Wednesday, 16 March 2011

How Much Is Enough?

The objective of The DIY Income Investor is to build up your wealth, reasonably quickly and reasonably safely. However, there is a valid question: How much is enough? What figure should you be aiming for?

"Just a little bit more" is how John D. Rockefeller famously answered the question "How much money is enough?"

The Daily Mail reports that US millionaires (i.e. with a million dollars to invest - excluding real estate and pension funds) think that they need $7.5 million to feel truly wealthy. That's a lot of money - and by definition only a few of us will ever accumulate that much. So what, really, should we be aiming for?

Money and Happiness

As this MSN article discusses: increasing income doesn't necessarily increase happiness, as shown by a number of studies of people in developed economies. Hence the growth in the number of people 'downshifting' and seeking a more fulfilling - and more frugal - lifestyle, rather than just chasing money.

What are you saving for?

Obviously, it depends what you are saving for. There could be a lot of reasons but because you are reading this blog, I will make the basic assumption that you are saving to become financially independent (and probably aiming to retire or semi-retire when you can).

'Wealth Potential' and your Target Wealth

In another post I highlighted the 'Wealth Potential' as a way of getting started on the DIY Income Investor approach. You may recall that it's a pretty simple formula:

                            Wealth Potential = Income - Expenditure

We can adapt this equation to give us another important relationship:

Target Wealth =  Annual (Future) Net Expenditure /  Average Income Yield (%)
In other words:
  • work out how much your future expenditure is likely to be (net of any other income you might be expecting, such as a state or company pension) - don't forget to allow for inflation
  • work out the current yield on your savings and investments (i.e. the income, after tax, as a percentage of the value of your savings/investment) - this is where the DIY Income Investor focus on income makes it easier
  • work out what would be a reasonable average yield for the future (i.e. be a little conservative)
  • divide your future annual expenditure by your expected income yield
It's pretty simple - but here's a worked example to illustrate the idea:
  • you believe your future net annual expenditure will be around £15,000
  • and your savings and investments are giving you around 5% return a year
  • then you would need a total amount of £15,000 divided by 0.05 (i.e. 5 divided by 100 or 5 per cent)
  • giving a total required wealth (or at least invested wealth - this doesn't include your other assets) of £300,000 
That might seem like a much more achievable goal than $7.5m?

Obviously, the more you can reduce your expenditure, the faster you can achieve your goal - not only do you have to save a lot less but you can save more each month!

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.