8 Principles for Happiness in the FIRE Movement

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Quiz!

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -8M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left.

8 Principles for Happiness in the FIRE Movement

FIRE stands for: “Financial Independence, Retire Early”. People aiming for FIRE save aggressively, as much as 50%-75% of their income, aiming to retire at a young age. They typically retire once they reach enough savings to support 3%-4% annual spending.

While the result may sound very appealing, the plan can result in an unhappy life or be abandoned, if not done right. Here are 8 principles that helped me in my process, and may help you:

  1. Spend for happiness: Drop all expenses that won’t make you much happier in life today or in the future, but keep and emphasize the expenses that are important to the core of your happiness, or to build a good future.
  2. Experiment and adapt: Keep dropping additional expenses, even if everyone tells you that the expense is as important as drinking water. Question every conventional wisdom, and you are bound to enjoy some pleasant surprises. When needed, reintroduce expenses.
  3. Keep low-frequency & lower-scale expenses: Eating out once a week (or month) instead of never can add to your happiness far more than the 5th weekly meal out. Going on a road-trip to a national park off season, and sleeping outside the park costs a small fraction of a flight to another continent with a stay in a nice hotel. Such a trip still gives you time away, with family or friends, nature, and relaxation – providing the bulk of the happiness.
  4. Save most when your spending/investment ratio is high: You will save more (1) early, compounding every dollar saved exponentially for longer – giving you free extra money, and (2) when your investments are low, and expected returns are higher.
  5. Invest for high growth: High growth helps reach independence earlier. In addition, high growth investments tend to be more volatile, providing excess gains to a consistent saver (read https://www.qualityasset.com/2018/07/31/how-to-use-volatility-to-make-money/ to understand). Two caveats: (1) Stay highly diversified across sectors and countries; (2) Be prepared to stay consistent through multi-year declines – something that comes with all high-growth investments.
  6. Aim for a conservative outcome: Aim for a 3% annual spending rate, to support a potential of many decades in retirement. Spending includes non-recurring and surprise expenses, including car upgrades, major home repairs, and healthcare costs, to name a few.
  7. Keep working at what you love: Once you reached financial independence, keep working at something you love. It can be your current job, a new lower- or higher-paying job, or a new business.
  8. Maintain 3% spending: As your investments reach higher peaks, you can raise your spending proportionately to enjoy the fruit of the optimizations leading to that point. You can call this modification the FIRES movement = Financial Independence, Retire Early, then Spend, Save or whatever makes you happiest. Whatever you choose, the compounded growth of investments is expected to grow the benefit exponentially over time.

There are several benefits to these principles:

  1. Maximum happiness gained from every dollar spent.
  2. Enjoying work in retirement from a position of power with no pressure.
  3. Decades of financial independence + growing spending. You are likely to enjoy far greater lifelong spending than the typical person.

Quiz Answer:

Imagine this simplified case: You make 100k net income per year starting at age 30, put your savings in an investment with 8% annual growth, and spend 3% per year in retirement. Compare the following 2 scenarios:

  1. You work for 40 years, save 10k per year (and spend 90k), and enjoy 20 years of retirement.
  2. You work for 20 years, save 50k per year (and spend 50k), and enjoy 40 years of retirement.

Scenario #1 involved doubling the number of working years + spending an extra 40k per year during 40 years of work. How much extra lifelong spending was provided, and what was the extra ending investment balance?

  1. +8M lifelong spending, with -2M investments left.
  2. +4M lifelong spending, with -2M investments left.
  3. +1M lifelong spending, with +1M investments left.
  4. Nearly equal lifelong spending, with +1M investments left.
  5. -3M lifelong spending, with -9M investments left. [Correct Answer]

Explanation:

The frontloading of spending created a disadvantage that was impossible to recover from, despite doubling the number of working years. Details:

  1. The extra spending in the first 20 years of scenario #1, led to a balance of 460k relative to 2.3M in scenario #2.
  2. 7 years later, with 13 years of work remaining for scenario #1, the annual spending of 90k was lower than the spending level of the person who retired already 7 years earlier.
  3. By the end of the working career, the 90k spending compares to 173k for the person retiring 20 years earlier. The investment balance grew nicely to 2.6M, but short of the 6.1M of the early retiree.
  4. By the end of retirement, the spending jumped to 196k relative to 460k for the early retiree. The investment balance reached nearly 7M vs. 16M for the early retiree.
Disclosures Including Backtested Performance Data

5 Rules of Thumb to Avoid Making a Painful Investment Change

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Quiz!

