• 03:47:37 am on November 1, 2008 | 3

    Rule of 20 or 40?

    Some of the MITs are struggling with whether to use the Rule of 20 or the Rule of 40.

    I have to acknowledge that I caused the confusion in the first place by writing in one of my earliest posts:

    A better way is to work backwards: decide how much you need to earn each year to finance the life of your dreams (more on this in a later post) and multiply by 20 (what most advisers recommend) to 40 (what I think) and that is The Number for you.

    Ultimately the Number that you choose is up to you, however here are some reasons to use the Rule of 20:

    – You will be entering into investments and/or undertaking activities that will take you to your Rule of 20 Number, but this won’t happen exactly ON your Date … if it happens before your Date, your wealth will keep growing.

    – Your investments/activities won’t magically stop producing exactly when you reach your Number; my investments more than doubled in the next two years (OK, so they’ve pulled back a bit – lot – now … but, I’m still way in front of where I hoped/expected to be).

    – You won’t stop working on whatever it is that you are doing just because you have reached your Date/Number (you may not be able to even if you wanted to … I had a 3 year contract to serve; I managed to get out after 18 months, but that’s still 18 months of earning and not spending … with a fat bonus at the end!).

    – Choosing a multiplier that’s too large will produce a compound growth rate that ‘forces’ you into higher risk / reward activities that you may or may not be suited for … choosing a lower compound growth rate Number, however, doesn’t stop you from undertaking the highest risk / reward activity that you feel is aligned with your strengths (an activity that may cause you to overshoot your Number, anyway).

    – It’s likely that your post-Number activities will still produce some income: e.g. Scott’s clinic/s; Debbie’s ventures; Diane’s writing; etc. – once an entrepreneur or investor, always an entrepreneur / investor.

    – It’s likely that your post-Number investments will produce MORE than the 10% after tax return that the Rule of 20 assumes; again, once an entrepreneur or investor, always an entrepreneur / investor.

    The bottom-line, you’re more likely to overshoot than undershoot if you use the Rule of 20.

    However, when it comes to living off your Number, I would then aim to apply the Rule of 40.

    Why?

    Because of the tendency to spend more than you originally thought you would … you have this idea of a life without limits, right?

    Not gonna happen: not on $5 Million, not on $10 million … probably not on $50 Million (you MAY be OK with $300M+) … so, get used to a life of budgeting and delayed gratification; it isn’t likely to stop just because you reach your Number.

    Each year, to be sure that your money will last as long as you do, the Rule of 40 says that you will take 2.5% of your entire Net Worth and spend it (after taxes) … freely and happily, doing what it is that you love … and, without fear or guilt.

    The next year you will recalculate your Net Worth – which will most likely have grown by far MORE than the 4% – 5% required to keep up with inflation and withdraw 2.5% of that to spend for the next year. Most likely this number will be larger than the year before.

    Now, you have a large buffer against market corrections; health issues; etc.; etc.

    So my advice is to use two separate rules:

    – The Rule of 20 for calculating Your Number, and

    – The Rule of 40 for spending Your Number!

     

Comments

  • Scott 11:24 am on November 1, 2008 | #

    Wow, what a wonderful post Adrian. You answered questions about the rules of 20 vs 40 that I didn’t even know I had. Now this makes much more sense to me. Thanks once again for the great advice.

  • AJC 3:20 pm on November 1, 2008 | #

    @Scott – Now, if I can only anticipate ALL of your ‘making money’ issues your Number is a ‘done deal’ 😉

  • Scott 9:46 am on November 2, 2008 | #

    LoL, no kidding huh.


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