The four different stages of financial competency in life

When I read Physician on Fire’s recent post on Financial Independence vs Financial Freedom my brain went wild (like spidey sense wild!) and I started wondering – Do we go through our life in different financial stages? Just like the well-known four stages of competency, I believe we do go through similar stages with our finance. Below are the four different stages of financial competency that I believe we all go through in life.

1. Financial incompetence

Most of us are financial incompetence at some point in our life. We have no clue about personal finance and we don’t manage our money well.

How do you know that you are financially incompetent?

  • You spend more than what you earn (i.e. expenses > income)
  • You think credit card is the saviour for all your financial problems
  • You carry a large amount of consumer debt
  • You celebrate when you receive an approval for another credit card, because you can put your current credit card balance on the new card, or you have more credits to spend
  • Your retirement account has a lot of zeros -> $000,000.00!!! (imagine using this as a pick up line! Oh boy!!!)
  • You fail to see the need to gain personal finance and retirement related knowledge

Fortunately, many people move out of this financial incompetent stage at some point.

2. Financial competence

The next stage is called financial competence. You finally realize that you are financially incompetent, so you start learning more about personal finance and investing. You start taking charge of your finance by making changes in your life.

You’re in the financial competence stage when…

  • You start having a budget and track your expenses
  • You pay yourself first
  • You live below your means
  • You pay credit card balance in full each month
  • You start investing for retirement
  • You look and ask for help to improve your finance
  • You start reading books and articles on personal finance and retirement related topics

Unfortunately not everyone will end up moving to the 3rd stage of financial competency.

3. Financial independence

I have been focusing on this stage of competency a lot on this little blog of mine. To me, financial independence means more choices and more freedom in my life. I get to decide what to do with my time instead having to slave away at a job for 5 days each week just to get a pay cheque every 2 weeks.

How do you know that you are financially independent?

  • Your investment is 25x of your annual expenses (If you’re using index ETFs)
  • Your passive income equal or exceeds your expenses (dividend growth investors would go under here)
  • You no longer worry about running out of money if you continue your current lifestyle
  • If you are working, you can quit your job at anytime without having to worry about the lack of working income impacting your life
  • You are working because you choose to, not because you have to
  • You are completely debt free (some may argue this isn’t a requirement for being financial independent)

For us, I believe we can become financial independent with a dividend portfolio of about $800k. Still a bit of work to do that’s for sure!

4. Financial freedom

Before reading Physician on Fire’s article, I have been using the term financial independence and financial freedom interchangeably. I used to think they are the same thing but I had an epiphany. Financial freedom is the ultimate stage of financial competency! You have even more power and choices when you are in financial freedom than financial independence. You can decide to live slightly less frugal, you can travel more, you can spend a year traveling in high cost of living countries, you can stay at hotels when traveling rather than Airbnb and hostels, you can go to fancy restaurants and order the expensive items, and etc. You can do all these things without regret, without having to worry about money, because your investment or passive income can cover the extra expenses.

What is financial freedom? Physician on Fire defined it as:

  • Your core spending + 2x discretionary spending

In our case where we tracked our expenses for the past number of years:

average annual spending

Based on 2015 our core annual spending was $31,241.88, discretionary spending was $16,028.28.

Using PoF’s formula, that means to be financially free, we would need $63,208.44 of passive income per year ( $31,241.88+ 2x ($16,028.28) ), or about $1.6 million (25 x $63,208.44).

When we made our financial independence assumptions, I estimated an annual core spending of $27,240 and an annual discretionary spending $11,400. Using these numbers, financially freedom means we would need $50,040, over $13k below the numbers based on our 2015 numbers.

Looking at our discretionary spending, I think our numbers are extremely low compared to other families.

So what does this mean?

  1. Our core and discretionary expenses are pretty low already
  2. We have very conservative financial independence assumptions
  3. Perhaps the 2x multiplier needs to be adjusted depending on your household expenses.

What if we change the multiplier to 5x?

Take our 2015 numbers, that would take us to $111,383.28. (~$2.8 million of assets needed).

Take our  FI assumptions, that would take us to $84,240. (~$2.1 million of assets needed).

What’s the correct number to reach financial freedom? Honestly I don’t know but I think we would live in extreme luxury with an annual spending of $112k. Spending $112k per year seems like a dream! To do this, all I know is that we would need to continue to grow our dividend portfolio to reach financial freedom.

Dear readers, what’s your financial competency? What’s your magic number to achieve financial freedom?

Written by Tawcan
Hi I’m Bob from Vancouver Canada, I am working toward joyful life and financial independence through frugal living, dividend investing, passive income generation, life balance, and self-improvement. This blog is my way to chronicle my journey and share my stories and thoughts along the way. Stay in touch on Facebook and Twitter. Or sign up via Newsletter