How to Fix your Financial Problems

Hi RIP friends,

Welcome to yet another post about “basics financial tactics” on the internet. I’d like to show my suggested strategy to face and solve your financial problems, trying to offer my unique point of view.

First of all, what kind of financial problems do people have?

Given that everyone has their own individual problems, let’s try to cluster them in few groups:

  • People struggling with debts, who have hard time keeping the head above the water.
  • People with a very tight cash flow, to whom any unexpected expense is a nightmare and won’t make them sleep well.
  • People with no job or a very unstable one.
  • People with no immediate financial problem, but locked into a job they don’t like.
  • People with apparently no financial problems, seeking for ways to improve quality of their lives.

Well, the list may go on and on but to keep the post readable let’s focus on the above mentioned categories.

What are the basic steps you should take to improve your situation? Let’s take a look!

Step 1: where are you?

First step should always be: write your financial self assessment. Where are you? What’s your actual financial situation? Instead of running after emergencies and panicking, take your time. Breathe. Sit down, set 2-4 hours aside and start your financial self assessment.

Understand and quantify your monetary assets. Sum up your valuable assets. Do you own a house? A car? A valuable collection? Money on your bank accounts? Other kind of equities/securities? Art pieces? Precious metals? Pension funds? Savings? Piggybanks? Lottery winning tickets?

Be realistic: only track assets you can actually monetise and track them at their expected resell value. I suggest to skip tracking minor stuff whose selling process may end up being more expensive than the item’s value itself.

Remember that over time some of your assets will depreciate (your used car, your jewelry, your used golf clubs set) while other may appreciate, like your house, your pension fund and your Coca Cola Company stocks. Note: there’s no guarantee that any of your asset will appreciate.

Understand and quantify your liabilities.

Do you have debts? Mortgages? Loans? Credit cards debts? Family debts? Unpaid bills?

Write all of them down. Write the full amount due and – aside – the interest rate you’re paying on each liability. The interest rate is not useful in this self assessment phase, but it will soon be when we’ll talk about taking actions.

credits: petrunway.co.uk

Produce your Net Worth document.

Your Net Worth is a number that tell you “where you are” on the financial path.

If you’re below zero it means you have more debts than assets. It means a homeless, or even a kitten, is richer than you.

Obviously that doesn’t mean the kitten will have an easier financial life than you: you probably have other non monetary assets that provide opportunities to change your trajectory, like your skills and your social/professional network.

I have my NW document publicly shared. Feel free to take a look and be inspired.

Before running to any conclusion, ask yourself few questions: did you expect to be where your NW shows you actually are? Do you feel relaxed? That’s good. Do you feel anxious? That’s good too.

Anyway, congratulations! You’ve taken first step toward a path that leads to improve your permanent well being. Who cares if your scale says you weight too much on day zero of your diet? It’s actually better, more room for improvements!

Step 2: where are you going to?

You now have a snapshot of your financial situation. It’s like a single frame in your lifelong financial movie. It tells you something but not everything.

Start tracking your Net Worth over time.

Your assets will change their value, your liabilities will increase/decrease. Track your first magic number over time, on a monthly/quarterly/yearly basis. Or have some mechanism in place to track it in real time, like financial apps (personal capital, mint, …) or a simple spreadsheet – and a nerdy attitude.

Tracking your NW will tell your wealth derivative: the rate of change of your NW. Is it increasing month by month? Is it decreasing? Where do you expect to be in a year if you do nothing? Does it scare you?

Let’s go further, let’s try to anticipate the future.

Take expectations into account.

Are there any financially impactful events expected to happen in the near future? Do you have huge bills expected to come? Do you have kids leaving your home and lowering your expenses? Do you have an expected inheritance coming sooner or later?

Try to do a qualitative analysis and see how these events will change your financial situation.

Take desires into account.

Are you planning for an expensive summer vacation next year? Do you want to buy a new car soon-ish? Do you want to have a kid? Do you want to move to a bigger home with your (possibly growing) family?

Play with numbers and try to do a quantitative analysis of the impacts of your desires on your Net Worth. Can you afford them? Are they worth? Most of them will surely be, some of them maybe not.

Understand unknowns and try to take them into account.

What if you lost your job today? What if you had an unexpected 1000 Euro expense tomorrow? What if your landlord wanted to evict you at the end of the month?

Do these questions terrify you? Sorry friend, you need to face them. Life will happen.

How to take them into account, though? It’s hard to understand the impact of the unknowns based solely on your Net Worth.

Step 3: why are you going there?

We’ve seen how to understand what’s your movie about, by analysing some frames and speculating over few known events. We don’t actually understand why things are happening, we’re passive spectators at the theatre, who just opened their eyes and discovered that’s an horror movie the one we’re looking at, not a Pixar’s one!

Track your cash flow.

Track down each of your income streams and each of your expenses. Make a budget. Understand where your money is actually going. Track this over time.

Do you have a positive or negative cash flow? Assuming your assets don’t change their values, if you have a negative cash flow your NW is going to decrease. If you keep having a negative cash flow you’ll have to sell some of them in order to pay your bills.

Do you have a negative cash flow due to low earnings or high expenses (or both)? Do you understand the impact of each entry in your cash flow?

I know tracking expenses may be a lot of work, but it’s an extremely valuable tool if you’re seeking for financial help. Whoever tells you how to fix your situation without looking at how you currently spend your money is a liar.

Tracking individual expenses is not always necessary, though. For example I’ve been lazily skipping that for a very long time, but I’ve always been in amazing financial shape and without big spending troubles. I belong to the category of those with “apparently no financial problems, seeking for ways to improve quality of their lives“. I restarted tracking my expenses when I started this blog (June 2016), with the goal of improving further my finances to reach earlier my goals.

Even if you don’t want to track individual expenses, I strongly recommend you to understand the total amount spent and to get a rough idea of your main expense categories.

Ok, now you have knowledge and awareness over your finances. You don’t just passively observe that “your NW increased by 500 Euro last month“, you knew and predicted that because “your earnings were 300 Euro greater than your expenses and your other assets appreciated by 200 Euro“. You can finally explain why your NW is changing over time.

… You achieved Financial Intelligence, congratulations! You’re fully aware of your current situation, your directions and the impact of each one of your choices.

You understand what’s happening on the movie so you can stop laughing when others are and actually understand the jokes instead!

Step 4: where else could you go?

This movie is a good one isn’t it? I like the characters, I understand their behavior, I can anticipate what’s happening… but are they taking the right actions? Are they driving the plot toward a nice ending? How many different finale can you imagine for the movie? How many interesting paths were left unfollowed so far?

Understand your tools.

Which tools can you use if you want to change your financial direction? You may have a job. You may have few other income streams, or potential income streams like business ideas. You have skills. You have passions. You have a social network. No, I’m not talking about facebook. I mean people who care about you: your friends, your lover and your family. You have a professional network. Well, yes, I’m also talking about linkedin here. But I mainly mean people who endorse you because of your skills, people who witnessed your quality and would help you changing your job/career.

What about your Net Worth, again? What about repeating the game of playing with desires and with unknowns? Is this the right time to buy a new car? Is this the right size of a mortgage? What if soon after purchasing this dream house interest rates go up and your mortgage’s interest rate raises by 20%? Can you still afford it?

Wait, now we’ve bound actions to consequences! What if Walter White just accepted Gretchen and Elliott’s help?

Can you think alternative scripts for your movie?

You’ve been tracking your numbers since few months now and you’re able to play with them and with your imagination. Is there only one possible future? Of course not! Well, unless you believe in predetermined fate. In that case you can keep complaining with your bad luck and do nothing to change your situation. You’re in good company, that’s what the vast majority of people do!

Step 5: where do you want to go?

We’ve played with characters in your movie, we understand what they do and what they could do instead. We can make hypothesis and expect outcomes… but how would you want the movie to end? If you were the main character, what would you want to achieve? You’re in a Horror movie, are you ok with that? Do you want to make it an action movie? a romantic one? Would is your favorite genre?

Define your financial goals.

Individuals have different goals, different ambitions. Take your time to define what matters to you. Without a goal there would be no way to suggest you the right actions. There would be no right action. Whoever tells you how to fix your situation without asking what are your goals is a liar.

It doesn’t have to be a long term goal, can also be a simple milestone or the end of a chapter in your life. It actually works better if the goal is small and reachable at first.

For example: “be able to make ends meet this month”, “get rid of debts”, “buy a house and not go broke”, “quit my job”, “have 10K Euro saved”, “be able to afford 6 months of unemployment”, “increase my saving rate by 10%”, “reduce expenses by 300 euro per month”, “get a raise”, “reach financial independence” and so on.

Be S.M.A.R.T.:

  • Specific: avoid vague or indirect goals like “be able to sleep at night”. A sleeping pill will do the job and you’re still broke.
  • Measurable: avoid “reduce expenses”, prefer “reduce expenses below 2K per month”.
  • Assignable: usually assignable to you. If you’re part of a family or a community working together to reach your goals be sure each member has a role in this.
  • Realistic: avoid “spend less than 100 Euro per month”, prefer “spend 100 Euro less per month”.
  • Time related: avoid “quit my job”, prefer “quit my job before July 2017”.

there is no favorable wind for the sailor who doesn’t know where to go. (Seneca)

Step 6: what are you going to do to go there?

