Rule of 4 – Ever heard of it?

The Rule of 4 is a pretty important rule to be aware of when it comes to the matter of financial independence and wealth creation – yet not a lot of people seem to know about it.

First things first, a key concept that the wealthy understand (and the masses don’t are never taught) is that the key to wealth is to spend income, never capital.

So you invest to accumulate capital, and that capital then generates income in the form of dividends (from stocks & shares); interest from savings and bonds and possibly rental income from property. You can then live off the income that the capital throws off.

But how much capital do you need to accumulate to live a comfortable life?

The definition of a comfortable life is in the eye of the beholder so you need to work out what cash you would need to achieve your ideal lifestyle (tip – it’s probably a lot less than you think. Tim Ferris wrote about this phenomenon in his iconic “Four Hour Workweek” book).

Say you think that £40,000 per year is your ideal income, then this is the amount of cash that your capital investments would need to generate. And just think, this income could be in perpetuity *.

So where does the Rule of 4 come in?

Take your £40k of annual income and divide it by 4% – this will show you how much capital you would need to have stashed away in investments (that generate dividend & interest) to see you through year on year.

Applying the Rule of 4 to £40k, you would need a cool £1m in capital. Another way of calculating this is to multiply your annual income needs by 25 – same calculation, just multiplying rather than dividing to get to the same answer.

Some might not need as much as £40k per year, whilst others might need more. It’s just useful to know your target capital number by applying the rule of 4.

* The 4% rule has been tested and obviously market conditions and timing impact on the % returns that can be achieved but 4% has held up well over decades. If you want to be ultra-cautious, a 3% rule might be more applicable as the 4% rule may nibble at your capital sum over an extended period whereas 3% is less likely.

** Not financial advice, yada yada