What is financial independence?
Someone asked me recently what my definition of financial independence is. After some thought, I tried to define it as having the means to live a comfortable life without having to work for someone else, and having full control over the amount of income you earn without having to answer to anyone but yourself. I thought my views on this might be of interest to my blog readers so I’m going to go a little bit further into achieving that hallowed state of financial independence.
To begin with, there are two forms of income we should discuss; active and passive, and the distinction between them is critical.
Active income is where you trade your most important commodity – your time – and use the skills you’ve learnt to complete a task that someone else is willing to pay for. Maybe you’ve gone to university and learnt how to design widgets. You then go to the job centre and see that the local widget factory needs a new widget designer to help bring their latest product into production. So off you go, giving your time and skills each day to the factory owner and at the end of the month, he repays you with a wage.
Unfortunately, you’ve got no real control over the work you do and you’re having to share the benefits of your time and skills with the factory owner and the government. The factory owner will be making a profit from sales your widget of which you’ll see a small proportion. A good chunk will also be given to the government so that they can spend it on the things that keep society going – health services, policing, pensions and other ever-increasing expenses.
However, you have a choice with what to do with all of this active income. You can spend it, have a great time, then go back to work on Monday and repeat the whole process. Or you can spend enough to cover your costs of living, and put the rest to work for you as what’s known as passive income.
This second form of income is by far the most interesting. It’s income that you receive that you aren’t directly exchanging your time for. What you’re doing is receiving income from activities that you’ve already done. Many people write an e-book that they can then sell on Amazon or maybe even self-publish from their website which would give passive revenue.
Alternatively (and of more interest to me) is earning income via dividends on a portfolio of stocks. So even when you’re tucked up in bed at night, dreaming of pots of gold buried at the bottom of the garden, passive income will still be increasing your wealth. Think about it. Even in dream-land, you’re constantly making money, and if you re-invest that money back into the stock market then you’ll be making money on that re-invested money too!
For me, the journey to being able to stop working for someone else has to begin with working for someone else first. Unless you have inherited a lump sum or you went into business for yourself, you’ve probably finished your education and gone to work to earn a living.
Of course, we all have bills to pay so a proportion of your earnings will go on the mortgage and associated living expenses, but if you’re smart some of this active income will also be saved into a portfolio of investments that will grow over time and begin paying out ever-increasing returns. The goal here is to get your portfolio big enough so that your passive income is enough to cover your costs of living. At that point, you no longer need an active income anymore. You’re financially independent!
My own dream is to fulfil this goal partly with returns from the stock market and partly from earnings on self-published books. Why not share with the site what your preferred method of reaching financial independence is. As always, please comment below.