Cash is King

“…and always remember, cash is king.” It is one the favorite quote of my finance professor from business school. He taught how hard it is to hide cash than to hide profits, and so he would devote more time to analyze cash flow statements than other part of the financial statements. His opinion is that good stable growth companies have one or more “cash cows” that yield steady multiple sources of revenue, much of which is in turn invested to “farm” new cash cows. It makes sense a lot, doesn’t it? But then we would go over dozens of case studies where company after company made the cardinal sin of of not investing in future growth, and within years, they become obsolete. Especially those in IT, even the mighty ones.

Almost all of us — either by social conditioning or otherwise — build our first source of income, our own personal “cash cow”: us. We go through many years of schooling and many layers of education that we hope provide the ability to get our first source of income, which happens to be our primary source of income and in many cases, our only source of income. The asset is us, which we built through our skill and/or sweat equity. Good stable growing individuals will continue to use the cash generated to build more assets that provide adequate cash, hopefully, to make them “cash independent” in the near future.

So if you are on path to your financial freedom, you need to understand what your “cash cows” are, if and when would it be enough to cover your expenses, and it’s cash flow stability or volatility during the course of your financial independence. The best asset you have now is time, doesn’t matter whether you are 20, 30, 40 or 50, you are always younger today then you will be tomorrow. So spend some time and thought on how to make yourself stable and valuable so that you have the option of investing to generate your “cash cows”. All assets are not created equal. Similarly, the cost of the asset doesn’t always reflect the magnitude of it’s cash generating potential. It so happens that in the modern day world, we are more focused on disposable assets that have little or no residual value, robbing us of creating more avenues to generate our “cash cows”.

Cash-flow Volatility

As I mentioned in the previous post, as asset provides us with the possibility to generate cash; it is up to us to convert the possibility into reality. To simply put, everything we own is an asset. My laptop, books, kitchenware and my wardrobe. And so are my investments and rentals. But guess which ones generate cash. Also, different types of assets are affected by different market factors. At the end of the day, all you should be worried about how risky or volatile your cash flows are so that you just don’t have to wake up one day and have your money go “poof” (hello 2008!). Even the hard cash you have in your hand or bank — the supposedly end product of all your investment ventures — is still volatile, as it is affected by inflation. There is no hard and fast rule to fix your volatility. Some like to create a stable foundation first before moving on to risky ventures. Some like to start with high risk/reward ventures. There is no “one glove fits all” approach here, and it shouldn’t be; we are all different and unique!

Cash vs Assets

When I decided to take control of my freedom, I have been getting many opportunities to talk to a few people to bounce off ideas for content and direction of the blog. I was surprised to find that there are many out there – people in 20s, 30s, 40s and even 50s – who have absolutely no clue as to how to be financially ready to be able to make the next leap in their lives. Many cannot even comprehend about the possibility of financial freedom that they are never able to make their leap, thus tied to the working monotony for the rest of their lives. I recently turned 32, and sure, I know a lot more about them when I was 22, but I thought I was one of the few underprivileged kids who didn’t get the opportunity to be exposed to basic financial tenets in early life.

This post is very simple, kind of “duh” obvious difference between cash and assets. I am embarrassed to acknowledge that for a long period of time, I was ignorant about the difference(s) between cash and assets. It sounds so simple and so obvious, and you would think everyone should know what they are. However, in my case, not only did I not know the differences, but also had been making the cardinal sin of financial literacy: making no effort to learn or understand. If at least one person out there managed to gain something out of this post, this post would have served it’s purpose. Note that I will be not talking about the financial definitions of cash and asset, but about their relevance and application in our journey to Financial Independence.

You know how some good presenters would go, “…so hey, if you haven’t got anything out of this presentation so far, I want to end it with three key points“? These are my three points for you:

1. Cash, in itself, is only good to spend towards one’s expenses.
2. An asset provides the possibility to generate cash out of it.
3. Use (some) expenses to create assets towards Financial Independence.

Three sentences. About 30 words. I wish middle & high school books would print this information so that kids can get to grow understanding this fundamental difference and relationship between cash and assets. I personally wish I didn’t get to wait for many many years to understand. It’s not that I am not smart to understand this intuitively (may be i am more dumb than I thought I am!), it’s just that I didn’t get an opportunity to sit, relax and think about it. I was busy trying to do my classwork, homework, sports and busy being a teenager and then an young adult. I didn’t bother to give a thought as to how I would like to spend the rest of my life in the relatively carefree way I was spending then.

