Updated: July 5, 2012
How much do you need to invest to be financially free?
That’s the question that our guest blogger for today, Anthony, tries to help us with.
Below, he gives us an illustration of how you can calculate the amount you need to save, and then invest, so you can live a financially independent life.
A stage that he calls, “Cross Over Point” – Anthony gives us a pretty interesting theory and formula on how you can give “financial freedom” an exact value.
Let’s now read what he has to say:
I really like writing articles about the “Cross Over Point” because it reinforces my drive to achieve it as soon as possible.
I’d like to share what Jepi and I talked about reaching our own respective Cross Over Points. It’s a nice thing for a couple to set a goal like this independently because it provides more chances for learning new techniques, implementing old or used strategies to saving, investing and spending.
I first shared with her the basic formula to determine one’s Cross Over Point (COP1):
where: first Cross Over Point (COP1) is your income from your assets and investments
Note: 8% is the average annual growth of assets and investments in Mutual Funds/ Stock Market. I know this is “lower” than what most people know, but if your money grows more than 8% per year, then you won’t hate me, right?
Like what I said in my blog article, Cross Over Point = Financial Freedom, I can determine the point when I’ve already achieved Financial Independence when I reach COP1 (and then do a lot more after that).
What are the essential ingredients you need to determine how you’ll reach this Cross Over Point?
Consider Eric as an example. Let’s say he wants to hit his COP1 in 15 years (be financially free in 15 years).
Eric’s Time Frame: 15 years or 180 months
Next, let’s say:
Eric’s Expenses: Php 50,000 per month or Php 600,000 per year
This amount covers Eric’s needs and wants, and a little extra. The values are different for every person. A very frugal person can spend less than Php 10,000 per month, or someone with a more upscale lifestyle can spend around Php 100,000 per month.
As a last step, let’s determine Eric’s Cross Over Point by dividing his annual expenses by 8%, the annual average interest growth of investments in mutual funds and the stock market.
Since Eric’s Average Annual Expenses is PHP 600,000, then his first Cross Over Point (COP1) is PHP 7.5 million (divide 600k by 0.08)
The result shows that Eric only needs to save and then invest PHP 7.5M to be able to live comfortably with a PHP 50,000 per month of expenses (Php 600,000 per year) for the rest of his life.
Of course, the assumption here is that he does not spend over his budget and that the annual growth of his investments is always more than 8%.
Once you have your first Cross Over Point (COP1), then you can calculate how you can achieve it:
Eric’s COP1: PHP 7,500,000
Eric’s Time Frame: 15 years or 180 months
Divide the COP1 by the time frame and you get your required income rate per month:
Savings and Investments Income: PHP 41,667 per month (PHP 7.5M / 180 months)
This means if Eric wants to get to his first Cross Over Point, then he needs to save PHP 41,667 per month for 15 years. Too high or difficult? Not really because this equation does not yet include the power of compounding interest.
If you compound 8% per year, then Eric actually needs to only save Php 40,000 per month for 11 years to reach his first Cross Over Point:
Some people may argue that achieving your Cross Over Point is the best possible way to be financially independent.
Moreover, some people will say that the time frame is too long and they can’t wait 10-15 years. For this case, the Cross Over Point becomes a limiter which hinders your potential of achieving financial freedom faster.
Meanwhile, some people will say that the amount needed to be save and invest is too big and they can’t put aside almost 80 to 100% of their monthly income. For this case, the Cross Over Point is not a S-M-A-R-T goal FOR NOW.
But personally, I think setting a Cross Over Point and then working hard to attain it is a good financial goal. And I believe there’s a great satisfaction in being able to achieve this.
This guest post is contributed by Anthony Dones. You may visit his blog Each Peso Counts to learn more about Cross Over Points and other personal finance tips.
Personally, I find this one very interesting. And the only criticism I have with his calculation is that he did not take into account inflation, which at current is around 3%.
However, factoring in inflation can be as simple as
adding subtracting it to the 8% which gives us a new constant for the formula, which is 5% (or 0.05). (Thanks to ForsakenOne for correcting me here.)
In any case, I understand that the values in the calculations are not absolute, and in one’s journey towards financial freedom, you need to constantly adjust your income, expense, savings and investment rates so that you stay on track with your goal.
I guess that’s it. I hope you liked our post for today. Do share your thoughts, and if you have any questions regarding this article, just ask them below in the comments section. Anthony and I will try our best to clarify anything about the formula and calculations above.
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