A No-Nonsense Guide to Early Retirement
(Edited 2024-07-18: Looking at this 3.5 years later, there’s a few changes I would make.
First, I avoided being too opinionated about asset allocation—but I now think it’s pretty important to have a high % of investments in stock index funds. I would not drop below 80%, except perhaps briefly during the early stages of retirement. I am currently 100% invested in stocks.
Second, I recommended establishing an emergency fund in cash, then paying off all debt above 3-4% interest rate. Interest rates have since increased across the board, and you can earn 5% just sitting money in a high-yield savings account, so this no longer makes sense. I also think it can make sense to save money in investments even while holding some high-interest debt—you might lose net worth, but you gain financial stability by having additional assets you can call on in case of job loss/etc. This is especially true if the debt is large, such as a mortgage.
Third, I recommended a flat 6-12 months of expenses kept in cash. If you have sufficient amounts in stocks that you’ll be financially safe even given a large market downturn, this is unnecessary. I keep ~2 months of expenses in cash (a money market fund) and the rest in stocks.
Fourth, I think Fidelity is ergonomically better than Vanguard, and ETFs are ergonomically better than mutual funds. I also don’t mention expense ratios. Nowadays, my default recommendation would be “Fidelity + buy VTI” instead of “Vanguard + buy VFIFX”.)
(Edited 2021-02-28: Added a section on how retirement is risky, and changed a few other sections to provide more context or clarify various trade-offs pointed out in the comments.)
Introduction
I wanted to be able to link people to a guide on early retirement that succinctly covered everything I thought was important, but I couldn’t find one that I was satisfied with. So I made this.
There are tons of communities and resources out there for anyone who wants to read more about retirement, investing, financial independence, etc—many of which I’m cribbing from. You might start here: https://www.reddit.com/r/financialindependence/wiki/faq.
This is an opinionated guide, which means a lot of it is kind of made up—but I think it’s ~95% in line with what you’ll find in financial independence communities across the internet. Even if some numbers are wrong, I have decent confidence nothing here should lead you too far astray.
Also, disclaimer: I’m a random guy on the internet, please be careful with your money!
Overview
To retire successfully, you need to have enough money to live on until you die. This requires saving money, and preferably investing it in assets that gain value over time.
Though there’s a lot of fiddly details and no one can predict the future, given some reasonable seeming assumptions the process for figuring out how long this will take you is pretty simple. Just calculate:
How much you’re saving per year
How much you’re spending per year
How much money you currently have invested
and then plug those numbers into an early retirement calculator like https://networthify.com/calculator/earlyretirement or https://engaging-data.com/fire-calculator/. As a rule of thumb, you need to have ~25x your yearly spending invested well to be able to live off of the returns. So to support a $30k/year lifestyle, you need ~$750k invested well. The actual number may be 15x or 35x based on the length of your retirement, the future performance of markets, whether you ever generate any income during retirement, how flexible your expenses are, etc. -- but we can use 25x as a ballpark.
So you need to save money and invest it in assets that gain value over time. The more you do this, the quicker you’ll retire. Here’s my ultra-sophisticated three part strategy to doing so faster, and consequently the three sections in this guide:
Spend less
Earn more
Invest well
Risks of retirement
Before diving in, it’s worth pointing out ways that retiring is risky. The main way that retiring is risky is that you might not have enough money at some point, and also might not have any good options for getting more.
Some reasons you might not have good options for getting more money at a later date:
Credential and professional network decay. If you haven’t worked in your profession for 10 years (or 1 year in some cases), people may not want to hire you for various reasons.
Age-related declines in health or cognitive function.
Ageism.
Automation and societal changes. Your profession may no longer exist in the same form in the future.
Hedonic adaptation. You may have a harder time dealing with the pressures of holding a job after you’ve gone a long time without holding one.
Retiring earlier is riskier than retiring later because you have to deal with risks over a longer time frame. You’re reliant on market performance you can’t control. The calculators and 25x rule mentioned above use historical market performance to estimate how much you need to retire, but the market may not behave like it did historically. The longer your retirement will be, the more room there is for the market to behave unexpectedly and wipe out your investment.
You also might need more money than you expect in the future. Perhaps you have children you did not plan for, suffer an unexpected medical expense, or encounter a significant opportunity that requires money. New technology might create such opportunities, e.g. costly anti-aging treatments. Unless you think money will lose most of its value, these risks can all be offset by just saving more than you expect to need.
Another way to manage these risks is to not fully retire. Maintain some level of professional activity, such that you can more easily jump back in to full-time employment if you need/want to. You could drop to part-time at your employer, try to start your own business, or try to find a consulting role which supports sabbaticals, working only X months out of the year. You could also use your newly found freedom to retrain for a new profession that better supports these goals.
You can control some of these risks by modulating your spending based on your investment performance; if the market goes down, downgrade your spending as appropriate. This can help substantially in back-tested simulations of retirement risk, although there are obviously limits to how far you can downgrade. This also doesn’t protect you from unexpected expenses.
Another, unrelated, risk to retirement is that not having a job could make you unhappy. In that case, you should get (or keep) a job! This guide may still be useful to you—even if you never want to retire, having significant savings and investment income can open up new opportunities. You could rely on savings to allow you to pick a job you’ll enjoy independent of its financial payoff, or to take risks in order to create your own company/non-profit/side-hustle. If you haven’t done so, you could also explore filling the “job” slot in your life with things such as research, volunteering, mentorship, media creation, lobbying, or anything else that you find meaningfully productive.
Spending less
Spending less helps in two ways: it lets you save more, and it also reduces the amount you need to save. Remember the rule of thumb that you need ~25x your yearly spending in investments to retire. If you consistently reduce spending by $100/month aka $1,200/year, your necessary investment for retirement is lowered by $30,000. A $500/month increase in rent becomes a $150,000 increase in necessary investment. Minor looking financial commitments can cost you years of your life!
It turns out that the calculation of years-to-retirement doesn’t really depend on your absolute level of spending or savings, just your relative level. If you save 80% of your net income, it will take you ~5 years to retire no matter what your income is. If you save 75% of your net income, it’ll take you over 6 years. This illustrates again how minor differences in the amount you consistently save can have a big impact on when you can retire.
It’s hard to give specific advice about how to spend money, since it’s so personal and situational. This area can also be surprisingly emotional; I recommend approaching it with gentleness and honest reflection instead of moralism. If you find that you can’t consistently spend less, it’s ok; you can rest satisfied with your current trajectory (which you should calculate), or you can also try to make more money.
First, look at how much you’re spending every month in categories like rent, groceries, eating out, shopping, etc. This might be scary, but knowing your spending in detail will help you control it and make trade-offs that you feel positive about. There are tools online to do this like Mint, but you can also just make a spreadsheet using LibreOffice or Google Docs, copy the information from your bank statement, and then use a pivot table to summarize spending by category.
If you know you have specific areas you tend to spend a lot in and would like to reduce, make a monthly summary for them that you monitor. Reflect on your most expensive areas first: saving $500 by selling your expensive car is worth more than saving $200 from not eating out which is worth more than saving $10 from cancelling a subscription.
Be careful of unintended effects. Reducing rent by moving further away from work and increasing your commute can have a big negative impact on your happiness, for instance.
There are massive reservoirs of information online about how to save money, but there’s no magic wand. If rent and groceries take up 60% of your income, then you’re never going to save more than 40% of your income unless you reduce spending on rent or groceries. If your spending is already pretty well tightened, you might do better by focusing on earning more.
Earning more
The way most people earn money is with a job, so all of my advice in this section relates to jobs. You also might be able to earn more by doing things like joining the gig economy, starting a side business, or renting out space in your house—definitely consider such options if they seem like a good fit for you.
Getting a better job
One of my biggest career mistakes (among many) was taking the wrong job after I finished school. I doubled my salary when I switched to a different job 9 months later—a job that I’d been qualified for the whole time, and which made no use of my 9 months at the first job.
My big takeaway: try applying for better jobs. Better might mean more pay now, more pay later on (for instance, by getting into a new profession with higher pay potential), or some other improvement (such as a job that fits your values better or offers you better working hours). The time commitment to apply is at most a few hours to work on your resume and cover-letter—the potential payoff is years off of your eventual retirement timeline. Imposter syndrome and self-esteem issues are big obstructions for a lot of people; if you self-identify as having either of those, you’re probably under-applying and should apply to more jobs. Apply even though you don’t think you meet the qualifications. Even if you’re completely happy with your current job, I’d propose you should send something like a dozen applications out per year just to test for even better opportunities. The only reason I can see not to is if it’d be hard for you to find a dozen better opportunities anywhere in the world.
