I have a soft spot for get-rich-quick schemes that promise to generate you passive income. I have to admit it. Passive income is that most ultimate of incomes, where your previous investment of time/money pays off endlessly into the future without requiring any further investment from you. Always, though, when confronted with such a scheme, I pull myself back from being sucked in. I didn’t buy a Bitcoin mining rig. I didn’t sell life insurance to my friends, though I was briefly licensed to do so. Despite working in marketing, advertising and I maintain a fairly cool relationship – I see that it powers the internet, but that wins it only grudging acceptance into my life. I once earned a payment of around $1.24 for an article of mine about bowling on a now discontinued rev-share site, which took several years to accumulate enough the necessary views to hit that payout. That’s the only time I’ve received payment from ads.
In each of these cases, a rational look behind the curtain made it clear that it wasn’t worth my time or interest.
But as I watched the views trickle in for that article five and ten at a time, I thought to myself, oh boy, this is the start. The passive income is a-comin’. If I just churned out an article this successful every day, the sky’s the limit! Of course, while I like bowling and enjoy writing, I do not enjoy churning out content for content farms and had no actual interest in turning myself into a content farm. So it didn’t happen, and I’m not sad about that. Still, the dream of finding a way to generate passive income remained with me. It’s the holy grail for someone who wishes to eventually free themselves from a financial obligation to work.
Last fall, I discovered Mr. Money Mustache and it changed my relationship with money. Suddenly the dream of passive income was attainable, and in fact near certain, thanks to a magic elixir of Vanguard index funds and compound interest. Yet one of the reasons I kept away from the other tempting ideas was that they seemed to appeal primarily to my emotions, providing a great boon to my hopes and dreams of being in control of my financial destiny without it really being very clear that they would actually succeed or make me happy. As someone close to me said when I first talked with her about index fund investing, “if this really works so well and so reliably, why isn’t everyone doing it?”
If you had asked me last summer about investing in the stock market, I would have told you that was risky behavior, that most people lose money and that it’s not something I’d do without tons of excess money laying around. Mere months later, I was advocating plunging every spare dollar not required for a safety net into these funds. Even now, with one of the “unlikely” safety net situations met (ahem, I am unemployed), I am still doing my best to grow my stash, even if just incrementally. While I feel extremely confident about doing this, it occurs to me I might be too confident… am I just clinging to a dream? It’s time to pull back the curtain and take a good long look at my plans for FIRE, and determining if it truly makes logical sense.
MMM and others have gone into this at length – here’s a link to a do-it-all MMM post you can take a look at for his take, some of which I will probably be repeating. Rather than trying to explain everything from the ground up though, this post is an effort by me to convince myself – and perhaps you, possibly skeptical reader – that my plan, in addition to being incredibly attractive, is actually realistic. This is my take from my perspective, but it should easily work for others.
The plan, in short, is to amass savings in low-cost Vanguard index funds. These funds have historically reliable performance over time because they essentially track the overall market at large, which over long time horizons, has never done anything but go up. Aside from generally investing in well diversified funds, I will continue to help myself thanks to the low fees that passively managed funds charge, the availability of tax-advantaged retirement vehicles, and a reduction in my overall expenses. Based on fancy math, when my portfolio is equal to roughly 25 times my annual expenses, I’m done, and more or less set for life. Projections based on my previous and not particularly large salary imagined I could hit this in 25 years, or likely less.
Let’s test these assumptions. Does my story check out?
Low-cost Vanguard index funds will perform well over time. This is the key assumption, allowing me to view investments as a safe and reliable vehicle for retirement. The stock market is well known for its volatility, full of sharp rises and falls, yielding more losers than winners. In fact, even when people choose good funds like the VTSMX, the behavior gap causes many to sell low and buy high, and they never enjoy the rather excellent 8%+ rates of return. However, the fact of the matter is that the market as a whole really has always risen steadily over time. Go ahead and input any years you want into the excellent IndexView, and you’ll see the S&P 500 has an excellent track record. It’s a great place to park your money, and it’s even better when you include reinvested dividends, which is an easy aspect to forget about, and will usually add 2%-3% to your returns annually.
But is investing in one fund truly diversified? What about stock/bond splits, mutual funds, REITs, junk bonds? In one sense, the answer is simply yes. A fund like the VTSMX is designed to broadly represent the entire US market, consisting of holdings in over 3800 stocks across a wide range of industries. Many individual companies have come and gone, but the market remains a solid bet over time, and funds like this make it easy to invest broadly in the market for as little as $3000. Traditionally a higher allocation of bonds has been recommended as people get closer to retirement, since they offer less volatility at the cost of less growth. While there’s nothing wrong with holding a small percentage of bonds as a hedge during the accumulation phase, over extended periods of time – even through stock market crashes – a 100% equities fund comes out on top. You can test this at the spiffy calculator cFIREsim, easily adjusting the percentage of bonds or equities in your theoretical holding. For an investor like myself who is early in the accumulation process, I have no qualms about investing in just one fund like this. As my assets grow, I intend to do more research about diversifying into global markets (as a hedge against America losing economic super-power status, and a corresponding shift of growth to international markets) as well as into REITs, as I’ve heard that’s another good way to broaden your exposure. As I near retirement I will probably add some bonds into the portfolio as well. For now though, all that’s on the back burner.
