5 min read
Suppose Bob can live on $25,000 per year.
If Bob has $25,000 sitting in the bank and decides to quit his day job, he could survive just fine for one year without an income.
But suppose he instead wants to invest this $25,000 into a total stock market index fund and support his lifestyle purely through investment returns.
If this $25,000 grows at 5% per year, his investment returns would be $1,250 during that first year. This would only cover 5% of his $25,000 yearly expenses. Bob would need to earn an additional $23,750 to pay the bills.
For Bob, $25,000 is enough to be a one-year money cushion, which means he could survive for one year without earning income thanks to this cushion.
Unfortunately, $25,000 is not enough to be a powerful money machine that produces investment returns that can support a significant chunk of his yearly expenses.
What if Bob had $100,000 instead?
If he chose to use that $100,000 as a money cushion, he could support his lifestyle for four years without earning an income.
And if he chose to invest it, a 5% return on $100,000 would produce $5,000 in investment returns. This money machine would cover 20% ($5k / $25k) of his yearly expenses.
The Benefits & Drawbacks of Each Approach
The benefit of using your savings as a money cushion is that it doesn’t require you to earn additional income to pay for your expenses. The drawback is that once your cushion is depleted, you are left with nothing.
Conversely, the benefit of using your savings as a money machine is that if you never touch your initial investment, this machine can survive virtually forever and keep producing investment returns each year. The drawback is that if your money machine isn’t enough to support all of your yearly expenses, you have to earn active income to cover some of your expenses.
Financial Independence: The Ultimate Money Machine
In the most extreme case, a money machine that can support 100% of your yearly expenses is synonymous with financial independence. It means you have so much money invested that you can pay for your yearly expenses purely through investment returns.
For many people, this is their ultimate financial goal: to have a money machine that can pay the bills for them indefinitely so they can go about living their lives without worrying about earning an income.
The biggest drawback of this type of money machine is that it takes most people 15 years or more to create from scratch. According to the Financial Independence Grid, it takes about 16.6 years to achieve financial independence (25 times yearly expenses saved up) for someone who consistently saves 50% of their post-tax income, assuming they start with $0 and earn 5% annual investment returns:
An alternative strategy to building an ultimate money machine that can support 100% of your lifestyle is to build a mini money machine, one that can cover a portion of your expenses and allows you to earn some type of active income to cover the rest.
In our example earlier, we saw that if Bob invests $100,000 of his savings and earns 5% annual returns, that’s equivalent to $5,000 which is enough to cover 20% of his $25,000 yearly expenses. This is an example of a mini money machine. In this case, Bob only needs to actively earn $20,000 each year to cover his expenses since his mini money machine covers the other $5,000.
Expanding on this idea, the grid below shows how much you would need to earn each year in active income to pay the bills based on your yearly expenses and how much money you have invested earning 5% annual returns:
For example, if Bob has yearly expenses of $25,000 and has $100,000 invested earning 5% annual returns, his investment returns are equivalent to $5,000 per year so he only needs to earn $20,000 to cover his remaining expenses:
Or if Bob had $200,000 invested, a 5% return each year would be equivalent to $10,000, which means he would only need to earn $15,000 each year to pay for his remaining expenses:
Which is better: a money cushion or a money machine?
Should you strive to create a money cushion or a money machine?
Well, that depends on what you intend to do with the money.
If you want to take an 18-month hiatus from your day job and travel the world, all you need is a money cushion that can support your expenses for 18 months.
If you’re at a later stage in life and you want to completely retire from working, you’ll want to create a money machine that can support most or all of your yearly expenses.
Perhaps you’re somewhere in between these two extremes and you simply want to work less and control more of your time. If that’s the case, you may want to build a mini money machine that can pay some of your bills so that you can earn income in a low-stress way that pays the remaining bills.
There is no specific financial route you have to follow in life.
Some people choose to create an ultimate money machine that can support their lifestyle indefinitely.
Others choose to work intermittently, building up money cushions and then spending them on mini-retirements and extended travel.
And some choose to build a mini money machine that gives them the financial means to quit a day job they hate to pursue income-producing activities that are more enjoyable.
Decide what you want. Then, choose a financial path that best enables you to get what you want.
As Carl Richards says,
“In the end, financial decisions aren’t about getting rich. They’re about getting what you want – getting happy.”
Technical Notes: This analysis assumes that if you use your savings as a “money cushion”, your money is in some type of account that you can readily access to pay for expenses (like a savings account or checking account). And if you use your savings as a “money machine”, it’s assumed that this money is in an account where you can sell shares and transfer the cash proceeds to your bank account to pay for expenses (like a brokerage account).
My favorite free financial tool I’ve been using since 2015 to manage my net worth is Personal Capital. Each month I use their free Investment Checkup tool and Retirement Planner to track my investments and ensure that I’m on the fast track to financial freedom.
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