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment.

5 Rules of Thumb to Avoid Making a Painful Investment Change

Have you ever seen your diversified investments perform poorly for an extended period of 5-10 years, and felt that it would be prudent to diversify to reduce your risks? Have you moved money to an investment that felt much safer based on those years? In most cases, such activity would increase your risk – the opposite of your intended action. In some cases, the results could be painful.

How can a shift to reduce risk end up being painful? Diversified investments tend to be cyclical. The risk of a tough decade following a tough decade is lower than typical, not higher. Furthermore, the risk of a tough decade after an exceptional decade is higher than typical. Here is a case that may be familiar to you: In the late 1990’s US Large Growth stocks seemed like the safest stocks in the world. A switch to these seemingly safe stocks could have led you to losing 30% of your money over the following 10 years (total returns, including dividends, starting 3/1999). If you would have switched away from the seemingly risky Value or Emerging Markets stocks, your pain would have compounded, by missing phenomenal growth.

How can you avoid making a flawed change? Here are a few rules of thumb:

  1. Compare your investment performance in the past 10 years to the long-term performance (ideally 30+ years). If the past 10 years were below average, the investment is likely to be less risky than usual, not more. Don’t make a change!
  2. Do the same for the target investment you want to diversify into. If the past 10 years were above average, the investment is likely to be more risky than usual, not less. Don’t make a change!
  3. Do the same when comparing valuations, as presented by Price/Book. If the change would increase your Price/Book, you would sell low and buy high, something that can hurt you.
  4. Imagine living through a period with the opposite recent performance – would you still feel that you are reducing your risk with the intended change? If not, the alarm bells should be ringing.
  5. Say that someone urges you to diversify your portfolio, given the risk of your current portfolio, as presented by recent performance. Check how diversified your current portfolio is. If it includes 100’s or 1,000’s of stocks, split over many sectors in many countries, you are probably already diversified. The phrase: “You should diversify”, is a disguise for the real intent: “You should buy the recent winners, no matter what it does to your diversification.”

How can you use the information above today?

  1. Just like in the 1990’s, US Large Growth stocks performed far better than their long-term average. They averaged about 13% per year over 10 years, compared to a 10% long-term average. You should realistically expect the returns in the next 10 years to be much lower, not just below 13%, but far below 10%. In addition, the P/B of these stocks is far above average, another warning sign for poor upcoming returns.
  2. The reverse is true for Emerging Markets stocks. They grew far below their average. For example, the MSCI Emerging Markets Index grew by a mere 4.1% per year in the past 10 years, compared to 10.5% nearly 32-year average. Returns above the 10.5% average in the next 10 years are the likely outcome.

A few words of caution: cycles don’t have a fixed length. Returns that are better or worse than average can continue longer or shorter than expected. In addition, long-term averages can fluctuate. While no result is guaranteed, the information above can help you work with the odds, and not against them.

Quiz Answer:

Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)

  1. Diversify and include some lower risk investments that performed unusually well in the past 10 years.
  2. Lower your risk by holding some bonds.
  3. Lower your risk by holding some cash.
  4. Don’t make any change.
  5. Increase your allocation to the investment. [Correct Answer]

Explanations:

  1. Answers 1-3: Diversified investments tend to be cyclical – selling after 10 tough years, is likely selling low. Buying an investment that performed unusually well at the same time, is likely buying high. This will likely increase your risk.
  2. Answer 4: While future returns are likely to be above average, and risks below average, no change will keep your risk profile at the same reduced level.
  3. Answer 5: Buying extra at a very low point may reduce your risk, if valuations (Price/Book) are far below average and the investment is diversified.
Disclosures Including Backtested Performance Data

Can you be Happy with your Volatile Stock Portfolio Whether it is Up or Down?

