Every person who begins their productive stage in life should keep in mind from day one that their goal is to achieve financial freedom in the shortest possible time. It will most likely take between 20 and 30 years to achieve this, considering the 4% rule.
Financial freedom is a term that can be somewhat ethereal; however, the 4% rule helps us to land a more concrete idea in this regard. What this rule provides us with is a way to establish what capital we must have available to achieve the objective of escaping from economic distress.
Simplifying the matter, the 4% rule, what it proclaims is that your cost of living should never exceed 4% of your liquid assets to consider you in a state of financial freedom. This reasoning is based on studies made of stock investments over a period of just over 80 years.
Empirical evidence
Financial specialists reviewed the history of the returns accrued between 1926 and 2010 and came to a conclusion based on the empirical evidence: average returns have remained above 4%, after adjusting for inflation.
This indicates that if we accumulate capital of such magnitude that our expenses represent 4% or less of it, we will never decapitalize, which implies that in theory we do not require new income.
If the dividends from our investments provide sufficient resources to support our standard of living, it means that our money worries have already succumbed to what we call financial freedom.
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Given this way of roughly calculating how much we need to achieve a retirement without financial upheavals, we can set more tangible goals and plan on a more understandable basis.
Doing the math
Let's take an example to clarify what we can quantify with the 4% rule. Suppose that Pedro aspires to maintain a standard of living that requires a monthly amount of 2,200 euros. Using the aforementioned rule, this annualized amount must represent a maximum of 4% of the invested capital.
Thus, we have that Pedro must accumulate a capital of at least 660,000 euros before considering himself free of financial ties, given that his annual expenses amount to 26,400 euros. The historical average offers Pedro a probability over 80% of keeping his assets intact.
The calculation that leads us to obtain the figure of 660,000 euros comes from dividing the total amount of annualized expenses by 4% (26,400 / 0.04 = 660,000). With that money available for investments, Pedro will be ensuring with enough certainty a monthly income of 2,200 euros.
The aforementioned study showed that only 18% of the investors who had applied the 4% rule during the evaluated period (1926-2010) would have failed in their intention to achieve financial freedom, so we can say that it is quite effective.
It is important to note that the inflation factor is already considered in this way of calculation, which should never be overlooked when we speak of medium and long terms.
Adjusting expenses
Taking into account these considerations we can estimate how much we can have a certain capital that we are using in productive investments; that is to say, how much we can spend without increasing the patrimony .
Let's assume that Pedro, after his productive stage, only managed to raise a capital of 420,000 euros and now he needs to know how to adjust his lifestyle so that it does not run out and serves as a permanent source of income.
In this case, it is enough to calculate 4% of the capital (420,000 x 0.04 = 16,400) to realize that Pedro will have to settle for 1,400 euros per month (16,400 / 12 = 1,400) to cover his expenses with a high probability not to run the risk of eventually running out of money.
Although the 4% rule is not infallible, it provides us with a clearer horizon on the financial goals that we must face if we want to achieve financial peace of mind. As we said at the beginning, this should be the main goal of every productive person.
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