Why true financial independence means eliminating financial vulnerability including not being overly reliant on stock market appreciation.
In this podcast episode you’ll learn:
- What does it mean to be financially vulnerable.
- What are the two paths to financial independence.
- Why we shouldn’t stake our financial independence and early retirement on the historical performance of stocks and bonds.
- What are the rules of thumb we can use to develop reasonable assumptions for stocks and bonds and how those assumptions will lead to lower portfolio balances compared to using historical returns.
- What has historical earnings growth been for U.S. stocks.
- Why stock buybacks will be less in the future due to high debt balances unless companies grow their revenues and overall earnings.
- How are actions lead to financial independence even when it is difficult.
Financial freedom is a worthy pursuit, but how exactly does one achieve it? Many find themselves stuck in a job that they do not want but have to keep because of reliance upon the paycheck. In this episode, David lays out the groundwork for securing financial freedom and why it all has to begin with a simple decision.
Watching his peers struggle with having to remain in a position they disliked because of financial needs made David decide to pursue financial freedom early on in his career so that he could enjoy a life free from stressful financial obligations. He didn’t want to find himself stuck. Financial vulnerability isn’t just finding yourself laden with debt. It can also be the burden of an unfulfilling or never-ending job that you cannot leave because there is no other form of income.
How can you build your future finances so that you aren’t reliant upon one source of income? David explores two different paths towards financial independence. One is a more passive approach in which you place money each month into investments and rely upon the earnings power of your portfolio to supply you with enough to fund retirement. The other path is an active strategy that requires you to essentially build your own business—creating multiple income drivers so that you are not solely reliant upon your investments.
Relying on stock market performance for your financial independence
Relying on your investments for financial independence may seem simple, but it comes with large uncertainties. David explains that it is impossible to know exactly what the market will do in the future, and it takes researched estimates to make an educated guess as to how the market will behave. While being dependent on just your investment dividends would be safer, most aren’t able to rely only upon the dividends with interest rates being so low; most have to rely on capital gains.
David explains that to estimate the returns of each asset class, you first need to consider the cash flow in terms of dividends, interest, and rent. You should secondly consider how that cash flow has grown over time, such as the earnings growth for stocks. Thirdly, you need to consider what investors are willing to pay for the future cash flow of those assets. How does it compare with what investors are paying for current cash flow, such as the price-to-earnings ratios for stocks.
Estimating a reasonable earnings growth assumption
David uses a Vanguard 70% stock and 30% bond portfolio as an example in estimating future earnings. The suggested return for financial independence when relying upon this portfolio is 9.3% because that has been close to the historical return. The highest annual return in its history was 41.1%. The worst year returned -30.7%. In almost a third of the years the portfolio existed, the investor lost money. When researching model portfolios, David suggests looking at the footnotes to see what comprised the returns. After 2013, Vanguard used the CRSP index for the 70-30 portfolio, which means that benchmark, which includes large, mid and small company stocks, could be the basis for estimating future returns.
To estimate the future return of the 70-30 portfolio, we need an assumpti0n for bond returns. A reasonable assumption is 2.16% return based on the SEC yield for the Vanguard Total Bond Market Index fun. Of course, the value of the bonds will go up as interest rates drop and will fall if interest rates rise. In order to get a 9.3% return on the 70-30 portfolio with a bond estimate of 2.16%, the stock portion would need to return 12.3% annualized. Currently, stock dividends are yielding 1.88% after fees, which means that earnings need to grow at 10.4% a year because the stock return is going to be the dividend yield plus the earnings growth, because dividends typically grow at the same rate of earnings. Is it reasonable to expect that?
The past five years have produced a 10.8% growth in earnings, which may seem promising. Historically, however, earnings growth of over 10% for two consecutive years has only occurred fifteen times since 1960. A regression analysis of historical U.S. earnings since 1980 shows average earnings growth of 5.4%, a more reasonable forward-looking assumption. In addition, the quality of earnings per share—that which drives the earnings growth of stocks—is falling. While companies can boost earnings-per-share through buybacks, they need to have the revenue to do so, which is not always strong enough to produce the level of earnings-per-share growth needed.
Actively pursuing your future is more than tending to your investments
In the end, it is simply unreasonable to stake your early retirement and financial independence entirely on the performance of your investment portfolio. Reasonable expectations are informed by the historical performance of different types of portfolios. Taking the time to do the math using various rates of return is important as well. For example, if you were to invest $208/month for 45 years with a 9.3% return, then your portfolio would have an ending value $1,708,000. If that return was lowered by even 1%, however, the value would be $1.2 million. At 5.8%, the return after 45 years the portfolio’s value would only be $539,000. While that is better than nothing, it is suggestive of the need to source your future income with other return drivers—other avenues. Be flexible in your strategy and diversify your portfolio. Create a business, continue to save, and find new ways to generate income.
Take action in the face of uncertainty and despite lost time
Financial independence begins with the choice to pursue it, and it’s never too late to start taking steps towards that goal. Yes, there is uncertainty, and there is always an opportunity for mistakes along the way. David uses the example of going vegan to have less of an impact on climate change. The goal is there, and each day provides an opportunity for action—to either eat vegan or to eat meat. The future of the climate is an uncertain thing, but that doesn’t mean we can’t try to take meaningful and positive steps towards a better future. Similarly, while the future of the stock market and our finances may be uncertain, we can take action now to make it more sustainable and independent.
- [0:17] Being financially independent begins with a decision.
- [2:33] Protecting yourself against financial vulnerability.
- [4:14] Should you solely rely on investment returns for financial stability?
- [7:52] Estimating the returns of asset classes.
- [13:40] Earnings per share drives the returns of the stock market.
- [17:31] Build an active and flexible strategy for financial stability.
- [22:49] Uncertainty doesn’t negate the positive effect of small actions.
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