Cash in itself is only good to spend towards one’s expenses

You don’t keep all the money you earn. You pay for bills, food, entertainment, gifts, travel and other basic and not-so-basic needs of your life. And whatever left over cash (if you are lucky!), just waits to be spent. And trust me, you will eventually spend it, sometimes, in a matter of days. In an ideal world, you would forever earn more than you spend, and the leftover cash is enough to cover your retirement, if and when you retire. Unfortunately for many of us, life isn’t that ideal.

As asset provides the possibility to generate cash out of it

Note that not all assets provide you with an ability to generate cash. The possibility depends on two factors: the perceived worth of the asset to the buyer (or in the market), and your knowledge about the asset. Let’s say you have $10,000 in 0% current/checking account, and another $10,000 in a 1% savings account. The former is just cash but the latter is an asset that generates $100 in one year. Your company’s stock options provide you with a possibility of a windfall in the future; if the company goes belly up, so do your options. Your car is an asset, but it doesn’t provide the possibility of generating cash unless you sell it or use it to for providing services through Uber or Lyft. (It provides you the option to spend money on it rather than on public transport, but the topic of Opportunity Cost is for some other day). In our journey towards financial independence, we need our assets to generate cash. And this point ties into …

Spending cash to buy cash generating assets is a great and a comfortable way to keep up with expected and unexpected expenses in the latter part of life. You don’t even have to go on a consumerist binge to spend more money in your future; healthcare and inflation are some of the factors that require more in tomorrow’s money than you would require today. You can either buy a third car for your family or invest the amount (along with monthly payments, interests, insurance and gas money). Both are considered assets, only that in the first case, the value of your asset depreciates (sometimes even 20% the moment you drive the car out of the lot). But in the second case, your prudent investments appreciate, generating cash after a while. Knowing that you would have a stream of cash coming in through your assets would keep your mind sane when you are trying to live your life out there, to the fullest.

If you happen to gain at least a tiny bit of positive information out of this post, drop in a comment!

Risk & Diversification

The Mighty Wikipedia defines Risk as “the potential to lose something of value.” In this post, that something is our portfolio. Imagine a huge water tank (my portfolio) which is is to be filled with water (my money) by an inlet pipe (my investments). I have fixed one pipe for outlet (SWR amount), to get water out of it for my future use. If this were the case in real life, all I have to do is hoard my money in a bank or in a mattress. However, in real life I will have the following factors to consider

1. I lose water to evaporation.
2. The water tank might be destroyed because I didn’t use a tank with proper structural integrity.
3. The government might put restrictions on when and how much of my water I can withdraw from my tank.

Sounds very trivial and foolish, doesn’t it. It’s not. Losing water to evaporation is akin to losing money to inflation. It will happen, so you better factor your input accordingly. This risk is Inflation Risk. This is the more apparent of the risks, and many people do hedge their assets against inflation by investing them.

Getting your tank destroyed is akin to losing your portfolio due to foolish investing or other extenuating circumstances. This type of risk is called Systematic Risk. If your entire portfolio is tied to your company’s stock or it’s pension plan or if the company goes under, so do your life savings and portfolio. On the other hand, investing in some run-of-the-mill-ponzi-scheme for the lure of usurious returns is a sure fire way to kiss your investments goodbye. You might not realize it in short term, but you’ll eventually realize. There are just so many examples I don’t know which one to give. How about you search for “Berni Madoff scandal” as a start?

Having your government poke nose in your investments is Regulatory Risk. One of the few ways I can think, on top of my head: levying or increasing capital gains tax from your investments, pushing retirement age so that it delays the time when you get to use your tax sheltered retirement accounts or just stopping you from withdrawing your money (capital outflow restrictions and government defaults by Argentina in 2011 and by Greece in 2015). This type of risk doesn’t happen as frequently as the other two, in fact might not even occur in your lifetime if you are lucky. However, if and when it manifests itself, regulatory risk is one of the most potent risks, derailing your entire path towards financial independence.

Let’s consider the water tank example mentioned above. I could counter my risks by:

• Using sturdy materials and scientific techniques to construct my water tank and making periodical inspections to make sure it remains that way.
• Creating multiple smaller tanks rather than one big tank so that if I happen to lose one tank, I can use the other tanks to sustain me until I rebuild or create a new tank.
• Placing tanks in multiple locations that are under different municipal boundaries.

Let’s apply the analogies.

