at zero. Why? Because to reach the goal of financial independence, debt is the biggest hurdle. Why? Rich people avail loan to leverage their profits. We take loan to buy things we cannot afford. That is why it is a hurdle. Set a target to be debt free. How to be debt free? The easiest way is to list down all debt/loans that one is carrying. Start by paying off the costliest debt first. Read: Plan to become loan free.
- #1.3 Build Cushion Savings: Emergency fund and debt-pay-off serves a different purpose. What is cushion saving? It is that money which can be used to run daily chores of life in case of emergency. What type of emergency? Unexpected loss or reduction of income. What should be the size of cushion savings? Minimum 6 months worth of present expenses. Use? Example: In case of income loss, livelihood can temporarily run from cushion savings. Read: About paycheck to paycheck life.
2. Implementation: Financial Independence
Financially, our ultimate goal of life should be to become financially independent. How to do it?
The only way to achieve it is by generating “enough passive income”. Passive income must equal our expense needs.
So this brings us to this logical question. Generating enough passive income is enough to achieve financial independence? The answer is yes and no.
- Yes because till there is enough passive income, there can be no financial independence.
- No because till we have a correct “mind-mapping”, enough passive income cannot be generated.
If one can first map their minds properly in favour of financial independence, building streams of passive income will happen automatically.
So let’s learn how to do mind mapping…
2.1 Mind Mapping: To Reach Financial Freedom
Mind mapping can be done by drawing of logical steps in a flow-chart style which explains the path to reach financial independence.
Such a flow chart is shown above. Let me explain in short the flow of ideas shown in the above mind map.
- #2.1.1 Ideal Income Model: What is ideal income model? A state of being where the person (family) is living a ‘frugal life’ in tandem with consistent ‘income growth’. Read more.
- #2.1.2 High Savings: A combination of frugality, and increasing income results in higher savings. How? Because such people grow their income at a rate faster than their expenses. Read more.
- #2.1.3 Equity Investing: People must learn to enhance the power of their savings. How to do it? By investing the savings. Where to invest? When time horizon is long, equity investing is best. Achieving financial independence is a long term goal, hence equity focus will be suitable. Read more.
- #2.1.4 Retirement Corpus (Asset Base #1): The idea behind investing in equity is build an asset base. When the asset base is big enough, it shall be used to build retirement corpus. This corpus will then generates streams of passive income. This will eventually lead to financial independence. Read more.
- Other Financial Goals (Asset Base #2): The asset base must also be used to take care of other financial goals of like (other than retirement corpus). Read more.
The most important step in the above list is #2.1.4. This is the step that is ultimately leading us to financial freedom.
But to implement this step effectively, all other steps must get equal weightage. Nothing can be neglected.
Let’s see these steps in more detail…
#2.1.1 Ideal Income Model:
There are two components of an ideal income model:
- Frugal lifestyle, and
- Continual income growth.
How they become components of “ideal income model”? Because working in tandem, they can transform even a pauper into a financially independent person. How?
What is Frugal living? Maintaining a lifestyle which is way lower than what one can actually afford. What does it mean? Such people saves a higher portion of their income (say 50%).
Combine frugal living with income growth, and it becomes a main driving force in attaining financial freedom. How?
Suppose there is a person who earns Rs.100,000 per month. He lives frugally (saving 50% of his income). His income increases at 10% per annum.
Let’s see his savings pattern for next 5 years.
In 5 years the savings of the person rose from Rs.50,000 to Rs.73,205 per month.
The person was anyways saving heavily (50%). But as the quantum of savings is increasing every year, its impact on financial independence is phenomenal. How?
Let’s read more…
#2.1.2 High Savings:
Frugality is a lifestyle which leads to more savings.
In the journey of financial independence, savings is the fuel. In this travel, less fuel will not serve the purpose.
Hence for a common man, practising frugality must be an acceptable compromise. After all, financial independence is no ordinary goal.
Tip: Calculate how much you are saving today. Try to increase the saving by 1% per month. Keep increasing the savings till you reach the coveted target of 50%. Please note, the start will be tougher. Once you cross the boundary of 25% savings, things will start becoming easier.
#2.1.3 Investing in Equity:
This is a very important milestone in the journey towards financial freedom. It must be implemented properly. Why? Because in equity investment, there is high risk of loss.
Then why to invest in equity? Because, if invested properly, equity can yield high returns. Moreover, investing in equity is also convenient.
So, three points that needs clarification:
- High Return: How much return one should expect from equity? On an average, 12% p.a. from equity is considered good. But it is also possible to touch 18%-20% p.a. by practising long term holding strategy in equity. Read: How long is long term?
