There are tons of math rules of thumb when it comes to personal finance. There’s the rule of 69/70/72 which helps you calculate when investments will double. There’s the rule of 4% that is used to estimate financial independence.
Few people write about one of the most important numbers*: Your Financial Inflection Point
If you aren’t familiar with the term inflection point, I was able to find two definitions from Google’s Dictionary search:
- Math – A point of a curve at which a change in the direction of curvature occurs.
- Business – A time of significant change in a situation; a turning point.
When you point both of these definitions together and apply them to your own finances you get something amazing:
Your money works more for you than you do.
As my tagline has said for years, “Making my money work, so I don’t have to.” That’s where the “Lazy” brand comes from.
Some people might not understand the concept of making their money work. It’s letting your investments make money passively. Even if you aren’t personally familiar with investing, you’ve probably heard the saying, “The Rich Get Richer.”
Let’s pretend you won a medium-size lottery and after taxes and getting the money at once, you had $10 million. If you invest it and earn 7% a year on it, they’ll make $700,000 a year. It takes a lot of McDonalds workers a lot of years to make as much money. Those investment dollars are working hard.
It’s fun to pretend winning $10 million dollars, but what if we looked at something more realistic?
Let’s take off a zero. If you amass a portfolio of a million dollars, your money can make you $70,000 a year (assuming 7% investment gains). That’s a very good second paycheck, perhaps even better than what you make working for yourself. While a portfolio of a million dollars may sound out of reach, the magic of compound interest can make easier than you think. (This may require you to earn a lot of money and/or avoid significant debt hurdles like tons of student loans or health problems. Here’s how you can get to a million dollars in 20 years.)
Calculate Your Own Financial Inflection Point
Over the last couple of years, I’ve noticed that our investments are doing very well. It’s not my imagination, investments have been well for almost a decade now. It got me thinking, have we reached our own financial inflection point?
The calcuation turned out to be surprising easy. It’s:
Income / Expected Return = Inflection Point
So let’s say that your income is $50,000 a year. You expect the markets to return 7.5%. The math of 50,000/.075 = $666,666.66. While that number looks evil, it’s actually not so bad. Maybe you want to call it $700,000 if the markets don’t peform as well as you think they might. It seema a lot more achievable than the million dollar example above, right?
When I initially did the math, I was extremely surprised to learn that we are far off of our financial inflection point. It felt like we were there.
What went wrong?
There were three problems:
- Our income has jumped a bit lately as I’ve taken on some substantial freelance work. The income number has recently grown. This raises the bar for the inflection point.
- I plugged in an expected return of 7.5%. While that’s a reasonable expectation, I was comparing it to the returns of the last few years… which were NOT reasonable. Someone should slap me with a mutual fund prospectus because “past performance is no guarantee of future results.”
- I was looking at the growth of our net worth, not just our investment gains. I have no excuses other than just being a bonehead.
When I first realized how far away we were, I was disappointed. Then I realized that two out of three of these “problems” were very good “problems” to have. Who doesn’t more income? Who doesn’t mind a period of double-digit investment gains skewing their expectations? Who doesn’t mind being a bonehead? (Ummm, ignore that last one.)
Fortunately there’s an easy fix. My wife has to retire next March when she’s elibible for her military pension (at age 43) and I have to remove all advertising here and quit any freelance work. That will solve that pesky income problem. I’ll also assume the markets will return 12% annual, because there was a time where that was normal. I won’t even get into any pesky asset allocation problems that could lead to less than my optimal expectations.
What’s the Value in your Financial Inflection Point?
If you didn’t catch my sarcasm in the last paragraph, shame on me for not being a little more obvious. I wanted to illustrate that on some level reaching your financial inflection point may not mean much. It’s definitely a great milestone, but it might not be realistic.
If you are a doctor making $300,000 a year, your financial inflection point would be $4 million (at 7.5% investment gains). If you “only” have half that amount in investments leading to $150,000 in gains each year, you’ll probably do okay.
Your financial inflection point is most helpful when it is combined with your expected expenses.
Last May, I projected our expected expenses over the next 45 years. (Yes, it was insane and you should read it, right away).
The quick and dirty answer is that we’ll likely have around $35,000 in expenses per year. We don’t need to replace our income completely like the financial inflection point suggestions. Our money only has to work hard enough for what we need it to do. This was one of the considerations in buying solar panels. While we might not be investing towards our inflection point today, we are investing in reducing our expenses in the future.
* At the time of publishing, I decided to do a search and found that The Green Swan covered this topic very well, but in a different way.