You’re no more a spectator of the movie, you’re the main character. You happen to be in a movie you didn’t plot – actually you did, but you lost control over time – but now you choose to be active and drive the plot. Maybe you’re in a drama or a Horror movie and you don’t like it. You envisioned your preferred finale, or what you think it would be a nice scene: “I’m gonna kill the dragon and kiss the princess before the end of the first act!”. Ok, cool, how are you going to do it?

  • Force yourself to have a positive cash flow, i.e. spend less than you earn.

If you’re driving your car against a wall you can push the accelerator or the brake. If you want to avoid the collision you need to brake. Depending on your speed and the distance between you and the wall, it may not be enough to brake softly.

Same is true with money. Main rule is: spend less than you earn. No matter how tough it is, no matter how many sacrifices you need to do, how thrifty your life needs to become. Spend less than you earn.

It’s a mantra. Repeat again: spend less than you earn.

Which means:

  • Spend less, i.e. reduce your expenses.

The Philosophical way: you’re not your purchases. Embrace minimalism and simplify your life. Take your budget, understand where your money are going and check if the expenses match your values. Cut expenses that bring marginal value to your life. Maybe cutting the top 100 Euro on your monthly grocery bill won’t sensibly impact your happiness while cutting more will. Then cut just 100 Euro.

The Psychological way: Don’t keep up with the joneses, don’t try to impress people you don’t like. Learn how to recognize differences between your wants and your needs. Avoid impulsive spending, apply the 10 seconds rule before an impulsive purchase. Invest enough time for major purchases, apply the One hour per 100 Dollars rule and the 30 days rule. Guess the price of an item (or the price you’d be willing to pay for it) before looking at its actual price. Get rid of those dangerous cognitive biases like Anchoring, Bandwagon effect and System justification.

The Pragmatical way: Embrace frugality, think long term. Buy used stuff. Learn DIY skills and get out of your comfort zone. Don’t throw money at problems, throw skills. Become a reinassance man.

The Funny way: it doesn’t have to feel miserable, make it fun! Gamify the process: find a community, join a shared challenge (like the uber frugal month challenge). Challenge yourself, see if you can live with zero for a week.

And also:

  • Earn more, i.e. increase your earnings.

On your current job: work harder, work more, work overtime, get better at it, be reliable, be autonomous, be proactive, show competence, show leadership, show impact, take more responsibilities, ask for feedback, document your progresses, negotiate a raise, get a promotion.

On your next job: always do interviews, don’t stay too much in a place you don’t like, change company when you think you’re not learning anything new, learn how to negotiate a salary, learn how to negotiate a severance package, get out of your comfort zone.

On your next career: learn new skills, be curious, become an idea machine, start a side hustle, fail, start another one, don’t care about revenues for the first 2 years, don’t care about revenues after two years, create value, get these thousand true fans, quit your job, go solo, think long term.

Don’t look for jobs, attract them. (Marco Montemagno)

Once your cash flow is greater than zero, amazing things happens. You now have a saving rate (i.e. savings/earnings), your financial situation is getting better month after month! It can be as low as 1% and as high as 70% or more, it doesn’t matter too much for now.

What to do next?

  • If don’t have one, build an emergency fund.

Cash is king. Without cash at hand you may need to sell some assets or get high interest debts. Without cash how would you feed your family in case you lose your job tomorrow? Do not rely on social security, your state can cut unemployment supports tomorrow if it needs be.

Build an emergency fund, sized between 2 and 6 months of your current expenses depending on your tolerance to risks and unemployment support in your country.

With a fat fund in your bank account you can take risks, you can sleep at night, you can bring food on the table tomorrow.

Don’t exaggerate though, too much money sitting in a low earning saving account looks like a bunch of wasted opportunities. Send your green army to fight for you instead!

You should learn how to invest but first…

  • Pay off your debts, always start from those with highest interest rates.

Once you have few months ‘stashed away and you can face bad news without panicking, it’s time to make your money go to work for you, bringing back more of the same.

What you want to maximize with your invested capital is the return on investment (ROI), i.e. how much (in percentage) that capital grows after a fixed amount of time. A commonly used metric is the yearly return on investment. If a dollar invested today becomes two dollars in a year, it’s 100% ROI. Pretty hard to achieve.

Lending money to you is a nice way to invest for your creditors. A nice way to get a good ROI is paying off your debts. If you have a 10% interest loan, paying it back is completely equivalent to invest the same amount and obtain a 10% return. Paying back a 10% loan is an investment with guaranteed 10% ROI.

10% ROI is very high and you can’t get anything better without risks. Credit cards debts, personal loans, payday loans, car loans… all these category of debts are usually in that range and should be killed before even start investing.

So kill your debts as a first priority once the previous steps have been taken. As a nice side effect, paying off your debts will reduce your total monthly expenses and improve your cash flow and your saving rate.

There’s a debate toward repaying low interest debts though. Mortgages, student loans… I don’t really have a position here, I’ve never been in debt.

If you think low interest debts are good, look at your debts and try to revert the question: “Would I borrow money at that interest rate to reinvest it? Which amount?

I suggest to pay off any debt whose interest rate is greater than half your expected investments return. My expected investments return is the equivalent guaranteed return I’d take for not investing. If someone comes to me tomorrow with this offer: “Borrow me all your invested money, I’ll return it to you in a year with X% interest, guaranteed“, which is X would you accept? I don’t know you but I’d take 6% for sure.

So my suggestion is to get rid asap of debts with interest rate greater than (put your number here) 3% and limit exposure to “healthier” debts to no more than 10-30% of your Net Worth.

  • Invest.

    image credits: chrishooper.me

Once no high interests debt (possibly any debt) is hunting you down you have to find other ways to make your little green soldiers (what a cool name!) work for you, i.e. you have to invest your money.

There’s a lot of common ground but in the end “how to invest” is strongly country specific. Learn about your country taxation, opportunities and synergies.

You can actively invest your time and energy along with your money to hope for a greater return or, as I’d suggest to beginners, just go passive and join a fund.

Anyway, by no means you should jump on something you don’t fully understand! Learn the basics, understand risks and expectations, build your own model and validate it against reality.

Read some books, like “The Simple Path to Wealth“, “The richest Man in Babylon“, “The Bogleheads’ Guide to Investing“, “A Random Walk Down Wall Street“.

Once you’ve enough confidence, write down your Assets Allocation policy and your Investor Policy Statement. State your goals, your strategy, your exit strategy, your failure conditions, your withdraw policy.

Then invest! Go for it!

There are well known investment instruments like: financial instruments (bonds, stocks, funds, options…), real estates (flipping, renting), precious metals, art pieces, businesses and a lot of other atypical opportunities.

I just discovered someone is still making a living by producing digital dresses and selling them on secondlife!

You don’t have to pick only one of them, you can – and should – differentiate in order to reduce risks.

Seek out tax advantage investments, like pension funds. Max contributions out and – given the right conditions – do extra voluntary payments!

And finally, invest in yourself! Choose Yourself! As James Altucher (the author) always says: investing a Dollar on yourself is likely to give you a 50x better ROI than anything else. True story!

  • Increase your saving rate

You’re already in the amazing world of the “positive cashflowers” (what an amazing name?? I gave you too many nerdy tips so far!) things will naturally keep getting better and better over time.

Reducing debts will lower your expenses and improving your cash flow. Investing will increase your earnings and improving your cash flow. Why not push the pedal down even more? Like with sports or with a diet: you see good results and you push harder! Let the positive feedback loop spiral you up!

Aim to increase your saving rate. Your SR is your best friend. It’s the number that matters the most when evaluating one’s financial situation. The higher your saving rate, the stronger the spiral force will push you up.

And it’s incredibly easy to reach SR of 20-50%. It’s easy for you, my financial intelligent reader, that quit luxury and useless stuff to embrace happy and funny frugality!

  • Differentiate & Automate

Do you have all of your eggs into the same basket? Bad!

Don’t get in love with a single strategy. Don’t rely on a single income stream. Don’t invest in a single asset. Don’t rely on a single currency. Don’t rely on a single bank/broker.

Differentiate. The more the better.

Differentiate your skills too, don’t become ultra specialist on a single task. Always be learning new skills and put them into work. Start a side project, start ten of them. Create more income streams.

You want to fail 100 times with your new projects and ideas to learn and iterate faster, but you don’t want to fail once with your wealth!

Automate.

Make your savings and investing as automatic as possible. Save life energies (like your time) for things you like more.

Make your income streams as much passive as you can. Automate your earnings. Get your stocks dividends while comfortably sitting on your couch. Create, and let your creations work for you while you’re getting tanned on the beach.

Again, think long term.

… congratulation, you achieved financial integrity! Financial Integrity is “taking actions” and you now master it. You’re a machine, you no more have financial problems, you have financial goals!

Is that all?

Next Steps

The movie never ends. You’ve reached the finale you think you wanted but spectators are not leaving the theatre! You may realize that’s not a finale, that’s just the beginning of another movie. Or you may want to change your mind and rewrite the entire story. You’re confident in your tools and you have so much control that you can start experimenting. If things go south who cares, you can fix them and write another script. You’re now more a screenwriter than a simple character of that movie.