When applying for jobs, getting a recommendation from an existing employee is much better than just sending your resume and cover letter blind. People have written mountains about networking, but I’m bad at networking so I’ll summarize with “meeting and befriending people in settings related to your profession can have high payoff.” Promising locales include real-life meetups, conferences, and social networking sites. Don’t use your lack of a network as an excuse not to apply for things though—you can apply now AND try again later if you end up finding someone to recommend you.
If you’ve worked at the same company for a while, try applying for other jobs even if they seem like lateral moves; you might be able to get a pay boost or promotion by switching companies. Raises and promotions at a single company don’t necessarily keep pace with your market value as your experience increases. Even if you don’t want to switch jobs, you may be able to negotiate compensation increases at your current company if you have another competitive offer.
For certain jobs, building or improving a public portfolio might increase your application success rate.
Depending on your situation, it might make sense to try earning credentials in order to land better jobs. This is extremely situational and you should do your own research before committing to anything. Here’s a scattered list of thoughts:
Look for data on salaries by school, degree type, and field before committing to any degree program. E.g., a Bachelor’s degree in Computer Science from Stanford is extremely valuable; a Master’s degree in Fine Arts from For-profit College X is probably worthless. Compare median graduate salaries with the cost of attendance and opportunity cost from lost time.
PhDs are almost never worth the opportunity cost, with few exceptions.
Programming is still quite lucrative if you can break into it. The field is saturated with entry-level applicants, but still has very high demand for experienced talent.
I’ve heard that law school has become a bad deal for most people, unless you get into one of the very top schools.
I’ve heard that med school has become a worse deal over time, but may still be a good deal on average if you can hack it + residency.
I’ve heard nursing can be lucrative.
Negotiating
If you’re in the application, interview, or job-offer phase with any company, there’s a number of things you can do to potentially increase your pay. There’s a ton out there about negotiation, so I’m just going to share the most important points as I see them.
In my overly simplified model of negotiation, your success has three primary inputs:
Your perceived value to the employer, which affects how much they’ll be willing to offer you.
Your best alternative to accepting the offer on the table, which affects how hard you should be willing to push.
Your ability to execute a basic negotiation strategy without making mistakes.
There are a lot of ways to increase your perceived value, some of which are very situational. Another scattered list of ideas:
Acquire prestige. This could be through schools, other jobs you’ve held, professional accomplishments, building a public persona, etc.
Be good at the job in a visible way. If applicable, build public portfolios which demonstrate your skill.
Practice generic good social skills. Try to get honest feedback from others about your social skills. This is obviously a big area to figure out.
If the interview process will involve any technical skill, practice that skill so that you perform well (e.g. LeetCode for programmers).
Practice answering interview questions out loud on your own or with a friend. Record yourself and examine the results.
During interviews, talk (honestly) about your positive qualities, achievements, and capabilities. Don’t focus on your negative qualities or failures—if they do come up, talk about what you’ve learned from them.
Don’t show desperation. Even if you are desperate, do what you need to do in order to hide it for the duration of the interview—the employer will not care and will find your desperation off-putting.
The impact of your best alternative is pretty straight-forward: if you’re about to be homeless, you’ll probably accept whatever someone offers you. If you’ve already got a comfy job that you’re happy with, you’ve got no reason to leave unless the offered pay is substantially better, so you can hold out or make multiple counter-offers. This is a good reason not to quit your current job before applying to other jobs.
As to basic strategy: try not to tell potential employers your current salary or salary expectations, as they’ll mostly use this information to low-ball you when applicable. You’ve got nothing to gain by giving up this information, and the person on the other end of the conversation is aware of this—it’s simply their job to try asking anyway. There’s a million strategies posted online about how to avoid giving up this information, but here’s a simple one that’s worked for me: if they ask for your previous salary or salary expectation, tell them you’d rather not share that information, but that you’re happy to confirm your expectations are within a given salary range if they have one—this puts the obligation on them to list a range. If they continue insisting without giving a range, just politely repeat that you’d rather not share. If they ask why, you can truthfully explain that you’d rather hear their range first to anchor the negotiation. If your current salary or salary expectations are required in a form, try entering the smallest number it will accept (like $0 or $1 or $1000). If a human tells you these numbers are needed on a form, explain the above and then ask them to enter a small number. If a human later asks you about the number on the form, repeat the above. I find it easier not to make mistakes if I just commit to never giving this information, no matter how weird things get—it’s extremely unlikely an employer will be petty enough to refuse to proceed based on this, and if they do you’ve got a great story you can share on reddit.
After you receive a job offer for a high-skill / professional class job, you should usually ask for more money. There is a chance that asking for more money will cause the employer to retract the offer, but as far as I know this chance is extremely low in most high-skilled industries if you ask for +10-15% -- most employers expect and plan around receiving counter-offers in this range. You might want to do some research on your industry in particular in case it’s weird about this. People in high-skill jobs tend to be overly paranoid about the chance of an offer being withdrawn.
If you receive an offer for a low-skill / high-labor-supply job such as retail or restaurant service, my impression is that attempting to negotiate at all might get an offer rescinded, so be careful.
A simple phrasing template for counter-offers: “Excellent! I’m excited about x,y,z. Unfortunately, the compensation is somewhat lower than I was aiming for. Would you be able to come up to <counter-offer>?”. Add your own voice as desired, there’s nothing magical about this template. If you’re unsure about your writing but have socially savvy friends, run things by them if you can.
If they don’t counter-counter-offer, but they also hint that higher compensation is still on the table, ask about a slightly lower number (+5-10%). If at any point they say they can’t go higher, then making further counter-offers might cause them to withdraw the offer. If you wouldn’t want to accept their current offer regardless, there’s no harm in continuing to hold out for the minimum you would accept. As an anecdote, my last three salary negotiations (as a programmer) have yielded 12%, 6%, and 7% salary increases respectively over the counterfactual of accepting the first offer given.
You have more at stake proportionally than a company does during negotiation, so to reduce mistakes I think you should negotiate carefully by email whenever possible. If pushed for answers or acceptance in person or over the phone, tell them you’re excited but you’d prefer to think about things and get back to them shortly via email. If they say or insinuate they need an answer immediately, refuse to give one and re-iterate that you’d like to think about it and get back to them shortly. If they withdraw an offer due to you not giving an instant answer, then I guess they’re either dumb or abusive—you probably don’t want to work for them anyways. If you do decide to negotiate over the phone or in person, make sure you have your decision tree clearly written out or rehearsed, and try to bail back to email at the first sign of trouble.
Investing well
Despite all of the intense social signaling around personal finance, investing well is surprisingly easy and boring. You can get 80% of the value of everything in this section by doing exactly the following without any additional context:
Build an emergency fund to cover a few months expenses
Invest in your employer’s 401(k) up to the matching amount. Buy whatever stock index fund they offer.
Pay off all of your debt unless the interest rate is very low, e.g. 3-4%.
Go to vanguard.com and open a taxable brokerage account.
Deposit $X each month.
Use that money to buy VFIFX.
Never look at stock market indicators and ignore all stock news.
Retire once the calculators say your account balance is high enough.
Sell as needed for money during retirement, keeping your expenses the same modulo inflation.
By doing so, you’d primarily be missing out on the advantages of using more retirement accounts (which help your money grow faster) and optimizing your index fund portfolio.
Note that this whole section takes what is called a “passive view” on investing. The alternative “active view” is where you dive deep on trying evaluate various assets and predict their market behavior on shorter terms than “when I retire”.
Even among professional investors, most people who take an active view end up making much less than they would with an index fund. Most of us are not at the level of professional investors, so should expect to do even worse. All of your friends who report making good money actively buying and selling are either 1. selectively reporting, 2. lying, or 3. got temporarily lucky, but are just as likely to get unlucky in the future. If you feel the need to be included in such games, set aside at max 5% of your monthly investment deposits for this purpose and put the other 95% into index funds. Never sell your index funds to buy into the latest investment fad.
You can “leverage” a passive indexing approach using various financial products, and the math on this might be better than just buying index funds directly, but this is definitely straying from No Nonsense to Reasonably Large Amounts of Nonsense, so I wouldn’t recommend it for most people. See this comment thread for some links and context.
1. Emergency funds
Your first investment priority should be taking care of your basic needs. Have you eaten today? Did you stay up all night writing an early retirement guide?
Your second investment priority should be building an emergency fund that you keep set aside for urgent and unexpected situations. Having an emergency fund improves your well-being by giving you leverage and letting you get through life events with minimal disruption. For example:
If your car dies, you can take Uber or rent a car.
If your roommate is late on rent, you can cover for them instead of being evicted.
If your fridge dies, you can replace your fridge and then buy new food.
Etc.
You should keep your emergency fund somewhere safe like a savings account, not in the stock market.
There’s debate over how big your emergency fund should be given your situation. Here’s a concrete recommendation that you can adjust to your comfort level:
First, save enough to cover 1-2 months worth of expenses.
Then, pay off any crazy interest rate debt (payday loans, credit cards).
