If you’re doing investing right, you’re saving a large percentage of your income every month (like 25-50%) and stuffing it into stocks, bonds, and real estate investments.
At first, even with a high savings rate, your net worth will be low, and the money made by your investments will also be low, like maybe a few hundred dollars a month. However, as your net worth increases, your investments will make more and more money.
The land of critical mass
At some point, you’ll be making the equivalent of a minimum wage job from your investments, followed by a lower-middle class income. Eventually, a magical thing will happen. Your investments will make more than your yearly spending, and you can do whatever you want in life. This is the so-called land of critical mass (coined by Bob Brinker of Money Talk).
It takes a long time to reach the land of critical mass, because it takes a lot of money to make a lot of money. How much money? Well, that depends upon the investment.
How investments make money
The amount of money an investment makes is determined by its price change and dividend yield.
For example, a bond fund might not change in price significantly, but may yield 2-3% per year in dividends (depends upon interest rates).
A stock fund may increase (or decrease) in price by 10% (or more) in a year, and typically yields 2% per year in dividends.
A residential real estate investment typically increases in price (appreciates) with inflation (currently around 2%), and can yield around 10% per year in the form of rent payments.
How much do you need to reach the land of critical mass?
The amount you need to reach the land of critical mass depends upon your asset mix (types of investments) and their relative performance.
If we take real estate out of the picture and just talk about a diversified mix of stocks and bonds, we have already seen that if your yearly spending is 3% of your portfolio value, you have essentially reached the land of critical mass.
What if you only want to live off the dividends?
Since the current dividend yield of stocks and bonds is around 2%, you may need to sell some of your investments to get to 3%. If you simply want to live off the dividends, then you will need to live on 2% of the total value of your portfolio.
In this case, you get around $20,000 per year (the equivalent of a minimum wage job) in dividends for every $1 million portfolio value. So, if you need $60,000 per year to live on, you can get this purely from the dividends if you have a $3 million portfolio.
Obviously, this is a very conservative way to look at the money made by your investments. Stock appreciation can far outpace the dividend yield. For example, in 2017, the stock market increased in value by 20% (not typical, of course). In that year, if you had a $1 million portfolio composed of 60% stocks and 40% bonds, you would have made over $100,000 just from your investments!
Clearly, it takes a lot of money to make a lot of money. This is no get rich quick scheme. If you want one of those, just scroll through Facebook or turn on the TV. However, if you save a large percentage of your income every month, after 20 years or so, you will eventually reach the land of critical mass where you can let off the gas pedal and enjoy your freedom.
“Live Free MD” is a sports medicine physician who blogs at his self-titled site, Live Free MD.
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