Happiness & Freedom

Here’s when money starts fading in background. You’re in awesome financial shape and headed toward never have to care about financial issues anymore. What’s next? It’s up to you. What do you value most? What makes you feel happy? Do you like your job? Do you like your house? Do you like the country you’re living in? You have tons of options. Here’s where you realize that money is the tool, the enabler. Once you have anything enabled money doesn’t matter anymore. Anything, not everything like the Joneses want to make you believe.

Intelligence is giving yourself more options, and I wholeheartedly believe that. As your financial situation gets better you can take important decisions like: taking a less paying but more interesting job, reducing your working time, retiring earlier than normal, retiring extremely earlier than normal, travel more, launch a business, fulfilling your dreams, seeking happiness and find your purpose in life. Achieve self-actualization.

My personal goals can be summarised as follows:

  • Pleasure: spend time with people I love (care).
  • Passion: learning as much as possible (curiosity).
  • Purpose: building something that positively impacts other people’s lives (creativity).

Spending too much life energy working on a job (even though I have the best job in the world) won’t bring me there, that’s why my next natural goal is to reach Financial Independence and quit the rat race as soon as possible.

Have a nice journey!

Investing Basics

Hi RIP followers,

Today we have another post in The Principles series, where I:

  • introduce fundamental philosophical/economical concepts.
  • show my vision/interpretation of them.
  • help you understand the subject from other points of view linking other online resources.
  • describe my own strategies and other thoughts on the same topic.

Today’s post is about Investments. I like to take looong and dirty country roads to describe something so intuitive so – sorry friends that’s how I’m wired – fasten your seat belts and get ready. I hope this helps some of you 🙂

investing
(image from milesweekly.com)

What does investing mean? As always, let me be helped by my guest star wikipedia:

To invest is to allocate money (or sometimes another resource, such as time) in the expectation of some benefit in the future.

Yeah, thanks wikipedia, that’s the kind of abstraction level I love! Investments are not just for bankers or for risk seeking rich guys. Everyone invests in one form or another.

A college degree? It’s an investment, where you seed your money (a lot if you’re in US, close to zero if you’re in Italy – but you get a close to zero quality degree) and your time (a lot, anywhere) in the hope to maximize your lifetime earning potential and to enjoy life more thanks to a higher understanding of how things work.

A gym membership? A nice pair of shoes? A ticket for a conference? A house? DIY repairing your own kitchen sink? Start a family? All are investments of some sort, where you give up some resource today or over time in order to get more in the future. Even frugality is an investment!

Investing is necessary in your life. You do it everyday and you know it’s the right way to do. So why when I switch to the topic of financial investing most of the people I chat with are scared?

Scared Friend: “RIP… you investing money? Aren’t you scared? Do you want to play the market??”

I: “I’m not ‘playing the market’, I’m simply investing my money. You are doing it too, but you don’t know.”

SF: “What?? No no no I don’t trust the stock market and all the sharks that populate it. I keep my (small amount of) money in a saving account at my bank. I get almost zero interest but I’ve seen too many people go broke with stocks. I’d buy a house, that’s something solid. And everybody knows that houses are always going to increase their value”

I: “You are investing. You’re investing all your money in a single currency. You’re playing the market in the worst way. What if hyperinflation hits your currency? I have a story to tell you: a friend of mine told me how his Ukrainian in laws become poor last year due to inflation rate above 50%. They were wealthy, they became poor. Weren’t they playing the market? Yes they were! Problem is that they didn’t know they were. Were they differentiating their wealth by currency, would they be better off today.”

SF: “but… there’s been a war there! European union is more stable…”

I: “Is it? Can you bet Euro will be a currency in 10 years? Are you so sure? Aren’t you playing the market?? Anyway, my imaginary friend, you’re playing the market: you’ve got a single bank account with a single bank. Banks may fail – especially in Italy – and you could lose everything overnight. You’re not trying to earn money from your investment, so you’re losing money due to inflation. The only long term investment you came up with is a house, that is ‘solid‘ you said. Well, personally I did the biggest mistake of my life with buying a house in 2010 – and my sister did the same mistake too. Was I unlucky? Well, maybe, but there are people way more expert than me that will tell you it’s not necessary a good investment. So? all your money, in a single currency, in a single bank, eaten by inflation, waiting to be thrown at a stack of bricks, along with a huge mortgage… and you’re telling me I’m being bold?”

SF: “RIP… what are those devil eyes? You’re scaring me…”

Ok, ok, let’s calm down. But the message I want to tell here is: if you are passive with your wealth management you’re not playing safe, you’re playing for someone else. You’re leaving opportunities on the table.

I realized it way too late. I did mistakes when I was young trusting bank’s financial advisers, buying high fees funds and selling them after 2 years of losses (just before the bull market of 2003). I didn’t want to play anymore since recently. Had I been adopting my current strategy since 2010, instead of buying the flat, I’d be at least 250k closer to FIRE. I didn’t play safe, I played stupid.

When thinking about living on my wealth, before my FIRE Epiphany, i measured opportunities by number of months of expenses savedIngenuous RIP: “Look, I’ve 30K in the bank! I can live cheap, 500 per month, so they’d last 5 years!” No inflation took into account, no interests neither. A static model. Now I know the missing piece: you shouldn’t plan to live on your principal, you should plan to live on the money your principal generates.

Investing is a necessity if you want to be FI. You’ve got to send your little soldiers to work for you if you want to watch the TV all day!

Let’s say it again out loud: investing is necessary if you want to be Financially Independent.

Now, what kind of financial investments are we talking about? There are several options:

Investing time (variable) in frugality.

Frugality means reducing costs on things that you don’t value, in order to save money for the things you value the most. It can be extreme or less extreme but the message is the same: cut unnecessary expenses and your life will benefit. Is it an investment strategy? Well, it is, of course. I’m a frugal person (even though spending 60-65K CHF per year would not classify me as such) and I consider frugality the single most important strategy to reach FI. Anyway, I’m not going deeper on frugality on this post, but friends, do expect a lot of rants on it in the future 😉

Investing time (a lot) & money (few) in your skills.

I’m a big fan of skill development. I’m spending time every single day on building new skills. I’m not too much into physical skills like DIY and repairs, but I’m devouring the internet on topics like science, astronomy, space exploration, finance, whatever. Really, whatever. I could spend my entire life studying.

My approach to learning is always by self learning. I’m not anymore in paying someone, attend a course, “get a degree”. I’m a researcher. The only one wise advise that HurryUp gave to me, that I still speak out loud (in my head) every day is: “we are researchers. We can learn whatever we want, we can become experts in whatever we want. Whatever. Wanna be on the cutting edge of biology? Go there. Wanna be on top of Cure for Cancer? Go there. You just have to pick the field you want to be a master and go there“.

So yes, investing in your skills is amazing and is a key ingredient for FI. DIY skills will lower your needs, gardening will lower your needs, professional skills (like software engineering) will increase your earnings, astronomy… well, if you can’t make money out of a passion (which you should always be able to) at least it will enrich your life from so many other angles!

Investing time (a lot) & money (variable) in your company.

Yeah. Go solo. Create business. Don’t depend on your boss. This is an advise I’m giving to you, dear friend, but mainly to myself. I’ve been there and loved it. I’ll be there again as soon as possible. You don’t need a shitload of money though. One of the amazing book I devoured is “The 100$ Startup” (it’s available for free in PDF) by the unconventional writer Chris Guillebeau. Start with a side gig while working, see what happens. See things fail, don’t be scared, try again. Jump onboard full time when chances of success are high. That’s probably the investment that scares the most. You don’t have a guaranteed return proportional to what you invest and this is scary. But the riskier and investment is the greater its outcomes may be.

Investing time (not that much) & money (a lot) in material goods

Material goods are… things. Like for example real estates. What? RIP, you were spitting on real estates few lines above! Wait, let me explain. I’ve been hurt by this strategy in the past and I’m biased, I know. Experienced investors say that real estates is one of the worst investment ever, due to illiquidity, taxes, fees, repairs, aging, immobility,… go read the JL Collins article about it, it’s enlightening.

Having said that, my personal opinion is: I’d buy the house where I live, if I plan to live there more than X years. X varies depending on house cost, location, notary fees, taxes,… but if you plan to live in the same house forever it’s definitely a good choice to buy your house. Be careful not to fall in the opposite problem: “since I bought this house, I need to stay there forever“. That’s something that scares me. I still feel like I want to be free to move and willing to relocate in another country whenever I want. A house binds you to a single place.

Anyway, buying the house you live in is an (arguable, eventually) investment strategy. What I want to focus here is Rental Properties. Houses, apartments, flats you buy for their dividend. The web is full of FIRE seeking people that are exploiting Rental Properties as a strategy. It basically consists of buying estate properties for the sole goal of renting them out and collect rent money. The strategy may be leveraged by aggressive mortgages but then you’ll be too much dependent of appreciation/depreciation of your properties. It’s a strategy I’m not very fond due to its active nature (instead of passive) but I may need to take into account in case it would be financially more convenient in my target country for retirement.

