I’ve recently been reading Malcolm Gladwell’s book, The Tipping Point. It’s a fascinating read that in a nutshell, explains how messages, trends and behaviors “go viral”. How small acts and events build upon each other until they reach a critical mass (the tipping point) where they simply take off and become something much larger than the sum of its parts. In the book he uses examples such as Paul Revere’s ride, the spread of a fashion trend and how a single person can start a “word of mouth” movement for a restaurant they’re a fan of.
As I was reading the book I couldn’t help but think of how the concept of the tipping point relates to our investing habits. We’re all aware it exists, and have probably read hundreds of articles mentioning the power of compound interest which is another example of the tipping point theory in action.
The Tipping Point For Financial Independence
Financial independence should be a goal for each of us in one way or another. Reaching a point in life where you can do what you want in life without having to worry about the financial aspect of it.
So the tipping point for financial independence would be the point where your investments are creating more income than you have in expenses. How much money do we need to reach that point? $1,000,000?! $10,000,000?!
You need much less if you listen to Berkshire Hathaway Vice-Chairman Charlie Munger. He’s famously quoted as saying “The first $100,000 is a bitch” (Which, in hindsight, would have made a much better name for this website)
To expand on that a bit, he’s quoted in the book Damn Right: Behind The Scenes With Berkshire Hathaway Billionaire Charlie Munger as saying:
Munger has said that accumulating the first $100,000 from a standing start, with no seed money, is the most difficult part of building wealth. Making the first million was the next big hurdle. To do that a person must consistently underspend his income. Getting wealthy, he explains, is like rolling a snowball. It helps to start on top of a long hill—start early and try to roll that snowball for a very long time. It helps to live a long life.
The historical dividend yield of the S&P 500 is around 3.26%. That means if you had $100,000 you could earn $3260 per year, or $9 per day from a simple index fund. Just for the simple act of waking up and not getting hit by a bus. If you re-invested those dividends into more shares you’d really have the power of compounding working for you and be on your way to reaching financial independence.
So while I can’t argue with Mr. Munger that $100,000 is where you really start to be able to see the true power of your investments at work, I’m guessing most of us have yearly expenses totaling more than $3000 per year. So we’re still a way off from our goal of reaching the tipping point of having our investments create more income than we have in expenses.
The First Million is the Hardest
A portfolio of $1,000,000 would provide you with over $32,000 purely in dividends. The average American family spends about $49,000 per year, but the average American family is financially illiterate. If you have your sights set on financial independence and can’t get your yearly expenses lower than $32k per year, you’re doing it wrong. This is why I use $1,000,000 as a very generic tipping point for financial independence.
There are obviously problems with the number. For simplicity’s sake I’ve used the historic dividend yield of the S&P 500 for these numbers. No one (hopefully) has their entire portfolio invested completely in an S&P 500 index fund. Income investors, who are laser focused on creating income from their investments focus on creating a portfolio of stocks, bonds and other investments that will have a much higher dividend yield than the “average”, thus providing them with more income from a smaller amount invested.
Everyone also has differing expenses. Pete, better known as Mr. Money Mustache, was able to retire in his 30′s and had expenses of just over $25,000 for his entire family. If you’re single you may be able to live on less, if you have a family you’ll probably spend more.
This example also assumes the entirety of your portfolio income is coming from dividends. There are countless other ways to create both investment, and passive income. FI Fighter is well on his way to financial independence and retirement at the ripe old age of 30 by creating a small empire of rental properties to produce the income he’ll need. Sam, at Financial Samurai has created a successful online business to supplement his investment and real estate income in early retirement.
The important thing is to have a firm grasp on how much money you’ll need to cover your projected living expenses. Tools like Personal Capital and Mint make this really simple, allowing you to analyze your finances from any angle you can imagine. Once you have a grasp on how much money you’ll need to generate, you can work on reaching the number at which your financial situation will “tip” and your investments will be creating enough money for you to live off of.
So while getting to $100,000 might be where you start to feel your investments taking some of the wealth creating burden away from you. Chances are, you’ll need much more money in order to reach your financial tipping point. The examples above show that there are numerous ways to get there, which one you choose is entirely up to you.
Readers: Have you reached either tipping point with your investments? Either where they’re really starting to take the work off your shoulders, or where they actually produce enough income to live from? If not, what’s your plan to reach your tipping point?