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Quiz!

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Can you be Happy with your Volatile Stock Portfolio Whether it is Up or Down?

High investment growth comes with volatility, and is treated as the price for enjoying the high long-term gains. What if you could stay happy even during declines?

Conditions:

  1. When working, live according to your income. Don’t spend beyond what you make.
  2. When retired, spend a small percentage of your portfolio every year. Don’t plan on running out of money in your lifetime. 3%-4% is appropriate for most diversified portfolios with a high enough stock allocation.
  3. Invest in a highly diversified stock portfolio, without any specific bets (specific companies, countries, etc.).
  4. Structure the portfolio for high growth (emphasize stocks, value investing, small stocks, fast growing countries).
  5. Maintain iron discipline to stick with your portfolio for life, and never make changes at low points (unless you move to another investment with at least equally low valuations and equally high long-term returns).

If you follow the conditions above, you can be happy in up and down times, as follows:

  1. By nature, you have a fast growing portfolio in the long run, a cause for underlying happiness.
  2. When you enjoyed high past gains, you can be happy with the past results.
  3. When recent returns have been poor and valuations (price/book) are low, you can be happy about the high expected returns.
  4. If you have any new money to invest (savings from work, inheritance, money elsewhere), you can be very happy, because investing this money at a low point turns a temporary decline into a permanent excess gain (the gains on buying low).
  5. Over the cycles, the dollar value of the percent spending can go up as you reach higher peaks, leading to happiness about growing cash flows.

Most people struggle with such a plan, because the media pushes them to think about parts of the cycle, e.g. 5-10 years. This leads investors to be unhappy during downturns, and sometimes even destroy their life’s savings by selling low and buying something else high. Any high-growth investments can go through downturns of 5-10 or more years (e.g. the S&P 500 lost 30% of its value in the 10 years from 3/1999-2/2009), so it takes strength to stay disciplined. The best tool to maintain discipline is to watch valuations (price/book). After your high-growth investment goes through a long tough stretch, you can compare it to another investment that performed very well in recent years, and you are likely to see that your investment is enjoying substantially lower valuations, leading to substantially higher expected returns in upcoming years. While there is no guarantee for a specific turning point, you enjoy the nice combination of lower risk and higher expected returns.

Quiz Answer:

Which of the following can make you happy while your investment is low? (There may be multiple answers.)

  1. You hold a company with a strong track record.
  2. You hold a company with market dominance.
  3. You take some risk off, and switch to bonds.
  4. You take some risk off, and switch to cash.
  5. You take some risk off, and switch to a well proven investment that did well over an entire decade.

Explanations: None of the answers are correct!

  • 1-2 depend on concentrated investments. History taught us repeatedly that single companies aren’t immune to irreversible downturns.
  • 3-4 may feel good at the moment, but they turn a temporary downturn (assuming your investment is diversified and consistent) into a permanent loss.
  • 5 may also feel good at the moment, but investments are cyclical, and the best performer of the past 10 years is likely to underperform your poor performing investment in the next 10 years. A glance at the relative valuations (price/book) of the investments can confirm this risk.
Disclosures Including Backtested Performance Data

Value Investing Is Alive and More Appealing Than Typical

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Quiz!

Which of the following are true about US stocks (multiple answers may be correct)?

  1. Value stocks outperformed growth stocks in the past 90 years.
  2. Value stocks have become more expensive than growth stocks.
  3. Growth stocks grow faster than value stocks.

Value Investing Is Alive and More Appealing Than Typical

I’ve seen a number of articles declaring US value investing dead.

What is Value Investing? Value investing refers to buying companies with low stock prices relative to their intrinsic value, or book value (i.e. low Price/Book or P/B). Over the past 90 years, the collective of US value stocks outperformed growth (high Price/Book) stocks.

Why would people question value investing now? US Value stocks have underperformed US Growth (high Price/Book) stocks for the past 10 years – long enough for people to believe that maybe there is a new normal and value stocks will underperform growth stocks moving forward.

