April 11, 2020
Most people who want to retire early have got their finances in order.
They’re heading in the right direction – saving, investing, paying down debt.
And in most ways, they’re already well-off.
Despite this, some of these folks have next to no chance of retiring anytime soon. That is, unless something changes. Why?
Because they lack one thing: Focus. Let me explain…
I don’t mean these people can’t pay attention. Or that they’re not sure of their goal – they are. What I mean is, their finances aren’t properly aligned with their goal.
Sometimes there’s an assumption that having all sorts of different investments is the most sensible thing to do. Most of us have heard the phrase, “Don’t put all your eggs in one basket.”
This totally makes sense on the surface. But some people take this too far, and end up with one egg in 27 different bloody baskets!
This might sound really safe and conservative to some people, and therefore sensible. But all baskets are not created equal. To butcher the metaphor, some baskets are better at holding (and producing more eggs) than others.
It’s fair to say that diversification means different things for all of us. But the goal of Financial Independence is the same.
As you’re about to see, taking a scattered approach to investing doesn’t really line up well with retiring early.
Let’s look at a totally made-up example to illustrate what I’m talking about. Our fictional aspiring early retirees are good savers with limited knowledge on investing.
So they used what can be called a ‘Spray & Pray’ approach to investing. They tried multiple asset classes and strategies, hoping something would ‘work’ and make them rich.
During 10-15 years of saving and investing, their investments did okay, but none amazingly well. Because of this, they often got frustrated and moved onto the next idea.
The overall focus was achieving a high net worth, but they also had nagging worries in the background about an upcoming economic downturn (clearly avid news watchers!).
For this reason, they decided to spread their eggs across lots of baskets.
This meant keeping some money in cash and bonds, as well as crypto and precious metals like gold and silver (because you never know – presumably that’d be valuable when the world collapses).
Our couple stopped short of hoarding baked beans and toilet paper though!
The goal was Financial Independence by 35. After joining forces in their early twenties, a strong savings rate allowed them to build a fantastic net worth of $1.6 million.
So, at age 35, are they now ready to call it quits and put their feet up for a while, before moving on to new adventures? Let’s take a look at their portfolio…
Home Equity: $300k. (value of home $600k)
Superannuation: $250k. (made extra contributions since it’s tax-effective)
Investment Property 1 Equity: $200k. (neutral cashflow)
Investment Property 2 Equity: $150k. ($5k per year cashflow negative)
Precious metals/Gold: $200k. (no income)
International shares: $150k. (pays $4k per year dividends)
Bonds: $100k. ($2k per year interest)
Cash: $100k. ($2k per year interest)
Speculative Growth shares: $75k. (no income)
Crypto/Bitcoin: $75k. (no income)
Quite a hefty spread of assets there. Here’s how it looks in chart form…
Most people would agree this couple have a very healthy net worth. And that net worth is parked in quite a diverse spread of places. Some would probably consider them hyper-diversified.
Sure, we can argue whether some assets are optimal or not. But they don’t appear to be doing anything all that crazy or reckless here.
At this point, a few astute readers will have already recognised the first issue. Despite the beefy net worth, across their whole portfolio, our couple is receiving just $3,000 per year in passive income.
Despite their enviable wealth, they’re another example of being equity rich, cashflow poor.
For completeness, let’s say they spend a total of $50k per year: $20k for their mortgage (home purchased years ago), and $30k for personal spending.
Looking at this set of spaghetti finances, I’d say not very close at all. Unless something drastic changes, that is.
Clearly, the current mix of assets doesn’t look to be getting the job done. But why is this?
First, putting extra on the mortgage saves interest, but it doesn’t improve cashflow.
So extra funds parked here earn a return, but it doesn’t change their $50k annual spending until the entire thing is paid off, which gets rid of that monthly mortgage cost.
Second, given their age (35), Superannuation won’t be accessible for the next 25-30 years. Tax-efficient for building long term wealth? Yes. Handy for retiring in your 30s? No.
Next, given the relatively high ongoing costs and low yields associated with most residential property in Australia, their investment properties aren’t very good at generating income either.
If these assets were paid-off, it would be better. But even then, the net yield will likely be quite low.
Finally, the money sitting in cash, bonds, metals, crypto and speculative shares provide very little or no income whatsoever.
So, what could they do to improve this situation? Let’s take a look.
At the broad level, what’s needed is for this couple to focus their savings on the goal of Financial Independence.
First, they could sell their metals and bonds which would basically pay off the remainder of their home mortgage. Straight away, this would knock out their $20k annual mortgage repayments.
With this one move, cashflow has improved dramatically and they now only need to cover $30k of living expenses, not $50k.