Understanding your investment portfolio is the best initiative you could take to hedge against risks. Learning about how an asset generates money over long term will let you to see past the shady and over-the-night schemes and invest in stable assets that you can be sure to be able to manage and control. Note that this level of understanding varies across individuals. If you have no clue about equities or stock market and, more importantly, unable to understand no matter how much you manage to learn, don’t fret and invest in bank deposits or real estate such as houses, rentals or land, assets that works on very basic of the economic principles. If you understand yields, bonds, dividends and stock exchanges, you can add some equities and debt holdings to your portfolio. If you understand how a business or a start-up idea work, you can invest in return for equity. If you know how to read a bluff, invest in some casino chips to play poker. You get the idea. Many of us — even me at various points in my past — try to part with money hastily without even completely understanding how the asset works and behaves under economic stress. That’s when investing becomes gambling. You will know if you didn’t understand an asset, when you lose it and you have no idea when and how you lost it.

When you invest in multiple assets — more importantly — multiple types of assets, you are diversifying your portfolio. Diversification leads to risk dilution. If your entire portfolio is based on a single company’s stock performance, you future is dependent on how this company performs, an event over which you have no control. Sure, you might understand the fundamentals of the company, but you are not a decision maker. It may have provided the best returns of any asset in the past 10-15 years in your country, but as we all know, past performance is not an indicator of future’s. Investing in multiple assets, if possible, complimenting assets (Stocks vs Bonds, liquid vs illiquid), would give your portfolio the much needed stability, especially during your part-time or retirement years. Many do this by (re)balancing their portfolio as they age, trying to bring risk to an acceptable level of their choice. If you are in doubt, consult a financial savvy friend or a financial adviser to get a portfolio makeover! Diversification is one of the best initiative you can take to counter financial risks.

Investing in assets that span across multiple regulatory environments is Regional Diversification. Regional diversification reduces regulatory risks, if executed correctly. A simple example is when investing in your country’s stock index, you could also try to invest in funds that track other countries’ stock index. There are plenty of international exchange traded funds available such as MSCI  that you can choose from. Governments do this all the time by buying bonds of other countries or stashing away a basket of currencies as forex reserves. This type of diversification might require help from legal or accounting services in some cases, especially if you hold illiquid assets in a different country. The radius of location, if you intend to regionally diversify, is completely up to your comfort level; it can be as small as your city to the entire world, if you can manage it. Don’t forget the basic criteria though; understand your potential assets first before diversification.

I initially intended to have risk and diversification discussed in two separate posts, but I believe a cure, if exists, must immediately accompany the disease. Trust me, spending time and effort to understand your assets and their associated risks is the best investment of your resources, even more important than the amount of money you invest. What good is money if you don’t know how to guard it.

Real Rate of Return

Numbers don’t lie but it sure can be deceiving – The Bronze Alchemist

No, it’s not a “thing” of mine to start the post with a quote. But if I can summarize this post in one sentence, it would be what I mentioned above. Let’s say you have an investment portfolio worth $100,000 and it gave you a return of $10,000 in the year, then you have earned 10% (actual return / portfolio value). Your asset “manager” (fund house, bank, debtors etc.) will acknowledge over an official looking transcript that you have earned 10% on your overall portfolio. There is no doubt on the amount you have earned; the return number on this transcript is as true as the sun in the sky. You are basking in the full shine (returns) of the sun (your portfolio) and it’s making you warm.

However, as it always happens, there are some dark clouds in the sky, preventing you from benefiting from the full warmth of your returns. This dark cloud, Inflation, is one of the most significant risk affecting your future returns.

There are many factors to consider, but for this post and for all practical purposes,

Real rate of return ≅ Nominal rate of return  – Inflation rate

i.e., to calculate your real returns from assets, you have to subtract the returns from the official looking transcript for inflation adjustments. ( In case of deflation, you add the rate to your returns ).

In the previous post, I showed you how inflation can throw a wrench in your retirement plans. This post on real returns could be considered an addendum to the previous post; and to serve a reminder: consider all factors a.k.a “risks” on the returns. Simply put, in 2015

• If there were a 2% inflation in your country, your real return is 8% (10% – 2%) or only $8000 and not $10,000
• For 5% inflation, real return is is 5% (10% – 5%) or only $5000 and not $10,000
• For 10% inflation, real return is 0% (10% – 10%) or $0 and not $10,000
• For 11% inflation, real return is -1% (10% – 11%) or -$1000 and not +$10,000

I know you are good at mathematics and can do basic calculations; but I cannot emphasize the above point enough. You lose money to inflation, for no fault of your own as an individual, just for having the privilege to be part of your country’s economy. Keep in mind that when I say -$1000, no one is going into your bank and take $11,000; your economy does it. So that’s why the numbers can be deceiving. You have $10,000 worth of money in your bank but you have to pay extra $1000 to be able to buy a group of items for which you paid $10,000 a year before. If this statement seems confusing, take a look at my previous post on inflation or search for it on the web.

