The magic number is the size of your investment portfolio that you need that will make you financially free. Different sources will have different definitions as to what financial freedom means and what constitutes a financial free portfolio, but this is what I am going with.
Now before I jump into the numbers, I suggest either getting a very simple financial calculator (I’ll show you how to calculate closer to the end of this article), or use an online calculator .
Any financial calculator will do, I recommend this one, which is under $30 as it has all the functions that you’ll need.
The reason why I recommend getting a financial calculator is because I want you to be in control of the numbers. Yes, the online calculators will definitely serve the purpose you need, but instead of relying on someone else (in this case a computer) to do the calculation, I’d rather you go through the process manually. I feel that it puts your more in control.
My goal is to teach you financial education and while these tasks can be mundane, the calculator itself will be a great way you to appreciate these numbers. Understanding how to decrease some of the numbers could mean years of not working for someone else and doing what you enjoy.
Either way, let’s dig right in!
Calculating Your Magic Number for Financial Freedom
I created the video above to explain how to do Time Value of Money calculations. Take a look!
For illustrative purposes, let’s assume that you need $2,000 per month after tax to survive. That might be enough for many and not even close for others, again this is for illustrative purposes only so relax! If we do the math $2,000*12=$24,000 per year. Let’s assume that taxes in whatever country you live in are 25%. So we therefore need $32,000 from your investment portfolio on an annual basis. If we have a portfolio that produces a 4% return, then you need an $800,000 portfolio.
Sounds like a huge number doesn’t it? You bet, $800,000 is nothing to sneeze at and the reason why this number is so high is because I don’t want you to deplete your investment. Your initial investment is in tact, when you visit the bank they often give you a smaller number because they calculate it so that once you hit retirement, you eat into your principal and they expect you to die by a certain age and at that point you have nothing left. Not even a penny.
I personally want to leave money behind, whether if that’s for my children or for charity is to be determined, but philanthropy is an important part of my life and what Warren Buffett did with his money really made me think as I’m sure it did to many. So the hurdle I’m setting here is high. No one said it was going to be easy. But my goal is to make it as easy, accessible, and understandable as possible.
Time is on Your Side!
If you have 40 years until you hit this number, at a 6% annual return on your investment portfolio you’ll need to invest $401.71 per month, so that’s around $13.39 per day for the next 40 years. If you break it down that way it’s not as bad right? If you want to achieve the same in 20 years, that number jumps up to $1,731.45, which is more than 4 times the monthly amount.
This is because of the compounding effect. And also a reason why you should start early and keep adding to your investments over time. Another reason why you should teach your children to start investing early or even start their investment for them when their a baby so that you can prove a point to them by the point they’re in their teens.
What $20 a week can amount to
Let’s pretend that you’ll give your children $20 a week as an allowance. If you started at age 0 and put away that money into an investment until your child was 16 at the same 6% annual return. By the time your child is 16, the investment would be $27,911. Now I don’t know too many 16 year olds with that kind of money. If your child continues to invest that money until they are 40 the same investment would reach $173,470.89. That’s for only investing $20 a week.
Having said that, not all of us have time on our side. And that’s why you need to look at the other factors. So let’s see what the factors of determining reaching your magic number are:
Time to reach your goal
Amount needed to live financially free
Annual Investment Return
Increasing the Amount your stash away
We’ve sort of talked about the time you have to reach your goal. Now let’s look at the other two.
Becoming a Minimalist
You should know what your expenses on a monthly basis. If you haven’t done that calculation yet, it’s a vital part of coming up with your magic number so I suggest you that right now.
The key is to see if you can reduce this number, by figuring out to reduce your expenses your magic number will become much more achievable over time.
For example, if we use the example above and reduce the monthly amount needed from $2,000 to $1,800 or $21,600 per year after-tax which at the same 25% tax rate would be $28,800 (calculated as $21,600/0.75=$28,800). At a modest 4% yield from the investment portfolio, you’re looking at $720,000, which is $80,000 less than before.
Using the numbers from the previous example, which had a 6% annual return, which by the way is very reachable especially if you’re investing for the longer term, in 20 years you’ll need to invest $1,558.30 per month which is $173.15 less per month.
This number is still very high as most of us will not be able to afford to put away $1,558.30 per month with our current pay especially considering all the monthly expenses that we have. For comparison’s sake at 40 years with a 6% return, it’s $361.54 per month. So as it stands this isn’t realistic at all.
