His proposition successfully combines several of the underlying principles that underlay the DIY Income Investor approach:
- the idea of Wealth Potential, or the difference between expenditure and income
- the more you reduce your expenditure, the quicker you can achieve your financial goals
- your financial objectives depend a lot on your future level of expenditure
What Roth points out is that a good way of measuring financial wealth would be, instead of just counting the monetary amount of savings and investments that you hold, rather to estimate the number of years of 'financial freedom' that have been accumulated. '...Money is essentially stored energy that allows us to do that something else, whether it’s spending more time with family or sailing around the globe."
And potential financial freedom can be measured by the following formula (slightly amended from the original article):
Financial Freedom (in years) = net worth / annual expenditures
As Roth points out: "Using this measure, a millionaire worth $2 million, leading an extravagant lifestyle costing $1 million a year, only has 2 years of independence. The person worth $150,000, who only needs $6,000 a year to supplement social security, has 25 years of financial independence. This person might never need to work again."
He hammers home the message of the equation by pointing out that there are basically two ways to accumulate more years of financial freedom (which can, of course be combined):
- earn more
- spend less
So, how much money you need to live on is a far greater factor in determining your wealth - in terms of potential financial freedom to do what makes you happy.
(And thanks to Monevator for including the article in his weekend reading list.)
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.
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