- Investing properly in Equity: How to invest properly? There are two ways to invest in equity: (1) direct through stocks, (2) indirect through mutual funds. To know about it read this article on direct equity investing. To invest properly through mutual funds, read this article on types of mutual funds.
- Equity is Convenient: Why? Because it is possible to start investing in equity even if ones savings is just Rs.500 per month. Compare this with gold, and real estate. It will not be easily possible to buy gold, or a real estate property with such low savings. Read: SIP in equity mutual funds.
[If you are new to equity and share market, I’ll suggest you to read this article on how to start investing in share market.]
What should be the objective of investor in this step? The investor must target to accumulate more equity over time. How to accumulate equity? By buying shares of companies, or units of equity based mutual funds. But care must be taken to buy only undervalued shares.
What is the benefit of equity accumulation? Equity appreciates faster in value. When undervalued equity is bought, it automatically appreciates in value with time.
Suppose one bought one share of worth $50. After passage of say 3 years, the same one number share will appreciate in value to become $70 (@12% p.a.).
#2.1.4 Creation of Asset Base:
In the above step, what is done is “equity accumulation”.
The duration of equity accumulation depends on the quantum of savings, and quantum of corpus required.
Suppose one needs to build Rs.2.0 Crore. His average monthly savings is say Rs.20,000. Consider return @14% p.a, how much time it will take him to accumulate two crores? 18.3 Years (use the below calculator).
|Corpus to be Built (Rs.Crore)|
|Expected Return p.a. (%)|
|Time (in years)|
|SIP (monthly contribution) (Rs.)|
Once the equity accumulation is complete, the next step is to convert equity in the following two asset bases:
- Asset Base #1 (Retirement Corpus): It consists of such assets which can generate streams of passive income. It must be remembered that not all asset types can generate passive income. Assets are suitable for income generation post retirement are shown here.
- Asset Base #2 (Other Financial Goals): It consist of most debt based assets (like debt mutual funds, bank deposit etc). These are goals like buying a home, car, child’s higher education etc. In the pursuit of financial independence these goals cannot be compromised. Due importance must also be given to them. Read more.
Let’s summarise the step #2 (Implementation: of Financial independence).
We have created a mind-map which helps us to visualise how to convert “income from job” into an “Asset”. To achieve financial freedom, we require such assets which generates “passive income”. Here, we must not ignore the requirement of “other financial goals”.
This way one can achieve financial independence. But complete financial independence cannot be reached at one go. It can be achieved only in stages.
Let’s know more about the three stages of financial independence.
#3. Stages of Financial Independence
Breaking down financial independence in stages can help achieving it easily.
Financial freedom is a goal which is like a 42Km long marathon. One cannot sprint and reach the finish line. It can be achieved only slowly, in stages.
What is the logic? When the goal is difficult, it is better to break it down into stages – like taking one step at a time. How to do it?
Stages: It is a concept like braking down big goals into smaller milestones.
There can be three stages of financial independence:
- Stage 1 (Basic Independence): When it comes to financial security, people must first cover their basic necessities of life (like food, shelter, clothing, bills, education etc).
- Stage 2 (Comfort Independence): When their basic demands are getting taken care regularly, people then start spending on comfort.
- Stage 3 (Luxury Independence): After basic necessities and comfort comes luxury spendings.
Everyone does not spend the same amount on basic goods, comforts and luxury. What is the pattern?
The pattern can be formed from looking deep inside ones basic necessities of life.
There are people who can spend as little as Rs.10,000 per month to cover their basic necessities of life. On the other hand there are people for whom the same basic necessities will need Rs.20,000.
In turn, these people will also spend differently on their comfort and luxury needs.
Why this difference? It’s because of the way they have been brought by their parents. Example: A kid who has always lived in an air conditioned home, will treat AC’s as basic goods.
Let’s see each stages of financial freedom in more detail.
Stage #1. Basic Independence.
This is the stage one (first milestone) of financial independence. What does it stand-up for? It tells people to first build enough asset to cover the basic necessities of life.
What does it mean? Building a large enough asset base, which ultimately yields so much income that it covers the basic necessities of life.
Which are the basic necessities of life?
- Utility Bills.
- Public Transport.
- Basic Clothing.
- Basic Health.
- Basic Emergency Cash.
- Basic Maintenance etc.
How to calculate the quantum of basic independence? By using this formula:
Basic Independence = 200 x N
- N = Portion of monthly income which is getting used to buy basic necessities of life.
Example: Suppose there is a person whose basic requirements of life costs him Rs.50,000 per month. This person will need an asset base of Rs.1.0 Crore (200 x 50,000) to reach stage one. What is the calculation?
How to understand the calculation? By investing Rs.1.0 Crore in an investment option which yields an annual return of 6% p.a., will yield an annual income of Rs.6.0 lakhs (or Rs.50,000 per month).