What is the theory for the new normal? The theory is that value investing became more commonplace, and the extra investing in value stocks led to bidding up their prices and eliminating the excess-return benefit compared to growth stocks.

Let’s test the theory. If the theory is right, the prices of value stocks increased all the way to match the prices of growth stocks (by definition, they cannot be any higher), eliminating the pricing benefit. It turns out that the opposite is true: the discount in Price/Book of value stocks increased significantly in the past 10 years.

Conclusion. The theory that value investing is dead due to overcrowding fails a simple math test. Based on the test, the opposite seems true, supporting the notion that the underperformance is part of a cycle, and value investing may enjoy greater excess returns than typical in upcoming years.

Implications for other investments. There are 2 other investment categories that show potential promise thanks to a similar simple mathematical test: US Small stocks & Emerging Markets stocks.

Quiz Answer:

Which of the following are true (multiple answers may be correct)?

  1. Value stocks outperformed growth stocks in the past 90 years. [The Correct Answer]
  2. Value stocks have become more expensive than growth stocks.
  3. Growth stocks grow faster than value stocks.

Explanations:

  1. This has been correct in the US for the past 90 years, and in other countries for decades.
  2. The opposite is true: value stocks are enjoying lower valuations (Price/Book, or price relative to the intrinsic value) today than in recent years.
  3. This has been true in the past 10 years in the US, but not in the long run.
Disclosures Including Backtested Performance Data

What Determines Investment Returns?

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Quiz!

Which of the following are factors that determine investment returns (may be multiple answers)?

  1. Past known world events.
  2. Central bank actions.
  3. Future unknown world events.
  4. Valuations

What Determines Investment Returns?

Most investors focus on one factor when trying to predict investment performance: past world events. In reality, investments are impacted by different factors, including: future world events, central bank actions (the Fed in the US), momentum, valuations and the natural growth of companies. Here are a few scenarios that tend to surprise investors and lead to unexpected results:

  1. Recently there was a negative event that led to declines. The next day brought a positive event along with gains. The reverse also happens.
  2. Recently there was a negative event that led to declines. A central bank (the Fed in the US) took actions to support the economy, leading to optimism and gains. Even as little as indication for future support can lead to gains.
  3. An investment is more likely to continue its trend of recent months. A high investment can keep going higher and a low investment can keep going lower.
  4. An investment with low valuations is likely to enjoy greater than average gains in the upcoming 5-10 years. In addition, it is more likely to revert from negative momentum to positive momentum.
  5. Beyond all factors above, you can expect diversified stocks to grow on average, thanks to the productivity of the underlying companies. It doesn’t happen in every specific day, month or year, but it happens on average, supporting long-term investors. And it happens more (on average) for certain groups of stocks including: small companies, cheap stocks (low valuations), and emerging markets.

Quiz Answer:

Which of the following are factors that determine investment returns (may be multiple answers)?

  1. Past known world events.
  2. Central bank actions. [Correct Answer]
  3. Future unknown world events. [Correct Answer]
  4. Valuations [Correct Answer]

Explanations: Past known events are already reflected in stock prices. Read this month’s article for further explanations.

Disclosures Including Backtested Performance Data

Is Your Growing Income Making You Less Financially Independent?

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Quiz!

Say you earn $100k per year ($80k net) and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year ($150k net). You double your saving rate from 10% per year to 20% per year. What is the impact on your financial security soon after the raise:

  1. Increased by 20%
  2. Increased by 10%
  3. Did not change
  4. Declined by 36%
  5. Declined by 54%

Is Your Growing Income Making You Less Financially Independent?

