7 stages of Financial Independence.

Ralpa Waldo Emerson famously said:“Life is a journey, not a destination.” I belive it is the same when it comes to Financial Independence. We all like to think taht Financial Independence is a final destination that we will one day reach. And once we reach it, that will be unicorns and fireworks, and all of our problems will just vanish. However, if we were to think this way, we would be in a world of disappointment.

Financial Independence, like life, isn’t a destination, it’s a journey. And like a good journey, each stage has its own set of adventures and lessions we can learn from. So, I want to talk what I learned from several books about 7 stages of Financial Independence. Each stage has its own unique value and its different level of freedom it can provide. We can think about what stage we are currently in, and what we can learning from it.

Stage 1: 1000 dollars emergency fund. Stage one of Financial Independence is to have 1000 dollars in our bank account as an emergency fund. Lots of finance exports advised making process in our personal finances begin with this. For many of us, we likely have already reached stage one. Have 1000 dollars in cash may not seem like much and definitely far from complete Financial Independence, but it is an important step to starting our journey. Some studies show that more than half of Americans can’t cover a 1000 dollars emergency expense with savings; and more than 40% of citizens in China even do not have any savings. By having 1000 dollars liquid cash in the checking account, you are doing better than half the people out there. So, if you’re already achieved stage one, give yourself a pat on the back and let’s move onto stage 2.

Stage 2: 0 dollars debt. Stage two of Financial Independence is to pay off all debt except the mortgage. This includes debt like credit card debt, housing loans, car loans. The pursuit of Financial Independence requires that you aren’t being weighed down by debt. If we have accepted debt as normal way of life, we have to start thinking differently. Debt shouldn’t be normal, especially for those of us pursuing Financial Independence. When we normalize debt, we normalize lifestyle inflation. We normalize debt payment as a regular part of life. And worst of all, we normalize the background hum of financial stress. If you have debt right now, vow to recognize it as somthing that needs to be rid of. not to be accepted as a normal way of life. Some finance exports advised we can use what calls the “Debt Snowball” method to pay down our debt. You essentially list out al your debts in order of balance, from the smallest to the larget, regardless of the interest rate. Then you squeeze out as much as possible from your budget and tackle the smallest one, until it is gone. Once it is gone, you focus your effort on the next, the second smallest debt until that one gone as well. You keep goint until all your debt is gone. By tackling from smallest to largest, you gain momentum in your debt paydown journey, like a snow ball.

Stage 3: 3-6 months of emergency fund. Stage three is to have between 3 to 6 months of expenses saved in our checking account as an emergency fund. The specific months depend on your personal preference and the stability of our job. I prefer the 6 months. Given I am more rish averse when it comes to preparing for unexpected events, but the key is to have enough cash in your checking account to handle emergencies and life events. Life events like job transitions, or our kid’s seriously ill, I don’t need to borrow money. I have already paid off all my debe in stage 2, so I don’t want to get myself into a position where I might need to be burdened by debt again. Stage 3 really starts to give me both the mental and emotional breathing room when it comes to my finances. I can start planning for a long-term future, I can strategize my careen pathway, and I am no longer making short-term financial decisions to survive.

Stage 4: 1-year of expense. Stage four is to have one year of annual expenses saved. And because this is a large sum of money, it would be a combination of our cash and investments. And this is what I believe is the real pivotal point where many of us go from a short-term survival mode to long-term wealth building mode. When I have one year of expenses saved, I essentially have what JL Collins famously calls, “The F**K-YOU money”. If I really don’t like my job, I have the ability to quit and look for a new one without the fear of financial catastrophe. If our company is downsizing and I am unfortunately on the list, I don’t have to stress out like many others. I can kind of welcome the downtime. We are living in a time where an everage person will have multiple careers in his or her lifetimes. For me personally, I’ve made 3 small career shifts in the last 10 years, from game develop industry to internet web development, then work as a freelancer until now. The world is changing quicker than many of us can adapt to, and having one year of expenses will give us the cushion to successfully make these transitions. Another interesting thing I notice starting happening at this point, is the power of compounding in my protfolio. When I have 1000 dollars in investments and the market is returning 10% a year, 100 dollars does’t feel like a lot. But when I have 100000 dollars in the market, now that 10% annual return just made me 10000 dollars without I needing to do anything. If the 10% return continues, my 100000 dollars will essentially double to 200000 dollars in little over 7 years. This is how the wealthy get wealthier. And at stage 4, I am getting a glimpse of it.

