The Concept of Financial Freedom
Every activity done by human beings is generally linked to a larger goal, a pursuit to achieve something important in life. Financial planning is also not very different in this regard. The month to month activity of financial planning is tied with a larger goal. For most people, financial freedom is an important milestone in this process, if not the desired end outcome. Hence, in order to understand any philosophy related to personal finance, we need to understand the concept of financial freedom and how it can be achieved.
What is Financial Freedom?
Most people around the world have to live their life bounded by financial constraints. This often means that they have to stick around in jobs that do not appeal to them or save money by foregoing activities that are important to them. Many people view this as a life that is bounded by financial constraints.
Financial independence is a financial condition in which a person is free to make his/her decisions without being excessively influenced by financial constraints. This is because the expenses that they need to live their day to day life are covered by the income that they earn passively from their investments. Hence, they can continue to live off the investments in perpetuity.
How Much Money Is Required For Financial Freedom?
The average person needs to save a substantial corpus in order to achieve financial freedom. Financial planners have worked out the detail and provided the formula in order to calculate how much money is required.
The rule of thumb is that 25x of the expenses that a person will incur before they retire need to be saved up in various income-generating investments so that they generate enough passive income to cover all the expenses.
Hence, if the expenditure of a person is expected to be $100000 before they retire, then they need to save 25x that amount which means around $2.5 million needs to be saved.
What is the 4% Rule?
The 4% rule assumes that the investor will withdraw only 4% of their corpus every year. If they do this, then their corpus will sustain them till infinity. This is because based on historical returns financial planners have calculated that the portfolio will grow by an average of about 7% each year.
On any given year, the fluctuation can be much higher. It could be as high as plus or minus 25%. However, over the long run, the portfolio grows by an average of 7% per annum. This means that if a person is only withdrawing 4% per annum, they are actually adding an average of 3% to the corpus. This 3% per annum gets compounded over many years and helps take care of the inflation which tends to increase their costs.
The 4% rule means that if a person only withdraws 4% of their corpus amount each year, then the corpus can fund their day to day life till infinity.
Why is Financial Freedom Important?
Financial freedom has become increasingly important because of certain factors. It is no longer optional but almost necessary for every middle-class person to consider this concept. The reasons have been stated below:
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