I've not been blogging for quite some time again. Pardon me for going missing as life gets busy with more projects at work, preparing for wedding, renovation for new house next year and the hustle and bustle of life. Sometimes I've not been able to sleep well and even during holidays my mind can't feel rested.
In view of the busyness of life, I've set a goal earlier this year to create more passive income instead of active income. I realised time is limited and its impossible for me to create any more active income. Despite not much time spent on stocks investing this year, dividends still come in regularly. This is passive income in the making. The good thing is dividends help to boost my savings quite significantly.
Financial planning for financial freedom can be complicated and a daunting task for many who look to get out of the rat race. When can I stop working? How much should I save? What ROI should I get for my investment? These are common questions which all of us have. In this post, let me share an easy way to visualise and make it easy for us to achieve financial freedom. I will show you how to determine what amount to save, how to use dividends to boost your savings and achieve the desired amount for financial freedom.
Determine the amount to save
The first step to financial freedom is to set a goal on how much to save. Financial freedom is having the money to sustain your desired lifestyle indefinitely without having to work. The most popular formula is the 4% rule which is a retirement study published in 1998 by three professors from Trinity University in Texas. The study found that 4% is the safe withdrawal rule for a portfolio of stocks to generate dividends indefinitely. This means having 4% dividends from your stocks is more sustainable than having say 7% or 8% dividends especially when we do not want to take on so much risk in our later years.
Based on this 4% rule, if you save up 25 times of your desired annual spending, the likelihood of you depleting your capital is very low. This means, if you desire to spend $40,000 annually (avg $3,333 per month) during your retirement years, you'll need to save up $1 Million dollars.
Summary of amount to save based on desired monthly income during retirement:
Work towards your target amount
The next step is to work towards your target amount. If you target to save $1 Million, you can use various ways to reach that target. The first step is to determine how much to save annually to reach $1 Million by certain years. Assuming we want to save $1 Million in 20 years, how much do we need to save annually? Here's the answer:
$1 Million divided by 20 years = $50,000 annually
Now, saving $50,000 may be out of reach to many of us. If you earn $3,000 per month, your take home pay is $2,400. Even saving all of your salary without spending a single cent, you won't be able to save up $50,000 annually. Its time to re-strategise.
In life, we must understand it is never a straight road. If we work backwards like this literally, we will be stressing ourselves too much at the start. When we are younger, naturally we will earn less money and thus its harder to have much savings. Nevertheless, it is still important to save up a significant sum of money when we are younger to let compounding takes it effect.
Achieving $1 Million savings goal in 20 years with $4000/month income and $2800/month expenses
I have curated a possible scenario to achieve $1 Million savings goal in 20 years with still a decent amount of spending so as not to compromise our current lifestyle. You can adjust accordingly to your needs.
The scenario is as below:
- Must have $200,000 savings to start off
- $4000 monthly salary
- 3.5 months bonus
- $2800 monthly expenses
- Invest 80% of savings with 4% dividends
The end result is a whole set of numbers below:
If you look at the above, $1 Million can be saved up in 19 years. $4,000 monthly salary with $2,800 monthly expenses and 4% dividends should be achievable for many people. Some of you may even earn more and can generate more dividends which you will be able to reach your target even earlier.
I would like to point out the significance of this scenario. If you look at the additional savings column, you will see that this person is able to save up quite a significant sum annually despite managing to save only 20% of salary at the beginning. Take note that for a $4000 monthly salary, the take home pay is only $3200 which is already factored in in the calculation. Spending $2800 out of the $3200 take home pay is quite a lot. However, adding on bonus and dividends generated from the initial savings of $200,000, this person still can save an impressive $22K annually.
Let's now dive deeper to the various components which makes this possible:
- Having $200K savings
- Earning at least $4000 monthly salary
- How to invest to get at least 4% dividend yield
How to achieve $200K savings?
There are many articles out there which talks about $100K savings by age 28 or 30 etc. This is an important milestone as it will set the tone for your savings habit. The first $100K is always the toughest but after that it gets easier somehow. This is probably because we have already built a savings habit and also we earn more income and invest more after we achieve $100K so the money gets compounded faster.
To save $200K, I would think give yourself 10 years which is to save $20,000 annually. Many of us will be able to achieve $200K in less than 10 years as we will also get returns from investment while we save up.
Earning at least $4000 monthly salary
Besides saving hard, income is also an important component in this financial freedom journey. If your income is too low, it is going to be very tough and a huge sacrifice to save up any significant savings. This is the reality of life. Therefore, using the above scenario, it is recommended to aim for at least a $4000 salary as we progress in our career. This should also come with good bonus of about 3.5 months else you should aim for a higher monthly salary.
If you can earn higher salary, its good for you as you can spend more than other people and still achieve the same goals. However, its always important to keep track of your spending as it can go overboard easily sometimes.
How to invest to get at least 4% dividend yield?
Investing is the next part of the plan. I would say getting 4% dividend yield is not a difficult task. Its a matter of investing in the right stocks. For my own investing, I don't usually use very complicated methods. In essence, investing is about investing in a company at good price and seeing that it has potential to do well. Reading of annual reports is important to know what is going on and a basic understanding of the industry you are investing into is also critical.
To invest in companies at a good price, we can use several valuation methods such as Price to Earnings (PE) ratio, Price to Book (PB) ratio, discounted cash flow model, discounted dividend model etc. You can read more on valuation methods in a previous post I wrote here.
To know if a company is good and if it has potential to do well, we can ask the following questions:
- What is the business about?
- Is the business expanding?
- Is the industry the business is in doing well?
- Who are the management?
- Does the management have aligned interest with shareholders?
- Revenue & Net profit increasing?
- Cash Flow increasing?
- Gross profit & Net profit increasing?
- ROE increasing? (Management efficiency)
- Debt to equity ratio? (Financial strength)
- Dividends sustainable or growing?
To summarise, a financial freedom plan needs to be thought out carefully with the following steps:
- Determine how much you need to save - 25 times of your desired monthly spending
- Start saving - Work backwards to determine how much you should save annually
- Earn a decent salary
- Target at least 4% dividend yield for your stocks investing
