When I first started my journey toward financial independence, one of the very first things I had to do was figure out how much I was earning and spending.
Basically, I had to develop a budget.
I knew I was broke. And I knew I wanted to be financially free before 40 years old.
But how would I go from broke to free? How could I go from where I was to where I wanted to be?
Well, that’s why a budget is so important. In order to go from Point A to Point B, you must first put together a road map. You can’t possibly go somewhere without first knowing where you’re at and where you’re going.
The budget is critical to the concept of reaching financial independence, as one’s savings rate largely determines just how quickly one’s able to quit their job and live off of their passive income (if they so desire). I knew that I had to save at least half of my net income if I wanted to go from broke at 27 to free by 40.
So a budget it was. I began to track all of my income and expenses, right down to the penny. (And I still track every penny to this day.)
What shouldn’t be a surprise to anyone is that I quickly realized I was spending much more money than I initially thought I was, and this was even after some thoughtful reduction in expenses to get things rolling. There was a lot of leakage. And my ship was thus barely staying afloat.
This is a situation that I imagine most people would find themselves in if they created a budget all of the sudden. It occurs to me that most people aren’t very good at managing money, which naturally manifests itself through one’s budget.
But if you can muster the courage to face that and then take the steps necessary to improve your relationship with money, amazing changes can and do result. I’m living proof of that.
However, when I first started budgeting, I wasn’t initially real sure what I was supposed to think of leakage – money that was frivolously spent on unnecessary luxuries without realization. Although I had the general awareness to recognize leakage when I saw it, I wasn’t particularly certain how bad this leakage was, or how much it was actually costing me.
Sure, it was easy for me to do the simple math early on, as my goal was to get my budget to a point where I was saving 50%+ of my net income. At that point, it’s just a matter of simply getting expenses down to 50% or less of my net income. So every extra dollar being spent (or every less dollar earned) was impeding me from reaching that goal.
If I were earning $3,000 and spending $2,000, I had to figure out how to cut at least $500 from my budget in order to get my savings rate to 50%+. As such, my initial attitude toward expenses were somewhat simplistic. I was only trying to get my savings rate as high as possible.
But by viewing my expenses only through the lens of either increasing or decreasing my savings rate, either speeding or slowing my journey to financial independence, I wasn’t realizing the true cost of expenses.
I now look at every expense through a lens of what I feel is the most accurate way to judge their true cost.
In my view, the true cost of expenses is how much capital would be required in order to generate the passive income necessary to cover the associated expense.
I’ll show you how that works.
Let’s say you have $200 worth of leakage in your budget. This is $200 per month of “fat” that you don’t need to really spend.
How much is $200 per month? Is it really that much money?
I’d argue it’s a hell of a lot more than “just” $200 per month.
If you really want to put yourself in a position to live off of your passive income, every expense has to be paid for by the passive income your portfolio is generating.
Well, I can tell you that my Full-Time Fund generates over $11,000 per year in passive income. It takes just over $335,000 of capital to generate this income. That’s thus a yield of 3.31%.
The yield on my portfolio has typically oscillated between about 3.5% and 3.6%; however, the recent dramatic rise in the price of stocks almost across the board has lowered their yields (price and yield for stocks are inversely correlated).
So in order for me to cover $200 worth of monthly expenses, I need to have ~$72,500 invested (at the current yield of my portfolio).
I arrived at that figure by multiplying that $200 by 12 – which is a year’s worth of that monthly expense. I then divided the resulting $2,400 by 3.31%, which is the yield I just noted for my own portfolio.
Sure, you could increase the yield up to 3.5% or 4%, but with the way stock prices are so high (and yields so low) right now, generating a portfolio-wide yield of 4% is anything but certain. That said, I’ve typically approached the math behind this idea with a 3.5% yield, as I’ve largely been able to attain/maintain that yield for many years now.
With all this in mind, and using the portfolio’s current yield as the base behind the math, the “true cost” of a $200 monthly expense for me right now is actually approximately $72,500.
When I first connected the dots and realized how seemingly small monthly expenses actually required massive amounts of capital invested in order to generate the passive income necessary to cover the expenses, it became very easy for me to start axing expenditures and significantly live below my means.
And it doesn’t even take that much to get to $200 worth of expenses for someone. I mean, I’ve heard of some people spending that much money on cable/internet.
So when I look at expenses through the “true cost” lens, I’m able to honestly ask myself whether or not the expense in question is actually worth the amount of capital that has to be tied up in order to cover it on an ongoing basis.
If I were to spend $200 on restaurant visits every month, I’d have to seriously ask myself whether or not these meals are worth $72,500.
After all, becoming financially free means one is able to live off of their passive income. Well, that passive income is generated from a capital base, generally. And that capital base requires a massive amount of work to accumulate in the first place.
Looking at expenses this way, I realized that every dollar of expense was not actually a dollar of expense at all. That dollar of expense was a small ball and chain that required a rather large underlying capital base in order for me to be able to one day freely move around with the added encumbrance.
Indeed, if we were to scale this example down, every added dollar of expense in my budget requires an underlying capital base of ~$363!
That’s basically how I now view expenses. The “true cost” of every dollar I add onto my monthly budget is actually $363, as that’s how much capital is required to be invested (at my current portfolio’s yield) in order to generate enough passive income to cover that extra ongoing dollar of expense.
I’d recommend you do a similar exercise for your portfolio and expenses, figuring out how much yield your portfolio is generating and then comparing that against your expenses. That should really put things into perspective, giving you extra motivation cut any unnecessary fat.
What do you think? Do you look at expenses this way? Why or why not?
Thanks for reading.
Image courtesy of: Sira Anamwong at FreeDigitalPhotos.net.