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Saturday, March 5, 2011

How much money is enough?

Almost everybody has a number. Truth is, when you get to it, or if you ever get to it, chances are your level of spending will be much higher, so you will need more haha. But anyways, it is a valid question. How much money would I need in order to retire?

Of course it all depends on your personal situation, country, currency and so on. Maybe I could live in Cuba easily for the rest of my life with 200 thousand dollars, but that would be impossible in New York. In any case I will try to do some maths based on my current situation, my current level of spending, city where I live etc. Which might not be the same for you but you get the idea and the principles will be the same.

I live on a 2500 dollars budget per month, give or take, it is in that neighborhood. That means, at my current level of spending and lifestyle I need 30 000 dollars per year, to keep my current standard here in Toronto.

If I were to live 50 more years that would mean 50 x 30 000 = 1.5 million dollars (Actually more than that because of inflation).

But that is without having my money invested. Investing gives me a shortcut. Let's say you have money invested in your TFSA throughout the years. That capital will grow there tax free. And let's also say you have it invested on a set of good mutual funds that average a 12% return per year. How much would I need in my account so that a 12% growth in the year could cover the amount of 30 000 that I need for my living?

30 000 / 0.12 = 250 000.

Meaning if I get to have 250 000 invested tax free in a set of mutual funds that could yield 12%, I would have enough for my yearly expenses. I would withdraw 30 000 at the beginning of every year, and let the rest work for me. The problem is my account will always keep a balance of around 250K, which over time means less and less due to inflation.

Inflation is a problem

The cost of life tends to go up year after year, based on historical evidence.

The reality is that 2500 dollars a month won't be enough soon. The deflationary nature of currencies among other factors artificially increases the cost of living. Let's assume for the sake of the example a 3% rate of inflation per year. Meaning, I will need 3% more each year, to keep the same lifestyle. How do we introduce this new variable into our numbers?

Well, having the same set of mutual funds, now I would like to leave 3% of its growth on it, so that my invested capital keeps pace in respect with inflation. Let's say my investments grow 12%, I would be withdrawing only 9% and the rest 3% will remain there, meaning I will have more money in terms of absolute numbers over time in my TFSA, but in the end it is the same value on a historical perspective when considering inflation.

30 000 / 0.09 = 333 333.333

Now, I would need a third of a million.

Life is richer than everything

The truth is, at some point I want to live with more than 2500 a month! And I don't know,... make a couple trips a year as a tourist, plus have kids, plus have some money saved on a standard savings account, or have some emergency little fund to help somebody in my family. So, instead of 30 000 a year, I think 50 000 a year is what I really need in order to feel safe.

In the other hand, I not only want my investments to keep up with inflation but also to grow a little as well!! So, instead of 9% of the growth I only want to use an 8% of the growth leaving the remaining 4% in the fund.

50 000 / 0.08 = 625 000.

Now, this is a more realistic number.
625 000 would grow up to 700 000 at the end of the year.

I would withdraw 50 000, and live off that for the next 12 months, leaving 650 000 in my investments so they can work harder next year.

Now, life is not as simple. And while there are years when the fund can grow 15%, there may be years when it will go down 15%. But hey we need a mathematical model pal!! This is just assuming a boring, never changing, perfectly quiet world in order to have an idea of what we need.

So, 625 000 seems to be a decent number to make a living off for the rest of my life in Toronto. But personally, we all have a number. And for some reason it is always more than that.
Mine is 2 million dollars, .....4 millions if I get divorced haha.
What's yours?

Related articles:
My plan B: Investing for the long term
Invest and Retire before you die
ETF Rotation Systems to beat the Market

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