Wealthy Maths: The 4% rule/Rule of 300

In Latest, Wealthy Maths by Stealthy Wealth

How much money do you need to be financially free?

It’s a question that everyone should be asking themselves because, at some point in your life, you’re going to have to achieve financial independence. You don’t have a choice – you will reach a stage where you will no longer be able to work, and you’re going to need your investments to provide you with an income large enough to cover your expenses.

So how much is enough? Well, it varies from person to person. Luckily, the 4% rule and the resulting rule of 300 make it pretty easy to calculate your financial freedom number.

The 4% rule

In a nutshell, the 4% rule comes from a study that analysed data from 1925 to 1995 to determine the maximum amount someone could draw from their investments in the first year of retirement to ensure they would never run out of money.

The answer was 4%.

In other words, if you draw 4% of your investments in the first year of your retirement and you adjust that amount for inflation every year going forward, you’re pretty much guaranteed that you will never run out of money over a 30-year period. That’s because the market tends to grow at least by inflation plus 4% every year, so your money keeps track with inflation even when you use some of it.

Let’s look at how you can apply this rule to determine how much money you will need to be financially free.

The 4% rule and the rule of 300

The 4% rule says we can draw 4% of our total investment value to cover our annual expenses. Let’s call the amount that you need to be financially free FF.

To be financially free, our annual expenses should be 4% of FF.

Or

However, most people don’t use annual expenses when budgeting or planning. We are much more familiar with monthly expenses.

Plugging (2) into (1) we get:

And now we quickly remember the “what you do on the left you do on the right” rule of equations and multiply each side by 100/4.

And finally, we get:

Therefore, the amount of money you need to be financially free is equal to your monthly expenses multiplied by 300.

This is why the 4% rule is sometimes called the rule of 300.

Applying the 4% rule/the rule of 300

To work out how much you need to retire you first need to look at your current monthly expenses. Then adjust these values to what they might be once you hit retirement/financial freedom – your house may be paid off, kids might be out of school, your commuting may be less etc. Then add in any new expenses you may have, like travel expenses, subscriptions or a lawn bowls membership.

Once you have done this, you can calculate the size of the investment you would need in order to cover those monthly expenses by multiplying your retirement expenses by 300.

For example, if you estimate that you would need R18,000 a month, you would need investments worth R5.4m.

And if you needed R30,000 a month, then your investment pot would have to be R9m.

A few things to consider:

  • The amount you need may seem daunting. The word “million” can scare a lot of people from even attempting to become financially free. But remember that compound interest can make big numbers look like child’s play – provided you give it enough time to work. Start early (there is no time like right now!)
  • The amount you need to be financially free has nothing to do with income (you may have noticed that none of the equations used income as an input) and everything to do with expenses. If you can reduce your expenses you’ll score twice:
    1. The amount you need will be less.
    2. You can get to that amount quicker because the less you spend the more you can invest.

Our friend Stealthy Wealth knows his way around maths. Luckily for us he also speaks human, which is why we asked him to explain the most important maths we need to know to be good at money. This is not your average maths class. Tune in once a month and turn into a money mathemagician.

http://www.stealthywealth.co.za/

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