It’s not exactly a secret that my wife and I are investing our money with a goal of financial independence. We achieved our goal of complete debt freedom – including our mortgage – in 2011, and so our natural follow-up goal was something even bigger, especially considering that we were no longer sending out a big chunk of our income to our lenders.
The big question that many people have asked is how we are doing this. What exactly are we doing with our money? That’s the very question I hope to address in this article.
Our Goal: Financial Independence
The best place to start when discussing investments is to look at our goals. Where, exactly, are we heading with our money? I’ve stated time and time again that our goal is financial independence, but what does that mean?
I define “financial independence” as a state of living in which neither Sarah nor myself has to work in order to earn an income and we feel very secure about that state for many, many years, ideally for the rest of our lives.
The money we would live off of in our day-to-day lives would come from the return from our investments. Ideally, this means that our annual investment returns make up enough money to not only cover our living expenses, but also cause our investment to grow so that everything keeps up with inflation (and a little extra breathing room as well).
This doesn’t mean that we would simply stop working when we reached financial independence, but that income would not be a reason or motivation for choosing what to do with our time. Neither Sarah nor I are idle people – we’d go insane without things to fill our time with. Financial independence just removes income generation from the equation for us.
For example, I could take a year to write a novel if I so chose. If that novel ended up being sold to a publisher, turned out to be popular, and sold a lot of copies, that would be a wonderful bonus. If I never found a publisher at all, though, it wouldn’t be a financial disaster for us.
Sarah and I have both discussed working for various charities at a full time level, whether for a very low wage or for free. Again, we would be doing this because we believed in the charity, not because of the income (or the lack thereof).
The purpose in our work would not revolve around income, though income would be a nice perk. If we get paid, that’s great, but it’s not the reason for how we would choose to fill our hours. Personal fulfillment would be a much larger part, as would the desire to help others and grow ourselves as people.
How We’re Getting There: Our Lifestyle Choices
For many people, that sounds like a tremendously exciting goal, but it doesn’t seem like a realistic goal. Regardless of one’s specific investment choices, it’s going to take a lot of money in investments to get there and for many people, coming up with a lot of money to invest is like squeezing water out of a rock.
So, the first problem to be solved is to come up with enough money from our daily life so that we can actually apply enough money to our investments to get to this goal at a reasonable rate.
This goes substantially beyond the usual retirement savings advice of saving 10% to 15% of your annual income. That’s a great number to use if you’re reasonably young and saving to reach financial independence close to your usual retirement age of 65 to 70. If you’re hoping to reach that level at an earlier age, you’re going to have to save more than that. There’s no way around it.
Living off One Income
Right now, our annual goal is to save about 50% of our income. Since Sarah and I make approximately the same amount of money, this functionally means that we live off of one of our incomes and bank the other one.
The important thing to remember here is that our finances are fully combined. Our money effectively goes into one shared pool from which Sarah and I live. Both of our names are on all of our accounts, we each individually have access to all of our funds, and we work together to make decisions.
In terms of how things work practically, the money I earn from my work goes into our business checking account, from which we withdraw money that amounts to my take-home pay (with other money in that account going toward professional expenses, like research materials, as well as income taxes). The take-home pay that’s withdrawn from this account goes almost directly into investments – in fact, it’s done automatically, with the only “income” we actually keep from this account coming out of money left over each year after the tax bills are paid (which is usually a pretty small amount).
So, to summarize: Sarah’s income goes into a shared checking account from which we make our day-to-day living decisions. My income goes directly into a shared investing account that’s building up for our financial independence.
Debt Freedom was the First Big Step
Our first big step in this journey was complete debt freedom, including our home mortgage. Not having any debt of any kind – no student loan debt, no credit card debt, no car loans, and no mortgage – freed up a lot of our income to be channeled into investments.
Imagine, for a minute, that you’re the typical American family of our age. That family has credit card debt. That family often has a mortgage – and if they don’t, they usually have rent. Often, that family has student loan debt as well as car loans or a lease, too.
Now imagine all of that debt vanishes. What could that family do with that money? That’s a lot of money each month.
How did we get there? We followed a straightforward debt repayment plan. In other words, we tried to get the interest rates of each of our debts reduced, then we listed all of our debts by interest rate with the highest interest rate on top, then focused on paying down the debt on top of the list while making minimum payments on the rest. We didn’t really start investing until all of the debts were gone.
A Life of Experiences, Not Stuff
Of course, this means that we actively live on substantially less than we earn, something we have done for almost a decade now. In terms of our spending, we live a lifestyle that adds up to about half of our income level.
What does that mean, day to day?
It means that we don’t go out to eat very often and that we make most of our meals at home. When we do go out to eat, our children are genuinely excited about it because it’s a special experience.
It means that we don’t own the biggest or nicest house that we could afford to own. We could own a much larger house than the one that we own, with some beautiful features. We choose not to. Our current house meets our needs quite well.
