Financial independence

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Financial independence is a state where an individual or household has accumulated sufficient financial resources to cover its cost-of-living expenses without having to depend on active employment or work to earn money in order to maintain its current lifestyle. [1] These financial resources can be in the form of investment or personal use assets, passive income, income generated from side jobs, inheritance, pension and retirement income sources, and varied other sources.

Contents

Gaining financial independence should not be confused with not doing any work. [2] Financial independence describes the freedom to make individual choices, including pursuing passions. [2]

Researchers posit that childhood experiences with money play a pivotal role in shaping values, attitudes, and financial behavior. [3] Financial independence is a subjective concept and can be interpreted differently by different individuals. [1] [4] Some people practice frugal living, save and invest a large percentage of income to achieve financial independence early in their career, as evidenced by people following the "financial independence retire early (FIRE)" movement, [2] while others are in pursuit of traditional old-age retirement. Financial independence can be a modest lifestyle or one with a higher standard of living. Having a financial plan and budget, can provide a clear view of current incomes and expenses, to help identify and choose appropriate strategies to achieve financial independence.

Theoretical frameworks and factors influencing financial independence

Researchers have developed several theories to explain how financial behavior is influenced by values, attitudes, and biases. Parents may knowingly or unknowingly influence their children's relationship with money. [5] [6] These theories offer insights into how an individual or family members think and feel about money, stages of development to embrace a change, ability to resolve money conflicts, and overcoming unexamined cognitive and emotional biases to build a healthy relationship with money. These factors can have major implications on an individual's or family's ability to achieve financial independence. [7]

Researchers have tested several methods of family financial socialization to study how young adults remember their parents teaching them about money when they were growing up and if it contributed in any way to their financial well-being and helped in achieving financial independence. [8] In case of young adults, attaining college education, having an income, owning assets, having basic money management and problem solving skills improved their ability to achieve financial independence. [9] Identity Capital Theory suggests that young adults grow up with the ability to manage money if they have access to physical resources like money knowledge and social connections, and are also able to take responsibility for their actions and able to make their own decisions. [4] These resources help individuals become financially independent later in life.

Psychological perspectives

One of the eight concepts of Bowen's family systems theory is the concept of triangles. [10] An elderly couple with an insurmountable amount of debt, who are not on the same page to pay off the debt, may seek help from their child and involve them in resolving the conflict. The resultant imbalance in the system, where three people each have different opinions, can further lead to unresolved issues and derail the retirement plan of the child. The family projection process explains how children can end up with emotional issues by being witness to their parents' toxic relationship. [10] Financial socialization theory and communication privacy management theory sheds light on how the feelings and attitudes about money developed and influenced by the family members in early childhood can result in marital conflicts later in life. [11]

Behavioral finance perspectives

The Behavior Portfolio Theory governs that investors are "normal" [12] and cannot always make rational decisions due to their cognitive and emotional biases. The field of behavioral finance defines several biases and heuristics that offer insight into individual behavior and how these biases influence an individual's investment decisions.

Prospect theory posits that individuals value gains and losses differently; the pain of experiencing a loss of $1,000 is more intense than the joy of gaining $1,000. [13] Investors also tend to get carried away with recent information, leading to recency bias. [13] An investor may hold onto a losing stock for long periods hoping it will increase in value in the future, indicating that an investor is loss averse. [13] An investor may mimic trades of other investors in hopes of making a huge profit, showing signs of herd mentality. [13] Hindsight bias, confirmation bias, anchoring, familiarity bias, endowment effect, similarity heuristics, affect heuristic are examples of other biases and heuristics. [13]

A couple may benefit from working with a financial therapist to resolve deeply rooted issues and feelings about money. A financial planner can help create a financial plan and increase awareness on the benefits of goal setting, budgeting, investing, diversification to help an individual or family stay the course to achieve financial independence.

Sources of income to achieve financial independence

Income can be classified into multiple categories. In the United States, there are three sources of income; active, portfolio, and passive. [14] The classification may vary by country. Wages, salaries, material participation in trade or business constitutes active income. [14] Portfolio income includes interest, dividends, royalties, annuities, capital gains. [14] Generally, income from rental activities, and activities where an individual does not materially participate are considered passive source of income. [14] An individual can tap into multiple sources of income to satisfy their income needs and maintain desired lifestyle after achieving financial independence.

The following is a non-exhaustive list of sources of income.

Approaches to financial independence

William Bengen conducted research to determine safe withdrawal rates from the portfolio and concluded that an individual can safely withdraw 4% of their portfolio savings in the first year of retirement and can adjust the withdrawal rate by rate of inflation in subsequent years. [15] If an individual can cover their annual expenses by withdrawing 4% of their portfolio savings, the individual is assumed to have achieved financial independence.

