It takes time, but once you have your annual expenses enumerated, well understood, and optimized you can calculate your target FIRE number. The dollar amount in which you’ll need to have invested in a stock/bond portfolio mix to allow you to safely withdraw 4% for your annual expenses with reduced risk of running out of funds over your retirement horizon.
Asset Allocation
We’ll get into this in more detail in later posts but speaking in general terms your stock/bond mix would comprise of a low fee, well diversified, broad based index fund, a popular choice is one that tracks the Standard and Poor’s top 500 companies (SP500) along with long/short term government bonds. Your % stock/bond mix depends on where you are in your FIRE journey and your risk tolerance. You can use the Trinity Study data to help guide your decision. However, generally speaking during your accumulation years, as you’re working toward building your nest egg to reach your FIRE number you’ll want to focus primarily on stocks to maximize growth then later rebalance your portfolio to achieve your desired stock/bond mix for safety from market volatility and to ensure your nest egg lasts through your retirement. This can happen in the last few years leading up to your retirement age target. Investing into bonds too early would cause growth drag which will just delay your retirement. Paul Merriman’s research shows that every 10% allocation to bonds causes a 0.5% growth drag on growth. 0.5% May sound small and insignificant but this drag compounds over years, and decades so do be thoughtful in your allocations.
Why a SP500 index fund? Track record. The SP500 has returned an average of about 10% annually in the last 100 years. With your knowledge of compound interest, you can imagine how quickly you can grow your money and achieve FIRE with this annual rate of return.
Why bonds? Protection from drawdowns in the market. Ups and downs are just part of a healthy business cycle. The SP500 returned on average 10% across the last 100 years but some years were down years, and others up years to average a 10% return. Bonds aren’t correlated to the market and pretty much guarantee a specified rate of return. Allowing a buffer or safety margin when withdrawing 4% of portfolio funds during down markets.
Note: For the majority of the population who strives for simplicity the 4% ‘rule’ is a good strategy to follow. Targeting 25x your yearly expenses invested into a combination of low fee, broad based index funds and bonds. It gives us a target to work towards, low expense ratios, and just ease of operation with a work, save, invest model. Not to mention safety for inflation and low taxes upon withdrawal. That said, for more hands on investors there are numerous, but less proven investment strategies requiring homework, tax planning, and yes, buying and selling equities as newer investment products prove themselves over time. In a future post ‘A Portfolio to Consider’ I’ll be going over one of these alternative strategies in which I employ to enable my retirement with higher monthly cashflow than the 4% rule but coupled with higher risk.
Notables
Inflation and Rate of Returns: There’s a difference between nominal and real rates of return. A nominal rate of return is the return at face value. The stated rate of return. For instance a bond that is advertised at 4% annual return. It does not account for inflation. A nominal rate of return is something we can calculate given an estimated annual inflation rate.
Let’s take the SP500 for example. Its average nominal rate of return is 10% annually. We’ll assume an annual inflation rate of 3%, which gives us a real (or inflation adjusted) rate of return of 7%.
So on the front end, during our accumulation years its advisable to use the Real Rate of Return to account for inflation. On the backend, during your drawdown years the 4% withdrawal strategy accounts for inflation. The strategy advises a 4% withdrawal in the first year of retirement and a 4%+inflation adjustment in each of the subsequent years. So there’s no need to put too much worry or thought into the affects of inflation so as long as we use an expected real rate of return growth rate in our calculations. i.e. 7% as opposed to 10%.
The Calculator
Annual Expenses: Enter the estimated cost of your annual expenses.
Withdrawal Rate: Use the Trinity Study to help guide your anticipated withdrawal rate, but to generalize 4% is something the majority will use [although new research from Bill Bengen shows that a withdrawal rate of 4.7% can be just as safe].
Current Portfolio Value: How much you already have saved/invested.
Annual Portfolio Contribution: The amount you’ll be investing on a yearly basis.
Expected Real Annual Growth Rate: If you’re invested in a low fee, diversified broad based index fund like the SP500 or whole market fund through VTI, SPY, VOO, etc. The inflation adjusted real rate of return is roughly 7% per year given past data.
🔥 FIRE Calculator
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