The first rule of financial independence is to never lose money. If you lose lots of money, you ultimately lose lots of time. And time is your most valuable asset. Don’t go too backwards!
The second rule of financial independence is to never forget the first rule. As one of the founders of the modern-day FIRE movement, it is important to keep going forward on your FI journey.
In 2009, I made myself two promises when I started Financial Samurai: 1) write 3X a week on average for 10 years and 2) never lose money again.
We had just gone through a financial beating where my net worth got slashed by 35% – 40% in just six months. The pain was too much to bear, so I decided to take up writing instead of drugs and alcohol.
I knew that worst case, if I stayed committed with Financial Samurai, in 10 years I’d have the option to escape full-time work. When you spend at least 10,000 hours on your craft, you will have opportunities.
Further, I knew that if I never lost money again, in 10 years by simply earning a conservative 5% rate of return plus annual savings, I’d surpass the net worth that I once had before the financial crisis by at least 2X.
Achieving financial independence takes discipline and patience. But once you get there, you’ll realize all your effort was well worth it.
The First Rule Of Financial Independence
The first rule of financial independence states that you should never lose money on your path to financial independence, especially after achieving financial independence.
If you lose 50% of your net worth, you need a 100% gain to get back to even. But worse than trying to recoup your losses is the loss of time. The older you get, the more you realize everything you want to do is a race against death.
Once you’ve experienced financial independence, when your gross passive income covers your desired life’s expenses, you never want to return to the salt mines again.
Ideally, your investments never go down, but we know from history that in any given year, there’s a ~30% chance the S&P 500 will end in the red. Therefore, it’s almost impossible to never have a down year with any of your risk assets.
So what is a financially independent person supposed to do? The solution is to either completely de-risk, diversify, or have alternative income streams beyond your passive income to bolster potential investment losses.
If you cannot avoid losing money in your investments, then you must certainly avoid an annual net worth decline. The solution here is to buffer your potential investment losses with aggressive saving and additional sources of income.
Financial Independence Archetypes
There are different levels of financial independence. Let me share some examples of various financially independent archetypes I’ve met. We’ll discuss how they plan to always follow the first rule of financial independence.
Financial Independence Archetype #1:
60-year-old couple, $3 million net worth, $90K passive income, $90K total income, $50K expenses
Due to inflation, $3 million is the new $1 million. We’ve got to move past the belief that having a $1 million net worth means you’re a millionaire. A $1 million net worth means you’re earning about $30,000 – $40,000 a year in gross passive income. This does not reflect the traditional millionaire lifestyle.
With a respectable $3 million net worth, however, archetype #1 lives a comfortable lifestyle off a low-risk 3% return or $90,000 a year in net passive income from AA-rated municipal bonds.
The 60-year-old couple has no debt and their kids are independent adults. They could increase their withdrawal rate and eat into principal, but they want to remain conservative.
The couple has no desire to work part-time or consult for money. They are happy with what they have.
Since they only spend $50,000 a year, they get to reinvest $40,000 a year to earn another $1,200 a year in net passive income to keep up with inflation and boost their financial buffer.
Their net worth should never go down because there has been a 0% default history on AA-municipal bonds in their state.
Further, within five years, the couple expect to begin receiving an additional $40,000 total in Social Security for the rest of their lives.
Financial Independence Archetype #2:
Late 30s, $10 million net worth, $208K passive income, $80K part-time consulting income, $288K total income, $130K expenses
This couple hit it big when the husband started early at a hot startup that went public after 10 years. At the age of 38, the husband decided to retire and live off the $10 million after-tax windfall after he sold all his company stock.
He married a school teacher eight years his junior. He then asked her to spend more time with him in retirement to travel. They’re planning to have their first child in the next two years. They want to do the crazy dual stay at home parent thing.
Because the couple is relatively young, they feel comfortable taking on more risk. Further, with part-time consulting income of $80K a year, they only need to earn about $50K after-taxes to fund their $130K in annual expenses.
As a result, their net worth is composed of: 20% in the S&P 500, 20% in their primary residence, 50% in AA-municipal bonds, and 10% cash.
When To Take More Risk
60% of their net worth will generate about $180,000 in passive income at a 3% rate of return. The $2 million S&P 500 index position also generates about $28,000 a year in dividends due to a ~1.4% gross yield. Add on the $80,000 in part-time consulting income, and we’re talking $288,000 in annual net worth increase, or 2.8% +/- any increase or decrease in the value of the S&P 500.
With $2 million of their net worth exposed to the S&P 500, this couple can afford to lose 13% in their stock holdings before their net worth starts going down. They are indifferent about the value of their $2 million primary residence because they plan to own it forever.
Their ultimate goal is to grow their net worth by a stress-free 4% a year. At this rate in 10 years, their net worth will have grown to about $15 million. If there is a particularly rough patch in the stock market, the husband will ramp up his consulting work. He has the capacity to earn up to $250,000 a year in consulting.