Other forms of material investments are precious metals, art piecescollectibles,… I’ve heard about people investing in Gold (and realizing a fortune in last year) or in Lithium (the white gold: think about the battery needs of devices, electric vehicles, Tesla Energy) or in art pieces but I’m not an expert here.

Investing time (very little) & money (a lot) in financial instruments.

That’s my favorite sector and I’ll devote next chapter of this series to financial instruments, even though one of my “mentor” says you should never own stocks and he has his points.

Financial instruments are stocks, bonds, funds and other more dangerous and more speculative assets like futures, options,… I’m not an expert here too. Anyway, financial instruments are liquid(able) assets that can be converted in cash with a click, that are usually traded in some stock market or sold directly by the state. One usually access to the market via a broker that sometimes can be a bank. We’re going to explore it more in depth in a future post.

I claimed in the section title you need to invest “very little” time in this area. Well, it’s not totally true. If you’re just a beginner and never invested before, the learning curve is quite steep. You don’t need to know everything, but I suggest to get to know at least the basics, and I’m going to provide most them in next posts. If you want to go very deep, you may take a look at JL Collins Stock series, which is biased toward US and the series is split in 30 posts.

Note that for every illiquid investment sector you can find a liquid equivalent one. You want to invest in real estates but don’t want to go shopping for houses? Buy a share of a fund that invests in that! You’re trading your mental energies for costs billed to you by the fund holder. Their costs may be way smaller than yours since they work with higher volume

Ok, cool, you convinced me RIP, I want to invest in something, somehow. How much? For how long? Following which strategy?

These are all valid questions to ask. Things here get a little bit personal. There are few general rules though, let’s dig into some of them:

  • Always invest toward a goal. Invest is a tool to reach your goals, a means to an end, not a goal itself. Define your goals. Define the path to your success. If goals change so should your plan and then your investment strategy. Define the time span of your investments. Different strategies work better for short term, mid term or long term investments.
  • EisenhowerDefine an investment strategy and stick with it. Write a plan. Write your values and your rules. Write down your investment strategy. An amazing idea i’ve found on physicianonfire that you should take time to write your Investor Policy Statement (or IPS). This is a detailed plan that contains goals, philosophy, asset allocation, exit strategy and detailed mechanics. I strongly suggest you write your IPS and review it every 6 months at least. “Cool RIP, where’s yours?” Ok, you got me. I’m a very bad “example” here, a bad master. My IPS is very long overdue. I keep telling myself I should stop and make a concrete plan before end of the year but I’m a master class procrastinator and since this is a quadrant 2 issue on the Eisenhower Matrix, I keep delegating it to my future self. I commit myself here that if I won’t write my IPS by end of year 2016 I’d shut down this blog and go flipping burgers.
  • Know what you’re investing on. Don’t follow advices you don’t understand. Don’t follow a trend because everyone does that (like buying a Million dollar house or getting 2-300K USD student loan). If you want to invest on something do your research and understand costs, risks and expectations. Be sure to shop around for better alternatives (less risks, better expectations) in your field, don’t just jump on the first option you’ve found.
  • If you need help, be sure to understand what the helper is interested in. I’m not a priori against financial advisers, estate agents, career’s tutors and any possible professional that could potentially help you. The problem is that those people have their own interests and they don’t necessary care about your success. Be sure to understand what a potential helper goal in your exchange is before trusting them. For example, in the field of financial investments, be sure you do a good screening and select fee only professional instead of a commission based one. Those whose goal is to make you buy something have their goal conflicting with yours. What if the product they want to sell is crap? Their individual goal is to sell it to you anyway, which conflicts with your goal of investing in something good.
  • Don’t be emotional. Investing should be 99% rationality and 1% feelings. If you have an IPS, stick with it. Don’t change strategy based on transient facts or feelings. Stick with the plan. The stock market crashes? Don’t sell. You got a bad professor? Don’t leave your college. Your mom told you need to buy a house because renting is a waste of money? Don’t rush to please her. Always make your self assessment and analyze the situation from a 3rd person point of view. Zoom out.
  • Invest in something you believe. Being speculative may lead to bigger returns, but be sure you want to live in the world you’re contributing to build. In your IPS you should mention your investment philosophy and ethical concerns. Do you want to finance weapon industry? Alcohol and Tobacco? Banks? Do invest in what you believe would be successful in the future and aligned with your values. Yes, surgeons make good salaries, but if you’re like me and you faint when you see blood, you’re better off getting a degree in computer science! Do invest in the market you value, but be sure you don’t fall into too much Home Bias. Speaking about it, next point is…
  • Diversify your investments. Don’t put all your eggs in the same basket. Diversification reduce risks. Diversification means also try to not invest in a market close to your profession. If the market falls, you lose twice: both your investments and your skills lose their value. I’m a software engineer and I make a good salary in the IT world. I should limit my investments in tech companies or funds based on tech. If we get another dot com bubble I may lose both my money and my job. Your job is an income generating asset, it should be on the table when taking into account diversification.
  • Know (very deeply) all the costs and fees associated with your investment. Fees compound over time and an apparently small difference in the order of percentage points or even decimals matters a lot. Take a look at this article by Trent Hamm for some math explorations. Know and evaluate all financial implications of your investments. Are there purchase fees? Maintenance fees? Deposit fees? Sell fees? other financial obligations? When calculating the Return of Investment (ROI) take all costs into account.
  • Know the tax implications of your investments. Taxes are other fees, but more subdole. They are not explicit, you need to discover tax implications among a jungle of laws. International investments add more complexity to the problem. International investments sold by an international financial institution and purchased via an international broker make things waaaay more complex. Taxes change over time. Taxes may screw your strategy up. Invest time to understand all aspects of it.

Bottom Line

Invest. Don’t be scared. Saw your seeds for a better tomorrow. Whatever path or combination of them you chose (skills, company, material goods, financial tools), whatever goals you have, be aggressive and invest. The younger you are, the more aggressive you should be. Define your values, your strategy, your plan and stick with them. Get help if you want, but be prepared to question the helper. Diversify for the win.

Are you investing? No? What are you waiting for??

Next article: financial investments

FU Number

Hi RIP friends!

Today we have another post in The Principles series, where I:

  • introduce fundamental philosophical/economical concepts.
  • show my vision/interpretation of them.
  • help you understand the subject from other points of view linking other online resources.
  • describe my own strategies and other thoughts on the same topic.

I’ve shown what is Financial Independencewhy I want it and how to withdraw from your NW to avoid depleting it. What’s missing here is: “when can I call myself Financially Independent”? That’s what I’m going to talk about in this post: what’s the target NW to make the call?

[Note: this post will be way less theoretical and more tailored to my personal situation and values. Mathematical details have been covered in the WR post, tl;dr: one needs a NW in the range 25-40x Yearly Expenses, according to risk aversion and expected number of retirement years. My personal choice is a factor 30x, which means a WR = 3.33% that adapts with NW fluctuations.]

Target Net Worth, Nest Egg, FU Money, FU Number, Walk Away Money, whatever… I like FU Number so let’s use it!

fum

[Fun Story: at the time of writing this post I have no idea what FU Number is going to appear at the end of the story! I’m actually sure I’m going to enjoy the process of getting lost into the math, number tweaking, hypotheses weighting and so on. I’m blogging mainly to make recorded plans (and to commit to them), to share them so that others can learn something and, most important of all, teach me something. If your plans include Financial Independence then I strongly suggest you to sit down and do the same exercise. It’s Financial Intelligence to the ultimate level!]

Given my WR of 3.33%, my FU Number is 30 times Yearly Expenses, so what I need to discover here is how much will I need per year/month to live at my chosen standard. Bear with me: for my specific situation, this is the toughest question to be answered. I can’t use current spending numbers as “chosen standard”, due to several factors:

  • Today we live in the most expensive place in the world and we’ll probably retire somewhere else. More likely in Italy.
  • Today we have no kids and we may (and actually want to) have kids in the future.
  • Today we have no cars and we may end up needing one or two in case we move to a cheaper country without such an amazing public transportation service.
  • We have no idea if we’re going to buy a house/apartment or continue renting. This decision alone is complex enough that can’t be fully analyzed here and no general rules apply.

Along with these RIP Family specific issues there are a lot of general unknowns that we must take into account somehow that range from investment performance (is the market keeping up with 7% average growth?) and kind (switch to rental properties? keep investing? On what?) to fiscality (how income, investments and wealth are taxed in the target country?) to inflation, to… too many variables!

When playing with so many unknowns what would a prudent person do? If I were an astronaut I’d consider the worst possible scenario, where every variable will get the worst possible value – I am a software engineer and I grew up as a very close friend of Murphy’s law. This is not suitable here though, most of the variables are unbounded (like inflation) and there’s no limit at the worst case scenario. And you can’t (and shouldn’t) account for every possible bad thing that could happen in such a very long term project like early retirement.

So what to do? Well, the plan I need to come up with should be robust enough to cover for a reasonably unlikely sequence of unlucky circumstances, but it doesn’t necessarily have to work in situations where even not calling ER is going to be a mess. For example: if inflation rate will reach zimbabwean levels wouldn’t it be a disaster in any case? If there will be a third world war and staples are going to cost 100x would being FIREd change the ugliness of the situation? Should I plan for such scenarios? No, I don’t.