It means that our cars both have more than 100,000 miles on them (and both are approaching 150,000). Yet we’re not visiting the car lot every day drooling over replacements. We’ll replace them when we have to – and when we do, we already have the cash set aside for reasonable replacements.
It means that we do things like carefully preparing meal plans and grocery lists in order to minimize food spending. Our planning involves using the grocery store flyer, upon which we base our meal plans, upon which we base our grocery list.
It means we buy many generic items and store-brand items, from breakfast cereal to flour. Most of our typical household purchases are either generic items or basic ingredients for making household supplies (like vinegar, for instance).
It means that we buy even little things like light bulbs with an eye toward the lowest possible cost over the long term while still meeting our needs. Most of the light bulbs in our home are LED bulbs at this point.
It means that many of our hobbies are simple ones. We spend our weekends doing things like geocaching or going to parks or playing board games that we’ve owned for years or reading library books.
It means that our social events often revolve around having people over for a potluck dinner or going somewhere in the community with them, such as to a community board game night.
When you add up all of those things and also remember that we don’t have any debts, it’s not hard to see how we’re able to save half of our income. It all comes from a mix of living without debt and living smartly.
Our Investment Strategy
So, now that we’ve established our overall goal and where our money for investing comes from, how exactly do we invest? Let’s dig in, step by step.
Index-Based Total Market Investing
The first idea that guides our investing is that we cannot individually compete with hedge funds, investment banks, or institutional investors. It is essentially impossible for us to have access to useful information or be able to act on that information with such speed as to ever beat them at the individual investing game.
Thus, our question becomes “how can we benefit from their efforts?” Is there anything we can personally do to take advantage of all of that effort?
The easy solution is to invest in everything. If you invest in everything, you’re going to catch every single surprising spike in stock prices or bond prices. You’re also going to catch all of the gradually rising value that comes from a strong, steady economy.
Sure, you won’t ever see your investments double in a day or anything like that. However, you’re also not carrying a risk of seeing your investments drop to zero value very quickly either.
How do you do this? Investment houses make this pretty easy through two financial tools. First, they offer index funds. Index funds are essentially mutual funds that are managed with just a few simple rules, which means that the costs of running those funds are very low compared to a normal mutual fund that’s run by a fund manager and a team of people actively studying stocks.
(A mutual fund is just a big collection of investments that people can buy shares of. So, for example, a mutual fund might own $1 million of company A’s shares, $1 million of company B’s shares, and $2 million of company C’s shares. That mutual fund might sell a million shares of itself. Those shares would be worth $4 each. The $4 value of those mutual fund shares is thus directly tied to the value of all of the investments owned by that mutual fund.)
This means that index funds also don’t carry one of the risks of mutual funds, which is that of the investors running the funds. You’re not relying on people to make smart, ethical decisions with your money.
Normally, a mutual fund charges costs to the people who own shares of that fund. Those costs take the form of a small amount taken out of the value of the fund each day – a tiny fraction, like 0.001% of the total value of the fund.
An index fund is cheaper to run than a typical mutual fund, so the tiny fraction taken out each day might be more like 0.0002% of the fund’s value each day.
Over time, that adds up to a ton of money. Let’s say you have $1 million in a fund that holds its value. Over the course of 10 years (with 300 investing days per year), the mutual fund described above would gobble up $29,554.61 in fees, while the index fund described above would only gobble up $5,982.04 in fees. Fees end up making a huge difference in your annual returns, in other words.
So, because of this, all of our money is invested in index funds.
The second key tool is total-market investing. This simply means that an index fund owns or tries to own a small portion of all of the investments in a particular market.
So, for example, if you own a total stock market investment, that investment would own a small amount of every publicly traded stock in America. If you own a total bond market investment, that investment would own a small amount of every publicly traded bond in America. If you own a total real estate market investment, that investment would own a small amount of real estate in every major real estate market in America. You get the idea.
Why would you do this? Two reasons.
First, such an investment is already really diversified. If you own shares in a total stock market index fund, that means you own a tiny amount of every publicly traded company in the United States. That’s about as diversified as an investment in domestic stocks can possibly be. You don’t need to worry about diversity in stocks any more.
Second, with that much diversity, you’re actually investing in the economy as a whole rather than in individual companies. I don’t necessarily have perfect faith in a specific company, but I do have faith in the American economy as a whole.
For example, when it comes to stocks, I believe that worker productivity will keep going up and I believe that American ingenuity will keep developing new products. Thus, over the long haul, the value of stocks will keep going up. This has nothing to do with the fortunes of one specific company, but on the fortunes of America as a whole. You are never underperforming the market. You are simply matching the market.
It is for these reasons that Sarah and I invest our money in total market index funds. Essentially, it boils down to the fact that they have low fees and they’re incredibly diverse, avoiding the “all your eggs in one basket” problem.
Another big advantage that total market index funds have is that they’re basically “hands-off” investments. You don’t really have to manage them at all other than peeking at them every once in a while so that you can see how they’re doing and perhaps alter your future investments. There’s no active buying and selling of stocks needed at all – you just steadily buy into whatever investments you’ve chosen.
