At some point in your life, you’ll reach an investment threshold where you may regularly start making (or losing) more from your investments than from your annual job income. When this happens, work starts to feel optional as you start questioning the trade-off between time and money. During a stock market crash or recession, your Return on Effort (ROE) for working drops significantly. As a result, the only way to increase your ROE is to work less.
You want to retire early or seek a less stressful and more fascinating career because stocks and real estate values climb roughly 70% of the time in a given year. Your age decreases your ability to tolerate workplace annoyances as time becomes more precious.
This article will assist you in determining the minimal investment threshold to strive for, enabling you to stay motivated and focused. Reaching a financial objective is considerably simpler when it is well-defined.
You should feel more empowered to make positive changes in your life after you reach the minimal investment threshold amount. My method can act as a wake-up call to quit wasting time for those of you who are further along in your financial journey and already have a large amount of money.
The Formula for the Minimum Investment Threshold
By calculating your gross annual income by the inverse of the asset class’s historical return, you can determine the minimum investment threshold at which work becomes optional.
Once you hit this investing threshold, there’s a good possibility your investments’ annual return will match or surpass your pay. You’ll also have an even bigger after-tax cushion because capital gains and long-term investment income are typically taxed at a lower rate than W-2 employment income.
You can change occupations, take a sabbatical, or even retire early if your investments can consistently match or exceed your yearly gross income. Before I offer three examples below, let me clarify a few important presumptions.
Given that incomes and inflation are connected, my investment threshold method has the beauty of including real-time inflation assumptions. Just run the numbers each time your earnings fluctuate. Moreover, inflation contributes to investment returns, which traditionally have outperformed inflation.
Please be aware that the purpose of my Investment Threshold Formula is to serve as a starting point for measuring your current situation or helping you set financial goals. After estimating the amount, you can make plans depending on additional factors.
Important Premises for My Investment Threshold Calculation
The financial freedom seeker is assumed to live within their means, not have any credit card debt that is constantly accruing, and save at least 20% of their annual after-tax income in my investment threshold model. The person pursuing financial independence is also presumed to continue with their customary spending patterns. Naturally, a lower investment threshold will be required if you decide to spend less, and vice versa. But since I consider cutting back on expenses to be “cheating,” I substitute a multiple of gross annual income for annual expenses.
I want you to reach your financial objectives without unduly sacrificing the lifestyle you want. It makes no sense to retire early and then live in abject poverty. Living close to poverty in order to retire early and carry on with that lifestyle is also not the best option. I’ve seen and profiled a lot of people who chose to live like monks, forgo travel and rent, live on a boat or in a camper, forgo having children, and make their spouses work in order to become financially independent since I helped launch the modern-day FIRE movement in 2009. It is not ideal to not be free to live fully.
Rather, I urge everyone to have a healthy life. You need to be able to preserve or perhaps raise your standard of living once you make the decision to leave the workforce.
Example 1 of the Investment Threshold: 100% Allocation in Stocks with a High Risk Tolerance
Assume that your annual income is $100,000. Since 1926, the S&P 500 has historically returned 10% yearly. Ten is the opposite of 10%. If you multiply $100,000 by 10, you will obtain $1 million. If you are a $100,000-a-year earner and you feel that your job isn’t fulfilling, you should feel free to look into other opportunities after you have invested $1 million in the S&P 500.
You could think that, at 38, you have a high risk tolerance and can invest 100% of your portfolio in equities. Let’s say you’re sick and tired with government employment and want to try your hand at a $40,000-a-year writing career. You have $1.1 million in stocks, which you have amassed over 15 years by saving and investing half of your after-tax income.
Using my investment threshold approach, you only need to invest $400,000 in stocks if you can live off a $40,000 annual wage without touching principal. But with $1.1 million in stocks, you opted to change careers at 38, so you have a $700,000 investment cushion. You may consequently feel immensely wealthy and liberated in your new way of life.
In the event that you would rather allocate your assets differently, you can find a new gross annual income multiple by calculating a blended estimated historical return.
Example #2 of Income Threshold: Prepared for Retirement with a 60/40 Stocks/Bonds Portfolio
Imagine that you are 45 years old and fed up with your job 23 years after graduating from college. You make $300,000 a year working in the famously unstable tech sector. You would rather have a 60/40 stocks/bonds portfolio than one that is 100% stock. When are you able to retire?
Bonds have historically returned roughly 5%, therefore a 60/40 portfolio has historically returned about 8%. 12.5 is the inverse of 8%. Multiply $300,000 by 12.5 to determine your investment threshold. The result is $3,750,000. Regretfully, you have no other assets and “only” $2.5 million invested in stocks and bonds. A compound return calculator predicts that, assuming an 8% annual return, your portfolio will reach $3.75 million in three years and ten months, based on your ability to save $100,000 annually after taxes. Of again, you could have to wait longer in a bad market.
You can relax knowing that you have a fair chance of retiring within the next five to seven years based on my investment threshold methodology.
Example #3 of an Income Threshold: Invest in Real Estate Rather Than Stocks or Bonds
Suppose you were raised in a society that placed a higher value on real estate than on bonds or equities. You put all of your retirement savings into residential real estate because it is physical, offers shelter, produces income, and is less volatile than stocks. Bonds are uninteresting and don’t offer enough potential gains. In the past, real estate has typically returned 4% yearly, which is 2% higher than the rate of long-term inflation. According to certain authorities, such as the San Francisco Fed, since 1850, real estate has traditionally returned 7% yearly. At age 26, you work as an associate in banking and make $200,000, but after three years, you’re already exhausted.
Use the same formula to determine how much real estate is required to make work optional. 25 is the inverse of 4%. You will obtain $5 million if you multiply 25 by $200,000. You now have to try your hardest to live on $200,000 or less, and save and invest as much of any income beyond $200,000 as you can.
The Capacity To Borrow To Cross Your Investment Threshold In Real Estate
Even though $5 million may seem like a lot of money, our approach enables those with steady income and strong credit to purchase real estate with just a 20% down payment. Therefore, you can purchase $5 million worth of real estate over time with just $1 million. $1 million is less than what you would need if you wanted to invest all of your money in the S&P 500, or 50% less. It goes without saying that property management will cost you extra money and time. Furthermore, you may experience more severe fluctuations in your real estate equity if you have a lot of debt.
Possessing rental properties with a healthy income flow is essential. Thankfully, rental yields typically exceed dividend yields on stocks by a significant margin. When paired with the approximate 4% annual appreciation of real estate, you should be able to make work optional. Expanding a property can be a hands-on project for those who wish to add value and generate more rental income. Additionally, investors who prefer to take a hands-off approach can opt to participate in a private real estate fund or public REIT, as these entities handle all the work.