So, my plan needs to be robust given a “normal enough” future. I don’t want to fail and have to come back to work 15 years after FIRE, but I don’t want to accumulate way much wealth than I need before calling it. It would mean having wasted healthy years in my 40s for nothing valuable but extra safety.

Let’s go with the plan then!

As I previously said, I need to estimate, as close as possible, how much I’m going to need per year, ideally each year. Each year, because yearly expenses are not stationary. I’m not talking about inflation, I’m talking about lifestyle changes mainly due to having kids. As a first safety margin, I’d try to estimate the average yearly expenses in today’s Euros for my family as the expenses we would have in the worst years, likely with 2 kids at home. A quick research on the web (US1, US2, CHIta) shows that raising a child has no peak years, costs are slowly increasing over time but mostly constant.

Plus: should I account for expected one-off expenses and/or windfalls? Let’s do this way: let’s try to estimate them and in case the windfalls are expected to be greather than expenses let’s not count them, as extra safety margin.

  • Windfalls/Heredity: my parents have a couple of properties that I and my sister are going to inherit sooner or (hopefully) later that are worth few hundreds thousands Euros. My father is a saver and a frugal person who doesn’t like to spend his money. He’s probably going to leave us cash in the order of few (one or two) hundreds thousands Euros.
  • Expected one-off expense: kids… I plan to help my future kids (and I want to plan for 2 of them) with a lump sum in the order of magnitude of 100K of today’s Euros, probably not given as a single fat check but in tranches over time. This is to help them with University, career, rent, startup,… I’d like to see them flying away on their own as soon as possible. The lump sum has nothing to do with a monthly allowance while living in our house (like my father did with me). That would be in the plan of yearly expenses.
  • Expected few-off purchases: we may need a car or two in the future. Either I consider a car purchase as a yearly expense (a fraction per year) in the plan or as a one-off here. I’d say let’s put them in the plan. I’m not a fan of new and expensive cars, so my car purchases would be in the “below 5K Euro” each, ideally a used car every 5-10 years to be driven till its death. That’s negligible in term of yearly expenses. Miss RIP is more oriented to new cars though. Need to discuss or plan accordingly.

Summing this up: one off purchases and lump sums are more than compensated with expected windfalls so I’m not taking measures to face them now. We don’t have kids now, in case we’ll have one or none things are going to be easier (financially). It’s very unlikely we’ll have more than 2 given our age, but who knows. Twins? Well, these are variables we’re going to discover before FIRE date anyway. We’ll adapt our plans accordingly.

Plus: should I account for annuities due to pension benefits? Let’s say no – extra safety margin – but calculate them under current legislations anyway:

  • Swiss Pillar 1 Pension: If I reach FI in 5 years I’d be accrued 9 years of Pillar 1 contribution. I’d get back ~400-450 CHF per month at age 65. Miss RIP will get a little bit less, depending how much she’ll work. Here‘s a link to get an estimate of your Pillar 1 Pension.
  • Swiss Pillar 2 (Mandatory) Pension: same here: 9 years, expected total = 54K, expected annuity (6.8% per year) = 3600 CHF per year = 300 CHF per month starting at age 65. I’m not counting the extra mandatory portion since I’m going to take it out as a lump sum when leaving Switzerland (or buying a house) so it’s in my NW (well, the mandatory part is in my NW too since there are situations where I can cash it out but it involves moving to a country without pension agreements with Switzerland, like US or other non-european countries). Miss RIP has no Pillar 2 at the moment and I think her employer should/must offer her a plan.
  • Italian Pension: I don’t actually know if I’m going to get some of the money I’ve paid during the years I’ve worked in Italy… Italian pension system is so messy, impossible to understand and biased toward traditional work history. I heard that if you don’t collect at least 15 years of contributions you get nothing. Maybe years worked abroad counts somehow… It probably depends if I’m going to retire in Italy or not. And eventually it will kick in very very late, somewhere around age 70 in the best case. It may be possible Swiss Pillar 1 and Italian pension would merge together. I don’t actually know and getting information on this topic is a real pain. Let’s say I won’t have any italian pension.

So, annuities with current timeline will kick in at age 65 (~20 years after FIRE) and are in the range of 8500 CHF per year. Still no, I don’t want to consider them in my plan. I like surprises 🙂

I’ve listed above few safety margins. Planning several of them is the way to handle a fair amount of uncertainties, as shown by MMM. To be as safe as possible (but not too much) I’m going to consider few more:

  • 3.33% WR is pretty safe.
  • Planned yearly expenses bigger than likely, both during family years (40-60) and traditional retirement years (60-??).
  • Two kids is the worst case (financial) scenario… and I’m sure there are tax discounts and/or other tools to mitigate the cost of a kid.
  • Windfalls not included.
  • Annuities not included.
  • Very unlikely that I’ll be earning ZERO for the rest of my life: side jobs, consulting, freelance, writing, sharing economy… some of my dreams will probably help me along the way.

Ok, cool, things are supposed to go smoothly if I stick with my pessimistic plan. Things are going to be better than planned. Probably. What to do if a series of unlucky events will hit hard (more expenses that planned, bad investment returns, asset loss due to financial institutions going bankrupt, earthquake that destroys my properties,…)?

  • As soon as I reach a significative deviation from the plan (planned 3.33% withdraw < 20% of planned yearly expenses) I’d try to shrink my budget and/or withdraw more than 3.33% and/or boost incomes (sharing economy, consulting, freelance). 20% is my Oh Crap threshold.
  • As soon as planned withdraw goes below 40% of planned yearly expenses I and/or MissRIP would look for a traditional job. 40% is my Oh Shit threshold. I sincerely hope this won’t happen.

Time to estimate yearly expenses, the hardest job. I’ve no clue but a rough idea that 3K Euros net per month will suffice, in Italy, with 2 kids. According to Numbeo, life in Italy costs roughly half of what it costs in Switzerland. I can’t simply cut in half our current spending (60K CHF per year), since other variables are missing in that budget (kids, cars) bot some may disappear (expensive vacations, dinners out, rent?).

More questions:

Housing: what would be our housing solution? Renting a flat? Buying a flat? Buying a house? Living in a RV? Living in a cohousing/ecovillage? I don’t know yet the answer, let’s plan for the “normal” scenario: buying a flat in the range 100-200k Euros and paying a low interest mortgage (or cash) for it. I’ve been thinking about buy vs rent. My opinion is that if you plan to stay in the same house for more than X years you should buy. X depends on several factors, but it’s in the range 3-7.

The equity portion of the flat would be in our NW but it won’t generate income and it will work against the 75% – 25% stocks/bonds investment split to meet the trinity study requirements. Should I consider just the investments as base for my WR or the whole NW? Should I take a mortgage and have higher monthly expenses (but more invested capital too) or pay cash and reduce the expenses and the invested capital (not an easy question: 1 – 2 – 3)?

I can’t answer right now. I’ll need to take a look at concrete houses and mortgage rates and look at the actual numbers. I can only speculate here. So let’s speculate: I’m buying a 100 square meters house for 150K Euros (120K price + 30K renovation costs) in a rural area in Italy not far from a major city. I’m paying 20% down (24K) and taking a 2-3% 20 years mortgage for the remaining 96K, plus paying cash the renovation costs. My investments will be hit by 50K, my yearly expenses by 6K.

Health Care: If in Italy, health care is “free”. We won’t need any insurance. Awesome! Well, it’s not that simple…

Taxes & investments: my stock/ETF investments are after tax money, so I don’t have to pay taxes on them. Investment earnings are taxed in Italy though. Both in the form of taxes on dividends and capital gain (not while I’m in Switzerland). I think there’s also some sort of extra tax for investments owned in foreign countries, need to investigate. I don’t know if I can keep my current investment account if I’d move to Italy. A lof of issues may impact my current FIRE strategy and make it stop working. Need to investigate.

One obvious thing to do to avoid unfair capital gain tax while in Switzerland is sell and re-buy just before moving back to Italy, to cash the tax-free capital gain. Anyway, after paying investment taxes I won’t have income taxes. Withdrawing money from my after-tax investments should be tax neutral. That’s awesome! Well, need to investigate that more since Italian tax authority is greedy with legally earned wealth (eyes are both closed with criminally earned one). In case my target country is not fond for living on investments earnings I may switch strategy and go for rental properties. I know how taxes work in that situation and I may make it work, even though I’d rather remain an index funds investor.

Do you see how hard it is? My current situation (living in Switzerland, no kids, renting, no cars) is so different from what I expect to retire on.

I can’t help but ask for more time to get to know some of the unknowns in my equation. For now let’s assume 3K per month will be good, given the above mentioned safety margins. 3K per month means 36K per year. At my 30:1 ratio, i.e. 3.33 WR it means 1’080’000 Euros. Let’s make safer, 40K per year. It means my FU Number is 1’200’000M Euros.

That’s a sad news, since so far I was aiming to a Million. It was not a secret, since my logo says 46.9% and my NW says 468’823 Euros 🙂

Maybe I’m taking into account too many safety margins and not trusting my ability of earning money even without having a job. A recent article from Financial Samurai shows how the fear of running out of money in retirement is overblown.

