Thursday, September 21, 2006

What is Financial Freedom?

I received a very kind comment the day before suggesting that I truly get what 'financial freedom' is about and I suddenly realised that I had never really talked about what that means to me. After all the very idea of this blog is to post about my journey to financial freedom - and yet that has got missed out on the way!

Different Interpretations

I guess there would be different interpretations for different people. Some might say financial freedom is when you have enough money to live off in the style you want and never have to work again. Others would tend to go with a more approachable definition of having enough money to ensure that living and other non-discretionary expenses are taken care of so one is then free to pursue other things free from the worry of paying the next bill. And for those among us who are saddled with uncomfortable amounts of debt, perhaps financial freedom is simply the ability to pay off the loans!

My Two-Stage Approach

I'm looking at financial freedom as a two-stage approach:

  1. Lifestyle Maintenance: Save enough to ensure you can meet living expenses from the interest (if you live off the pricipal then of course you'll be back to square one in no time at all!)
  2. Retirement: Then look at saving enough to retire and live a happy and comfortable life (again on the interest otherwise your kids might be a little unhappy at inheriting nothing from you, heh heh)

The first is rather easy to calculate - add up or estimate your living expenses per month, extrapolate that into an annual budget and add in any non-monthly expenses you regularly incur in order to determine your budget.

Examples of monthly expenses would be house rent, utility bills, food / groceries, entertainment, fuel, loan repayments, education-related expenses etc. Non-monthly regular payouts would include insurance payments (not an expense but a regular payout that must be accounted for nonetheless), annual vacations etc. Also factor in an anual lumpsum for large purchases that tend to come up every so often like purchasing appliances etc.

Since this will have to be met out of the interest on your savings, you can work out what the savings should be. I'd guess the interest would be about 5-6% on any capital-protected instrument (like perhaps govt bonds) so you need to have saved 17-20 times your annual budget in order to even get to Stage 1 of financial freedom.

It might be tough, but it is definitely possible for all of us. And this calculation will also give you excellent visibility on your spending habits. If you simply cannot figure out how to get to Stage 1 with your current lifestyle, perhaps it might be worth re-evaluating the necessity of some of your expenses.

Stage 2 is another story, though... will get to that in the next post! Till then, please give me your views on the subject.

5 comments:

Prasanth said...

Amit,

I agree with your two step def of financial freedom. One thing I strongly feel about is that my kids should not have an "entitlement" mentality and expect anything from me. Of course, this does not mean that i will not leave anything for my children or that I will not pay for their college education - it's just that i expect that them to be financially independent of me once they start earning. In return, i will not expect any financial help from them !!

One more thing - instead of saying living off the interest, may be you should say - living of indirect income (which may be interest, capital gains, rent from properties etc ).

Regards,

Prasanth

Amit said...

I agree on not cultivating an 'entitlement' mentality in your kids. However, I think that if you are well off, they should have enough to ensure they can follow their chosen vocation free of any pressing need to earn money to 'make a living'. Of course, how much would be appropriate is an individual decision.

Perhaps we should emulate Buffet and Bill Gates in giving away the remainder to worthy causes.

I also agree on changing the wording away from 'interest' but would prefer to call it 'investment income' rather than 'indirect income'. And will not include capital gains in the list - that should add to the principal.

jinxed said...

The trick in most of financial planning lies in the initial assumptions abt interest rates, inflation, and often they lead us to make plans which arent good enough for even 5 years.. however i agree one must keep some benchmarks

Sanjiv Singhal said...

On "inheritance" mentality - I believe it is a part of the social contract. You take care of the parents in their old age and you get to inherit the fruits of their hardwork.

Li Ka-shing's recent comments linked inheritance and charity in an interesting way - he called charity his "third son" promising to split his wealth 3 ways!

indirect sourcing said...

Very nice post. I am a management student and this is a concernd subject.. I will be benefited from this. Finance managemet- is important for all organisations weather big or small. It helps to achieve the desired goal. Thanks for the informative share. Will surely look forward to it.