There are various important investment concepts that are not talked about yet they are practical rules of thumb, just like the 50-30-20 rule of budgeting, that you can apply to your personal finances.
Some of these concepts include:
- How to calculate your Financial Independence Number
- The 4% rule of retirement preparation
- The rule of 72
Now, what do these 3 important investment concepts represent?
1. Financial Independence Number
A financial independence number is a concept of accumulating enough wealth to give yourself the financial freedom to make work optional, because you can comfortably live off of your investment returns.
Achieving financial freedom allows you to pursue your passions without worrying if it will cater to your expenses. It allows you to choose whether to work part-time, pick up a career of your dreams or choose to never work another day of your life.
Imagine having that kind of freedom.
So how do you calculate your financial independence number?
i) Determine your annual expenses.
The first step to calculating your Financial Independence Number is to be clear on your annual expenses.
If for example, your expenses are Ksh. 60,000 per month, your annual expenses will be Ksh. 720,000 per year.
Ksh. 60,000 * 12 = Ksh. 720,000
Note: you cannot be clear on how much your expenses are if you do not track your expenses.
ii) Multiply that number by 25 (this is a financial rule of thumb)
Ksh 720,000 * 25 = 18 Million
This is how much you would need in investments to achieve Financial Freedom.
iii) Adjust the number for inflation.
The next step should be to account for inflation.
The number you get after the calculation doesn’t account for inflation so remember to inflate it by a standard 7% to 10% to take into account the future value of money.
Your Financial Independence Number should be your general guideline to help you estimate what your investment goal should be as you aim for financial freedom.
2. The 4 percent rule
Research done by financial planner William Bengen on market returns over a 50-year period showed that upon retirement, you can safely withdraw 4% of your investments annually without exhausting your funds.
This was after looking at some of the worst years in the stock market and accounting for inflation.
Whether you are in your 20s, 30s or even 40s, you should be investing for your retirement. It’s never too early to start investing in your retirement and you can choose to retire at any age.
This 4 percent rule allows retirees to have a steady income while leaving the balance to continue earning interest throughout the retirement period.
How long your retirement savings will last will depend on a variety of factors;
- How much you will have saved
- How the funds will be invested
- The investment returns
You also need to factor in your retirement expenses, inflation and future income needs.
The 4 percent rule should guide you in determining how much money you would need to have in investments to help you retire comfortably. (Multiplying your annual expenses by 25 while calculating your Financial Independence number above, is derived from the 4% rule which assumes your money will be earning a bare minimum 4% per annum, and that you can comfortably live off of that annual interest).
3. The Rule of 72
One of the other important investment concepts you need to know about is the rule of 72.
The rule of 72 is a simple way to determine how many years an investment will take to double given a specific annual rate of interest.
The rule of 72 formula
72 / Annual Interest = Number of years it will take for your investment to double
Time is your most powerful resource in the journey to financial freedom.
You can use The Rule Of 72 to make informed choices about an investment option.
If you choose to take a riskier investment with higher returns, it may take you a shorter time to double your money.
The journey to attaining financial freedom may be long and may take some time. But it’s a worthwhile journey that you will never regret.
You just have to take the first step and start.
Your first step could be as simple as starting to track your monthly budget today.
Get yourself a done-for-you budget tracker and start your journey to financial freedom.