Stage 5: 5-year of expense. Stage five is where we have 5-years worth of annual expenses saved and invested. In the Financial Independence world, this stage is what would also be called “Coast Financial Independence”. Essentially, this is where if you arrive at the stage at earlier point in your life, like before your thirtys, you have enough invested in the market that even if you don’t invest any more money going forward, the compounding will allow you to have enough to retire when you reach the age of 65. If you are at this stage right now, really congratulations. You have really achieved more that 95% of Chinese will ever achieve in a lifetime. And the compounding effect on your portfolio is really kicking in now. For example, let’s say my annual family expense is 10000 dollars, and I have saved and ivested 50000 dollars in the market. At a simple 10% market return, my portfolio is growing at 5000 a year. That’s half of my annual expense. Of cause, I won’t spending this amount and it’s being reinvested into my portfolio which allows I to grow that portfolio, let’s say a same trajectory of 10% a year. Which means without I doing anything, my investment will have grown to 100000 dollars in little over 7 years. I’m simplifying everything here, of course, there are a lot of factors that go into market returns. But the point here is that when I get to stage 5, I will really start to feel the power of Financial Independence. At this stage, I can take calculated risks in my life. I definitely felt this when I reached this stage, it allowed us to start freaming about where we wanted to be in 10 years.

Stage 6: 10-year of expense. You could reach stage six when you have 10-year worth of annual expenses saved and invested. At this stage, our portfolio returns could be equal to our total annual expense. Using the same estimate as earlier, assuming a 10000 dollars annual expense, we new have 100000 dollars in our portfolie. At 10% annuak return, our portfolio is generating 10000 dollars from market return alone. yes, it’s quite amazing if we think about it. Imagine how many hours we have to work a year to make that 10000 dollars a year. Our sweat, blooad and tears go into making sure our family is financially taken care of. The 10000 dollars pays for our food on the table, insurance, my son’s study fee. When I have 10=year worth of annual expense in the market, it essentially is generating that same amount, but without the sweat, blood and tears. Let me talk about passive income. It is quite an amazing feeling when I reached this stage, we might even start to feel rich. And this stage is also where I also need to check myself, because it represents a danger point for many. When I have this much money in the market, and I feel the emotuinal freedom that comes with it, it’s also possible to fall into complacency when it comes to my budget. Someone stop looking at the right side of the menu when they order food, instead of continually shopping at the wet market, somebody jump to supermarket. We can’t just skip it on our way to lifestyle inflation. I should definitely congratulate myself when I get to this stage, but also can’t lose focus.

Stage 7: 25-year of expense. Stage seven is 26 times our annual expense saved and invested. This is the utimate Financial Independence because when you have 25 times your annual expense invested in the market, you have the choice to complately retire from work. The retionale behind the 25 times your annual expense comes from what’s called the 4% rule. The base of the 4% rule is that when we only pull 4% from our portfilio a year, the investment will continue to grow ahead of inflation allowing us essentially to live off our portfolio forever. Like a goose that continuously lays the golden egg. In the exmple of 10000 dollars annual expense, this means you have a portfolio of 250000 dollars, you are basically financially free. You can pull 10000 a year from your 250000 dollars portfolio for the foreseeable future and it will never run out. Of course, there are a lot of nuances here that I’m not covering like inflation and prolonged market downturn, but that’s no a problem. The basic notion here is that when you achieve stage 7, you can retire from work if you choose to do so. Or you can pursue a different career that you didn’t before, because of financial reasons. Or you can choose a travel the world with your family. The choice is yours and the world is your oyster.

If you feel like you are too late to the game and you don’t think you’ll even reach the stage, don’t lose heart. There are many who are pursuing Financial Independence even much late in life. If you like this diary of Financial Independence, I would like talk about some steps to Financial Independence next time.