Then, save enough to cover 6-12 months of expenses. This gives you time to find a new job if you lose your current one.
Finally, put your excess into paying off other debt or buying investments.
Make sure you save for your actual expenses, not your budgeted ones. Look at bank statements as discussed in the “Spending less” section to know how much you’re actually spending.
Although investments will provide you with additional cushion (you can sell them in an emergency), you should plan to not sell investments until you really need them since any gains you’ve made on the investment will incur tax when you sell.
2. Debt
Debt is an anti-investment with a guaranteed negative return (its interest rate). For this reason, it’s basically always a bad idea to go into debt just to buy consumption goods. Treat any purchase that comes with a monthly payment as extremely suspect. Buy consumption goods (including cars) up front whenever possible, so you can’t hide their true cost from yourself. You may sometimes need to go into debt temporarily to survive; if so, work on escaping that situation as quickly as possible. The other techniques in this guide might help.
Debt can be a good idea when it’s used to finance creation of future value; for instance, taking out student loans which allow you to get a valuable degree that doubles your expected lifetime earnings. Just be careful; if you misjudge the value of what you’re buying, you might end up worse off.
Mortgages and houses are a complicated topic that I’ve not researched much. My current opinion is that having a mortgage is probably slightly better than renting in expected value, but riskier (your property might decline in value) and with much higher transaction costs for moving. Those transaction costs lock you into a geographic location, which reduces some opportunities for making more money or reducing spending. Think carefully before locking in.
If the interest rate is small enough, investing money in index funds can be better in the long run than paying off debt. For instance, say you have a 3% mortgage and you think the expected yearly gain from an index fund is 10%; then you could make 7% a year by investing instead of paying off your mortgage. You could even try to borrow more money at a low interest rate in order to invest it.
The catch is that interest rates are certain and index fund gains are not. You take the risk that your investment does not pay off in any given year, which can be psychologically difficult when combined with debt. Debt also increases your baseline expenses through minimum payments—this could put you in a worse short-term situation if you lose your job at the same time as your investments decrease in value. Still, if you think the markets will go up on average over time and you can cover the minimum payments, you should win out in the long run if the interest rate is low enough. I would personally not do this with an interest rate over 4% unless I had a ton of other assets to cover me in case of a downturn or unemployment.
Make sure you have enough money to cover expenses before paying off debt. Having debt paid off is no good if you can’t pay rent.
3. Retirement accounts
This is the most complicated part, because tax law is dumb. This part is also entirely U.S. focused—I’m sure other countries have their own dumbnesses, but I don’t have knowledge of them.
Retirement accounts are accounts with money in them that you can use to buy investments like index funds. You either open them yourself or have them opened by an employer. You put money into them manually or through automatic paycheck deposits. A non-retirement account for buying investments is usually called a “brokerage” or “taxable” account. Retirement accounts have various tax benefits over non-retirement accounts, so are often called “tax-advantaged” accounts. You generally make more money long-term by investing in retirement accounts, but they also come with various limitations.
I’m going to talk about 3 specialized retirement account types which are all that 90% of people should need to touch: traditional and Roth 401(k)s, traditional and Roth IRAs, and HSAs. There’s a few others floating around (like Solo 401(k)s and 403(b)s), but they work on a lot of the same principles anyways.
IRAs are accounts opened personally by you at some provider. I recommend vanguard.com. They’re pretty straight-forward to use: you put money in and then select investments to buy. The only catch to IRAs is you can’t contribute to them if your income is too high.
401(k)s are opened by an employer, but you own the money in them. Employers will often offer a “matching percentage”, where they’ll give you free money in exchange for investing in your 401(k) -- this is usually an awesome deal that you should definitely take. Unfortunately, sometimes employers use bad providers with bad asset options and bad websites, so you have to find the best option you can among what’s on offer. I’ll talk more about this in the section on index funds below. You can eventually “rollover” a 401(k) into an IRA at the provider of your choice, usually after you’ve left the employer.
HSAs are only kind of retirement accounts, with their nominal purpose being to give you tax benefits on medical spending. They can be opened by either you or your employer, although you pay less taxes if your employer deposits money directly into the HSA from your paycheck, so you should have them do that. You can only deposit into an HSA if you have a High-Deductible Health Plan (HDHP). You can withdraw from an HSA at any time to pay for “qualified medical expenses”, or you can hold the HSA until age 65, at which point it works mostly like a traditional IRA (see below). Some HSAs are basically savings accounts with no investment opportunities; some others will let you buy things like index funds. HSA’s are not to be confused with FSA’s, which as far as I can tell are really dumb and will eat your money.
All retirement accounts have limits on how much you can put into them per year. Having multiple accounts at different institutions does not increase the limit; it’s a total limit across all accounts. For instance, for 2021 you can contribute a maximum of $6000 to IRAs, or $7000 if you’re age 50+.
If you withdraw money from an account before a certain age, you’ll have to pay a penalty on your taxes. The age rules differ for every account type, but the cutoff is always in the 55 to 65 range. I’ll just say “retirement age” to refer to these cutoffs. The penalty has either one or two parts:
You’ll always be taxed a flat percentage of what you withdraw; 20% for HSAs and 10% for most other accounts.
You might additionally owe regular taxes on some of the money withdrawn, even though you wouldn’t owe taxes for an “authorized” withdrawal.
There are some important exceptions to the penalty rules, which we’ll discuss shortly. Those exceptions play a major role for early retirees who want to withdraw money before retirement age.
You’ll notice the words “traditional” and “Roth” used above; these refer to two types of tax advantages. The short summary:
Contributions to traditional accounts are tax free in the present (you get a deduction for what you contribute); you pay taxes when you withdraw money after retirement age.
Contributions to Roth accounts are taxed in the present (no deduction, you contribute with post-tax income), but then you can withdraw tax-free after retirement age.
With both versions, activity within the account isn’t taxed; you can buy and sell different assets or receive dividends with no tax consequences.
Compare to a taxable brokerage account: you’re taxed in the present (no deduction, you invest with post-tax income), and you also pay taxes on sales and dividends. Taxes on dividends will drag down your returns somewhat, and even if you only buy once and sell once you’ll still have to pay 0% to 20% in long-term capital gains tax that you wouldn’t pay in a Roth IRA. If you buy and sell more often then you’ll drag down returns even more, since any gains you realize will be taxed and that tax money can no longer be kept invested.
You get to choose whether to invest in traditional or Roth accounts; you can mix and match however you want. Which of the two options is better is kind of complicated—here’s an article with more details: https://www.reddit.com/r/personalfinance/wiki/rothortraditional. The short answer:
If your tax bracket / income is low right now, you should probably do Roth.
If your tax bracket / income is high right now, you should probably do traditional.
If it’s in between, there’s pros and cons but probably either is fine. I lean toward Roth.
Back to those penalty exceptions—there’s two big ones:
The principal amount you invest in a Roth IRA can be withdrawn at any time, penalty and tax free. This is the main reason I would lean Roth for middle tax brackets—extra liquidity is very good for the nerves. You can also access the principal of a Roth 401(k), but first you need to roll it over into a Roth IRA. Most service providers allow such rollovers while you’re still employed, but supposedly a few do not—thus you might not be allowed to do this unless you quit your job.
You can convert funds from a traditional IRA to a Roth IRA at any time, pay taxes on the conversion amount, and then withdraw that money penalty and tax free after waiting at least 5 (tax) years. You can also do this with a 401(k), but you have to roll it over—again, there’s a small chance you might need to quit your job to do this.
Combined, these two exceptions let you access a good chunk of retirement account assets early without penalties: Roth principal whenever you want, and traditional principal+earnings if you can plan it 5 years in advance. Roth earnings, unfortunately, are stuck until retirement age, as are HSA principal and earnings for every purpose besides qualified medical expenses.
(EDIT: An important point I left out here—the official record of your Roth IRA principal lives on tax form 5498 that your brokerage will send you or allow you to download each year. As far as I understand, officially you need to keep these forms until age 59.5 to justify any early withdrawals to the IRS. Brokerages tend to delete these forms after a few years, and they don’t separately track a “contribution” or “conversion” number attached to the account. I found this out the hard way when I transferred my Roth IRA between brokerages, my transaction history was deleted, and no one from either brokerage could tell me my contribution or conversion basis.)
Since you can convert from traditional to Roth whenever you want, you can control what year you pay conversion taxes in. This means you can pick a year when you have low income (say, during an early retirement), and fill up your deductible and lower tax brackets with conversion money. Think of your deductible and lower tax brackets as a resource which expires every year; traditional to Roth conversions let you make use of that resource whenever it makes sense. This leads to a tactic called a “Roth Conversion Ladder”, where each year you convert just enough to cover predicted expenses 5 years hence.