Ideally, your choice of asset class should be able to provide you inflation beating returns. In terms of Safe Withdrawal Rate or SWR, if you have a specific percentage, say 3%, you have to make sure that the nominal return is at least 3% (or 300 basis points) above inflation rate. If inflation is 5%, you need 8% returns. But if inflation is 0%, you only need 3% returns. If there is a -1% inflation (or 1% deflation), you only need 2% returns. You get the picture.

Enough of this monkey business! Nothing hits harder than the truth so let’s look at some actual numbers. I did a simple projection of calculating USA’s S&P 500 index performance from 1995 to 2014 (20 years) with and without inflation adjustment. I assumed my initial portfolio value to be $100,000 that I will invest in a strict S&P 500 indexed fund on Jan 1, 1995. I am not adding any subsequent amounts to the portfolio, just letting the market do the work for me. Look at the results below:

Source:
Inflation: http://www.inflation.eu/inflation-rates/united-states/historic-inflation/cpi-inflation-united-states.aspx
S&P historical performance: https://ycharts.com/indicators/sandp_500_total_return_annual

My $100,000 portfolio has grown to $634,496 by the end of 2014. However due to inflation, the actual value of my portfolio in today’s dollars is worth only $505,448, losing almost 1/4th of the portfolio value (a factor of 1.2905 to be exact). And you know what the bad thing is? I cannot do anything about it. In fact, I should consider myself lucky to have invested in S&P 500. If I had invested in Certificates of Deposits (CDs), T-Bills or other bonds, I would have been barely able to improve my portfolio, definitely not to the tune on the amount returned by S&P 500. What if I were paranoid about the stock market and just hoarded all $100,000 under my mattress? Well, that would have yielded only $55,000 worth purchasing power in today’s dollars.

With regard to the point I am trying to make – use real return rate in SWR calculation – all is fine and dandy, except for one small issue: inflation lags behind by the unit of time that takes for your government to publish inflation rates. In USA, you can get monthly rates, so it is easy to adjust if you want to do it monthly. Yearly adjustment would do just for USA, the inflation rates are relatively steady in this part of the world.

My point, keep it real.

As a bonus, I am presenting below the projections from India to understand how things are with good developing economies. India is part of the BRICS bloc (Brazil, Russia, India, China and South Africa). Indian economy developed rapidly in the past two decades thanks to IT boom and then later to manufacturing boom. I used BSE SENSEX as the benchmark index and started with ₹100,000 portfolio. As per the data, I lost over 67% of the returns to inflation or by a factor of 3.6253 for every rupee. Wow! Although, the ETFs in India don’t do as well as actively managed funds over there. It’s possible to have better returns using good and stable active mutual funds, good blue chip stocks or if money were invested in real estate; the valuations growth were phenomenal in the past 20 years.

How about this for an observation?

Even though the average^#1 returns from India was 9.71% over the 20 years, because of the average^#1 inflation of 7.3%, the average real rate of return was only 5.21%. Compare that to USA’s, whose average^#1 returns were only 9.68% However due to average^#1 inflation being only 2.28% over 20 years, the average return came out to 8.44%; better than India’s. Warning: Things are never as simple as this in real, there are many complex factors to consider, and whatever adjustments we make, we always end up comparing apples to oranges.

Source:
Inflation: http://www.inflation.eu/inflation-rates/india/historic-inflation/cpi-inflation-india.aspx
BSE SENSEX historical performance: http://www.bseindia.com/indices/IndexArchiveData.aspx

^#1Compounded Annual Growth Rate or (CAGR) is calculated by the formula

CAGR = [(Final value/Initial value) ^ (1/number of time periods)] – 1

For example, with initial value ($100,000) and final value ($634,496), this would be 9.68%. In excel you would use this formula “=RATE(20,0,-100000,634496)”

Inflation

“Inflation eats your money faster than termites.” – The Bronze Alchemist

One of the underlying principles of Financial Independence is letting your money work for you. Forget about assets, portfolio, investments and all other jargon for a minute; they are just candy wrappers over the “real deal”, money. Letting YOUR money work for YOU is akin to letting it exercise; money initially works out slowly but as time progress it exercises faster and better, and is able to “bulk up” and be alert and nimble to “unforeseen financial accidents.” Unlike us, however, there is no limit to how much money can bulk up. But if you let money just sit idly, it loses it’s “power” and agility and slowly withers away, eventually becoming a shadow to what it was once. So it makes sense to let the money “work out.”