Worst case, they could invest $10 million of their liquid net worth in 10 years in a portfolio of municipal bonds. These muni bonds would yield them $300,000+ in after-tax passive income. Thanks to the Fed aggressively hiking rates, Treasury bonds now yield over 4%.
Even if their expenses grow from $130K to $200K after conceiving a child, they’ll still have a $100,000 a year gross surplus of cash flow. This couple is unlikely to ever lose money again.
Financial Independence Archetype #3:
40s, $5 million net worth, $150K passive income, $300K active income, $450K total income, $120K expenses
$5 million is the recommended minimum you’ll need if you want to retire comfortably in an expensive city with a child. One look at the budget and you’ll recognize this reality.
Archetype #3 is in their 40s with one 5-year old child who began attending private kindergarten that costs $30,000 a year. The couple’s total after-tax living expense is $10,000 a month.
The couple is financially dependent and are no longer working full-time jobs after 20 years of grinding away. The difference with this couple and the other two couples is that they have an online business. It generates $300,000 a year in gross income.
The wife started her online store selling a variety of women’s goods on the side while working as a Marketing Director.
She read Financial Samurai and thought, why not utilize my expertise at my day job and create something of my own. After all, one of the best ways to get next-level-rich is to grow your own equity.
Solid Income Generation
With a combined $450K a year in gross income and only $120K in annual after-tax expenses, they have roughly a $300K annual gross buffer. Therefore, this couple is willing to take more risks with their investments.
Their net worth is currently composed of 30% in various large cap dividend stocks, 25% in real estate, 40% in AA-municipal bonds, and 5% in a high yield online savings account.
With $1.5M in stocks and a $300K annual gross surplus after expenses, this couple is able to withstand a 20% decline in their stock portfolio before they start losing money.
Using Financial SEER, this couple’s Risk Tolerance Multiple is a reasonable 13.8X if using a 35% expected average bear market decline. Their risk tolerance multiple is just just 7.9X if using a 20% expected decline in their stock portfolio.
This couple’s ultimate goal is to achieve a $10 million liquid net worth by their 50s. Once they do, they can generate ~$300,000 a year in passive income and hedge against a decline in their online business.
Never Lose Money Again
Unless you’re risking other people’s money, it’s actually hard to lose much more than 20% in a well-diversified public investment portfolio. Yes, we know the average bear market declines by roughly 35% since 1928. However, that’s for stock performance alone.
Once you construct a balanced retirement portfolio of stocks and bonds, the volatility declines tremendously. Add on alternative investments, and it may be even harder to lose 35% in any given year.
Take a look at the worst year performances of the following balanced portfolios below. Even with a 60% / 40% weighting in stocks / bonds, -26.6% was the worst annual decline.
Major Point For Financial Independence
If you’ve actually achieved financial independence or are clearly on your way to financial independence, there’s no way you should be risking the majority of your net worth in risk assets. Build alternative income streams.
You are already comfortably happy with what you have. If you are not, then you have not yet achieved financial independence. In other words, your financial independence number is not real if you don’t change your life.
We must also recognize that except for 2018, it’s been easy to make money each year since 2009. Not only have stocks performed well, but so have bonds, real estate and other alternative investments.
Therefore, let us not overestimate our investing prowess. Confusing brains with a bull market is a dangerous mindset. I’ve known too many people to take excess risk only to lose it all and then some.
The good thing about the 2022 bear market is that wakes people up from complacency. Complacency leads people to violate the second rule of financial independence: never expect your income to always go up. The second rule of financial independence is also the second biggest financial mistake you can make.
Learn To Be Happy With Enough
The feeling of never losing money is wonderful. We just need to be aware that there’s a never ending amount of money to be made. It’s okay to love money. But, as soon as we find a way to let go of our desire for more, we tend to feel more satisfied and happier.
Finally, the great irony of following the first rule of financial independence is that you may actually end up making much more money long-term. When you’ve structured your finances to be bulletproof, you’ve essentially created your own perpetual trust fund.
It is precisely your financial security that allows you to take more risk. And it is the risk-taker who tends to gain all the spoils.
Recommendation To Achieve Financial Independence
It’s easier to achieve financial independence if you diligently keep track of you finances. To do so, sign up with Personal Capital, a free financial tool online. It aggregates all your financial accounts in one place. I’ve been using Personal Capital to track my net worth since 2012. As a result, I have seen my wealth sky rocket during this time period.
Their 401K Fee Analyzer tool is saving me over $1,700 a year in fees. They’ve also got a great Retirement Planning Calculator. It uses real data and Monte Carlo simulations to produce realistic retirement results.
There’s no rewind button in life! Let’s not waste any more time.
Pick up a copy of Buy This, Not That, my instant Wall Street Journal bestseller. The book helps you make more optimal investment decisions so you can live a better, more fulfilling life.
For more nuanced personal finance content, join 55,000+ others and sign up for the free Financial Samurai newsletter and posts via e-mail. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009.