If you have money in taxable accounts, you should usually withdraw that first before hitting your tax-advantaged accounts, since money in tax-advantaged accounts grows faster.
That’s a lot of info; I’ll summarize my recommendations on how to use retirement accounts in the section below on “Putting it all together”.
4. Index funds
An index fund is a pool of money that someone invests in a bunch of different assets, with the goal of having returns match an “index” of some kind. Usually that index measures the total value of some big market. Index funds are generally really good at tracking their indices—they just buy up a proportional share of everything in the indexed market. Because this is a really easy strategy to execute, they’re cheap to run. Plenty of providers will let you buy into their index funds, and thus you as a tiny investor can easily get an investment return that tracks the total value of a huge market. Providers will usually charge a fee, and the smaller this fee is, the better. I recommend vanguard.com; their ownership structure is designed to incentivize small fees.
I am not going to do justice to the theory behind index funds, so here’s the short and probably misleading version of why they’re such a good idea:
The performance of an individual stock is really hard to predict, even in the long-term.
The total value of the entire stock market is much easier to predict in the long-term—or at least it looks that way based on historical data. Inflation-adjusted, it seems to go up about 4-10% annualized over long enough time periods.
This fact is related to a math thing, where diversification (having lots of somewhat different assets) reduces risk without hurting returns.
Basically, picking individual stocks is a suckers game and no one is any good at it—though lots of people pretend to be. On average stocks are good, but any individual stock is an unpredictable rollercoaster that might eventually go bankrupt. But if you pick ALL the stocks, things smooth out into a blissful upward rise—at least, historically they do over investment time frames of 20+ years
The observation about diversification being good applies to basically any type of asset, not just stocks. The most popular assets besides stocks are “bonds”, and of course there’s index funds for them too. Bonds are (on average) a lower-risk, lower-return asset than stocks. The main way people manage risk-reward tradeoff in a portfolio is to mess with the proportion of stocks vs bonds. More stocks give higher risk, but also higher average return over the long-term.
So that’s all good, but which index funds should you buy? If you’re on Vanguard:
“Target Retirement Funds” such as VFIFX are one-stop shops that are hard to screw up. These funds hold a couple of other big stock and bond index funds, and automatically shift to fewer stocks/more bonds over time as you approach their target retirement date. VFIFX targets a 2050 retirement so currently has a more aggressive 90⁄10 stock/bond portfolio, but there are funds available for every 5 year increment. VTTVX targets 2025 and has a more conservative 60⁄40 ratio.
You could buy VTWAX (total world stock market) for a one fund stock-only portfolio. Lots of people would advise against having no bonds, however.
If you want to roll your own allocation, you could buy some mixture of VTSAX (US stock), VTIAX (International stock), VBTLX (US bonds), and VTABX (International bonds). You could start with the mix from a Target Retirement Fund and go from there—details are available on the fund pages. If you do this, you might need to occasionally “rebalance” to maintain your target percentages as some investments grow more quickly than others.
You could read countless arguments online about exactly what you should do, and then do whatever. As long as your strategy is “buy X% of some stock index funds and (100 - X)% of some bond index funds” it’s probably sane, although IMO X should be at least 50.
If you’re not on Vanguard, I recommend first figuring out what you’d do if you were on Vanguard, then finding the nearest equivalent on your provider. Vanguard is so popular that many online conversations are phrased in terms of its funds. Your 401(k) is probably not on Vanguard, but many 401(k)s now offer at least some Vanguard options anyways. If not, look for terms like “S&P 500”, “total US stock market”, and “US large cap”—these will all track relatively large stock market indices. You can Google to learn more about the distinctions if you want to optimize, and you can use your IRA or taxable accounts to help balance out the poor selection in your 401(k).
5. Don’t screw up
Don’t sell assets when the market crashes. Stock markets have always recovered after crashes, and then some. If you sell after a crash, the main thing you’re likely to accomplish is missing out on the eventual recovery—even if more crashing happens in the meantime! There will never be a clear signal of when you should buy back in, so when you do buy back in, it will only be after you’ve seen that the market has already substantially recovered. You’ll have missed out on that recovery. Just buy investments and then don’t touch them. Market crashes mean things are selling at a discount, which is great for you in the long-term! Keep steadily buying with your paychecks! Ignore market performance! The road to inner peace is to just admit that in the short-term you have absolutely no idea what the market will do and when it will do it. Just steadily invest and ignore short-term results. This is the most important point in all of investing. You are actually better off not investing at all ever if you end up selling during crashes.
The paragraph above exists because humans instinctually want to sell their assets during crashes. Note this about yourself and take precautions. You might try buying a few shares in some volatile stock for a fixed period of time—not enough to mess up your plans, but enough that a loss will hurt a bit. Just see how it feels when the value goes down substantially. Practice monitoring it daily, but only selling after the designated time period has passed.
If given all of the above you still predict that you’re likely to sell if the market crashes, try moving to a less risky investment allocation NOW before the market crashes. For instance, put a larger percent of your investments in VBTLX (total US bond market) or VFITX (intermediate duration treasuries). The maximally safe place to keep your money would be VMFXX, or even better a savings account at your bank. If you don’t take any risk with your money, however, you won’t get much reward. VFIFX has returned ~10% per year over the last 10 years, wheras VBTLX has returned ~4% and VMFXX has returned ~0.5%. Not having enough money to achieve what you want in the future is its own risk.
A less obvious way to mess up is to buy too much of the wrong assets. If you really want to buy an asset that’s not a stock or bond index fund, then just be careful not to buy too much of it. I’ll talk about four that seem to be popular: gold, other investment products, houses, and cryptocurrency.
Looking at historical returns, gold is just not a very good investment for its risk level—the same applies to its cousin silver. I think there’s some trend around buying gold related to fear of hyper-inflation/market collapse. I’ve not read anything that convinces me it’s a good idea; if you’re convinced, just keep the amount you buy relatively small.
“Other investment products” is a big category, but some common ones: specific stocks, ETFs that don’t track a large market index, actively managed mutual funds, various commodities, annuities, futures, option contracts, and whole life insurance. I’m pretty sure that 99% of everyone would be better off never buying any of these. But if you do, just don’t buy very much of them.
I mentioned houses when I talked about debt. But debt is not the primary reason I think houses are dangerous. Houses are dangerous because people tend to buy too much house. Even with a paid off mortgage, money you have invested in a house is money that’s not invested in the stock market. You could own a $500k house and pay 5k/year on repairs and $5k/year on property taxes—or, you could own $500k in index funds and safely withdraw $20k/year. That -$10k to +$20k spread is money you could use to pay up to $2.5k/month of rent. That seems pretty reasonable—until you step back and wonder whether you should be paying effectively $2.5k/month rent in the first place. Downgrading to a smaller apartment that costs $1k/month in rent would lower your necessary retirement investment by $450k, saving you potentially many years of your life. But moving from a $500k house to a $1k/month apartment can become too big of a psychological leap for people to even consider. So if you’re going to buy a house, I think you should try hard to buy a small/cheap one until you’ve achieved all of your other financial goals.
I have no idea what the hell is going on with cryptocurrency and it has consistently surprised me, so I think it’s completely sane to buy some cryptocurrency. As of this writing, cryptocurrency has a market cap of ~$1.6 trillion, with ~$1 trillion of that being Bitcoin. The total market cap of all stocks is ~$100 trillion, so overall investors are putting ~1% as much into Bitcoin as into stocks. So far, cryptocurrency has been extremely high risk and high return as an asset class. If you have a higher risk vs reward preference profile than the average investor, I can imagine going up to 5-10% crypto investment. However, I don’t think anyone really knows what’s going to happen with crypto—it may be a speculative bubble.
In all of these cases, I think it’s ok to make a mistake and buy the wrong thing, or to take a risky gamble that doesn’t pay off—as long as that thing is only a small portion of your investment portfolio! You’ll be totally fine whichever way the gamble lands if you use 10% of your disposable paycheck for a few months to buy Dogecoin. But if you sell everything to buy into a fad, and then the fad crashes, it will suck. Be ok with getting rich slowly.
Putting it all together
Given all of the above, here’s my detailed recommendations on how to invest:
Save an emergency fund of 1-2 months of expenses in a savings account.
Contribute to your employer’s 401(k), but only up to the matching amount. E.g. if they match half up to 6% of your salary, then contribute 6% of your salary. Use contributions to buy your choice of index funds. Default to just buying VFIFX if available.
Pay off high payday loans/credit cards/other crazy debt.
Increase your emergency fund to 6-12 months of expenses.
Pay off other debt (unless its interest rate is ~3% or less).
Put aside any money for large expected purchases (school, car, etc) in a savings account.
Max out your HSA if you have one. Buy your choice of index funds if it has that option. Default to just buying VFIFX if available.