My analogy might be over the top, but I believe you got it’s essence. It’s an absolute waste of your potential to let the money you earned to just sit idly rather than have it invested, so that your money doesn’t lose its purchasing power due to inflation. Let’s start with a simple example based on USA’s CPI numbers. There is a nifty online inflation calculator that I’ll use for my illustration.

• In USA, if it had cost you $100 to purchase a basket of items in 1990, you will need $181 to purchase the same basket of items in 2015.
• This amounts to an average increase of 2.40% per year for 25 years.

Okay, it is not that bad. Only $81 increase over a period of 25 years with a measly 2.40% average yearly increase. Now let’s plug in this data into our hypothetical cash flow requirement of $55,000^#1 per year.

In USA, if I needed $55,000 to pay for my expenses in 1990, I would need $99,563 in 2015 to keep up with the same standard of living.

Let the above statement sink in for a second. I didn’t modify any parameters, just changed the initial $100 to a more realistic value that might mirror my expenses. And the extra $81 has now morphed into a humongous $44,563. As I always say, past might not be a predictor of future, but even if the average yearly inflation in USA is assumed to be just 1% over the next 30 years, $55,000 required today will have to be $70,533 in year 25, and $74,131 in year 30.

Let’s consider our usual hypothetical portfolio. Assume that I have “all cash” portfolio of $1.83 million, using a Safe Withdrawal Rate (SWR) of 3% to give $55,000 during first year of retirement. I’ll also assume an average yearly inflation of just 1% and that I would like to adjust my withdrawal to the inflation, so that I can enjoy the same standard of living. Take a look at the below projections.

Just look at how SWR crumbles over the years! You’ll see that at the end of year 28 (or beginning of year 29), I am, hmm, how to put delicately, caught with my pants down. This is the same scenario that gave me a 100% success rate over 50 years using firecalc. Now if I adjust the inflation to 2.40% (previous 25 year average), my cash portfolio runs out at year 23. And we all know that life is never one smooth ride (if it is, what’s the fun in it anyway!). And there will be unexpected expenses such as health, travel and repairs/maintenance along the way. If I won’t let the money grow, all these amounts are gone from my portfolio, FOREVER.

For sure, having $1.83 million in your retirement folio is no mean feat; in fact, less than 10% of USA nationals manage to amass anything more than $210,000 in retirement accounts as per a survey conducted by US Federal Reserve in 2013. Rest assured, those with a million dollar nest egg would be a rare breed indeed. What about the country you live in, if you are not from USA? Just check the government data if available, and I can assure you that the nest egg that you have in mind will be definitely within the top 5% in your country. Why else would you be reading this blog anyway!

How do I remedy this situation? Simple, I need to make sure I let my money earn at least 1% on the portfolio on average per year so that I can keep the SWR unchanged. That’s it. You need to let your money work so that you control your SWR instead of inflation controlling it. And you let your money beat the inflation by investing in assets that you understand and can control.

#1 For simplicity purposes, I have assumed that I don’t receive any pension, annuity or social security benefits. If you do receive them, great! But the social safety net provided in USA and a few other developed countries might not be available in many countries in the world.

SWR Rigidity

In the previous post, we discussed Safe Withdrawal Rate (SWR) of our portfolio and how to pick parameters to make sure that we have enough money to keep up with our needs throughout our retirement. The concept of SWR can be extended to any type of portfolio, but the flexibility of the portfolio in terms of varying SWR differs based on our portfolio composition.

Let’s say my portfolio consists only of real estate, considered an illiquid asset. I have two rental homes with total asset value of $550,000 generating $4600 as rent cheques per month, a situation that’s reasonably less fluctuating than stock market. Mind you, there is no such thing as guaranteed returns, as many things can go wrong while holding valuable real estate that affect the periodical rent cheques. Less than 100% occupancy rates, delinquent tenants, major repairs and damages are some of the reasons affecting your cash flow. Many of the costs might have to borne by the landlord completely if insurance doesn’t exist or doesn’t cover. But as I said above, real estate offers a relatively stable income stream compared to non-real estate investment instruments.

Now the downside of this portfolio is, you guessed it, it is stable. You can raise rents, but not be able to raise 10% – 20% to match the market returns or index it to the inflation. If you are in parts of the world with rent regulation/rent control, there is a ceiling as to how much you can raise the rent. More importantly, you cannot withdraw more for sudden expenses, unless you sell your real estate, take the money you require and buy another real estate with left over money^#1. In most of the cases, the resulting rent cheque will be lower than the previous one. And when you do this, your cash flow for the subsequent periods will be diminished and you have to reduce your retirement lifestyle FOREVER. Note that there could be scenarios where the real estate might have appreciated in value and/or you might be able to generate the same rental value but for general cases let’s assume: lower cost of rental = lower value in rental cheque.

