Ditching the 9-to-5 job is something I am sure we all dream about, and I personally have been dreaming more about it as I age gracefully. I am intrigued by the brave souls who do just that: take the plunge, get out of the rat race, pursue their true passions, and travel the world. They are doing the things they really want to do.
I’ve been reading up on the concept of “financial independence, retire early” (FIRE) for a while now. However, I am a bit skeptical of one particular strategy used to maintain FIRE.
The strategy I am talking about is accumulating assets through the purchase of stocks, then using the stock market as a means to finance their retirement by withdrawing a small percentage (e.g., 4%) every year to cover their living expenses.
I firmly believe that this strategy is a recipe for disaster down the line. I notice two vital misconceptions within this plan.
Misconception No. 1: The stock market will give you the highest return in the long run.
The market on average will give you a decent nominal rate of return of around 10% long term. But in the short term, the stock market goes up and down. It can make you a fortune in one year (think 1999, 2005, and basically any time from 2008 to present), then make you poor in the next (the Great Depression, 2000, 2008, and likely the near future).
The issue with folks withdrawing a small percentage of their net worth every year over a long period of time is that they are assuming the stock market will recover quickly in a crash and that, overall, the stock market will go up right after.
Well, I’ve got news for you — that is completely untrue. In fact, between 1969 and 1982, the S&P 500 went from 779 to 309.08. Yeah. Can you imagine trying to finance your retirement in a prolonged downturn (e.g., 13 years)? Good luck with that. Even worse, my bet — though I really hope I am wrong — is that since the stock market has been going up since 2008, we will have a painful downturn soon that will throw a giant wrench in the FIRE strategy.
Misconception No. 2: Interest rates will stay low.
Warren Buffet said it best: “Interest rates basically are to the value of assets what gravity is to matter.”
In times of low interest rates, all asset prices rise. This is exactly what has been happening since 2008. Look at real estate and stocks. Asset prices have scaled unbelievable heights, mostly thanks to the Federal Reserve’s ability to consistently purchase bonds (i.e., quantitative easing), which artificially drove down interest rates.
But inflation is starting to come back now, and it has the potential to squeeze early retirees on two fronts.
The first way is from the Federal Reserve being forced to raise interest rates in order to combat inflation. If interest rates are raised too quickly, then prices of stocks and real estate will have corrections of magnificent proportion. In this scenario, those who retired early could realize that the nest egg they worked so hard for is now significantly lower.
The other way is from inflation itself. Due to the rising prices caused by inflationary pressure, a cost-of-living creep (the definition of inflation) will result in higher costs in all goods, which means the FIRE lifestyle will be more expensive to upkeep.
These are just some of many risks of relying on the stock market to finance your retirement.
Three pillars to building a better foundation
It has taken me 20 years to realize my retirement strategy.
Before I tell you my strategy, I want to clarify that there is no fail-safe plan that will guarantee full protection against every possible financial disaster. Because time is your enemy, I truly believe that given enough time, all those possibilities will be realized. What I mean is that over time, there inevitably will be stock market crashes, real estate market crashes, bank failures, wars, famines, etc. The key is how to mitigate those probable failures. To this extent, I think my plan is more solid against disasters, but I welcome comments or suggestions to help me improve my plan or to look at angles that I have not seen.
My plan essentially contains three buckets, which I call the three pillars.
These three pillars are cash, cash flow, and appreciating assets, such as the S&P 500.
First pillar: cash
The first pillar is pretty simple. I keep a giant cushion of cash because for me, cash buys flexibility and opportunities.
With cash, I am like Muhammad Ali. I can dance with the best of them in the ring and quickly get in on investments (with a degree of caution).
Cash also affords me a degree of protection. If I have an emergency, I don’t need to rely on selling appreciating assets, especially when assets depreciate (e.g., stock market crashes). Instead I put this money in short-term CDs, savings accounts, and/or series I bonds to keep up with inflation as best as I can.
Second pillar: assets
The second pillar is appreciating assets. In the long term, this is money that will grow. Over time, most of my money should be in this pillar. This is all never-take-out money, meaning money I put into the stock market (e.g., S&P 500) and forget about. If I ever do have to take money out, it should always be during a time when stock is booming.
You see, I can say this statement confidently because I should have enough money in the first pillar and income from the third pillar that I am going to talk about.
Third pillar: income
The third pillar is my bread-and-butter pillar. This pillar is made up of the passive and active income I get through real estate, REITs, high-dividend-paying companies, pensions, bonds, annuities, etc. This steady income ensures that I don’t need to dip my hand into the first or second pillars.
This third pillar is all about ensuring your normal day-to-day costs are taken care of. In this category, I place real estate at the top of the list because out of all the income-generating instruments, I believe real estate, even at today’s prices, is cheaper and less risky (provided you purchase it with a 30-year mortgage at today's interest rate) than other income-generating instruments.
Further exploring real estate
Now let’s get into my favorite investment: real estate. Real estate is a hybrid asset class that is both an income stream (pillar 3) and an appreciating asset (pillar 2).
I can’t think of another type of passive income that you can buy with an 80% discount — yes, 80% discount. How, you ask? It’s all about the 30-year mortgage. Let’s say you put down a 20% down payment and purchase a house when you are 30 years old. You keep this house rented out and have the rental income cover all your expenses. After 30 years, the house is yours.
So in this scenario, you not only have a nice, healthy cash stream every month, you also have only put in 20% of the cost yourself. Even better, during these 30 years, since real estate generally keeps up with inflation long term, if inflation goes up, you make a return that is five times the inflation value of that house!
Think about it like this: If your rental house goes up 1% due to inflation, then you have made a 5% return on that rental property because you only actually put a 20% down payment on that house.
Don’t believe me? Do the math. If you bought a house for $100,000, put 20% down ($20,000), and financed the 80% with a mortgage, then at 1% inflation, that house value is now worth $101,000 ($100,000 × 101% = $101,000). That means you made a $1,000 gain on house value. But because you only put $20,000 down, your return on investment is 5% (i.e., 1000 ÷ 20,000 = 5%).
Keep in mind that when inflation occurs, the house value is not the only thing that goes up. Your rental income also increases. However, your mortgage payment stays the same. Thus, your real estate investment will return more income over time, and your asset price will go up due to inflation.
The only thing that erodes over time is the value of your mortgage principal. Imagine that you borrowed a substantial amount of money to buy a house, and you got a mortgage at today’s low interest rate. If inflation kicks up for 10 years at, say, 3% a year, it means that over time, the mortgage from the bank is going to be less and less expensive in terms of real money.
Let me give you a perfect example: According to Google, the average home price in America back in 1960 was $11,900. Back then, if you put down a 20% down payment and financed the rest with a 30-year fixed mortgage, the bank would have loaned you $9,520. So considering that today that same house’s value is probably a lot more than $11,900, the $9,530 debt is negligible.
For all the above reasons, I prefer real estate investments over other asset classes.
Thoughts on your own retirement strategy
I’m always willing to learn and am curious about your thoughts on this topic. Which approach would you be more likely to use, and why: the FIRE strategy, real estate, or something else? Let me know what you think in the comments.