Why 6% p.a. return and not more or less? A suitable risk-free debt based investment portfolio can easily yield an average return of 6% p.a.
Quick Tip: The trick lies is identifying the basic necessities of life. Categorise all your expenses. How to do it? Read more about expense tracking here.
Stage #2. Comfort Independence.
This is the stage two (second milestone) of financial independence. What does it stand-up for? It tells people to build more asset to also cover those requirements of life which makes them comfortable.
Here one will have to build a bigger asset base than in stage #1. This asset base will be so big that it will cover both basic necessities and comforts of life.
Which are the comforting requirement of life? These are such spendings which cannot be tagged as luxuries, as they tend to become “basic necessities” in times to come. Few examples are shown below:
- Household help.
- Basic Shopping.
- Person Vehicle Costs.
- Child Plan.
- Basic Investments etc.
How to calculate the quantum of comfort independence? By using this formula:
Comfort Independence = 400 x N
- N = Portion of monthly income which is getting used to buy basic necessities of life.
Example: Suppose there is a person whose basic requirements of life costs him Rs.50,000 per month. This person will need an asset base of Rs.2.0 Crore (400 x 50,000) to reach stage two. What is the calculation?
[Note: As per my observations, people spend equally on basic & comfort needs of their life, If a person spends Rs.50K on basic needs. He is likely to spend same amount of money (Rs.50K) on comfort needs as well.]
What does this calculation say? By investing Rs.2.0 Crore in an investment option which yields an annual return of 6% p.a., will yield an annual income of Rs.12.0 lakhs (or Rs.100,000 per month).
Quick Tip: People who spend on their comfort needs often overspend. Hence it is advisable to build an expense budget and spend accordingly. Read more about 50 30 20 rules of budgeting.
Stage #3. Luxury Independence.
This is the stage three (final milestone) of financial independence. What does it stand-up for? Here the asset base built by the investor is so high that all type of expense requirements of life is met.
Here one will have to build the biggest asset bases, more than what has already been done in stage one and two.
Generally people tend to spend much more on luxury than they do on basic goods and comfort needs. Why? Because of two reasons:
- Luxury is costly.
- Luxury is also tempting.
Hence the size of asset bases required to cover luxury needs of the person is quite high. The proportion can be like shown in the pie chart.
Which are the LUXURY requirement of life? These are those spendings which people generally incur when they have excess cash in hand. People generally spend money here to uplift their standard of living.
- Purchase of bigger home.
- Buying a bigger car.
- Investing for net worth building.
How to calculate the quantum of luxury independence? By using this formula:
Luxury Independence = 1200 x N
- N = Portion of monthly income which is getting used to buy basic necessities of life.
Example: Suppose there is a person whose basic requirements of life costs him Rs.50,000 per month. This person will need an asset base of Rs.6.0 Crore (1200 x 50,000) to reach stage three. What is the calculation?
[Note: As per my observations, people spend twice on luxury than what they spend on basic & comfort needs of their life.]
What does this calculation say? By investing Rs.6.0 Crore in an investment option which yields an annual return of 6% p.a., will yield an annual income of Rs.36.0 lakhs (or Rs.300,000 per month).
Quick Tip: People who can afford to spend on luxury shall take extra care in making their asset size grow faster. Why? Because it will further increase their monthly income. Read more about asset building here.
Importance of other goals of life
Achieving financial independence is an important goal. But there are goals which are equally important:
- Car purchase.
- Annual Vacations.
- Home purchase.
- Higher Education.
What about these goals?
It is equally important to manage other goals along with financial independence. Why? Because if not done, they will eventually eat-away your built ‘financial independence corpus’ anyways.
So the right strategy will be to put money proportionally in each goals separately. The idea is to keep the goal of financial independence isolated from other goals.
Financial independence can be achieved when “required” income will continue to drip-in even when we are sleeping. We should not be required to work to generate income to manage our expense needs.
Income generated from job or business is not passive income. It is active income. The idea is to work and generate active income. Then divert at least 50% of the active income to accumulate equity.
But equity accumulation not enough. It is more important to convert equity into a “passive income generating assets“.
Which are such assets? Few best examples of such assets are the following:
A sure way of becoming financially independent starts with living a frugal life. Frugality does not mean leading a life of misery. It means, diverting a bigger proportion of ones income towards net worth building.
A person who lives a frugal life, ensures that a big chunk of his/her income is available as savings. This is a huge advantage. Why?
Because this available liquid cash can be used to invest in equity.
As equity earns higher returns, over long term such investments can built a sizeable corpus.
- First part of this corpus shall be used to manage “other financial goals” of life.
- Second part shall be used for “retirement” (financial independence}.
Have a happy investing.