So a couple of “bad’ years in expenses during your retirement years ( medical expenses, unexpected travel etc.) can seriously diminish your average yearly cash flow.^#2 My point here is not to show real estate portfolio in a bad light; in fact, real estate it is one the best asset class to hold. I merely want to state that how rigid your SWR becomes in a pure illiquid portfolio. In fact, a decent dose of real estate in your portfolio would add the much needed stability to your yearly cash flow, kind of giving you “minimum guaranteed returns” on top of which you can design your yearly expenses.

Based on the above observation, we can define SWR rigidity as “the degree to which SWR can be modified year-on-year as per withdrawal needs.”

SWR Rigidity = Amount of illiquid assets/Amount of total assets

SWR rigidity is directly proportional to the ratio of illiquid assets in your portfolio and inversely proportional to the volatility of your yearly cash flow. So, more illquid the portfolio, more rigid the SWR and less volatile the yearly cash flow.

#1 I am not even factoring broker fees, other sundry transaction costs and applicable taxes.
#2 You can still do plenty of things here, sell the assets and use the cash directly or getting a reverse mortgage.

Safe Withdrawal Rate

In the previous post, we took a look at an hypothetical equity portfolio of $550,000, generating a cool $55,000 per year at 10% return on average. Here we have assumed yearly rate of return to be 10%. There is only one problem with this assumption: this return is on average. On average. On average. I think I made my point quite clear here. So why am I putting such an emphasis? Well, there might be will be certain years where the real rate of return is less than 10%. In that case what would you do? Simply, you might reduce the amount of withdrawal to match the return%, say 5%. But that would mean you have to drastically reduce your lifestyle (by half, in this case) for an year. Worse, what is your investments yield negative returns?

So we have to make sure that we are able to safely withdraw a defined percentage of money from our total portfolio so that our retirement kitty is able to sustain us over a long period of time after factoring in market highs/lows, inflation and other adjustments. This rate of withdrawal is defined as “Safe Withdrawal Rate” or SWR hereafter. Our portfolio is a success if it is able to sustain us throughout our retirement (..till death do us..), a failure otherwise. For the US demographic, there have been many studies conducted to find the optimal SWR, most famously, the Trinity Study, benchmarking the SWR at 4% in 1998. Of course, we have seen at least 2 boom-bust cycles in the stock market, and now people are clamoring over 3% or even the ultra conservative 2% as SWR.

What does this mean:

If I know my yearly expenses are $55,000^#1, SWR at 3% says that I should have a minimum portfolio size from which I can withdraw 3% every year throughout our retirement so that my portfolio doesn’t run out of money. This would mean

$55,000 = X/3%  or X = $1.83 million.
At 4% SWR, we would need = X = $1.38 million
At 5% SWR, we would need = X = $1.1 million
and at 10% SWR, it would be exactly $550,000, our original amount.

Now if I had saved $150,000 so far, I can calculate my “Freedom Days” at 3% SWR by the following formula

Freedom Days = Current Portfolio * SWR / ADW
where ADW = Average Daily Withdrawal = Average Yearly Withdrawal / 366

In this scenario, ADW = $55,000/366 ≅ $150
and that gives 30 Freedom Days ( $150,000 * 0.03 / $150 )

If you happen to be in this position, congratulations! You are financially independent for one whole month in an year for the next 50 years^{on average}. Keep up your progress!

You now have 2 questions to ask yourself, and only you can know the answers for them:

1. What are/would be my yearly expenses?
2. What SWR is applicable to MY stock market?

Kindly note that the initial study and subsequent updates on Trinity Study are based on the USA stock market performance over the last 90 years. Based on this past performance, there is an awesome online retirement calculator firecalc that will run simulations based on your inputs on Portfolio Size, Yearly Withdrawal and number of years of retirement. Since there is no such thing as 100% success rate in real life, especially in statistical analysis, consider anything above 95% success rate as success for your portfolio. Again, this firecalc tool pertains only to the USA stock market.

However, it is not really that big a leap to apply it to one’s individual stock markets. Let’s assume your average length of retirement is 20 years. Take past 20 year returns of your domestic stock market, start with a lump portfolio sum and make a SWR withdrawal WHILE ADJUSTING FOR INFLATION every year to check whether your portfolio is able to stand the test of time. One caveat here is past performance is not never a predictor of future performance of the market. (If you take 21 years, you get two “20 year periods” to analyze. Needless to say, the longer you look back, the more data you get to analyze and hence, be more confident in your data points). For USA, you will see that for the scenarios calculated using firecalc, a 3% SWR would give almost 100% success rate over a period of 50 years.

