[dropcap background=”” color=”” circle=”0″]I[/dropcap]t would be very challenging for a 25 year old to achieve financial freedom at 40 by investing in the stock market. They would first need to make sure they had most of their assets in a diversified fund in the stock market to get maximum return. They would have to make very high contributions each month and they would need to make sure that they didn’t sell out or try to time the market over the period. If the investor was able to extend their time frame until they turn 50 years old, those additional ten years would make it much easier.
To build wealth from investing make sure to have high exposure to the stock market when you are young
A young person who is focused on achieving financial freedom will need to be very disciplined. I have a pretty complex financial simulation model to try to answer this, but I will try to keep it simple with this post. The person’s first step will be to take on a very high level of equity market risk, this cannot be achieved by putting money into a bond or the bank. My advice is to hold 110 minus your age in a highly diversified passive equity fund (The best I can find is: Vanguard Total World Stock ETF).
If that choice is not available then consider a diversified and as low cost equity fund as the investor can get. This would mean that a 25 year old should allocate about 85% to equity. Next a 25 year old would need to determine at what age they want to target achieving financial independence. Then they need to determine their per month income target – their definition of financial independence income. After that they must estimate long term returns of stocks and bonds, as well as their expectation of inflation over that time. Finally, they would need to consider the amount of savings or investments they already have which can be applied to achieving this goal.
Questions to ask
- What age do you want to achieve financial independence?
- What does financial independence mean to you?
- What are your long-term stock and bond return expectations?
- What do you expect inflation to be over this time?
- Do you already have some savings or investments in place?
It takes very high monthly contributions and a long time to build wealth in the stock market
So a person who wants to be financially independent at 40 years old, should start by thinking about the income in today’s dollars that they would need to live on. Let’s assume that US$5,000 per month would be enough passive income. Next they need to estimate their long term returns in the stock market over their 15 year investment horizon, let’s use 8% (maybe 5% from capital gains and 3% from dividend yield-but remember to reinvest those dividends!). And for bonds they expect 4%. We next need an estimate of inflation to see what US$5,000 per month would become at the end of the period and let’s use 3% for that. Finally, do they have any savings now, let’s say no.
We can now combine this info with other assumptions that I make in my model of this and we can calculate that to achieve this dream the person would need to be investing about US$4,300 per month. This amount is much larger than many would think. Part of it is that the person’s investment horizon is short. If we extend it to 50 years old it would reduce to US$2,500 per month. If the person was lucky and the stock market returned 10%, it would require US$1,600 per month. Of course this is all based on assumptions and things can always go differently than planned, so an investor may want to exceed their predicted contributions, especially in the early years.
Own a diversified equity portfolio, invest regularly, don’t try to time the market and don’t sell
A 25 year old dreaming about financial independence through investing at 40 is facing a very difficult task. When it comes to investing, time is probably the most important factor. This is because over time your money compounds by earning interest on the interest you earned in the prior periods. The exponential increase from this really starts to take off after about 20 years. So a 15 year time horizon does not really allow for this full benefit. To achieve this task you would need to get high exposure to the equity market since that is the only place where you can get as high a return as was need. Probably most important with regard to this is that you make regular purchases of the equity fund or ETF and that you almost NEVER sell, only buy. From my analysis it is nearly impossible for a professional to time the market, an amateur may find the task impossible, so keep buying and holding.