If your income is low enough to be allowed to contribute, max out your traditional or Roth IRA. Pick traditional if you’re high tax-bracket, Roth if you’re low tax-bracket. Open one on Vanguard.com if you don’t have one. Use it to buy your choice of index funds. Default to just buying VFIFX.
Finish maxing out your 401(k).
Open a taxable brokerage account on Vanguard. Dump the rest of your investment money in here. Buy your choice of index funds. Default to just buying VFIFX.
Never look at stock market indicators and ignore all stock news. In principle, look at your total portfolio value every 6 months or so to check whether you have enough to retire. Never click the sell button.
Retire once you have enough.
Start converting some traditional funds to Roth if you’ll need the money 5 years from now or have space in lower tax brackets due to low income.
Sell and withdraw as needed, starting with your taxable accounts.
Keep your expenses the same modulo inflation.
Do whatever you want! Keep some level of professional activity / money-making to further reduce your risk.
Here’s another great flowchart that I mostly agree with, with more detail in certain areas: https://u.cubeupload.com/demonlesondledon/FIREFlowChart.png.
Conclusion
In its ideal form, this guide should become an extremely boring set of procedures and habits that you execute in the background of your life, taking up roughly 0.1% of your attention. Then as a consequence, at some magical future date far in advance of what it should be, you are freed forever from basic financial concerns. A boring set of procedures and habits that can grant you additional decades of freedom and autonomy strikes me as a surprisingly beautiful artifact. I’m not sure if this guide will live up to that ideal for anyone reading, but I hope it helps and makes your future just a little brighter.
Don’t discount bonds just because they have lower returns. They also have lower volatility. E.g. BND (Vanguard total bond market) has a Sharpe ratio of about 0.81, while VTI (Vangaurd total stock market) has a Sharpe ratio of about 0.56. That makes BND a better investment overall. If you had borrowed money to leverage BND up to the same volatility as VTI, you would have gotten a better return than from VTI alone.
Buying index funds is a much better plan than not buying assets, or using that money to buy liabilities. But I Can Beat the Index, and it’s not that hard.
The key concepts here are diversification and leverage. A portfolio containing both stocks and bonds tends to have lower volatility than either would alone. Both tend to go up over time, but they have a tendency to move in opposite directions (i.e. they are anticorrelated), so a lot of the noise cancels out. That means you can borrow money to buy more assets and get better returns than you could from either while targeting the same amount of volatility exposure as you would get from the portfolio of stocks alone.
And with further diversification of assets one can do even better. They don’t have to be anticorrelated. They’re helpful even if they’re uncorrelated.
Skimming that link, I think it shows backtesting; have you actually beaten the index yourself with real money? For what time period / amount of assets?
I mostly avoided leverage in this post because I don’t use it and kind of don’t trust it. But if I had to give a better defense of avoiding it, it would be because 1. it’s really easy to lose a bunch of money if you use it wrong and 2. I’m not sure there’s a reliable way to borrow money at low enough rates to get good results. Most of what I’ve read about leverage pretends the interest rate is 0, which it’s not—looks like Robinhood offers 2.5%? What’s the most reliable interest rate people can get, and does this rate kill results?
Definitely agree not to discount bonds though; without leverage, small amounts give you large risk reductions for small reductions in growth. I personally am 100% stocks because I’m preferring to maximize (unleveraged) growth, and have decided I can tolerate the increase volatility over 10-20 year time spans.
I am not rich yet. I haven’t been doing this long enough for my results to be meaningful. Ask me that again in five years. Or ten.
[Not an argument from authority; Yudkowsky just explained it well.] In the meantime, to the best of my knowledge, we should be using leverage, and weighting the bonds more heavily than the stocks. I’m confident enough in this that the bulk of my portfolio is leveraged bonds balanced against about half as much in leveraged stocks, and most of my savings are invested in my portfolio.
I agree that it is wise to be skeptical of backtests (as a rule of thumb), but rejecting them categorically is a mistake.
So let’s back up a step. Why be skeptical of backtests? Because any monkey can overfit to noise and make a backtest look good, but such a strategy is useless going forward. The more parameters in a backtested strategy, the more suspicious you should be. Wait, that’s an oversimplification. There’s a one-parameter equation that can exactly fit any scatter plot, but it might take hundreds of thousands of digits to do so, and getting even one of them wrong gives you a completely different plot. That’s extreme compared to even a run-of-the-mill overfit backtest. (Occam’s razor as typically worded is wrong, but Solomonoff fixed it for us.) So let’s say the more fine-tuned the backtest has to be to look good, the less likely it works.
So, how fine-tuned is my strategy? Well, how much can we perturb it before it breaks? (For the one-parameter scatter equation, it’s a ridiculously tiny amount.) For a typical overfit backtest, it’s bigger, but usually still pretty small. So,
Does it matter what year it starts? Not really, for the period when we have data.
Does it work if we scramble the order of the years? Pretty much.
Does it have to be
BND? No. Other long-term bond funds, e.g.TLTalso work.Does it have to be
VTI? No. Other stock market funds, e.g.SPY,IWM, andQQQalso work.Does it matter how often we rebalance? Not really. Once per quarter, once per month, or triggered at 10% absolute deviation all work.
Where’s the fine tuning? This strategy seems pretty robust. Is it the relative vol weighting? Targeting the same volatility as the stock portfolio alone? The easiest type of backtest would set this with the benefit of hindsight. But volatility is much more predictable than price. So I’m not very concerned. And indeed, a walk-forward backtest that dynamically weights based on a 1-month simple moving average of historical volatility to estimate future volatility also works. But 1-month is arbitrary, right? Maybe I fine-tuned that one. But 3 months works even better. And 2 months also works. And so does an exponential moving average. We can perturb that parameter quite a bit. A fixed 1:2 ratio of stocks to bonds the whole time also works. As does 1:3. No fine-tuning here.
Do we at least have a plausible explanation for why this strategy should work? Yes. Bonds are a “safe haven” asset. When stocks look scary, people look for “safer” investments. That explains the anticorrelation. And yet we expect both asset types to appreciate in value over time. Stocks pay dividends and companies get bought out at above-market prices. Bonds pay interest. They’re both pretty good investments in their own right.
Past results are no guarantee of the future, but I think it’s valid to use induction here. If we dynamically target vol, then if the anticorellation or relative ratio relationship breaks, we’ll still do OK.
Very true, and important. Overbetting is the second-fastest way I know to lose money in the stock market (after overtrading). Don’t bet the farm. Don’t bet over Kelly. I explained this in my link. But with reasonable precautions, leverage is pretty safe. Not 100% safe. After all, you can die in a car accident before you have a chance to enjoy your early retirement. Big index funds have not historically dropped to zero overnight. You would have had time to make adjustments in a crash. And there are relatively inexpensive ways to hedge against the extreme tail, like far-OTM puts or VIX calls.
But what are the chances that the optimal Kelly bet is exactly 1x leverage? On priors, for the stock market, I’d start with 2x. But you can do better with dynamic vol targeting.
Inflation is a drag. Taxes are a drag. And yes, interest rates are a drag when using leverage. Leveraging up is never going to improve your Sharpe ratio by itself, because leverage isn’t free. Some brokers are unreasonable here. You can buy a leveraged ETF and not bother with margin loans. These funds have the scale required to get the good rates. This even works in an IRA. It’s not as flexible as margin, but you don’t need it for this strategy.
For other strategies, you can finance with box spreads to get very good rates, even as a retail investor. These are more dangerous if you don’t know exactly what you are doing (and very safe if you do), but the more passive investors can just use the leveraged ETFs.
After reading around for half an hour, I think there’s a decent chance that some form of leveraged investing via e.g. ETFs might be a good idea. The basic idea makes sense to me.
This is currently completely out-weighed by my “being too clever in markets is a great way to lose all of your money” prior. But I’ll probably look into it more and see how convincing I find the numbers and historical evidence. If I’m pretty convinced I could see myself allocating 10-20% of my investments in a leveraged strategy at some point in the future.
A cursory look at box spreads makes me think it’s the kind of thing with so many caveats that I’d never feel certain I’d eliminated enough tail risk from it.
For posterity’s sake: I became convinced this is practically doable (using either treasury futures, leveraged ETFs like NTSX, or maybe options which I don’t understand as well) and probably a good idea/not very dangerous if done correctly. I think that fact is slightly info-hazardous for a couple reasons:
You shouldn’t trust most people to correctly advise you on financial products, to not be delusional, or to have your best interests at heart. So it’s hard to figure out exactly what to do. Index funds overcome this problem through the sheer size of their giant pile of empirical evidence and expert consensus; basically everyone agrees that they work as advertised, and no one reports getting accidentally burned using index funds—except when the whole market crashes, where they behave as expected.
If you learn that it’s probably a good idea when done correctly, you might feel obligated to go do it, and then you might do it incorrectly and foreseeably lose a bunch of money.
