The Basics: Investing for Financial Independence Retire Early (FIRE)

It’s unlikely that you’ll amass enough wealth to achieve financial independence retire early (FIRE) if you don’t invest your money. Sitting on large amounts of cash is not an effective way to increase your net worth.

I’m not a certified financial planner (CFP), but the best part about investing for financial independence is that you don’t need a CFP.

I’m not going to give you a prescription or tell you how to invest, but I am going to share some key points when you’re determining how to best invest your money for FIRE.

The Risk of Investing

No investment is without risk. Some investments carry a large amount of risk (cryptocurrency) while others are relatively "safe” (bonds).

In order to mitigate risk, consider investing in multiple asset types (diversification). This ensures that your investments are protected against a downturn in any one asset class.

Consider stocks and bonds. They’re typically understood to have an inverse relationship. When the stock market is under-performing, bonds may stay relatively stable.

The more risk you take on, the more volatile your portfolio may become, but the greater your return may be. These are your peaks and valleys, ups and downs. Depending on your risk tolerance you may want to take on more or less risk.

Typically, the younger you are, the more risk you can take on as you have a much longer investing horizon than someone who wants to retire in 5-years.

Expect 5%-10% Returns

Contrary to popular belief, you don’t need to be a professional stock picker to make a fortune in the stock market. You simply need to earn 5%-10% average annual returns over your investing career.

We want to reduce our risk and capitalize on the fact that the stock market tends to increase over time. We’re simply hitching a ride on that wagon.

A chart of the S&P 500 from 1990-2015.

Let’s take a look at the return of the most popular index fund in the world, Vanguard Total Stock Market Index Fund (VTSAX).

VTSAX has averaged a 6.45% annual return since inception (2000). If you invest just $6,000 per year ($500 per month) in VTSAX for 40-years, you’ll end up with over $1 million.

Image of compound interest over 40-years.

The three levers you can manipulate when it comes to investing for financial independence are your contribution, investing timeline and your rate of return.

You might think rate of return is out of your control, but you’d be mistaken. If we’re looking at the market returns on a long timeline like 20-30+ years, we can reasonably assume the performance will continue.

In 20-years, there will have been recessions, pandemics, terrorist attacks, wars, etc… You can see how the investment performed during these times and if it recovered after a down turn.


ROTH 401k VS Traditional 401k

According to Charles Schwab, “The difference between a traditional and a Roth 401(k) comes down to when you pay the taxes.”

  • While Roth accounts have generally been advised for younger savers, a Roth 401(k) can also give older savers a chance to benefit from tax-free distributions. 

  • If your employer offers both, you don't necessarily have to choose one or the other. Consider splitting contributions between the two.

A huge benefit of a Roth account is tax free growth. This means that my contributions are invested post-tax and the growth my account enjoys will be tax free come withdrawal time.

Interesting tidbit: Company match contributions go in as traditional 401k even if you elect to contribute to a Roth 401k. It’s the same total in the account, but for tax purposes, the employer contribution will be taxed as traditional.

Low Fee Index Funds

Low fee index funds have many advantages over actively managed mutual funds. Here’s 4 benefits:

  1. The primary risk is market risk

  2. According to Standard & Poor, in the 10 years ending June 30, 2015, 75% of actively managed domestic stock funds under-performed the S&P 500 Total Market Index

  3. 40% of actively managed equity funds available to investors on June 30, 2005, were no longer in existence 10 years later

  4. Most actively managed funds under-performed their benchmark index after costs are deducted

“long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.” - Warren Buffet on index funds

You can diversify by owning different index funds. Consider my approach of owning multiple Vanguard index funds including VNQ (Vanguard REIT ETF).

If you really want it on autopilot, the Vanguard LifeStragtegy funds may be a great choice for you. They will automatically balance between stocks and bonds depending on how far you are away from retirement.

Compound Interest Basics

It’s rumored that Albert Einstein once said, “the only force stronger than gravity is compounding interest.” Compound interest is interest on interest.

It's the result of adding interest earned to the principle, then compounding the total . This cycle perpetuates year after year after year.

Simply put, if you have 100 dollars and it earns 10% you will have $110. That $110 then earns 10%, you now have $121. That $121 Earns 10% you now have $133.1.

This is the primary way financial independence can be achieved. Through compound interest and appreciation of the asset.

The graph below shows the power of compound interest compared to simple interest. The Y-axis is money and the X-axis is time (years).

As you can see, compound interest reaches a point where it goes vertical (exponential growth) compared to simple interest simply continuing on a linear path.

Compound interest vs. Simple Interest

How Much to Invest for FIRE

The amount you will need to contribute will be unique to you and your financial goals. I’ll provide the framework, you can fill in the blanks.

The simple chart below illustrates how much you need if you want to have the corresponding annual spending in retirement. For example, If I want $50,000 a year in retirement, then I will need $1,250,000 or 25x the annual income.

This is best known as the 25x rule, 4% rule or the Trinity Study. Here’s the science behind the 25x rule.

Considering a 4% safe withdrawal rate. This is how much you will need in order to cover your expected annual expenses.

Depending on the amount of money you would like to have in retirement, you may fall somewhere on the LeanFIRE or FatFIRE spectrum.

Use a FIRE Calculator

Once you determine your financial independence (FI) number, you can then plug everything into a FIRE calculator to get an idea of how long it will take you.

I recommend manipulating your interest rate, time line and contributions to get a good idea of how they effect the equation. This may help you decide what goals you want to shoot for.

At the end of the day, the earlier you starting saving and investing the easier this equation becomes.

Summary

Investing for financial independence isn’t rocket science. It’s fairly easy to grasp, but the implementation is difficult.

It’s not easy to stick with budgeting, saving, investing month after month, but it’s critical to your long term financial success.

If you found this article helpful, please consider sharing it with a family member or friend. At the very least, leave a comment below or connect with me on Instagram.

Editor’s Note: This post was originally published in June 2019 and has been completely revamped and updated for accuracy and comprehensiveness.

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