The only thing you really have to do with this type of investment is figure out which total market index funds you’re going to buy and in which proportion. Then, you simply set up automatic investments to buy those funds at those proportions.
Each quarter or each year, you check the comparative balances of those funds and then change the automatic investments accordingly to steer things back to your ideal balance. (You have to do that because some of your investments will grow faster than others.)
Even the problem of figuring out which total market index funds to buy is a pretty easy problem to solve. There are many, many examples out there for you to follow, most of which have pretty good explanations of the advantages and disadvantages of each. Just read about some, pick one, and stick to it.
I’ve found that I prefer “three-fund portfolios,” which you can read about here on the Bogleheads wiki. A “three-fund portfolio” means that you simply own a piece of three different total market index funds – one made up of the United States stock market, one made up of international stock markets, and one made up of the total bond market. A quote from that link explains the logic very clearly:
ADVANTAGES OF THE THREE-FUND INDEX PORTFOLIO
Diversification. Over 10,000 world-wide securities.
Contains every style and cap-size.
Very low cost.
No manager risk.
No style drift.
Avoids “front running.”
Easy to rebalance.
Never under-performs the market (less worry).
Mathematically certain to out-perform most investors.
— Taylor Larimore, co-author, The Boglehead’s Guide to Investing
That pretty much sums it up.
For us specifically, we use a 60/30/10 portfolio. 60% of our money is in domestic stocks (specifically, the Vanguard Total Stock Market Index), 30% of our money is in international stocks (specifically, the Vanguard Total International Market Index), and 10% of our money is in bonds (specifically, the Vanguard Total Bond Market Index).
How We “Rebalance”
Ideally, we want to stick to those ratios – 60/30/10 – but we want to do that without buying and selling investments so we don’t have to deal with taxes until we actually sell out.
The way we do that is easy. Let’s say, for instance, that we started out with $60,000 in the first investment, $30,000 in the second investment, and $10,000 in the third investment.
About every six months, I’ll sit down and figure out what the ratio of our actual investments are like. Let’s say, for example, that during those six months, our investments grew to having $70,000 in the first investment, $34,000 in the second investment, and $11,000 in the third investment, giving us a new total of $115,000. That means that, currently, 61% of our portfolio is in the first investment, 29.5% is in the second investment, and 9.5% of our portfolio is in the third investment.
Normally, I don’t make any changes unless one of the pieces is 10% or more off of where it should be, so I wouldn’t make any changes. However, let’s say it had wound up being 63%/29.5%/7.5%. In that case, I would take 5% from each of the other slices for our contributions and move it to the underperforming slice. (In the case of an overperforming slice, I’d take 10% from that slice and give half to each of the other pieces.)
In other words, I’d go into the website, change our contribution to the top investment from 60% of our money to 55% of our money, change our contribution to our middle investment from 30% of our money to 25% of our money, and then change our contribution to the small investment from 10% of our money to 20% of our money. That means that I would be contributing at a 55%/25%/20% rate for the next several months. I would leave that in place until at least one of the fractions was more than 5% off of our target again, then I would alter the contributions again.
That’s all we do in terms of “rebalancing” or managing those investments. Aside from that, we just let it sit. We intend to stick to that 60/30/10 portfolio for the long haul, even into financial independence.
So, the final question that really needs to be asked is “how much?” How much will we need in our investments before we feel as though we’re financially independent?
Our goal is for our total investment value to be equal to 25 times 150% of our annual living expenses.
So, for example, let’s say our annual living expenses are $30,000 a year (this is a little high but fairly close – I’ll use this number as a nice round number for calculation). For the sake of flexibility and safety, we want to be able to have the freedom to take out 50% more of that value each year if we so choose (to cover taxes and any other special things we might do), so our annual number is $45,000. We then multiply that by 25 to find that we need $1.125 million in our portfolio before we would feel good being financially independent.
Of course, we’ll still be earning some income when we reach that point. I’ll still have book royalties and several other little passive income streams, and Sarah and I may earn money from doing other things. Our intent is only to withdraw money as needed (and to have all dividends just go into our checking account).
From what we can tell, most years we will withdraw substantially less than $45,000. On top of that, our portfolio is aggressive enough that it will grow at a rate faster than 4%. We believe those two factors combined will more than defeat inflation over the long haul.
Our game plan is to keep investing in the 60/30/10 portfolio described above until we reach a balance of $1.125 million, at which point we will view ourselves as financially independent. We can both quit working if we so choose at that point.
We’re able to invest because we’ve paid off our debts and consciously choose to live a fairly frugal life. The money we save due to those choices provides the resources we need.
Is it a perfect plan? No plan is perfect. Could it be better? Maybe. Much of it depends on one’s personal goals, risk tolerance, frugality, and so on.
Still, we feel as though this plan will work very well in terms of taking us to where we want to be.