Because the pile of empirical evidence is less giant, it might not turn out to be such a good idea in retrospect, so it’s fundamentally riskier (even taking into account the risks people calculate). I’m sure someone would argue the pile is giant, but even if true that’s probably only the case if you’re sufficiently expert to judge more obscure evidence piles which most of us are not.
So I’d STILL recommend you not do this unless you’re extremely curious in this area, have no hang-ups, feel competent and trust your own judgment around things like intimidating financial products, have no track record of unwise gambling behavior, and have a stable enough life that if you fuck up you won’t be in a bad situation.
Here’s some resources. If you’re not interested enough to read and enjoy stuff like this, probably avoid doing this:
https://www.aqr.com/Insights/Research/Journal-Article/Why-Not—Equities
https://www.amazon.com/Enhanced-Indexing-Strategies-Utilizing-Performance/dp/0470259256
https://www.bogleheads.org/forum/viewtopic.php?t=143037
But I’ll probably do it myself and might write a blog post about it.
I’m a big fan of NTSX and have done a bunch of back tests to see how it would have performed in various conditions. In all reasonably long time periods that I simulated, something like NTSX had lower volatility and higher return compared to SPY. About a year ago I went ahead and replaced most of my US equity exposure with NTSX.
As a follow-up: I did this for a while, but I’ve become convinced there are a couple effects that make this not as good as it sounds:
Futures have taxes paid in the year gains are made, which significantly reduces returns in simulations I’ve run. In an ETF or mutual fund, you can instead let those gains ride.
Futures have an implicit financing cost, and portfolio performance is very sensitive to this cost if you’re using a lot of leverage (e.g. for intermediate term bonds).
Leveraged ETFs fluctuate a lot, and need to be rebalanced with the rest of your portfolio. This causes taxes like above. If you don’t rebalance, your leverage ratio changes which causes the portfolio to behave poorly as well.
With all of these effects accounted for, the gains from leveraging look very modest and depend a lot on what time period you look at. Given the risks, I’ve decided against it for myself.
Given those findings, is the strategy feasible in tax-sheltered retirement account? My backtests indicate that quarterly rebalancing is usually sufficient, even with leveraged ETFs, but it’s still worth intervening sooner when vol gets high.
In a taxable account, does tax-loss harvesting to offset your short-term capital gains help? You would rotate among leveraged ETFs. You can also indirectly reduce exposure by hedging with a different ticker rather than realizing short-term gains by selling immediately. You can either short-sell or buy an inverse ETF. LEAPS are also an option (heh), but you have to remember to roll them.
Investing everything in a single ETF (especially at a single brokerage) is possibly fine, but seems difficult to justify. When something looks rock solid in theory, in practice there might be all sorts of black swans, especially over decades (where you lose at least a significant portion of the value held in a particular ETF at a particular brokerage, compared to its underlying basket of securities, because something has gone wrong with the brokerage, the ETF provider, the infrastructure that makes it impossible for anything to go wrong with an ETF, or something else you aren’t even aware of). Since there are many similar brokerages and ETF providers, I think it makes sense to diversify across several, which should only cost a bit of additional paperwork.
Even if in fact this activity is completely useless, obtaining knowledge of this fact at an actionable level of certainty (that outweighs the paperwork in the expected utility calculation) looks like a lot of work, much more than the paperwork. Experts might enjoy having to do less paperwork.
(For example, there’s theft by malware, a particular risk that would be a subjective black swan for many people, which is more likely to affect only some of the accounts held by a given person. The damage can be further reduced by segregating access between multiple devices running different systems, so that they won’t be compromised at the same time, but the risk can’t be completely eliminated. Theoretically, malware can be slipped even into security updates to benign software by hacking its developers, if they are not implausibly careful. And in 20 years this might get worse. This is merely an example of a risk reduced by diversification between brokerages that I’m aware of, the point is that there might be other risks that I have no idea about.)
Great read; just one thing I’d add re the housing discussion which I think is sometimes neglected is that unlike essentially all other assets everyone is naturally short housing as they’re always going to need somewhere to live. As such buying a similar amount of housing as one plans to use in the future (this can also be done via investing disproportionately into housebuilding stocks or buying shares of various properties) can reduce your risk to future price increases (which historically have been large, especially if you value living in cities/desirable locations).
Housing could therefore be a sensible investment even if you thought an index fund would yield slightly higher returns. This effect is further heightened by the fact most individuals have extremely limited access to leverage unless buying a house and the tax advantages associated with a mortgage too.
I roughly agree with this. My biggest concerns around buying housing are:
The transactional friction of buying/selling homes causes opportunity costs.
People tend to buy too much due to low-interest credit.
But you correctly point out upsides that I don’t dive into.
Too often I see discussion of buying a house from purely a mathematical/investment perspective. I agree that the numbers need to be top of mind for this type of purchase… however these discussions neglect the non-tangible aspects of home ownership that are very real and important. Sense of physical security, familial bonding, community involvement—all can be increased with home ownership.
The intent isn’t to neglect these advantages; rather, I (probably wrongly) assume that everyone is familiar with these advantages—this is my intent in noting the psychological difficulty of dropping from a 500k home to a $1k/month apartment.
The intent is instead to bring to attention the nature of the financial trade-off. I use a pretty simple model, but you can dive into the counterfactual yourself: what’s the price you’re paying for owning your home instead of owning an index fund and renting? How low could you go on rent, and what would be the impact on your financial life? Is that tradeoff worth it to you for the advantages
The answer can certainly be “yes”—but I think people are biased toward assuming yes when they haven’t actually examined the issue.
I’ve seen the advice to buy only if you plan to be in the area for ten years and that if you do buy, to get the longest term fixed mortgage you can, with the monthly payment at what you’d be willing to pay in rent
The rationale is that since the bank can’t call it in at any time (like they could in the 1930s), you can live there as long as you’re making the payments. If the house has appreciated in value when you’re ready to move, sell and receive the equity. If the house has declined in value, the mortgage is only collateralized by the house (is this typical?), so either convert it to a rental property (with a rent rate that brings mortgage plus maintenance to breakeven) until the market recovers, or just walk away from it and view the money spent as ‘rent’ paid to the bank instead of a landlord.
On the topic of housing: this is going to vary very widely from market to market and person to person, but I want to bring up a few points.
A home is primarily a place to live, not an investment. Don’t spend more on a home than you comfortably can just because you see it as an investment
If you have skills to do repairs and improvements yourself, or can acquire such skills, this can let you buy much cheaper, and/or sell higher if you do so carefully and thoughtfully (buying something you like that most buyers in your area don’t, or renovating in a way that will appeal to many buyers).
Leverage. On average home values in your area may only go up 3% a year or whatever (in my region it’s been slightly higher since the time I bought in 2014, and much higher in 2020), but I bought my house with 5% down (20x leverage) at 3.5% interest. In addition, my mortgage + interest + PMI for the first 2 years + higher utilities was still less than I’d previously paid in rent for a two bedroom apartment, even before accounting for the equity I was building. By the end of year 3 I’d more than made up for the transaction costs of buying and (at some point) selling. Also, I had more space, no landlord, and no annual rent increases.
Legal protections for owners in some states are different than those for renters. In my state, up to 500k in home value is protected from seizure if you declare bankruptcy, and from many types of liens. In some states, homeowners have their annual property tax increase capped.
Capital gains: 250k (500k for a couple filing taxes jointly) is exempt from federal capital gains tax when you sell your primary residence. This may not matter if you’re comparing to an IRA or 401k, but it matters when comparing to sales of investments in a normal brokerage account.
Income taxes: In previous years the mortgage interest deduction made a difference to me of a few thousand dollars a year, but when they raised the standard deduction to over $12k/person and capped the deduction for state and local taxes, I stopped being able to benefit from this (I would still gain some benefit if I were single, or if I lived in a more expensive house, or if I had lots of other deductions I could claim).
And on emergency funds: right now my emergency fund is smaller than I’d like, but I also have a low-interest HELOC I know I could borrow against if I needed to, without locking up as much cash (which matters to me because in the meantime I can use my cash to pay down other debts). I am planning, early next year, to sell the house and greatly reduce my fixed monthly expenses in order to pay off my remaining debts and start saving a lot more. Once I do so, I will need a significantly larger emergency fund than I have now.
I made a simple spreadsheet recently to help project my future net worth based on market returns and expenses. It takes as input your current net worth (the asset class breakdown is just informational), recurring expense categories and predicted inflation rates for those categories, predicted one-off expenses, predicted future year income, and S&P 500 history, and simulates potential outcomes based on simple models like “if I earned 8% yearly” or “if I started in 1980 and owned the market.”