Suppose a person can generate enough income to meet their needs from sources other than their primary occupation. In that case, they have achieved financial independence, regardless of age, existing wealth, or current salary. For example, if a 25-year-old has $1000 in monthly expenses, and assets that generate $1000 or more per month, they have achieved financial independence. On the other hand, if a 50-year-old has assets that generate $1,000,000 a month but has expenses that equal more than that per month, they are not financially independent, as they still have to earn the difference each month to make all their payments. However, the effects of inflation must be considered. If a person needs $100/month for living expenses today, they will need $105/month next year and $110.25/month the following year to support the same lifestyle, assuming a 5% annual inflation rate. A person's assets and liabilities are important in determining if they have achieved financial independence. An asset is anything of value that a person owns, whereas a liability is what the person owes. [16] Increasing savings, reducing expenses, consistently investing with a long-term horizon, and having a well-diversified portfolio can help achieve financial independence. [1]

See also

References

  1. 1 2 3 Robin, Vicki; Dominguez, Joe (2008-12-10). Your Money or Your Life: 9 Steps to Transforming Your Relationship with Money and Achieving Financial Independence: Fully Revised and Updated for 2018. Penguin. ISBN   978-0-14-311576-2.
  2. 1 2 3 Rieckens, Scott (2019-01-01). Playing with FIRE (Financial Independence Retire Early): How Far Would You Go for Financial Freedom?. New World Library. ISBN   978-1-60868-580-6.
  3. ↑ Gudmunson, Clinton G.; Danes, Sharon M. (2011-09-18). "Family Financial Socialization: Theory and Critical Review" . Journal of Family and Economic Issues. 32 (4): 644–667. doi:10.1007/s10834-011-9275-y. ISSN   1058-0476. S2CID   144466286.
  4. 1 2 Butterbaugh, Sarah Martin; Ross, D. Bruce; Campbell, Alyssa (2020-03-01). "My Money and Me: Attaining Financial Independence in Emerging Adulthood Through a Conceptual Model of Identity Capital Theory" . Contemporary Family Therapy. 42 (1): 33–45. doi:10.1007/s10591-019-09515-8. ISSN   1573-3335. S2CID   254418805.
  5. ↑ Britt, Sonya L. (2016-05-03). "The Intergenerational Transference of Money Attitudes and Behaviors" . Journal of Consumer Affairs. 50 (3): 539–556. doi:10.1111/joca.12113. hdl: 10.1111/joca.12113 . ISSN   0022-0078.
  6. ↑ Brown, Jenny (1999). "Bowen Family Systems Theory and Practice: Illustration and Critique" . Australian and New Zealand Journal of Family Therapy. 20 (2): 94–103. doi:10.1002/j.1467-8438.1999.tb00363.x.
  7. ↑ Klontz, Brad; Chaffin, Charles R.; Klontz, Ted (2022-09-27). Psychology of Financial Planning: The Practitioner's Guide to Money and Behavior. John Wiley & Sons. ISBN   978-1-119-98372-9.
  8. ↑ LeBaron-Black, Ashley B.; Curran, Melissa A.; Hill, E. Jeffrey; Toomey, Russell B.; Speirs, Katherine E.; Freeh, Margaret E. (2023). "Talk is cheap: Parent financial socialization and emerging adult financial well-being" . Family Relations. 72 (3): 1201–1219. doi:10.1111/fare.12751. ISSN   0197-6664. S2CID   251509392.
  9. ↑ Xiao, Jing Jian; Chatterjee, Swarn; Kim, Jinhee (2014). "Factors associated with financial independence of young adults" . International Journal of Consumer Studies. 38 (4): 394–403. doi:10.1111/ijcs.12106. ISSN   1470-6423. S2CID   145682919.
  10. 1 2 Bowen, Murray (1993-12-01). Family Therapy in Clinical Practice. Jason Aronson. ISBN   978-1-4616-2849-1.
  11. ↑ Koochel, Emily; Astle, Nathan D.; Markham, Melinda Stafford (2020-01-25). "Treating Financial Conflict in Couples Through a Bowenian Lens: Applied Financial Socialization and Communication Privacy Theories" . Contemporary Family Therapy. 42 (1): 77–83. doi:10.1007/s10591-020-09535-9. ISSN   0892-2764. S2CID   254417837.
  12. ↑ Shefrin, Hersh; Statman, Meir (2000). "Behavioral Portfolio Theory" . Journal of Financial and Quantitative Analysis. 35 (2): 127–151. doi:10.2307/2676187. ISSN   1756-6916. JSTOR   2676187. S2CID   51947571.
  13. 1 2 3 4 5 Dalton, James F. (2022). Investment Planning: Concepts and Strategies (3rd ed.). Money Education. ISBN   978-1-946711-11-3.
  14. 1 2 3 4 Langdon, Thomas P.; Grange, E. Vance; Dalton, Michael A. (March 2023). Income Tax Planning. Money Education. ISBN   978-1-946711-23-6.
  15. ↑ Bengen, William P. (October 1994). "Determining Withdrawal Rates Using Historical Data" (PDF). Journal of Financial Planning: 14–24
  16. ↑ Dalton, Michael A.; Dalton, James F. (July 2021). Fundamentals of Financial Planning. Money Education. ISBN   978-1-946711-39-7.

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