Ok, so we’ve determined that a single equities index fund can be a safe and smart starting point for an investor seeking FIRE. Still, why Vanguard? The primary reason is the fees. Head back over to that VTSMX page and notice the expense ratio of 0.17%. Amble your way up to $10,000 in investments over time and you can upgrade to “Admiral Shares” and invest in VTSAX, an identical fund with a miniscule 0.05% expense ratio. The expense ratio is essentially a fee the fund managers take right off the top of your investments. Many actively managed mutual funds recommended by financial brokers charge 1%-2% or more, but when you study their returns over a long period of time, they usually fare no better (or sometimes worse) than the market as a whole. On top of that, many brokerages will charge you annual fees and other nonsense just to hold your cash for you. Vanguard, so long as you are ok with getting your statements via tree-saving email, doesn’t charge you a penny to hold your investments. I’ve gotten good support from Vanguard and it’s been simple to set up recurring investments online with little fuss. There are other good places to invest in quality index funds – a trusted friend invests with Fidelity – but I use Vanguard.
As for the tax advantaged accounts, I currently make exclusive use of a Roth IRA (though I did contribute to a 401k when I had one). Given the length of this post and the fact that I have considered dedicating a post of its own to the subject, I’ll just say I love it as a place to start because your principle is 100% liquid, so it lowers the risk for investing even if you lack large reserves and are concerned about possible expenses that your safety net won’t cover, while still netting you tax-free growth. If you have said reserves, it’s more debatable whether it’s the “smartest” place to put your money from a tax perspective. If you’re new to tax-advantaged accounts, I wrote a longer article describing them all on HubPages a while back.
Now, what about the fancy math part of this? If you looked at the charts and calculators I’ve linked to above, you can see that over time, the market has reliably grown. An oft-cited paper called the Trinity study analyzed seventy years of stock market history, including the Great Depression, and found that a withdrawal rate of around 4% would have been a safe withdrawal rate for an investor over a thirty year period. This study was authored in the 1990s, but looked at more recently by an economist named Wade Pfau. I am stealing this idea directly from MMM, but here is a handy chart made by Wade that details the historically safe rates of withdrawal for a balanced portfolio.
As you can see, the chart never dips below 4% – much of the time it’s actually higher. The 4% rule has come under fire in recent years, including by Wade himself, citing all-time-low bond returns. We have several advantages over the Trinity study however that may leave it intact – for instance, we’re not robots and know how to adjust our spending during down years, and the Trinity study also assumes you never earn another dollar in your life, which is probably not the case for virtually anyone, even if it’s just what’s left of social security. Still, maybe 3.5% is the new safe withdrawal rate. If that’s the case, instead of needing 25 times your expenses, you need about 28.5 times. If we assume that by the time you’ve hit 25 times, you’re generating average returns equal to just under your expenses, plus still investing your income, it’s likely this will only add another couple of years to your working life. I am 100% in favor of playing safe and saving beyond any imaginary “minimum lines,” but for me this is all still a long time a way. I’m focused on getting the snowball rolling, and the exact size it has to be when it’s all said and done is a debate I can settle a little later. The point is, as a rough estimate, it is reasonable to think a withdrawal rate between 3% and 4% should last through retirement, and probably quite safely. This is based on all the best estimates of very smart economists, and on the fact that I am not a machine and will be able to adjust to the times as needed.
Lastly, was 25 years ever a realistic timeline? As I start to answer this question, I want to pause and recognize that it’s a distinct privilege to even be able to contemplate the idea of early retirement. While many may be able to reach it and don’t know it, many others face unique challenges that make this goal particularly difficult if not impossible to achieve. I am fortunate in that I am a relatively young, healthy person who had two loving parents and a good education, from which I retain no debt. I originally began to assemble data from the US Census and other places, hoping to speak broadly of averages, but while that research may find its way into a future post it quickly began to feel off topic. The point is, I looked at calculators like cFIREsim and FIRECalc, and based on my income and expenses, 25 years checked out as realistic. Buoyed by the hope of a steady annual raise and plans to chip away at my expenses, I was optimistic I could make that number look safer and even reduce it. Though the pink slip changed that, I remain optimistic in the long run. (By the way, the very short version of my research: Take the per capita disposable income of an American, reduce the per capita expenses by about 15%, and this average person can retire in just over 25 years too. Pretty crazy.)
At the end of the day, even after all the math and research, one of the reasons not to be wary of the emotional pull of this plan is that it is not a get-rich-quick scheme. Even in a best case scenario, hitting financial independence is a process that takes years, if not decades. But it is possible, and given that the alternative is even more decades spent under the obligation to earn money from someone, it still has a bit of a magical feel. Despite that, a look behind the curtain reveals not a wizard but a slow-turning gear, rotating consistently, that I’ll be able to watch and care for along its dependable path.
It works for me.