I can stick with my original rough estimate of 1M – reachable in 5 years, at age 44 (actually linear forecast says 4 years, based on 2016 performance… but I doubt that both the market will keep running at this pace for next 4 years and future kids won’t impact our saving rate) – or accept the new estimate of 1.2M – reachable (stretch) in 6 years at age 45. I don’t think it’s going to change a lot. In case I’d go for 1M I’ll probably surrender to the OMY syndrome and will end up working another year anyway. With the safer plan of 1.2M I’d pull the trigger as soon as I reach the goal.

I’ll take my time to think about it. For now, let’s set the FU Number at 1.2M and site logo will be updated accordingly at end of August 🙁

As expected, this post created more confusion than clarity. Instead of helping clearing my mind I’ve come up with more questions and things to go deep with than I had before start writing it. It’s been necessary though, and more questions are going to come in the near future. Is Italy suitable for early retirees? Is really 3K Euros a reasonable monthly expense with a family of 4 persons? Will I have some unplanned passive income streams at FIRE time that can lower my withdraw necessities? Are there any expected windfall coming from Miss RIP side? Are we really going to create a family? Follow me in this journey and you’ll know!

What’s your FU Number??

Withdrawal Rate

Hi readers!

Welcome to another post of The Principles series, where I:

  • introduce fundamental philosophical/economical concepts.
  • show my vision/interpretation of them.
  • help you understand the subject from other points of view linking other online resources.
  • describe my own strategies and other thoughts on the same topic.

Today I’m going to talk about Withdrawal Rate: how to actually use your wealth when FIREd to cover for your expenses in a sustainable way. Enjoy.

Did I already tell you about Financial Independence? What? Only a dozen times so far?? Cool, time for one more! Here’s the the Wikipedia definition:

Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities.

For financially independent people, their assets generate income that is greater than their expenses.

In a recent post I’ve explained my point of view with respect the first sentence of the above definition. Here I want to address the second (highlighted) sentence: how exactly your assets are supposed to generate income that’s greater than your expenses?

Well, the actual mechanic is different for each different asset category. Passive income generating assets for FI seekers are essentially clustered in two categories:

  • Asset: Rental Properties – Income: rents.
  • Asset: Stocks/Bonds/Funds – Income: appreciations, dividends.

There are other forms of semi-passive incomes, like royalties (you wrote a book and keep earning money from sales passively and forever), business activities (you buy a shop and you sit and wait for money to come), entrepreneurship (you launch a successful startup), sharing economy exploiting (you rent your extra rooms on airbnb, cook for strangers on bonappetour, babysit kids on bsit, drive people around with uber,…), blogging/writing/crafting (ads, promotions, consulting, copywriting, online sales…let’s be honest, it’s the only reason I started this bl).

The semi-passive incomes are amazing tools that provide safety margin to your strategy, but they’re not fully passive by definition. If you rely on some of these strategies to cover your expenses you’re not fully FI and you can’t “retire”. Depending on which portion of your expenses you want to cover with side gigs, you could slow down from your traditional job and switch to a form of semi-retirement. That’s what happened to Trent Hamm when he quitted his job. If quitting is too risky for a not yet FI family, you can switch to part-time or become a one-(traditional)income-family instead of two. Semi-retirement is a fuzzy concept and even though it may slow down the actual retirement it’s an amazing tool to use in case of work related stress, burnout or simply to taste what retirement could be. It’s a taste of freedom you can only allow yourself if your Financial Integrity is solid.

Let’s analyse the more common FI strategies: rentals and stocks/bonds/funds. One can argue that the rental properties strategy too is not fully passive (due to managing tenants or managing a property manager) and should be listed in the semi-something list. I don’t care much since it’s just a matter of definition. And it’s not my strategy at the moment!

Here I’m going to focus on my strategy, which at the moment is mainly buy&hold index funds, currently in the form of Exchange Traded Funds (ETF). I don’t know now how stable my choice is. I may be switching in the future if I find that in the target retirement country the laws and the market push for a different strategy or against my current one. But for now, in Switzerland (no capital gain tax), I’m investing in the stock market. You can find some details in my Net Worth post. More about my investments and how to invest in Switzerland in future posts.

When you hold stocks/bonds/funds (mutual/ETF) your assets generate wealth in 2 ways:

  • appreciation – the positions you hold increase their value over time.
  • dividends – the companies whose positions you hold distribute part of the revenues among their shareholders. If investing in securities that reinvest the dividends (like accumulating ETFs) or on stocks of companies that – by choice – don’t pay dividends (like Berkshire Hathaway, Google, Amazon, Pfizer, …) then you can consider just the appreciation component.

In both cases, your NW is expected to grow over time. The history of S&P 500 (an American index based on the 500 companies with biggest market capitalization) shows that given any 30 years window over the last 100 years (including the 1929 crisis) the index grew on average by no less than 7% per year (plus most of the companies in the index pay dividends). Of course, past performances are not a guarantee for future ones. There’s even a speculation trend among bloggers and analysts that the market is currently overpriced, that we are long overdue for a bear market. Anyway the truth is that no one knows the future so I’m planning my future sticking with the 7% yearly expected growth rule.

7% is the average expected return over a long period. It doesn’t mean you should expect 7% every year. For example, the value of the index in March 2000 was the same of March 2013… 13 years to recover losses! That’s why investing in stocks can only be effective on average as a long term strategy.

sp500

So let’s assume your NW is increasing both because of assets appreciation and dividends (that you may reinvest) and finally you’re FI and you want to live off of your wealth-generated income. How to do it?

What you usually do is uninvest part of your invested capital every year/month and use it for your expenses. The actual mechanic is different for each legislation. For example in US is common to apply the Roth IRA conversion ladder to avoid tax penalty for withdrawing on tax advantage accounts before some conditions are met. In Europe things probably change country by country but I think it’s generally simpler since investments are generally not available for pre-tax accounts like pension funds. For example in Switzerland I can’t invest my Pension Pillars 1 and 2, and I have very limited and expensive options for Pillar 3. So 100% of my stocks investments are from after tax accounts thus withdrawing should be painless I guess.

The amount you withdraw from your NW every year is called Withdrawal Rate. if your NW is 1 Million and you withdraw 10K per year, your WR is 1%. If you withdraw 1% and your NW grows by 7% per year you are probably going to be safe and not depleting your Nest Egg over the long run. If you withdraw 7% and your portfolio grows by 7% you’re simply keeping your NW constant (not exactly, since +7% and -7% is not zero!), which means you’re losing money over time thanks to inflation.

So, assuming I want to be able to constantly withdraw money from my investments, for the foreseeable future and never going to deplete my Nest Egg, what should be my WR? Here things get personal because it really is a personal issue. If you’re retiring at 30 or below you need your strategy to last 60+ years so you want to play safe, if you’re retiring at 60 years, you may withdraw more aggressively since there are less expected years left for you. The portfolio composition matters too: the more stock oriented your portfolio is the more aggressive your strategy can be.

Before moving on, let’s explain why WR matters: it defines, along with your expected yearly expenses, the amount of wealth (your Nest Egg) you have to accumulate to call yourself Financially Independent.

If you want to be safe and only withdraw 2% and you think you’ll need 30K per year than 30K have to be 2% of your Nest Egg, i.e. you need to reach 1.5 Millions. If you want to withdraw an aggressive 6%, you just need to reach 500K. Note that it doesn’t mean that being more aggressive makes things easier. In the first scenario the Nest Egg is probably going to grow over time even when withdrawing from it while in the second case the risk of a failure is extremely high.

I’t up to you to choose your safety level and define your own WR. History helps us though. History shows that if you had adopted a similar strategy in the past, starting at any point in the last century with a nest egg of X dollars and had withdrawn 2% of X each year (adjusting for inflation), your money would have survived till today. Not just survived, you’ll probably have way more than X (inflation adjusted). That shows that a 2% WR is way too safe, you can comfortably increase your WR.

What about 3%? 4%? 5%? Can I run some analysis over the historical data with other values for WR? Yes you can (and you should if you plan to be FI!). Apparently someone else did that for us and came up with interesting results. Three professors at Trinity College wrote a very influencing paper about sustainable WR. This is the so called Trinity study, and the results they found are simply stated as follows: based on a portfolio composed by 75% stocks and 25% bonds the maximum sustainable WR you could have had starting in year X (in the range 1925 – 1981) in order to not deplete your portfolio within the following 30 years has never been below 4%.

swr
source: https://retirementresearcher.com/the-trinity-study-and-portfolio-success-rates/

This is usually called the 4% rule and has been discussed on almost every personal finance blog (MMM, JlCollins, TheSimpleDollar). A withdraw Rate of 4% is usually referred to as the Safe Withdrawal Rate. Numbers have been ran over more than 100 years of recorded history, starting even before the great depression of 1929!

Again, past performances are not a guarantee of future returns, but 4% has been the Nest Egg depletion WR only in the worst case scenario in the last 100 years. It’s not unreasonable to stick with the SWR. JL Collins in his blog claims he’s going to withdraw “somewhere north of 5%“, others stick with the 4% or some variation of it, like Justin at RootOfGood that’s going to adopt a variable withdraw rate of 4% of Portfolio Value each year (in bull market they’re going to withdraw more, in bear market less). There are others who are going to play safe and withdraw below 4% to get more safety margin. Anyway, the strategy may be dynamic and playing safe at the beginning will more probably lead to an increase of your NW that in turn would allow for more freedom in the future.

