In January I posted Part 1 of this series. The homework for that part was to track your expenses for a few months. It’s been five months since that article, so if you’ve been tracking your expenses the whole time, Mazel Tov! You have a much better understanding of your financial picture than the majority of the population.
Even if you only tracked your expenses for 2-3 months, you should have a good amount of data to move onto the next steps.
Categorize You Spending
If you are using one of the websites I referenced before, Mint or Personal Finance, or your bank or brokerage’s tools, this is probably done automatically. Even so, take a look at your transactions and make sure everything is categorized correctly. I often find that my dining or grocery expenses are mis-categorized. You can go in manually and fix any errors to put transactions in the right category. I suggest doing this once a month, because if you wait too long to check the categorizations, you may not be able to remember what a certain transaction was to know what category it is in. You can use whatever categories work for you, but try to be consistent so you can continue to track your expenses and compare more recent spending to the same categories in the past.
Calculate Your FI Number
Now that you have a few months of data, you can go ahead and calculate your FI number. This is the amount of money you will need, at your current spending, to be able to retire.
- You’ll take your average spending for the months you’ve tracked, and multiply by 12 to get your annual spending. So, for example, if your tracking has shown you spend an average of $5,000 per month, then your annual spending would be $60,000 per year.
- Next, take your annual spending, and multiply by 25. Why, you ask? This is based on the Trinity Study, a study conducted by researchers at Trinity University which is used extensively by the FIRE movement. The study tested financial portfolios with various makeups (100% bonds 50/50 bond stocks, 100% stocks, etc.) over every 30-year period from 1925 to 1995 to determine a “safe withdrawal rate:” how much of a portfolio could be withdrawn each year without running out of money. They ran thousands of simulations of market conditions, with and without inflation. The study determined that with a 4% withdrawal rate, you would be very unlikely to run out of money (over 90% chance of not exhausting your portfolio), thus coining the “4% Rule.” The original study was updated with data through 2009. In 2022, an Updated Trinity Study was conducted with data from 1871 to 2021, and looking at periods up to 50 years, concluded that the math of the original study held, and the 4% Rule was consistent with longer periods and more recent data. To be even safer, many people use a 3.5% or 3% withdrawal rate, but we’ll start with 4% because the math is easier.
- So, you’ve multiplied your annual spending by 25. If your annual spending was $60,000, then your “FI number” is $1.5 million. That’s the number you have to meet before you pull the trigger on early retirement. Easy peasy.
Now, What Do You Do With It?
Great. You know your FI number. If you never increase or decrease your spending, you know how much you need to be able to retire with the same standard of living you enjoy now (We’ll come back to this later). The number’s probably not as high as you were expecting, or as you’ve been told by financial planners, but it still seems pretty far away, right? That’s okay. This is not a goal you reach overnight. At least you have a number to aim for. But how do you get there?
There are really only two ways to reach your FI number: increase your saving/investing, or decrease your spending. Ideally you’ll find ways to do both. By decreasing your spending you’ll lower your annual expenses and actually lower your FI number. Plus, you can save the money you’re not spending anymore, and thus increase your savings. And by increasing your saving, you’ll be using a bigger shovel to get to your number faster.
We’ll get into the nitty gritty of how to do this soon, but for now, take another look at the expenses you’ve been tracking. Do you see any places where you can cut back? How many streaming subscription services are you paying for, and how many do you actually watch? Do you also have cable? Do you need both? How much do you spend on dining out? Are those fun dinners with family and friends that you enjoy and don’t want to give up? Or is it a $15 sandwich you’re buying from the corner deli on your lunch break because you didn’t have time to make lunch in the morning? Have you had the same phone plan for a decade? Are you using all of the features you’re paying for? If not, is there a cheaper one that would work better for you? How’s your grocery bill? Are you throwing out a lot of food that goes bad before you can eat it? Do you go to the store with a list, or just grab whatever looks good? Are you paying for a monthly gym membership that you don’t use?
If you are doing any of these things and they bring value to you, then that’s fine, keep doing what makes you happy. But if you are doing these things because you just haven’t thought to change something, then you may be wasting money that you could instead be saving to get to FI. This is not a guilt trip. Merely tracking your spending is likely to make you think more carefully about how you are spending your money. Maybe you’ve even made some changes after just a few months of tracking.
Next, we’ll talk about more about specific ways to move the needle to increase your savings. Stay tuned.