We all need money. But how much money is enough?
You must have money to survive. To have a place to eat, sleep and live. To cover those unexpected expenses. To fully experience the world. To help out others in need.
Having enough money to do all that is important.
But figuring out how much you need is not easy.
The 4% Rule: A Common (But Wrong) Answer
Many personal finance bloggers and financial planners will tell you that you need 25 times (25x) your annual expenses. At that point you have financial freedom.
This is known as the "4% Rule". (Because 25x = 4%)
There are assumptions built into the 4% Rule you should know:
- You invest in diversified public stocks and bonds
- You take no withdrawals other than income (no special purchases)
- You pull money pro-rata across all investments (same % of each)
The idea behind the 4% Rule is that you should be able to withdraw 4% from a pot of money, increase that income for inflation each year, and not run out for a long time (30+ years).
This is the most common rule of thumb in personal finance.
And like most rules of thumb, it's wrong. Or at least it's not completely right.
Four Ways the 4% Rule is Flawed
There may be more, but here are 4 ways the 4% Rule is flawed.
I'm not saying you're doomed if you use it in your financial planning. You just need to understand some of the nuances and drawbacks of the 4% rule.
You'll learn a few important options you won't hear from most finance people. Especially if they are not entrepreneurial.
Let's jump in.
Flaw #1: Pulling money pro-rata from investments
Pro-rata just means pulling the same percentage from each of your investments. So the overall mix of investment types stays the same.
A simple example:
You have $100,000 split 60% stocks and 40% bonds.
You would take $2,400 from your stocks (4% x $60,000) and $1,600 from your bonds (4% x $40,000). That gives you your 4% of income.
Leaving the overall balance still split 60% stocks and 40% bonds.
Why is this a problem?
Because of the sequence of returns risk. That is the risk that your first year or two of pulling income happens when the stock market is down significantly. That has the potential to blow up the 4% Rule.
So how should you pull the income instead?
From ONLY the bond/safer portion until it is exhausted. And leave the stock portion alone. That means do not rebalance. And allow the portfolio to get more aggressive as you get older.
Most people get this completely backwards, suggesting you get more conservative with your investments as you age.
Doing that actually adds risk to your retirement success.
Flaw #2: The 4% Rule Does Not Include Social Security or Pension Income
Social Security is the primary income source for a lot of retirees. It may be one of your major income sources too.
Unfortunately, the 4% Rule does not factor in Social Security income. Or pension income, if that still exists.
This is a big flaw in using the 4% Rule for your financial planning. It may cause you to over-save or retire later than you could have.
You don't want that.
Flaw #3: The 4% Rule Does Not Account for Inflation
Let's say your current annual expenses are $55,000. And you're in your 30s.
Using the 4% Rule, you figure that once you get $1,375,000 saved, you're home free. ($55k / 0.04 = $1.375mm)
But what about inflation?
If it takes you 30 years to save that much, and inflation is 2.5%, your same expenses in the future will be $116,344.
Which means you'll need $2,908,600 saved. Which will take longer than the 30 years you planned.
You can see this is a major issue if you're using the 4% Rule for financial planning and not accounting for inflation.
Flaw #4: Ignoring Cash-Flow Equivalence
The 4% Rule assumes all your money is invested across varied domestic and international stocks and bonds. Some financial advisors call that diversification.
But that is not real diversification.
Why? Because in public investments (stocks, bonds, ETFs, mutual funds, etc.) you're at the mercy and whim of all the other investors.
You have zero control.
If other investors are freaking out, you can't call and calm them down. If Apple and Microsoft are making changes you don't like, tough. When the president tweets something that sends the market tumbling, you have no recourse.
To be truly diversified, have some of your investment money NOT in the public markets.
The Power of Private and Personal Investments to Increase Your Wealth and Cash Flow (aka Business Ownership)
I like to think in terms of private and personal investments (as opposed to public).
- Private - Joining with a limited group of investors/owners in a non-public deal
- Personal - A business or income source you own directly
Example of a private investment
Some of my clients are involved in a private real estate investment. They have put in money with others to buy 3 apartment complexes. There are less than 100 investors total.
The money is used to update and enhance the apartments so they can raise the rents.
The cash-flow from this type of private investment is typically 6-9%. The total return after 5-7 years can be 12-15% (IRR).
So that means you could invest $50,000 in this private investment and get the same income as $100,000 in public stocks and bonds.
That is cash-flow equivalence: How much money do I need to invest to get the same cash-flow as a portfolio of public stocks and bonds?
With personal investments the possibilities are even better.
Examples of personal investments (businesses)
Here are 3 personal investments (businesses) that yield over 20% to the owner:
I have literally hundreds of listings like this. Businesses that are for sale and that provide an established income to the owner. Most are in the 20-40% yield range, depending on price. Often with limited involvement from the owner.
Of course, these are personally-owned businesses:
- The benefit is that you're in control. You're responsible.
- The risk is that you're in control. You're responsible.
But think about the cash-flow equivalence. Use the 4% rule to figure out how much money in stocks and bonds you would need.
To get the same $208,000 in income (example 3), you would need a stock/bond portfolio of $5,200,000. You can buy this business (income stream) for $698,000.
That's the power of understanding cash-flow equivalence. And business ownership.
Now imagine spending $5,000 to start an internet-based business. And in 3-5 years you're earning $10,000 a month.
That's a 200% return on your initial cash EVERY MONTH. What!?!
There's a reason the wealthiest people in the world (and likely your city or town) are mostly business owners. Now you understand why.
So How Do You Figure Out How Much Money is Enough?
I'll answer this question two ways.
- Understanding the flaws mentioned above, you could still use the 4% Rule (25x annual expenses) to get a general idea of how much money is enough. A VERY general idea.
- To fix the flaws of the 4% Rule and account for things like private and personal investments and business ownership, you need an advanced wealth planning system.
This is software where you input your financial information, connect your various accounts, enter your Social Security estimates and then test different scenarios to see the results.
You can make assumptions like:
- What if I start a side gig and grow it to $2,000 a month in 3 yrs?
- Say I spend $5,000 to start an online course business and it provides $10,000 per month in 5 years.
- How much faster can I pay off the mortgage if I Airbnb our garage apartment?
- If I get an inheritance, what is the impact of buying a cash-flowing business versus putting it in stocks and bonds?
- What happens if I just make my current investments more aggressive (or conservative)?
With an advanced wealth planning system you could try all these ideas and get your future financial picture in real time.
It's really cool.
This advanced wealth planning system is included with Wealthific membership. We call it the Wealth Academy. And you get a lot more. Like direct help from me.
You could do some of this in Excel or other spreadsheet programs. But it gets complicated quickly. Especially when you try to factor in taxes, capital gains, paying off debts, different asset allocations and more.
Now It's Your Turn
Now that you know about the flaws of the 4% Rule and the power of private and personal investments, you need to decide.
Are you going to:
- Go the long, slow road of saving for 40 years and hope you're still in shape enough to do the stuff you want. That's fine as long as you know what you're in for.
- Take 3-5 years to learn and build an income that you own. A business you control that allows you to fully experience the world and build meaningful wealth.
It's up to you.
If you think the second option sounds good, I'd love to have you join me in the Wealth Academy. If you have questions, just ask in the comments below. I'll read and respond.
Thanks for reading.