Now it is absolutely subjective, and it SHOULD be, to choose your portfolio size and a proper SWR. Everyone of us is different, and each of us has unique traits, tastes and needs that would severely alter the composition of our expenses; everyone’s would be unique like a snowflake. So while calculating, always arrive at your portfolio size through your expenses and not through your income.

#1 Always calculate your portfolio required based on your expenses rather than your income. it will give a realistic idea of your needs and wastefulness.

Freedom Days

So I have used big words and claims so far: financial independence, controlling your destiny, and enjoying your life. Is this even possible? It very much is, if you understand your current financial situation and how much you need to account for in the future. It doesn’t have to be an exact science, even starting with a ball park figure should suffice.

Let me illustrate a simple concept:

Let’s assume that my average yearly expenses E = $55,000. In this amount I include essentials for my family, health expenses, children’s education and savings and enough buffer to enjoy the vagaries of daily life.

I will also assume the average rate of return in the market is R = 10%^#1

Now if I have retirement money M = $550,000 in my account that yields 10%, I can retire right away as the amount will yield $55,000 per year, forever^#2. That’s it. It is that simple.^#3

Many people calculate their “M” and they will track how far away are they from achieving the target. This is a great way, it shows whether you are 35% or 95% away from the target. You modify your savings, and if lucky, your income to achieve this target quicker. However, for many of us who earn salaries just above or below the country’s median, this could be a few years away.

To keep myself motivated, I keep track of how many days I am able to “buy” with my current savings. In this case, I divide $550,000 by 366 days, and it gives $1500 approximately. That’s it! Every time you save $1500 of your earnings, you are buying one Freedom Day for your future, FOREVER^#4. Thinking of upgrading your TV from already monstrous 55″ to a ridiculous 80″ ? Save that $3000 and buy 2 days of your future. Thinking about getting a 2015 version of a car when a 2011 would do just fine. Save that $6000 and buy yourself 4 days of your future. You only have to make 366 “$1500 decisions” to buy 366 Freedom Days, and suddenly you find yourself Financially Independent! The best thing about keeping track of this way is that you make decisions to alter your work schedule. Want to go 50% part time? Just have 183 Freedom Days bought and you are good to go!

#1 Average market returns are only that; average. I am not using Compounded Annual Growth Rate (CAGR) here. Some years markets perform well and some years don’t as in year 2008. It also behooves well to diversify your holdings into bonds, fixed rate deposits, real estate rent etc. More on this in later posts.
#2 This concept is called perpetuity. Depending in your country, a 10% market return Y-O-Y may not be achievable, and in that case we would use a safe withdrawal rate (SWR) that is a few points below this rate of return.
#3 We will get into the brass tacks on how to calculate this rate in later posts and what to do when market doesn’t do well as in the case of 2001 or 2008 financial crises. Also, we would discuss in detail about inflation, an agent that derails many a retirement target.
#4 Same as #2. For simplicity purposes I have assumed that I will be able to get 10% from portfolio forever. In reality, it won’t be and I discuss this in detail in the post about SWR.

What’s with the Alchemy

So why alchemist? First, to have a cool blog name! Second, seriously, to have cool blog name. In all seriousness, when I decided I would start a journey to be financially independent, it seemed like an impossible goal to accomplish. So brainwashed was I that the very thought of controlling my own destiny seemed like magic to me. Honestly, I almost named the blog some Financial Magician, or that sorts. However, claiming it as magic only makes it sound impossible, whereas in reality, it is not. In fact, to be financially independent one requires just the following three characteristics:

• Discipline – To control spending and put money away in savings.
• Patience – To give the saved money enough time to give adequate returns.
• Perseverance – To not lose sight of goal during the many inevitable financial crises one would face during the journey.

When I talked to a few of my friends and relatives across three continents, I began to realize that many of us don’t. Sure, the pattern varies slightly among the different demographics, but the underlying theme was same: I don’t earn enough to take care of me now and I cannot afford to save for the future. I’ll admit, a few of them are in precarious financial position with urgent needs. However, a majority of them aren’t, in fact quite well off financially, with a few of them being dual income households. But they are obligated to so many bills and payments that almost all of their paychecks are earmarked to pay the past month’s bills. We don’t seemed to disciplined with our money, so we never get a chance to see the money working for us.

And when I decided that I would “buy my future” with the money I earn, I began to realize that it is the best bargain I could get in my life. Imagine a life where you can get up at anytime you want, do the work you love, spend time with your family and friends, and travel to experience the wonders of this world! That’s 24 hours, 365 days of the year of your living life, truly dedicated to enjoy the riches of this mortal world. Once you realize that you can buy chunks of your future time with the money you earn now, you will never look at spending in the same way. It is that simple. Using something as simple and universal as money to buy such a special and unique gift – the process of alchemy.