Say you earn $100k per year and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year. You double your saving rate from 10% per year to 20% per year. The table below shows the impact on your finances (all amounts are in dollars):

Increase Spending Based on Income: Financial Security Drops
Before raise After raise Change
Gross income 100k 200k
Net income (an example) 80k 150k
Saving rate 10% 20% x2
Saving amount 10k 40k x4
Spending (net income – saving amount) 70k 110k +57%
Spending rate = annual spending / total saved. Lower = higher financial security. 70k / 120k = 58% 110k / 120k = 92% +59%

The paradox. You just doubled your saving rate, quadrupled the amount saved each year, have 57% extra to spend, yet you quickly become more stressed about money than before the raise! What happened? Your spending increased by 59% relative to your total savings, making you less financially secure and more dependent on your job. The stakes are higher, making work a lot more stressful. I believe that this is a big reason for rising stress and declining happiness along with rising incomes.

Is there a Solution? Yes. Instead of counting on potential earnings, increase your spending only (1) based on new money that you already saved, and (2) in a sustainable way. In the example above, you keep your spending at $70k right after the raise, and increase it only using 3% of the money that you already saved and invested. 3% is an example of a likely sustainable withdrawal rate from a diversified stock portfolio. The table below shows the progression over 3 years (all amounts are in dollars):

Sustainable Increase of Spending (3% of New Money Saved): Total Spending & Financial Security Keep Going Up
Calculation Formula Before raise Year 1 Year 2 Year 3
Savings
Year-start savings Last year’s Year-end savings 120k 120k 212k 269k
Investment growth [Made up returns, with 10% average] 10% -10% 34%
Investment dollar growth Year-start savings x Investment growth 120k*10% = 12k -21k 91k
New savings Net income – last year’s Total spending 150k–70k = 80k 78k 76k
Year-end savings Year-start savings + Investment dollar growth + New savings 120k 120k+12k +80k = 212k 269k 436k
Spending
Added sustainable income New savings x 3%, rounded 80k x 3% = 2k 2k 2k
Total spending Last year’s Total spending + Added sustainable income 70k 70k + 2k = 72k 74k 76k
Financial security (annual spending / total saved), lower is better Year-end savings / Total spending 58% 34% 28% 17%

Key points:

  1. Higher income never hurts financial security. This plan eliminates the big dip in financial security after the raise. Instead, it provides growing financial security. Note: Your overall financial security could decline during big enough down years for your investments, but this is not related to your increased spending. It is the result of owning volatile investments. Volatility is the price of high long-term expected returns. It can hurt you when between jobs, but should help while you are in saving mode (see: How to Use Volatility to Make Money http://www.qualityasset.com/2018/07/31/how-to-use-volatility-to-make-money/).
  2. Sustainable new spending. By increasing your spending by a small percent of new savings, the new spending is expected to be sustainable even in the face of severe investment declines.
  3. Plan not reactive to investment volatility. The plan does not change spending along with the investment’s ups and downs. Declines don’t hurt spending, while gains are left to compound until you reach financial independence (retirement). When independent (spending/investments <= 3%), you can further increase your spending to 3% of your investments, whether you are working or not.
  4. Relatively simple calculation. By tying your spending only to money you save from your income, the calculation stays relatively simple: Once a year, you can total your additions (minus withdrawals, if any) to your investment portfolio, and you can raise your annual spending by 3% of that amount. Your investment advisor should have this information, and do the calculation for you.
  5. Reward for rising income. By tying your spending only to money you save from your income, you reward yourself for increases in income, instead of investments that you cannot control.
  6. Spending, total savings, and financial security all set for growth. Thanks to compounded investment growth, the available money to spend, the total savings, and financial security, all should grow exponentially over time (beyond the dips during down periods in the cycle).
  7. Baseline spending. The first step is setting your baseline spending. To find that, go over every item in your spending, and ask if you are willing to trade it with a more relaxed life. Once you completed all the trades (spending reductions), you maximized your financial relaxation. The lower the baseline, the higher your financial security, the faster it will grow, and the sooner you will reach retirement – the point from which you can keep growing your spending, independently of income.
  8. Resolving the paradox of: higher income = more stress. Many people have strong desires for increased spending immediately as their income goes up, making this plan seem too extreme. If you feel that way, think about something even more extreme: the prospects of becoming more stressed and less happy “thanks” to your higher income. Keep this paradox in mind before rushing to add to your spending based on growing income and not actual savings.

