When you think about your pool of money, it's important to think of it as a series of funds.
The two funds that people are most familiar with are your retirement fund and your emergency fund.
Your retirement fund can be spread out across several accounts: a 401(k), a Roth IRA, a pension, or whatever. The structure is unimportant. Conceptually, you think of them all as a retirement fund. For asset allocation, you want it to be aggressive when you're younger and slowly glide into a more conservative mix as you near retirement.
Emergency funds are like the first line of defense in your financial fortress. You can have them in a high yield savings account or in a CD, but the concept is to save 6-12 months of expenses in a yield-bearing account. It's there for protection, not to make money or grow significantly.
Once you've funded your retirement and emergency funds, it's time to build a Flywheel Fund.
What is a Flywheel Fund?
A flywheel is a mechanical device that efficiently stores energy, specifically rotational kinetic energy. In principle, you can store energy by spinning the flywheel and you can extract energy from that spin (which slows it down). The lower the friction on the bearings of the wheel, the more efficient is the storage. Basically, it's an old school battery.
When you start spinning a massive flywheel, it's very hard because you're starting from zero (no motion, no energy). But with each push, it becomes easier and easier until the flywheel spins on its own. Each subsequent push makes it spin faster and there's more energy stored in the wheel.
With that concept in mind, I have what I call a Flywheel Fund.
A Flywheel Fund is a fund (pool of money) that generates cash flow to offset our expenses. It's a storage of cash flow. At first, the fund only partially pays for our fixed and semi-fixed expenses. As it grows, through our own contributions and its own growth, it will eventually cover all our expenses. We build this while we have income from other sources, so we don't need the cash flow to pay for our expenses.
As you add more money to the Flywheel Fund, the cash flow can be reinvested into the Flywheel Fund. It starts to do something that doesn't happen in real life with a flywheel – it pushes itself! That's when it starts to feel like sorcery.
Where Does the Flywheel Fund Fit?
If you look at all your savings needs, a Flywheel Fund is the most junior of your savings needs.
These savings goals supersede your Flywheel Fund:
- Emergency fund
- Retirement savings
- Individual savings goals – house, car, vacation, education
Emergency funds, as long as you're lucky enough not to have to tap into them often, have finite ends. You reach 6-12 months and you are able to stop.
Retirement savings are more nebulous because you have IRA limits as well as 401(k) limits. For 2019, the IRA limit is $6,000 and the 401(k) limit is $19,000 – totaling $25,000 a year. That's a ton!
Then, you have individual goals like a home and a car – again those are a little more nebulous.
The point of this isn't to prescribe how much you should save and where; that's for you to decide based on your schedule and needs. But, once you've reached your own limits for each, the next step is to build your Flywheel Fund.
How to Build Your Flywheel Fund
There is no single account that you can open and call your Flywheel Fund. It will be a series of accounts based on what you wish to invest in. The goal is to get a mix of assets that generate cash flow, and it will not be possible to find it all in one place.
The first step is to look at your other investments (such as retirement funds) and find asset classes that help with your allocation mix. You don't want to be too heavily invested in any one area and throw your allocation out of whack.
For example, your 401(k) is most likely going to be invested in volatile assets such as the S&P500 index. For your Flywheel Fund, you could look to dividend stocks or funds to generate cash flow but also offset the smaller cap nature of the S&P 500 (the S&P 500 is very big so there will be overlap, but I think you get my point).
Dividend stocks are a great base for a Flywheel Fund because they pay on a regular basis, are very liquid, and heavily regulated. Many a retiree have built a monthly dividend paycheck using blue-chip companies.
Alternatively, you could invest in a variety of other passive income investments such as real estate or farmland. They provide yields, are less regulated and less liquid, but aren't correlated with the stock market.
The Hidden Power of a Flywheel Fund
There is a hidden power lurking in a Flywheel Fund. As you save, and as it grows, your fund will provide greater and greater amounts of cash flow.
It will take time for your Flywheel Fund to grow. Brick by brick, stone by stone, it'll grow until the cash flow is something you can be proud of.
Once the cash flow from your Flywheel Fund exceeds your monthly expenses (all of them), you're financially free.
Listen, I get it. Dividends aren't as sexy as other investments (crypto!); but, over time, they become very impressive.
Many years ago, I was reading Warren Buffet's Berkshire Hathaway annual letter when he touched on their stock holdings. He was an early owner of Coca-Cola and has nearly four hundred million shares at a cost of just $1.299 billion (it's worth $18.940 billion). Last year, Coca-Cola paid Berkshire Hathaway about $624 million in dividends (2018). That's a yield of 48%. That's absolutely bananas!
I'm no Warren Buffet but this isn't too shabby!
One last point about financial freedom: the idea of financial independence has been closely tied to retiring early, (FIRE is a handy acronym!) but it's not necessary. Financial freedom gives you options and options are always good when it comes to designing your own life.
As an entrepreneur, I enjoy working on projects and building new things. Our Flywheel Fund gives me the flexibility to pursue these projects. It took a bit of sacrifice on the front end, but that sacrifice has blossomed during this remarkable bull run in the stock market to create a fund that generates cash flow we can use to support our spending.
You Can Rent a Flywheel Fund
A Flywheel Fund takes a while to build up, but what if you're concerned you might need cash flow before it gets there?
One close approximation to a Flywheel Fund is disability insurance. Disability insurance is essentially paying for a policy that replaces part of your paycheck if you cannot work. You pay premiums, just as you would save into a fund, and the policy produces the cash flow when you need it, like when you lose your job. The only difference is that the policy has no value, whereas a Flywheel Fund will still have the assets you've invested.
You can think of disability insurance as renting a Flywheel Fund that only produces when you're in a jam. It's not the same as building your own Flywheel Fund, just like renting a house is not anything like owning one.
Insurance does not replace a Flywheel Fund! It's merely there as a safety net. As your Flywheel Fund grows, and the cash flow grows, you should consider self-insuring against disability (rather than working with a disability insurance company). This means ending the policy and saving those premium payments in the Flywheel.
What do you think of my concept of a Flywheel Fund? Do you have something similar?