So if you have begun to embark upon this journey, you too, are an alchemist. You have decided to be in control of your future. You have taken it upon yourself to let YOU do the things YOU want to do in only a few years. I’ll like to add a disclaimer at this point: I am not commenting about your job, education or salary. If you have a job that you love, or provides a good work/life balance, or a buttload of money, good for you! Still, you have to exchange between 9 and 11 hours of the most beautiful time of your day away, working. If you still not convinced that you need to buy your future, stop right here; this blog is not for you. But if you want the money work for you, where you get to choose to share your time and money with the people you love, doing the things that make you fulfilled and content, let’s get started!

Introduction

I am going to make an audacious claim today, both to myself, and to you: You are in Control of Your Future. Did it sound ridiculous and pretentious when you said it aloud? It did to me at first, and then I said it to myself a few times, and over and over again, it didn’t sound as ludicrous as it did before. In fact, making that statement over and over only lead to more questions. Am I not in control of my future? Who is responsible of my future then?

I proceeded to pacify my mind: hey, I hold a masters degree, I earn a very good salary and I am in a very respectable position in my company. Even if I lose my job, I can find another position with almost the same pay and I can continue being awesome. But it wasn’t a satisfying answer to the question, “am I in control of  my future?” The answer was a resounding NO. To be honest, the reason I wanted to fool my mind is that “ME” controlling “MY” future sounds such a tedious and a scary task. I mean, who want’s to take responsibility for their own well being! If I accept that I CAN control my future, it would mean that I cannot shift blame on to my parents, spouse, kids, friends, relatives, government or the almighty for my failure to be independent.

However, once I accepted that, currently, I am not in control of my future, and more importantly, I would like to be in control of it, I felt that it would be nice to have one tool, one cure, a panacea of sorts, that will help me to control my future. And then I realized that such a tool indeed exist, and it’s called MONEY. It sure takes different forms such as dollars, euros, gold, land, home and vintage wines, but the underlying theme was same. You can spend some of this “money” fellow and can get whatever you want, well almost. And apparently, this almost seemed to cover 99% of my daily regular needs, a situation many in this world would love to be in. Now imagine my surprise when I realized that I indeed get this wonderful tool on a regular basis for an amount of time that I spend working for someone else. If only I can retain some of this money so that I can buy the things I would need in the future! But I was only wasting most of it on frivolous spending.

Such a simple concept, but it evaded me for a good 31 years of my existence. I have never been a saver; I spent almost all of my money, and sometimes the money I didn’t have on instant gratification. However, a particular bad day at office started the above discussed train of thought: I am not in control of my future. I want to be in control of my future. I want to be able to spend my time on earth the way I deem it to be fit. I don’t want to spend almost 9 hours of my every day existence working for someone else. After I estimated my current situation, I was in a precarious position, unsurprisingly.

I have now decided that I would now strive to be “Financially Independent” or FI, a concept that seems to elude almost all of current working class generation. I wish to be financially independent of any entity, so that no one can make a claim on my future time. Now initially I fantasized about winning  a lottery or selling my imaginary company for multimillion buttload of money so that I can continue to, in fact spend on more frivolous things in my future. In fact, for an average joe like myself, lottery or a windfall seemed to the only ways in which I could aspire to be financially independent. That surely can’t be right; is the current system loaded so much against an average person?

In fact, it is not. I realized it when I found that I have spent 60% of my past 2 year expenses on the things I absolutely wouldn’t have needed. 60%! It varied from many unnecessary restaurant and pizza orders, useless subscriptions/fees, credit card interest, home furnishings, and countless other things I am too ashamed to put here. What a waste! And then there was this “click”: I was wasting my opportunity to secure my future by spending on stupid things.

Trust me, once you realize it, there is no going back. It’s like you have awaken from the Matrix, like Neo, and you see yourself and the world for exactly who you are. That you are running on a consumer treadmill, sadly, for no reason except that your neighbors, friends and relatives are also doing the same. That you have given up the thought of getting out of it, and taking a stroll on your own space while enjoying the beauty and the riches of this world. That you are grooming your progeny to take over your treadmill once you are too tired, or dead, to continue.

This is my journey towards that not so elusive target of being “financially independent” or FI. There are many definitions of being financially independent, but in my opinion, it means that I don’t have to do anything for the sake of money. That I I’ll have sufficient income to cover my needs throughout the rest of my life that I don’t have to do anything I want to. That is true freedom.