Let’s play with math a little bit more. 4% Rule means that you need to reach a NW of ~25 times your yearly expenses or 300 times your monthly expenses. If you plan to live on 2K (whatever currency) per month and trust the SWR you need to have 600K NW. At our current spending rate of 60K CHF per year, if we want to stick with the SWR we’d need 1.5 Millions CHF, too much to retire before target age of 45.

[Anyway, the current 60K CHF expense rate per year is totally unstable. It’s going to either increase, in case we’re staying in Switzerland forever and have kids and move to a bigger house, or decrease, in case we’re moving to a cheaper country like Italy and go rural instead of big expensive cities]

Ready for the mind blow?

If you’re ok with 700 USD per month, and you stick with the SWR then you just need 210K USD.

mindblow

Wow.

I could already be retired if I choose to live with so little. I could actually already be FI if I want to allow myself a monthly allowance equal to my current NW / 300, which with today’s numbers (August 2016) is ~1600 Euro per month. Which is more or less my salary when I was working at GameCompany!

You can see how spending less and saving money will manifoldly quicken your FI race: the less you spend the more you save and invest, the quicker your NW grows, the lesser you have to accumulate in order to be FI. Win win win!

Here’s the amazing math behind the SWR rule: any recurring monthly cost of X you want to add to your lifestyle costs 300X in term of NW. Do you want a gym membership of 50 Euro/month forever? Easy, accumulate 15K more and you have 50 per month forever!

The reverse is true: if your NW is greater (or equal) than zero, you can already be FI if you accept to live with NW/300 per month. Are you just starting and your NW is 50K USD? Well, if you can live with 166 USD per month (I doubt you can) you are FI! Is your NW zero? No problem, you can be FI if you can live with zero per month (an homeless is already FI).

Another way to put it into perspective is: what’s the difference between your desired monthly allowance and your current FI monthly allowance (your NW/300)? If you are not yet FI the former is bigger than the latter. When they meet you are FI! In my case my desired monthly allowance is not yet defined (somewhere between 2500 and 4000 Euro per month, but I’ll explore hypothesis with more details on a future blog post), while my current FI monthly allowance is 1600.

What’s the impact of a fixed cost somewhere in the future on your today’s Nest Egg? Simple, take the expected cost of that expense in today’s monetary value (no inflation counted) and let’s call it X. Take the years left between today and the expected expense year and let’s call the difference N. The cost of a future expense X in N years is Y = X/[(1.04)^N]. It’s discounting the value X by the SWR percent every year. If you invest Y today and it grows by 7% on average per year and inflation erodes 3%, there you are! after N years you’ve X inflation adjusted!

For example, let’s assume I want to take into account a future donation to my 2 hypothetical kids of 100K Euro in 20 years from now for their studies. 1.04^20 ~= 2.19 so Y = 45630 per kid so ~91K in total. 91K of today Euro will become 200K of today Euro in 20 years, i.e 352K Euro.

Same logic applies for expected windfalls like heredity. Note that this is purely hypothetical and it’s valid for very long time frames like 10 years or more. Market is too volatile in shorter time frames.

Time to showdown some of my numbers:

I want to play safe for several reasons:

  • Trinity study is about US stocks and even though I can invest in US from wherever I want (and I’m investing in US too much already), I don’t want to be too USD dependent. Currency fluctuations can kill my nest egg even when the market runs.
  • I have this feeling that markets are a little bit overpriced right now, so 7% expected over the long period may not hold for the future (I know, it’s a bias).
  • I want an extra safety margin, at least at the beginning of my FI journey.

Given the above reasons, I’m planning a WR of 1/30 of NW each year: 3.33%. So in the above formulas, when you see a 25, consider it a 30. When you see a 300 consider it 360 for me. It’s not written into stones though, I hope to withdraw as less as possible in the early years of Early Retirement (ER) because I plan to have few other semi passive income streams – I don’t plan to retire to sit and watch TV all day, I’ve got plenty to do.

In next chapter we’re going to talk about the desired Spending Rate and consequently the needed Nest Egg to sustain the spending rate, given my chosen withdrawal rate.

The target Nest Egg to call yourself FIREd is sometimes called FU Money – or more politely Walk Away money. The money you need to say NO. The money you need to be FI.

What’s your target WR?

Financial Freedom

Here I’m going to write my first post on a new series on Principles. I’m going to introduce concepts that are widely know to the Personal Finance community that you, my dear reader, may not be very familiar with. I’m going to talk about higher values and my philosophical and ethical approach to personal finance. In this series I’m going to talk about my ideal society, the meaning of work, the meaning of money, time economy, life energy, consumerism, minimalism, frugality, stoicism, self reliance, renaissance man, happiness, nature, pleasures, passions, purpose,… Not all of them in this post, obviously 🙂

Here I’m going to talk about Financial Freedom.

In last chapter of my financial story series I explored the why I want to reach Financial Independence (tl;dr: to achieve self actualization). Here I’m going to define what it actually means and what are financial steps to walk along this very path.

In the amazing book Your Money or Your Life, that is the main reference for this post, the authors (Joe Dominguez and Vicki Robin) introduced the three Financial stages a financially healthy person would pass thru their life. Let’s take a closer look at them. BonusHere‘s an amazing collection of chapter reviews by Trent Hamm.

Let’s pretend we’re following a journey of a person from the very financial bottom to financial independence. If you need a real scenario, you can read the story of Trent Hamm, founder of The Simple Dollar, who perfectly documented all the stages in his life, from his financial bottom to the celestial walk to FI.

So, let’s assume you’re in financial trouble, maybe full of debts, maybe working on a job you hate, maybe living paycheck to paycheck. That’s a very common situation, actually the most common one. In Italy, for example, we use to say “I can’t reach the end of the month“, that basically means that the fourth week of each month is very lean and you need to cut expenses to survive till next paycheck. It’s a so desperate and so common situation that we just assume it’s normal. But it isn’t! One works very hard and all they get is to be able to almost reach next paycheck.

[ Well, in Italy none asks “ok, I’m in this shitty situation. How can I make some improvements?“. We’d rather blame the government, the immigrates that steal our jobs, the inevitability of the (third for the family) car loan payments,… There’s no way you can have a chat with Italian friends or acquaintances for 15 minutes straight without having them start complaining about their inability to “reach the end of this month” ]

Dear Italian friend – just saying, I know I won’t have many Italian readers, I know you don’t speak English – first step is to get the so called Financial Intelligence.

piadinutellaLet’s make a food analogy: you’re overweight and feel depressed. You keep eating unhealthy food because it tastes good and gives you immediate – but false – joy. After yet another piadina with Nutella you feel like shit. You’re fat, you don’t like your body, you can’t walk the stairs without feeling dead for the fatigue. You can’t work out because you’re too fat for most exercises. Your doctor keeps telling you that you risk heart diseases, diabetes and other illnesses but you don’t care because it’s not an immediate threat. You watch other people running and you complain that they are “lucky”, that they have better metabolism, that whatever but you can’t survive without lasagna,…

Do you want to improve you life? Time to acquire the first but most important skill: Financial intelligence.

Level 1 – Financial Intelligence.

Financial Intelligence is awareness. Knowing the basics before trying to control them. Do you know what’s your Net Worth? Do you know what’s your Cash Flow? Your Incomes? Your detailed Spending? Do you know what are the interest rates of your liabilities? Do you know your actual hourly wage?

It seems it’s the simplest step one can do, but actually very few financially-in-trouble people do it. It takes willpower and/or desperation to make the first step. It also requires some knowledge. Many people don’t think they can actually make it, they feel doomed and it leads to a dangerous vicious cycle where one compromises their financial situation even more because “there’s nothing I can do. I can’t live like a homeless and still be full of debt. So, better to enjoy life and buy a shiny new car“.

The value of books like YMOYL or online communities come into play providing the information you need, assuming you’re seeking out for a cure to your financial disease. Blogs like Wise Bread, The Simple Dollar, Mr.Money Mustache, Early Retirement Extreme (and many others) are doing the incredible job of showing people that a different life is possible and you can make it, assuming you’re willing to make few important changes in your routines/habits/behaviors.

So you’re in trouble, full of debt and/or with an addiction to impulsive purchases and you feel doomed. First thing to do when you’re in such a hole – and this is valid outside personal finance too – is breathe and understand where you are. Get the full picture and be honest with yourself. Understand where your money are flowing away. Break numbers down into categories, measure the impact of your debts and negative interests, do budgeting. Then you’ll be Financially Intelligent.

In our food analogy, our financial intelligent overweight Joe decided to monitor his every day weight, his workout sessions, calories burned and calories eaten. He discovers, looking at food labels, that just a single marshmallows, that he really loves, is worth 5 tomatoes of calories. Wow. He discovered that 30 minutes of running is not enough to burn half Big Mac. It’s an eye-opener experience that may depress a little, but in the end makes him aware.