Next, I’d probably look at selling the two investment properties (IPs). As we can see, these are generating no income, yet there is a good chunk of equity sitting in there.
That looks like an opportunity to me!
So from the $350k of equity, after capital gains tax and selling fees, we’ll be conservative and assume sale proceeds of $250k.
They could also sell their bitcoin and speculative shares and raise another $150k. They could be up or down massively on these so I’ll take the middle ground and assume no tax for simplicity.
Speaking of tax, they may choose to do this process over a couple of years to minimise CGT on the properties and make the transition much less stressful.
Also, investing $50k of their $100k cash pile would improve passive income further.
In total, these changes result in $450k of cash which they can add to a more sensible income-producing share portfolio.
Our couple already have $150k of international shares. So let’s say they add Aussie shares to this and go for a split of 50/50.
How does their net worth picture look now? Let’s look at where their savings are parked and the outcome of these changes.
Home Equity: $600k. Now paid off.
Aussie shares: $300k.
International shares: $300k.
Here’s the new net worth breakdown in chart form…
As you can see, a lot less moving parts. It’s simpler overall, but there is a huge amount tied up in home equity and super.
While this might look sub-optimal for early retirement, in this case, it’s actually not detrimental. Luckily, our couple has relatively low expenses and doesn’t require a huge personal portfolio to live off.
The home equity now provides ‘paid-for’ housing. And their $600k share portfolio should sustainably provide around $24k per year in passive income.
With personal spending of $30k per year, this only leaves a cashflow gap of $6k. This means they need just $150k more in shares to retire forever.
And that would only take a couple of years to achieve from this point. What a massive turnaround from their starting position!
All by structuring their finances in a much more focused way that is 100% in line with the goal of early retirement.
Of course, they could semi-retire straight away and only need to earn a very small amount to plug the shortfall.
Another option is they could start living off a larger percentage of their portfolio by selling a few shares each year, because super is still growing in the background and will become available later on.
Of course, we can argue that they could’ve still retired with the Spray & Pray portfolio too, by selling off bits and pieces over time and living off the proceeds.
And that’s fair. In fact, it’s kinda what we’re doing ourselves.
We stopped work essentially in a negative-cashflow position and a pool of equity. We’re selling down properties over time, living off some cash and building a share portfolio simultaneously.
I outlined this strategy in the following post: Turning Equity into Income – Property-to-Shares Transition Strategy.
So yes, they could have muddled through from where they were. Retiring with a less than optimal portfolio can still be done.
But guess what? It also kinda sucks. It’s not fun to have lots of outgoings and little income. Or to be juggling a messy portfolio in retirement.
On the other hand, having low outgoings and passive income from investments is very fun! And having a simple set of finances is surprisingly fun too.
That’s why I strongly urge people to set things up simply from the start.
Another point to mention is that when you zoom out, our couple had an odd bunch of assets.
They were approaching investing half in the Armageddon-is-coming camp, and half in the Prosperous-future camp. Add to that, they also succumbed to get-rich-quick thinking from time to time.
But since these mindsets are somewhat contradictory in nature, it’s hard to build a concrete strategy by combining them. You’d be forever second-guessing different parts of it.
Before investing a single dollar into an investment, you have a choice to make. You either think the future is probably going to be pretty good, or it’s not.
If you think things will generally turn out okay, despite the ups and downs, then buying-and-holding shares and/or real estate over the course of many decades makes perfect sense.
But if you think otherwise, then investing in these assets probably isn’t for you. Instead, hoard cash, put your tin foil hat on and join the Baked Bean Brigade or the Kleenex Krew and bunker down for the coming apocalypse.
Markets are scary, I totally understand. But that’s not an excuse to listen to the doomers and load up on speculative, non-productive assets.
If you want to punt on bitcoin or gold or marijuana stocks, that’s fine. But don’t confuse this with long term goal-specific investing.
As we’ve been discussing recently, we need to remember the progress humans have made and have faith that things will continue to improve in various ways.
I’m not saying you shouldn’t have different investments in multiple asset classes. You can!
Just make sure they all combine to make a portfolio that can deliver you the income and growth you need to sustain a comfortable early retirement.
Even though this is (yet another) silly made-up example, I hope it illustrates an important point. Where we put our cash really matters!
Sometimes, having a high net worth is not enough to become financially independent.
Our portfolio must be built in line with our personal and lifestyle goals. If yours isn’t, then start taking steps in that direction.
A simple portfolio of good quality income-producing investments, and maybe a paid-off house, is where you want the majority of your long term savings to be.
Diversification and focus don’t have to be opposites.
You can still have a highly diversified portfolio, while having that portfolio intensely-focused on the goal of early retirement.