Your Annual Investment Return
For the examples I used an annual return of 6%. Many of you might be thinking, “Michael there’s no way I can get 6% a year!” Think again! Between 1990 and 2014 the S&P 500 had an average annual return of 11.29%. That’s including the tech bubble bursting and the insane financial crises that we’ve had with the downfall of Lehman Brothers among many other financial disasters. See for yourself here, Money Chimp has an awesome tool to give you the average return for any period of the S&P 500. http://www.moneychimp.com/features/market_cagr.htm
If the stock market can average a return like that in the worst of times, it means that if you invest for the long term you can survive any bear market.
If you are smart enough and spend time on Freedom Nova and other websites, read and educate yourself you’ll likely be able to invest a little more aggressively. While I can’t force you to do this, it makes sense to as the if you can raise your average return from say 6% to 7%, in the 20 year timespan, reaching the $720,000 now requires a monthly investment of $1,382.15. At 40 years, it’s $274.31 per month. Do you see where I’m going with this?
Increasing the amount of money you stash away
Now comes the juicy part. We’ve already talked about decreasing your expenses and the importance of having a decent return and so this section will talk about the how big of a difference saving more money can make.
The median household income in the US in 2013 was around $51,939, that’s “household” by the way, not per person so it shows you how hard it can be to earn a good income. Therefore, if you can limit your expenses there are two benefits. The first we’ve already talked about which will lead to a lower magic number. The second is that you can stash away more money on a regular basis.
We’ve already learned how hard it can be to create an investment portfolio that will make you entirely financially free. This is why you’ll likely need to do everything I’ve talked about and some (like increase your income), to actually reach your magic number.
In the last section I said you need to invest $1,382.15 per month if you want to reach the $720,000 in 20 years. Unless you’re earning a very solid income that likely isn’t going to happen. So as it stands you’re likely going to need to either plan it so that the monthly contribution is more manageable. The rule of thumb is to automatically save 10% of your pay. Let’s say you make $45,000 a year, that means you’re saving $4,500 a year or $375 a month, which is far from the $1,382.15.
At $375 by the way, you’re looking at $195,347.50 in 20 years or $984,305.02 in 40 years. So the key here is to find your magic number and do the calculation accordingly.
What I’m ignoring
When I’m calculating these numbers, I’m ignoring quite a few things. The one major fact is that you’ll likely have a pension either from your job or government. You can definitely add these to your calculations, depending on your age and life stage, especially if you are close to being able to take advantage of either or both of these.
However, if you are just starting out or have a long way before you can access your company pension or government pension plans, then it makes sense to ignore it for the time being and come up in your current status. When you eventually get the pension, think of it as gravy.
I’m also ignoring the fact that you could be a couple which will mean lower expenses for each person and a higher amount of money that can be stashed away. If this is the case, then all you need to do is adjust the amount of expenses for your household and calculate accordingly.
Super simple financial calculation
Now let me get into how to calculate these numbers. These calculations are called Time Value of Money or TMV. Rather than me reinventing the vehicle, your best bet is to read this article on Investopedia (http://www.investopedia.com/articles/03/082703.asp) about what Time Value of Money is. I’ll go through a simple example to give you an idea.
With Time Value of Money (TMV), there are 5 numbers to the calculation. You need 4 numbers to calculate the last number. The 5 numbers in the calculation are time (t), interest (i), payment amount (PMT), present value (PV), and future value (FV).
I’ll use the last example to illustrate this.
If you have $375 per month to invest and you can hopefully earn 7% a year for 20 or 40 years.
t (time)=20 or 40 years, but since we are calculating on a monthly basis we multiply this by the number of months in a year, so 20×12=240 months or 40×12=480 months.
The next is the interest rate, which we also have to change to a monthly interest rate. At 7% a year, we divide this by 12 and get 0.58333% (7/12).
The payment amount is $375 as this is already a monthly amount.
So to summarize:
t=240 or 480 (depending on if you are calculating for 20 or 40 years)
i = 0.58333
PMT= -$375 (this is a negative number as you are losing money from your wallet to put into an investment)
PV = $0 if you are starting with no money.
FV = This is the future value of the calculation. This is how much it will amount to. If you have a financial calculator, this is the number we would be computing for.
Try it on this site to see if you get the grasp of it. If you must know only one financial calculation, let it be this one.
Hope this helps! Now get back to the financial blueprint to see what else needs to be done. This is only one of the first steps!
Be sure to share this with anyone that you care about, thanks for reading!