Money Toolbox

Investing for Early Retirement

If all you did on your quest for financial freedom was increase your income and decrease your spending, you’d make slow and steady progress toward your goal. But your progress would likely be too slow to ever reach financial independence or to retire early.

Fortunately, there’s an easy way to accelerate your saving: smart investing.

To start, it’s important to understand that if you choose not to invest, because of inflation you actually lose money. Even low rates of inflation gnaw away your nest egg over time.

21 Years of Inflation (from Carpe Diem)

Most people know they should invest for the future, but many are scared to start. It seems complicated and overwhelming. Investing doesn’t have to be difficult. You can invest on your own and receive reasonable returns, all with a minimum of work and worry.

One smart, easy-to-understand investment strategy for early retirement is to buy and hold index funds. Put as much as you can into these funds – and do it as soon as possible. Contribute to tax-advantaged accounts – such as your IRA and 401(k) – before funding taxable accounts.

Although you’ll put most of your money into a low-cost stock index fund such as VFINX or VTSAX, you’ll want to spread the risk by putting some of your money into a bond fund like VBMFX.

How much should you have in bonds and how much should you have in stocks? There’s no universal answer to this question.

One common guideline is to use a 60-40 split: Dedicate 60% of your investment portfolio to stock and the remaining 40% to bonds. This so-called balanced portfolio allows investors to enjoy long-term market gains while softening the blows that come when the market crashes.

Whatever asset allocation you choose, it’s important to understand one thing. Research into sustainable withdrawals during retirement shows that in order to maximize the longevity of your wealth snowball, when you quit work you should have at least 50% of your portfolio in stocks, but no more than 75%.

This strategy isn’t just great for investing novices. Even market professionals endorse it. In his 2013 letter to shareholders, for instance, Warren Buffett outlined what will happen to his vast wealth when he dies. Most of it will go to charity; some will go to his wife. How will his wife’s money be handled?

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors…”

If all of this seems too complicated, it’s still possible to follow a passive indexing strategy through the use of single stand-alone funds.

Most fund companies offer what are known as “target date funds” or “lifecycle funds”. These funds are intended to age with account holders. If you aim to retire in 2040, for instance, you’d pick a Target Date 2040 fund. Today, that fund might comprise 85% stocks and 15% bonds. As time goes by, its asset allocation will become less aggressive. By the time 2040 rolls around, it might be split 50/50 stocks and bonds.

Here’s one thing you should know about these funds, though. They’re balanced for average risk tolerance. If you already know that you’re not comfortable with a lot of risk, pick a target date fund intended for somebody older. Don’t pick the Target Date 2040 fund; pick the Target Date 2030 fund instead. On the other hand, if you have higher risk tolerance, you might be better off with a more distant target date.

Are there alternatives to index-fund investing that might provide similar returns? Sure. But these approaches require greater education, sophistication, and attention on the part of the investor. Unless you know for a certainty that you have this education, sophistication, and attention, you’re better off sticking with index funds. A solid rule of thumb is this: “If you have to ask what to invest in, you should almost certainly stick to index funds.”

If you’d like a more thorough discussion of the virtue of index funds, I highly recommend the book The Simple Path to Wealth by J.L. Collins. (The material in this book is also available as the stock series at Collins’ website.)

Additional Resources

Finally, here’s a list of additional resources if you’d like to learn more about the concepts in this lecture. First up, here are some books on this topic:

If you’d rather read material on the web, here are some related articles:

And don’t forget: If you’d like some general resources for financial independence and early retirement, I’ve created a page here at Money Toolbox that links to useful FIRE apps and tools.