The main reason I did it instead of using existing tools (e.g.) is that most existing tools seem to think I will constantly work until time T and then “retire” and never work again, which makes zero sense to me unless you assume there is some time T where I suddenly get a giant windfall of money, or unless you assume that I value each marginal dollar at infinity until I am unemployable or dead. I want to be able to play with questions like “what if I don’t work until my kid is 10 years old, and then resume working.”
Some notes:
To spend little, move to a country or region with low living costs. To earn much, work in a country or an industry with large salaries. For best effect, combine these via remote work, or work for a global company which (like some giants) offers US-competitive salaries outside the US. Some companies also help existing workers with relocation.
In many industries and careers, early retirement can be very hard to reverse if you decide to return to work many years later. Your knowledge and skills won’t be up to date, your resume will be suspicious, and some professional licensing boards (eg medicine) may revoke your license after some years of unemployment.
The future is hard to predict. Your assets may lose value. Your cost of living may rise (eg more expensive housing, new medical costs, changes to housemates). You may want to spend more money on new products invented after your retirement (eg the Internet, flying cars). You may just want to change your lifestyle, or go on more vacations.
In such cases, it will probably be easier to increase your income (or reduce your expenses) if you’re still working, compared to returning to work after having retired. And so, when planning to retire on $X savings, it’s dangerous to set X to exactly what you calculate you’ll need. It’s safer to save more, perhaps much more, than you think you’ll strictly need, before retiring.
Re: 1., I’m personally unwilling to move outside the U.S. but agree it could make sense if you can make it work for you while maintaining a high salary.
Re: 2 and 3, I completely agree. I think in particular about longevity medicine as a potential future expense. You can certainly build up support for higher-than-current expense levels to address these risks. You might also retire to less profitable or more risky activities that you find more enjoyable (but that supply >0 income), or simply stay in your current profession—but with the advantage of having higher option value.
Two notes:
I’m in a pretty high tax bracket, but I still do Roth IRA/401k contributions. This is because if you are maxing out your accounts (which if your goal is “early” retirement, you almost certainly will be) you are protecting more real dollars from taxes. The contribution limits are the same regardless of whether you contribute on a traditional or Roth basis. If I can protect $6000 and never have to pay taxes on it or protect $6000 that I’ll eventually have to pay taxes on, I’d rather take the tax penalty now and protect more real dollars. I never see this discussed anywhere, but it’s my primary motivating factor in doing Roth. There is also the flexibility consideration which you mention. (There are also more advanced strategies such as backdoor Roths and mega-backdoor Roths that you didn’t really touch on, but they’re not super important.)
One thing you don’t discuss is the tax advantages of owning a home. All interest you pay (in the US) is tax deductible. Commentary on the prudence of that aside, it doesn’t seem likely to change any time soon. Besides which, interest rates are currently so low that it probably makes sense to finance other items as well, even if you have the ability to pay for them out of pocket. But I’m not up to speed on car/student/etc. loans, so that might not be true for other asset classes. My recently refinanced interest rate on my home is 2.5%. At a rate like that they are literally giving money away, if you assume 3% inflation every year (admittedly a debatable assumption). If you are risk-tolerant (most people aren’t risk tolerant enough, remember) you should generally be happy to finance debt to invest the returns in the market.
Note: As of 2017, mortgage interest is (effectively) no longer tax deductible for families, because the Standard Deduction was increased, making all deductions that aren’t given special treatment moot (cash contributions to charity have a special call-out, and there may be others like student loan interest—consult your tax professional, I am not one).
If you are single, and have a large mortgage, the amount of interest(and other deductions like property taxes) over your standard deduction does provide some tax advantage.
This was a bigger deal back pre-2000 when mortgage interest rates were ~6% instead of the ~3% they are now: prices have gone up, and more of the monthly payment is non-deductible principal, not interest.
Is this true? I don’t think it is. From irs.gov: “You may deduct charitable contributions of money or property made to qualified organizations if you itemize your deductions.”
From https://www.irs.gov/newsroom/how-the-cares-act-changes-deducting-charitable-contributions
Here’s how the CARES Act changes deducting charitable contributions made in 2020:
Previously, charitable contributions could only be deducted if taxpayers itemized their deductions.
However, taxpayers who don’t itemize deductions may take a charitable deduction of up to $300 for cash contributions made in 2020 to qualifying organizations. For the purposes of this deduction, qualifying organizations are those that are religious, charitable, educational, scientific or literary in purpose. The law changed in this area due to the Coronavirus Aid, Relief, and Economic Security Act.
The CARES Act also temporarily suspends limits on charitable contributions and temporarily increases limits on contributions of food inventory. More information about these changes is available on IRS.gov.
Three hundred dollars is a pretty minimal deduction. I expect there are at least a few effective altruists on here who have significant enough charitable contributions that it still makes sense to itemize deductions even with the increase in the standard deduction.
Mentally, I categorize “donating half your income” as “exceptional circumstance” and trust people in that 1% sliver of the population to make the right choice for them. Also, too, heavy donors probably aren’t the same people looking to retire early
I only give 10%, but that is enough to make itemizing deductions worth it for me, when combined with my mortgage interest. I am also looking to retire early (or at least become financially independent and increase donations substantially). Good financial advice is always relevant to everyone.
Re 1: This is a good point; I did the math on this at some point for myself and ended up still landing on traditional by a large margin (even though I wanted it to turn out pure Roth for simplicity). But it’ll be dependent on your expected tax rates, opportunities for low-tax conversion, and your retirement timeline (more tax-advantaged money dominates on longer timelines).
Also yeah, I skipped backdoor and mega-backdoor to keep things simple. The goal was to give people a linkable 90⁄10. The outcome I was aiming for is that people read, get the important parts of the memetic package, and then some of them will dive in more to find things like that for themselves—for instance, they’re mentioned in the flowchart I linked.
Re: tax advantages of homes, yeah . Homes are probably a better long-term expected value than I make them sound for this and other reasons. Still, transaction costs suck, and I think they stop being a good idea if you buy/sell them too often—I’ve heard you need to hold ~5 years on average to break even on transaction costs vs mortgage advantage, but haven’t done the math myself. I am biased toward the flexibility of being able to change my physical location in order to take better jobs, decrease my commutes, decide to decrease my expenses, etc. If you do buy a home, you can ameliorate these concerns by just buying a small home so that you can more easily decide to eat the proportional transaction costs if necessary.
Re: financing things at low interest rates to instead invest in the market, I agree this is correct to maximize expected value but 1. it’s not all that big of an impact for things smaller than a house or new car and 2. I think most people would do better by avoiding the over-spending tendency that credit brings, and the negative psychological effects of future spending obligations. If you’re buying a house or new car regardless and can get a low interest rate, I agree you should take out low interest debt instead of buying it with cash.
I wonder if there is room for Bitcoin in this early retirement strategy. Or any high risk investment, like self picked stocks. What percentage could be safe to invest recklessly?
Bitcoin is just a bit over 5% of my portfolio at the moment. I’m using the same dynamic volatility targeting I use for the stock and bond ETFs, but because of its sky-high volatility, that means I have to leverage down. BTC has historically been (mostly) uncorrelated with the stock market, which makes it a powerful portfolio diversifier.
This means that your portfolio’s overall volatility can actually be made lower by adding the extremely volatile Bitcoins to the mix, counterintuitive as that may seem, but only by adding them in sufficiently small amounts.
Bitcoin is (by design) very deflationary, which can make it a good investment in the short term, but I fear the risk of total collapse in the long term can’t be ignored. But at only about 5% of my portfolio, Bitcoin could drop to zero tomorrow, and I’d still be OK. In the meantime, I’ll be pulling out money as the bubble inflates by keeping my volatility exposure to it balanced in my portfolio.
Crypto started off like 5% of my portfolio. Now it is like 70%. I have actually been selling crypto lol.
Is that because your portfolio’s crypto ratio inflated that much on its own before you started rebalancing, or did you sell other assets to buy that much more in crypto?
This is mentioned in the “don’t screw up” section. By market cap, crypto was 1.7% as big as the world stock market, and Bitcoin 1% as big, so those seem like good starting points—adjust from there for your desired level of risk vs reward.
IMO, self picked stocks are dumb. You give up diversification benefit for no reason, unless you think you know better than the market (which you don’t).
I think it’d be good to add an endnote mentioning that while saving for your FIRE number is relatively straightforward, withdrawing it can be much more complicated. I know my intuitions didn’t serve me at all when thinking about that phase. https://earlyretirementnow.com/2018/06/27/ten-things-the-makers-of-the-4-rule-dont-want-you-to-know/
This is a good guide. Thanks for writing it!
