Investing is one of the best ways to generate what the kids are calling “passive income”. That is, income generated with no time or effort required. Investing can earn you passive income because they pay the holder a dividend/return.
All you have to do is accumulate enough assets such that your expenses are covered by your investing total return (return + yield), and you’ll never have to generate income again.
Tim sits down and thinks about how much, if he really thinks about it, does he need to live a happy, fulfilled life. Through some mysterious method of extrapolation and forecasting and guesswork he arrives at 50,000 GBP. “How can I”, he wonders, “generate this income passively by investing?” To work that out he needs some other assumptions.
Let’s forget about inflation for simplicity and suppose Tim thinks in terms of real numbers. He figures out that with a total return of 5%, when he hits a portfolio value of £1M, he can spend £50,000 per year without his portfolio decreasing in value.
Tim considers himself a smart, hard-working, all-around-good guy. In his head this means he’ll earn £100k per year for the next 20 years. Assuming a tax rate of 40% and expenses of £30k per year, this leaves him with £30k to invest to get to that magic £1M number.
Let’s see how long it’s going to take him to get there:
So with Tim’s assumptions, he basically does it: he reaches his retirement number in (roughly) 20 years. Go Tim.
I assume that’s wrong
But he only gets there with his assumptions. Young Tim assumes:
- He will be ultra-disciplined about saving. He simply must save £30k a year. Every year.
- No other significant investments/big purchases. Spending on anything that does not equate to a higher portfolio value is not allowed. Want to pay for something big like a house or a wedding? Nope. Sorry. Vetoed. He assumes he won’t change his plan (and that no shit will happen along the way).
- Income is high and constant. Median annual pay for full-time employees in the UK was £33,000 in April 2022. And no – this doesn’t change much as you move to older age brackets. So Tim is massively backing himself to out-earn. He also assumes he receives this high income straight away, allowing him to benefit from early compounding.
- Expenses are also constant. £30k a year might be reasonable when Tim was living his bachelor lifestyle, but what about when he wants to have kids? Or if he acquires a partner with expensive tastes? Or has to make mortgage payments? Lifestyle creep is very hard to fight.
- Real return and yield are reasonably high and constant. Obviously not true in reality. Inflation can go rogue. Assets can under-perform for 20 years. Sequence of returns matters, too.
In fairness to Tim, it’s not his fault. Forecasting with many complex variables is really hard. I gave him these faulty assumptions to illustrate this fact. Poor Tim.
But the calculations Tim has just made are not far off those being made in reality. It’s a seductive concept – just grind and save for 20 years and you can be free for the remaining 60. Sure, you do have to partially sacrifice 20 years of your life. But people doing FIRE, as well as others shooting for this type of passive income, know this. To them, it’s a worthwhile trade-off.
And it might be for some, particularly if the end state is guaranteed financial independence. But it’s not, because the asset environment when you start spending your accumulated pot might be unfavourable. Tim is assuming his pot will stay at £1M forever. My feet are sweating thinking about how precarious that is. Does he have financial independence? Sort of, I guess. But not really.
The actual solution to the actual problem
Let’s take a step back. Let’s remind ourselves of what Tim really wants. From above: “how much, if he really thinks about it, does he need to live a happy, fulfilled life.”
That’s it – he never constrained his requirements by stating how he needed to arrive at this level of income. So let’s think about some other ways he can get there.
One way is to always have the ability to make more money. If Tim knew he could work for 2 weeks and earn £50,000, he wouldn’t have to do much saving or investing Because he knows he can just earn money when he needs it or wants to. This is obviously pretty extreme so here’s something more realistic: spending 1-3 months or 1 day a week consulting per year (after spending 20 years building skills, knowledge, and a network that enables you to do this).
This is an especially good option if you make money for fun. If you love what you do, you won’t want to stop. If you know you won’t want to stop, you know you’re going to continue to generate income, and you won’t have to be as strict with your finances.
If Tim is particularly lazy or paranoid or fragile, he might want a guarantee that he doesn’t have to work beyond a certain point. He might think that lying on a beach is more fulfilling than building something, helping people, being creative, adding value to society, etc.
As we have seen, investing can get you there, via passive income in the form of total return on financial assets. Another way is by owning a business – by owning a share of the profits from a business which you have successfully extradited yourself from. This has the added benefit of owning equity, which can lead to a big payoff in the event of a sale. In some circumstances this can negate the need to generate income at all: if you get £5M from selling your business at age 60 you probably don’t need to ever work again. You can also get this big pot from a high-risk investment that paid off.
Uncertainty is cheaper
Tim just wants to get to a point at which he’s comfortable. In two ways. First, he wants a big enough pot such that he feels confident it won’t run out. Second, he wants a big enough pot such that he receives enough income to live comfortably.
This is partly just maths. Most people would struggle to live comfortably on £100 a month. But this is also a psychological problem. This is the amount of money that Tim would feel comfortable having, certainly not the amount he needs, and probably not the amount he would actually be comfortable having, either. He can lower this amount by getting more comfortable with uncertainty and a little bit of social abnormalcy.
What’s also useful to think about is maximum usable wealth. At what point does more wealth make no real difference to your life, aside from flexing/boosting your ego? No, you don’t need a yacht. No, you don’t need to build a new library at your alma mater. For me, that number is about £20M. £50M max. I really wouldn’t know what to do with money beyond that point. I mean, I even feel like that now sometimes and I only have £248.50 in my account.
You want to at least have the possibility of getting to this number, or close to it. This is very difficult to do by saving and investing.