Quiz Answer:

Say you earn $100k per year ($80k net) and save 10% of your gross salary. After a number of years, you built an investment portfolio of $120k. You recently got a big raise from $100k/year to $200k/year ($150k net). You double your saving rate from 10% per year to 20% per year. What is the impact on your financial security soon after the raise:

  1. Increased by 20%
  2. Increased by 10%
  3. Did not change
  4. Declined by 36% [The Correct Answer]
  5. Declined by 54%

Explanations: Read this months’ article for an explanation.  Technical note:  The 59% increase in spending rate mentioned in the article is equivalent to a 36% decline in financial security: 1/(1+59%)-1 = -36%.

Disclosures Including Backtested Performance Data

Do Stocks Decline after Yield Curve Inversions?

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In late March the yield on short-term bonds (3-month) was higher than longer-term bonds (10-year) for a week. Normally you would expect higher returns for offering a 10-year loan than for offering a 3-month loan, leading to an upward sloping curve of yields of bonds of different maturities. What we saw in late march is called a “yield curve inversion” – longer-dated bonds providing lower yields than shorter ones. This often occurs when the Fed raises short-term rates fast relative to current conditions, and can be a precursor to a recession. It was true in both 2000 & 2008. Should you expect a decline to start soon? No. There is usually a significant lag between the inversion and stock declines. Here are the returns between the inversion and the stock decline for the S&P 500 and Extended-Term Component (ET) in the 2 prior cases of 2000 and 2008:

Inversion 1 Peak 1 Duration S&P 500 Return ET Return
9/30/1998 1/31/2000 16 months +39% +165%
01/31/2006 10/31/2007 21 months +18% +95%

1 I used month-end dates, given better access to historic return data on a monthly basis. The missing/extra partial-month impact on the results should be minimal.

These ET surges that are typical leading to peaks are a reason for you not to be concerned, and even be optimistic. Additional thoughts:

  1. Leading to peaks, ET tends to significantly outperform the S&P 500. It is great for your risk plan to be in a much stronger position in the face of future declines.
  2. The recent inversion was very short-lived, and current interest rates are still very low historically. It is possible that a recession is even further away than typical after inversions.
  3. While the statistics above provide a reason for optimism, I continue to be prepared for declines at any point – there are no guarantees on timing and results in investing.
Disclosures Including Backtested Performance Data

Should Higher Earners have Higher or Lower Saving Rates?

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Quiz!

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. What should your new saving rate be? Please select the best answer.

  1. Increase your savings nicely to $13k/year (but lower your saving rate to 13k/160k = 8%).
  2. Keep your saving rate at 10%, increasing your savings to $16k/year.
  3. Increase you saving rate to 20%, increasing your savings to $32k/year.

Should Higher Earners have Higher or Lower Saving Rates?

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. Should you keep your saving rate of 10%, increasing your savings to $16k/year? Should you increase your savings by less than that or even more? For many reasons, you should increase your saving rate, leading to new savings greater than $16k/year. Here are a few reasons:

  1. Usually, the higher your income, the lower your job security. Many more people compete for CEO or VP roles, than a fast food restaurant employee. You need to build security through savings faster to make up for your declining job security.
  2. If you lose your job, there are fewer jobs to choose from, the higher the income.
  3. The excess happiness obtained by increased spending goes down quickly as the amount goes up. Reducing financial stress typically brings much greater happiness.
  4. Social security covers a smaller portion of high incomes. If you earn $30,000 per year, social security will give you a retirement greater than half of your earnings. But, at $300,000 per year, social security income covers a small portion of the income you got used to. It is up to you to make up the difference. To get income of $300,000 from a portfolio that can generate 3% per year, you would need to build savings of $10,000,000. If you want to enjoy anywhere near the standard of living you got used to, you need a very high saving rate combined with investing for high growth compounded over many years.

The good news is that even at 20% = $32k saving rate, your income available to spending grows by a substantial: (160k – 32k) – (100k – 10k) = 38k minus income taxes. You get the double benefit of higher spending along with a big increase in your saving rate.