I wanted to comment on one important aspect that people sometimes feel uncomfortable about. That’s the assumption that you need to save roughly 25x your annual expenses to survive on the proceeds. Or in other words, you can approximately support a 4% spend every year from your savings. People are often uncomfortable with this rule of thumb since there’s so much uncertainty built into it about how the market will do. But it’s possible to completely do away with this uncertainty at a traditional retirement age by instead buying a Single Premium Immediate Annuity (SPIA). Here you just fork over your savings at (say) age 60 to an insurance company, and they’ll just pay you 5% of what you gave them for the rest of your life. It’s a guaranteed return independent of the market. The exact number (5%) will depend on your age and gender. But you’ll often get more than 4%, because you’ve given up your principal to the insurance company and there’s nothing to leave to your heirs. So you may not want to do this, but it’s good to know at least that in the worst case, when you turn 60 if you have saved X dollars, you have the option of getting (say) 5% every year until you die.
I would worry about the counter-party risk with annuities; if a single company goes out of business, you might be bust. Even if you distribute across many companies, I’d think it’s more likely that the whole sector goes bust than that your portfolio devalues to 0 in some other way.
For that reason I’d lean toward not putting too much of my assets in annuities—but maybe it works out so that the counter-party risk is smaller than the risk of running out of money otherwise.
The fear is not that the stock market goes to zero, just that it rises slowly enough that withdrawing 4% leads you to deplete your portfolio before you’re dead. Ending up in the horrible situation that you have no money and are still alive. Even proponents of the 4% rule will say the simulations only show that you don’t run out of money (say) 90% of the time. There’s a decent 10% chance that you will run out of money. The original 4% calculation was done during a great time in US market history, so I’m not sure how optimistic I am about that being the case in the future.
Anyway, that 10% risk has to be compared to the chance of the insurance company not paying out. You can of course spread out your annuity into 4 different insurance companies, say. But even if you don’t, just like your money in your bank account is safe (up to a certain amount) even if your bank goes out of business due to FDIC insurance, and your stocks/bonds are safe (up to some amount) even if your broker goes out of business due to SIPC insurance, there’s an equivalent for insurance companies. All states in the US have state guarantee associations that back at least $250K of present value of annuity benefits. See here for more: https://www.annuity.org/annuities/regulations/state-guaranty-associations/
I’m not saying annuities are a great idea for everyone. But they might be a good idea for those who are risk averse enough that they don’t trust the 4% rule and want guaranteed (up to some major system collapsing event that causes even the state guarantee associations to fail) income.
Learning about the existence of state guaranty associations has decreased my sense of how big I think the counter-party risk is; thanks for sharing this.
Re: running out of money, I’ve added a section on the risks of retiring too early to address this concern in more detail. I now agree that annuities might be a good idea to address this if you are old enough, and I was probably overly worried about counter-party risk.
Re: the 4% rule, it is indeed more of a guideline than a guarantee. More details are available here: https://thepoorswiss.com/updated-trinity-study/. The link shows a 100% stock allocation with a 3.5% withdrawal rate has a historical 98% success rate over 50 year periods starting from 1871 -- if you are never going to generate income again and are never going to increase real expenses, you may be able to buy quite a bit of safety by going to 30x instead of 25x and holding a 100% stock portfolio.
3.5% might be safer, although I should have emphasized that I’m skeptical because the link you gave assumes you’re invested in only US stocks. This is hindsight bias because it so happened that the US market beat the world market in the last 50+ years. A more unbiased calculation would use a world market index (something like VTWAX instead of VTSAX).
And also maybe one should do the analysis without assuming that your home currency is US dollars, to avoid the bias that the US has been very prosperous in the past century? Not so sure about this. Maybe everyone should redo the analysis using their own home currency (e.g., Canadian dollars, Euros, etc.) and then decide what X% they can safely withdraw in retirement.
Great point; I agree. Also a great example of missing an obvious risk; I hadn’t noticed that before linking.
The calculator here allows simulating withdrawal rates by asset allocation, although it only has data back to 1970 so is a bit limited. I get the same safe withdrawal rate (4.3%) for 30 year retirees using either 100% US or 50⁄50 US/ex-US over that time frame. 100% Japan had a 1.5% safe withdrawal rate.
That’s quite interesting! What was the stock/bond allocation in your examples that gave you a SWR of 4.3%?
100% in US stocks gives a SWR of 4.3%;
Good compilation, I more or less agree with the suggested prioritizations and such. One thing that I think may be worth a sentence or two in the appropriate section: management fees for the various funds in employer-sponsored retirement accounts vary widely. While aiming for Vanguard will generally result in a low management fee, if some 401k plan doesn’t have any Vanguard funds, the next best heuristic to choose between various index funds is whether the management fee is under 0.1%/yr (assuming it fits your other criteria w.r.t. diversification, etc). The target-date funds that are commonly pushed by the 401k administrators often have absurdly high fees (1%+) which eat into returns a lot.
Technically, you could also just… die soon. (Early Retirement Actually-Extreme.)
Jedi mind trick: If you feel like an imposter, tell yourself it is your moral duty towards the society to remove yourself from the workforce by early retirement as soon as possible.
More seriously, no matter how incompetent you are, I assure you that there is a person who doesn’t know half of what you do, and makes at least twice as much money, in the same profession.
If you don’t have a network, the first thing you can do immediately is make a list of colleagues you have good relations with. Write a short description of your relationship (you may forget it 10 years later), and ways to contact them other than the company e-mail: private e-mail, private phone, pages on social networks… (The more the better, because some of these may not be valid in a few years.) This is the list you will call 10 years from now, asking: “Hey, how are you? Where do you work? Do you like that work? Is your company hiring?” If you are still at school, write a list of your classmates.
If for whatever reasons you find yourself psychologically unable to follow this strategy, a possible alternative is saying 1.5 × your current salary. (Make it 2 × your current salary if you are less than 5 years out of school.) It is a number even a shy person should be able to say with a straight face. You can practice it with a mirror.
Some companies try the trick with “fixed part of salary + part that depends on performance”. (Spoiler: at the end of each year they will say “well, this was an exceptionally bad year, so we are not going to pay the performance bonuses.”) In that case, ask for 2 × the fixed part of your current salary, and then agree that 25% of that number can be the performance bonus. This will make both sides happy.
Also, you will be less tempted into buying all kinds of small insurance, that people will keep pushing on you. As a rule of thumb, self-insurance (that is, if the emergency happens, you solve it by taking the money out of your emergency fund) is cheaper than insurance.
I found my favorite strategy for responding to salary questions on r/negotiation several months back: “Right now I’m focused on trying to figure out if this job is a good fit for the direction I want to take my career. If we both decide it is, I’m sure we can come to an understanding on salary.”
Then, if they press: “Well I don’t think it’s fair to consider just salary in comparing job offers. I’d have to look at a total holistic benefits package to fairly compare two offers.”
Then if they insist: “Look, you and I both know that my naming a desired salary puts me at a negotiating disadvantage. Please don’t ask again.” At this point, you probably don’t want to work at this company anyway.
A few comments on aspects I think under/not noted.
Always take advantage of any company matching program. If they have a good employee stock purchase plan that too can be free money. (But don’t put all your eggs in the company basket!)
People really need to think about what their spending will be during retirement. It will not be the same as during your working years. I think the comment about choosing where to live also factors in here.
We don’t really need to split our plans into working-retired in my opinion. For some (many?) maybe but choosing your career and who you work for or with should be considered. If you really enjoy what you do how is working really different from retiring? Or perhaps more relevant, how is working with 40+ years of experience and competence, and some of the perks that come with that, in an area and with a company you really enjoy? Moreover, negotiation around what flexibility one has, either hours or in locations is something to consider as one moves through their career as it relates to the retirement life they envision.
I think perhaps sometimes the retirement focus on the financial aspects only could miss some important aspects of that retirement as well as reduce the options set considered for accomplishing the more general goal of achieving those “golden years”.
Good points—don’t forget to diversify your life: you’re already putting a lot of eggs in the basket of “my employer does well enough to not have to lay me off”—no need to double down with an equity position in the same company.
There are a number of ways to half-retire. If you’re valuable enough, your employer might be OK with keeping you on with reduced hours & proportional reduced pay (could be either fewer days/week or months on leave each year). In some fields you can become a consultant/contractor and just work one 3-6 month project every year or two. If you were keeping your expenses at 1⁄2 your salary, going to half-time once you have ~20x expenses saved can bridge you to full retirement with less risk (you stop contributing new $, but don’t draw down)
Got anything on optimal rates of annual spending?
If I’m reading this correctly, one should identify an optimal rate of spend, acquire as many multiples of that rate as possible, and invest everything above it.
I conceive of needs using the a ‘STIMS’ concept. Everyone needs shelter, transportation, income, medical, and social engagement for themselves and their dependents. I class things like servants to ‘buy back’ your time as ‘social’.
I wonder what the numbers for all of those that hit the point of diminishing returns are. Arguably, thanks to veblen goods, social can really grow without limit, and medical at the extreme end can probably get pretty high (100 million dollar endowments for a family member’s medical condition a la ron perelman)