I’m lucky enough that I never had to see the financial bottom. I grew up with a basic but good enough financial education (thanks to my father) and I’ve never been in debt. I had to handle my finances pretty early in my life and thanks to this I’ve been monitoring Net Worth and Cash Flow since the dawn of time. My Net Worth has always been positive and I’ve never struggled to reach the end of the month. I’ve always been Financially Intelligent.

Ok, now you’re Financially Intelligent. You know your assets and liabilities, you started a budget and you are tracking earnings and expenses over time. Now it’s time to move up!

Level 2 – Financial Integrity

Financial Integrity means taking actions. Once you have a good picture of your situation, it’s usually easy to find and grab low hanging fruits: “huh… am I really spending 200 Euro per month on videogames?“. So, strategies like cutting superfluous expenses come natural and they are easily implemented.

What will happen when you start taking action is that you better define your values. You understand easily that you need to spend less than you earn if you want to get back in financial shape. To do that, you either earn more or spend less (or, better, both). The latter is simpler and quicker. To cut spending you need to take decisions and define priorities. Your own priorities. You need to define your “enough” for spending on each category.

You’ll quit unhealthy behaviors like impulse spending or buying advertised products just because they are popular. You may eventually discover frugality and/or minimalism, and actually like them. You make transformations in your lifestyle, in how you chose the people around you, in how you interpret consumerist signals from society (commercials, ads, the Joneses). You will probably look at purchases from a Life Energy point of view, i.e. “how much time do I need to work to cover this expense?“.

You may be enjoying the freedom not having to think about next paycheck brings to your life and start saving, building an Emergency Fund. Eventually, when you have enough cash to survive a year (people recommend 3-6 months) without working, you’ll stop hoarding cash and start investing and/or paying back your debts, sending your money to work for you thanks to the immense power of compounding.

You may also work on the earning side of the equation: once you ‘stash a year of salary you may consider working part time and take some classes or learn a new skill or start a side gig to boost your earnings. You may realize your commute takes too much time and it’s costing you a lot of life energies (opportunity cost) and living far from your office is not worth the few bucks you’re saving.

You’re taking actions, you’re a different person now. You took time to explore what matters to you. Your financial actions reflect your values. You achieved Financial Integrity.

loseweightIn the food analogy, having acknowledged that you are not ok, you start a diet and do sports. At the beginning eating less was frustrating but now you feel full eating a quarter of what you used to. And you like that! It was hard to get your sneakers on and go running at dawn – you were able to run 5 minutes and then everything ached – but now you wake up happy to go running your 10 kilometers, it may actually be the best part of your day, and try to break your record on that distance. You’ll plan a half marathon and draw a working out plan to prepare yourself. You lost 5 kilos, then 10 kilos, then 15 kilos and the more you get in shape the more you like the process itself.

In my case, again, thanks to both my father who taught me the basics and to my genuine lack of passion for luxury I was born with some sort of Financial Integrity. I was educated to manage my money and do budgeting very early in my life. I started earning money at high school doing math lessons. I always spent less than I earned. I sought opportunities to earn more and implemented frugal tactics. I didn’t have big goals though. I didn’t investigate my values deep enough. It took me ~25 years to see the big picture.

You’re now in good financial shape and instead of spending your mental energies on “how to pay the pile of bills that are waiting for me at home” or “I hate my boss but I’ve no other options, I need to keep my job” or “the government approved another law that will move retirement age in the mid 70, holy shit I have to work forever!” you may relax and stop caring about immediate money problems. You’ll start focusing on what really matters and how to move your attention and money/time/energy toward these passions/people/projects.

From now on the path is not necessary a straight line. Not every financial healthy person wants to reach independence. I know a lot of people who genuinely like working and/or love some luxury and they budget for that. I know people who fear the freedom that Financial Independence will suddenly allow. Anyway, it’s a matter of personal values and none is here to judge. What happened to me – and apparently I’m not alone in this – is that I started to ask myself “what to do with this accumulated wealth?“. Buying more things didn’t seem too much appealing. So I started seeking freedom.

Bonus: here’s a link to the original 9 steps Financial Integrity program by the authors of YMOYL.

Level 3 – Financial Independence

Financial Independence means tasting freedom. You no long have to work to maintain your lifestyle, since your money are working for you instead. Your passive incomes (like stocks appreciation, dividends, rental properties income,…) cover your living expenses and you’re free to choose what to do.

You may keep current job, try a different career, go back to school, take entrepreneurial steps, work less, work none. You may have dreams you want to follow, people you want to take care of. It’s really up to you. You’ve got freedom.

Freedom here stands for freedom from selling your time for money. You no longer need it. You’ll rely on your passive incomes robustness, like betting on average market returns of 7% per year (inflation adjusted) on the long run or a combination of good tenants, rent/house appreciations and low vacation rate for your rental properties.

Before you call it FI, you’ll have ran your numbers and considered several safety margins. Eventually you’ll have planned an exit strategy if things would go south. I love the “Oh Crap, Oh Shit” idea shown in livingafi blog.

You adapted to a lifestyle you like and have a good strategy to support it with passive income for (hopefully) the rest of your life, which is a very bold statement since you may retire pretty early, in your early 30s or even in your late 20s. Yes, if FI is what you seek, you may go extreme frugal and obtain it as quickly as possible. Reducing your spending by a lot makes things way easier, since you both save more money and need less money to maintain your lifestyle. It’s a win-win scenario!

The extreme frugality path has been perfectly explained in the amazing book Early Retirement Extreme, in the associated blog or in other frugal-centric blogs like the frugalwoods family’s one.

independenceSadly the food analogy can’t keep up with the financial story I’m telling here. There’s no such thing as compounding: you can’t exploit “accumulated weight loss” to keep losing weight and thus eating what you want and still be healthy. Actually it works the other way around: the fitter you are the stronger you have to keep up with diets and workouts or else you lose benefits quite soon. Bye bye (former) overweight Joe.

Here’s where I’m heading to. I’ve been financially “Integral” (is that the right way to say? It sounds weird!) since forever but I had no clear vision for my future. I have been naturally frugal, I’ve accumulated some kind of wealth but then what? Just for “financial security“? With the income boost provided by Hooli I started dreaming high. I plotted an actual plan, threw out some numbers and found a break even point, a target NW to call it FI. The so called FU Number. The plan is going to change, the FU Number is going to change according with life decision like: do I want a family (spoiler: yes)? How many kids (spoiler: >= 2)? Do I want to retire in Switzerland (spoiler: no)? In Italy (spoiler: maybe)? Somewhere else (spoiler: maybe)? Is there a wealth tax there? Do I plan for windfalls? Should I account for annuities at one point? Social security? How much per month/year do I want to allow my family to spend? What should be my withdrawal rate? Do I plan to keep “working” on activities that may earn money, like renting a room on airbnb? All these factors will impact the actual dynamic strategy.

Anyway, as you see one has to take decisions, cutting corners, making plans to be able to achieve FI. It’s freedom, but it comes at some costs.

So you’re now part of the club of the few people who are walking on the heaven of FI, who can avoid caring about job market, unemployment rate, bosses that suck, shitty jobs, economy (well, not exactly). Life is awesome and you’re not scared at all by the future.

Or… are you?

Level 4 – Financial Freedom

Financial Freedom means removing money from the equation. It means, as Mr Money Mustache suggests in his Rule of Free:

I try to make all spending decisions as if the price were $0.00

And I make all work and income decisions as if the wage were $0.00

That’s true Financial Freedom.

Note: this is not one of the YMOYL steps. I first read about the concept of FF on this very good post by Financial Mentor. Then I got enlightened by the above mentioned MMM post. Financial Mentor says:

For example, extreme frugality would limit my ability to take my family to France for a month (like I did last year), which honors my values for adventure and life experience. I wouldn’t be able to honor my values on education by paying for quality, private school for my kids.

I wouldn’t be able to honor my health values by paying for professional services like sports training, physical therapy, or expensive organic food. All these things would be luxuries in a world dominated by frugality thinking.

These would all be limitations to my freedom and would dishonor my values. In my personal experience, that’s antithetical to true wealth and personal freedom

I don’t fully agree with the above quotation, but I do understand his point.

freebraveYou can think of FF as FI with almost International Space Station’s security measures against unplanned events. Rock solid FI, with a monthly budget well beyond your most desirable spending regime at your safe withdrawal rate. Or, equivalently, a withdrawal rate of 1% or less at your current spending regime.

No economic event in the foreseeable future (excluding catastrophes, world war or a sudden depletion of earth resources) can put your plan at risk.

I’m not heading there though, at least not for now. FF means you’ll cross FI threshold and either keep building wealth, to reach passive income streams that total well above your wettest dreams – a là Financial Samurai – or you reach a state were you don’t know what you would do with more money – a là Mr Money Mustache or Jacob, with 117 years of spending stashed at the time of writing this article, August 2016. Either you become very very wealthy, or you become very very frugal with no desire of spending more.

Pursuing FF should be planned while walking toward FI, it’s not something that comes natural. Pulling the Early Retirement trigger too early prevent you from following the super wealth path, leaving you with only the Zen one available and not everybody is suited for it.

Where are you on this ladder?

What? Level 0? What are you waiting for?? 🙂