Quiz Answer:

Say that you earn $100k/year, and you save $10k/year, or 10% of your income. You got a big promotion, and your income jumped to $160k/year. What should your new saving rate be? Please select the best answer.

  1. Increase your saving nicely to $13k/year (but lower your saving rate to 13k/160k = 8%).
  2. Keep your saving rate at 10%, increasing your savings to $16k/year.
  3. Increase you saving rate to 20%, increasing your savings to $32k/year. [The Correct Answer]

Explanations: Read this months’ article for an explanation.

Disclosures Including Backtested Performance Data

How Much Should You Spend? A Rule of Thumb for All!

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Quiz!

Which rule of thumb for spending can be useful for all personality types?

  1. Save 10% of your income and spend the rest.
  2. Save 10% of your income for incomes up to $200k, and 20% for incomes above that. You can spend the rest.
  3. Keep your spending as low as needed to avoid chronic financial stress.
  4. Save as much as needed to allow you to retire by a reasonable age such as 65 or 70. You can spend the rest.

How Much Should You Spend? A Rule of Thumb for All!

This article offers a rule of thumb for a healthy spending level for all personality types.

Full sustainability: No matter your preferences, you can feel comfortable to spend an amount that is likely to be sustainable for as long as you live, whether you work or not. This is: your current social security payments, pensions and other guaranteed income, plus a sustainable withdrawal from your investments (e.g. 3%-4% for many globally diversified stock portfolios, reduced enough to account for surprise expenses).

Rule of thumb for all: Early in your career, full sustainability is rarely possible. A rule of thumb is to keep your spending as low as needed to avoid chronic financial stress. The benefit of this rule is that it can apply equally to different personalities. Here are a few examples:

  1. Risk averse: If you are risk averse, you may become stressed by any income instability or large surprise expenses. It may be worth keeping your spending as close as you can to 3%-4% of your portfolio. It may involve a large initial adjustment, but in return you will get many rewards. You will take the fastest road out of financial stress. You will enjoy the extra savings, plus the compounded growth of the extra savings. This will lead to a positive snowball effect of fast growing sustainable income along with relaxation.
  2. Time-sensitive spending: Some expenses lead to benefits that may not be available if delayed. Examples include children’s education & healthy eating. If you are risk averse, a compromise may be delaying most expenses, but still retaining your time-sensitive expenses.
  3. Instant gratification: If you are averse to delaying gratification, and don’t get too stressed without much of a safety net, you may choose to spend the bulk of your income, no matter how limited your investments are. Any loss of job, and many surprise expenses will require quick adjustments and potential stress. With low total savings to enjoy compounded growth, you will likely have a lot less money to spend in your lifetime, and your dependency on work will stay consistently high. But if immediate gratification is your top desire, and the consequences don’t stress you, it may be worth the tradeoff.

Important notes:

  1. Be realistic about upcoming expenses. Many types of non-recurring expenses are bound to happen. Examples include medical costs, house repairs, car repairs, new cars, loss of job and business downturns. I’ve heard people refer to these as bad luck. Switching your mindset, and seeing them as expected non-recurring expenses, can significantly increase your happiness and success in life.
  2. The benefit: The rule of thumb of avoiding chronic financial stress can be helpful regardless of your priorities. If your spending creates ongoing stress, you are probably not living an authentic life, and the price could be greater than any benefit you are getting by the spending. This is true whether you think you are spending very little or a lot.
  3. Stable jobs with guaranteed pensions. Because most jobs are far from guaranteed, the ultimate way to avoid chronic financial stress is to depend on sustainable withdrawals from actual money in the bank (investments). If you are lucky enough to have a very stable job that has a guaranteed pension, the pressure to reduce the dependency on work is lower. Please remember, though, that such jobs are rare, and pensions may not be as guaranteed as they used to be.
  4. If you are married, it is worth discussing spending, with a clear goal of resolving and preventing chronic financial stress. To motivate the talks, realize that one person’s stress typically hurts both members of the couple – even the person who is less risk averse and eager to spend more.
  5. Perspective: You can maximize your happiness by comparing yourself to people living in a basic structure with no running water and no electricity, and realize how fortunate you are. No matter how much you lower your spending, you are very fortunate in life.

