Each of us invests to reach a financial goal in the future; it can be a simple one like buying a car or a complex one like a pension. The first one is simple because the target is very specific, the price of the car, and usually the time we give us to reach the target is short.
Building a portfolio that will generate enough income to guarantee us the same lifestyle we have now is more complex for different reasons. For my generation is a pension, for the young and hip is financial independence, still we are talking the same s**t.
First you have to define what is the income part generated by the portfolio. When stocks are involved, the FIRE community is obsessed with dividends, I guess because it easy to differentiate: a dividend is income, price appreciation is portfolio appreciation. This is wrong for many reasons (I hope I will write a post on the topic in the future), all cash flows are part of the portfolio and income is the % of the portfolio you can spend each year while maintaining an account balance the keeps income flowing through the rest of your life.
For a stock and bond portfolio, financial literature set the magic number at 4%, which represent more a rule of thumb than a guarantee. Why?
- No one knows when he/she going to die and how much you will have to spend in healthcare
- Inflation: what 1 EUR will buy in 30 years?
- Stock market path: we can assume that the stock markets grows 4% each year NET of inflation but we know for sure that this growth will not be linear. A market crash in a year where you are still building your portfolio is way less dangerous (is in fact a good news) than a crash 10 years after you retired.
There are a lot of things you cannot control. You cannot control the yield on your investments, or its time distribution.
But there are few things you can control, and these are the things you should focus on. Instead of being obsessed with yield, focus on cost. Focus on taxes.
Focus on your saving rate.
The first concept, simple but easy to overlook is that building wealth has little to do with your income or investment returns, and lots to do with your savings rate. Your saving pot is just the accumulated leftovers after you spend what you take in.
More important, the income your portfolio has to generate is relative to what you need (well, net of the above mentioned healthcare costs). A high savings rate means having lower expenses than you otherwise could, and having lower expenses means your savings goes farther than it would if you spent more. Since people require vastly different amounts of spending to get by each month, 1 EUR of savings to one person is worth something totally different to another.
Spending past a pretty low level of materialism is mostly a reflection of ego, a way to spend money to show people that you have (or had) money. Think of it this way, and one of the most powerful ways to increase your savings isn’t to raise your income, but your humility.
Savings gives you options and flexibility, the ability to wait and the opportunity to pounce; if you have flexibility, you have the time to wait for no-brainer opportunities to fall in your lap.
What most people want out of savings is freedom and control. Less worry. Something to free up mental bandwidth from the “what if?” scenarios that narrate our money worries and desires. What many people really want from money is the ability to stop thinking about money. To stop caring about it so they can think about other stuff.
One of the biggest reasons people have a hard time saving money is because they never bother to track their spending in the first place. It’s impossible to develop good saving habits if you have no idea where all your money is going in the first place. Compartmentalizing your spending sources can help.
Then there are the FIRE hardcores, to whom I would like to give a counterintuitive advice. Young people should see the world, meet people, and learn new stuff.
Just remember two things.
- If you can’t enjoy time with friends without spending all your money, you’re doing it wrong and your friends don’t actually like you.
- The decision isn’t between saving or not saving, but finding a balance between the two that lets you enjoy life while being smart about your future.
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