Mile markers on the road to Financial Independence

By Slow Dad - March 17, 2017

Looking for a way to evaluate your progress towards Financial Independence? Some suggestions here, though be warned if you live in a big city!
Roughly half the guests on personal finance podcasts seem to say that reading Stanley and Danko’s Millionaire Next Door set them on the path toward financial independence.

I must admit I was sceptical, anyone using words like “millionaire” tends to set off my bullshit detector.

After holding out for around 20 years I had an Amazon gift voucher that was due to expire, and was loading up my Kindle with books for my next holiday. So I figured what the hell, I would give it a read and see whether the book lived up to the hype.

I started reading (and eventually finished) it during an omni-shambles of a commute earlier this week.

My first impression I had was that it seemed to be thoroughly researched.

My second impression was that the book draws a lot of inferences from correlations, but we all know that this does not necessarily equate to causation.

Still from a purely voyeuristic perspective it made for interesting reading (to a point) to see what others do.

This seems to be a popular theme these days, with the Tim Ferris style focusing on adopting the habits of the rich/successful. The reasoning seems to be along the lines of “if Warren Buffet drinks coke and eats hamburgers, and he is the world’s richest man, then if I were to drink coke and eat hamburgers then I too could be the world’s richest man”.

So what did I find interesting?

The book observes that the tax system favours capital growth over income. This is true in many jurisdictions, and a major pet peeve of mine.

If I have an asset that generates income, then for the life of that asset I have a renewable income stream. Get enough of them to cover your living expenses and you’re Financially Independent, without needing to rely on the state pension. I'm not sure about you, but to me that sounds like a win-win situation.

On the other hand if I sell that asset, hopefully realising a capital gain, then I now have a finite bucket of funds. Dipping into that bucket to support my living expenses for a while may sustain me, but eventually the bucket will run dry. Now I have no income generating asset, no remaining funds, and am fully dependent on the state pension. That doesn't look like winning to me.

To my simple mind the behaviour the tax authorities should be encouraging is the establishment of income streams, rather than punitively taxing investment income while concessionally taxing the selling off of the underlying assets responsible for generating that income.

How are you tracking on your journey?

The authors propose a formula for assessing whether your pile of wealth is as large as it should be, given your income and age. This represents an interesting milestone along the path to financial independence.

The road to Financial Independence can be a lonely one.
The journey to Financial Independence can be a lonely one.
“Multiply your age times your realised pre-tax annual household income from all sources except inheritances. Divide by 10. This, less any inherited wealth, is what your net worth should be.”
A little bit of explanation is required to decipher this formula.

Realised pre-tax income” is your gross salary + dividends + rent + interest income + royalties + any capital gains you made on the sale of assets. Note this should not include any inheritances you received.

Net worth” is what you’ve got less what you owe.

[Age] * [Household Pre-Tax Income from all sources] / 10 = [Benchmark Net Worth] - [Inheritances]

I plugged my numbers into the formula, and saw that my number was more than 3 times what the formula suggested it should be.

Then I did the victory dance, because it is important to celebrate the small wins.

Then just after my kids begged me to stop dancing because I was embarrassing them.

Does that make me rich? No.

Does it make me feel rich? Still no.

I am comfortable, but would I still be feeling that way with 1/3 my current net worth? Hell no, I couldn't even see Financial Independence from there.

Finally I concluded the formula set the bar way too low.

High cost of housing is like driving with the hand brake on

The other interesting observation I took from the book was the point it made about many underachievers (when it comes to wealth accumulation) live at or beyond their means. This rang very true.

The book suggested that the average price of a house paid by the several thousand millionaires they surveyed was no more than 3 times the same household realised income figure you used in the formula above.

“The market value of the home you purchase should be less than three times your household’s total annual realised income.”
The sentiment stuck a chord with me, but this one is definitely more challenging if you live in a major metropolitan area.

To put that in context, if you input the average UK annual income into the formula, and then do a search on Rightmove for London properties costing up to 3 times that amount you are presented with an interesting array of:

  • car parking spaces
  • lock up garages (with very short durations remaining on the leasehold)
  • small house boats (with at most a 1 year mooring).
There is not one single habitable fixed dwelling in the results. None.
Is big city living crippling your financial independence chances?
Is big city living crippling your financial independence chances?

So what?

The moral of the story here is that living in a high cost of living locale is definitely going to slow down your journey towards Financial Independence.

This is hardly a revelation, but if you put any stock in the analysis conducted by the authors then it raises some troubling questions about whether the 8.5 million people who call London home are kicking a financial own goal by living there.

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  1. I suspect that back when the book was first written (and the research conducted) in the late 1990s, the authors didn't anticipate how property prices were to going to balloon in the way it has over the last 15 years.

    Also, according to their net worth calculation, I'm well under what it says I should be at for my age, yet versus my own goal/calculation, I'm on track! ;-)

    It was an enjoyable read anyway, I would highly recommend it to anyone who has aspirations of growing/maintaining their wealth, though not necessarily to become millionaires.

  2. Thanks weenie.

    The timing thing shouldn't matter. From what the author's described the surveying/interviewing process they undertook had been conducted over an extended period of time. One of their findings was that "millionaire next door" types were predominantly self-made people aged in their 50s or 60s. Throughout their careers there would undoubtably have been an assortment of market conditions, some good and some not so much.

    The net worth formula they proposed (for what it is worth) should be a relatively timeless yard stick.

    The general advice that people should try and choose to live somewhere that won't bankrupt them or keep them in struggle town would also remain true over time.

    The fact that the property market in London (or Toronto or Sydney or Singapore or San Francisco) has gone bananas doesn't change the wisdom of what they are saying (e.g. the less you spend on rent/mortgage the more you can afford to save/invest), rather it questions the logic of those claiming to be trying to get ahead while potentially scoring a financial own goal by buying into those already expensive markets.

    If the "bigger idiot" theory holds true then providing they can afford to hold on long enough the rising market will rescue them... but they can only realise the benefit from that rescue by downsizing or moving someplace cheaper.

    I'm a big believer in setting your own goals and measuring your own progress against them, so that is great to hear you're tracking nicely towards achieving yours!

  3. True that. House cost is a major determinant in FI. If the greater fool theory holds by the time a big city dweller decides to retire, then he can convert that massive house asset into a perennial income stream like dividends by investing in high quality stocks. But the sheer concentration risk of having so much of net worth tied to one asset in one location in one city in the world is not for me.

  4. Well said Mr TFR, concentration of risk can be a scary thing indeed.

    Kiyosaki made a good point when he described owner occupier property as not being an asset, it might not be while the owner lives in it... but if the owner intends to downsize or relocate they will sure wish it had been! It is one of the many reasons why dream homes tend not to make the transition into stellar investment properties.

    I believe there is the potential for significant wealth to be made from property, even from owner occupier property. Approaches such as house hacking can be a very useful tool. Or purchasing well located property with significant upside potential that can be realised through subdividing or extending. A share of the proceeds from these endeavours should be diversified into other asset classes to spread the risk.

    However any strategy that relies on a rising market to deliver the desired outcome is definitely an unsound one, regardless of asset class!