Quiz Answer:

Which rule of thumb for spending can be useful for all personality types?

  1. Save 10% of your income and spend the rest.
  2. Save 10% of your income for incomes up to $200k, and 20% for incomes above that. You can spend the rest.
  3. Keep your spending as low as needed to avoid chronic financial stress. [The Correct Answer]
  4. Save as much as needed to allow you to retire by a reasonable age such as 65 or 70. You can spend the rest.

Explanations:

  1. Your saving rate depends on how much you have saved, how soon you desire to retire, your spending rate, your income level, your job stability, and a number of other factors. There isn’t one percentage that applies to everyone.
  2. All else being equal, you should save a greater percentage of your income, the higher it is, since it is tougher to replace higher incomes, and your basics are more likely to be covered already. But, spending and saving rates depend on many other factors, some of which are mentioned in #1 above.
  3. Stress is a protection mechanism that tells you that you are not acting in an authentic way. If you are chronically financially stressed, you are acting against your internal beliefs. This rule of thumb can help everyone.
  4. There are many problems with this advice. A few of them: You cannot count on a specific growth rate on your investments to know when you can retire, you cannot anticipate health problems, loss of job, volatile business income, and the list goes on.
Disclosures Including Backtested Performance Data

Your Neighbor’s Grass is Brown!

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Quiz!

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that.
  2. He is wealthy.
  3. He lives in a fancy house.

Your Neighbor’s Grass is Brown!

Have you ever seen a friend’s or neighbor’s fancy car, or heard about her fancy trip, and thought how lucky she is? After nearly 1.5 decades in this business, I’ve heard many people’s stories, and learned that things are rarely what they seem. Specifically:

  1. Each person emphasizes certain expenses, while often keeping other expenses much lower. A person can fly business class, while living an otherwise modest life. Another may lease a fancy car, while renting a modest home. A third may live a simple life in a fancy home. A fourth may pay for a very expensive private school for her children while living a modest life. These are all examples based on people I personally know. I believe that only a small fraction of people who spend big in a few categories, can afford to spend big in all categories. It makes sense to choose the most important things in your life and focus your spending on them, rather than spending evenly across all categories, whether important to you or not, leaving less money to your top priorities.
  2. Many big spenders are chronically stressed. It fits with a recent study showing that income above $105,000 in North America paradoxically leads to diminished happiness. Anyone with high income faces the temptation to spend a big portion of their income. Say you gross $1M and net $600k per year. You save what feels like a respectable 20% of your net income: $120k, and spend $480k. After a number of years, you built a nice investment portfolio of $1M. You are still highly dependent on your income, and replacing such high income can be a big challenge. This can lead to unusually big stress. In addition, high income often comes with big responsibilities (CEO, business owner), putting extra pressure. To sustain $480k of spending from a stock portfolio that can handle sustainable 3% withdrawals, you would need to reach savings of $16M. Such a level of savings is not common, and probably a lot less common than spending of $480k per year.

If you are able to satisfy your basic needs (food, a place to sleep, basic clothes, etc.), and spend modestly relative to your savings, you are under a fraction of the financial pressures of many big spenders. You may think that their grass is greener, but it is brown compared to yours. Peace of mind, lesser dependency on work, and appreciation for the little things in life are worth a lot more than what big expenses can buy along with the stress involved. You are the source of envy of some very big spenders who realize that your grass is greener. Next time you see a big spender, you may replace feelings of envy with some compassion.

Quiz Answer:

Your friend told you about a business-class flight he took for a trip. Which of the following are most likely to be true.

  1. He values the pleasure of a business-class flight, and decided to spend on that. [The Correct Answer]
  2. He is wealthy.
  3. He lives in a fancy house.

Explanations:

  1. People often spend money on things they value.
  2. People usually spend money based on their income, even if their total wealth (savings/investments) is low.
  3. People usually spend big money on several categories, but not all.
Disclosures Including Backtested Performance Data