Into Independence

Photo attributed to Flickr. 401(K) 13

I was recently thinking about the early months of 2009.    This was a time of tremendous fear in the stock market and a lot of panic selling.   It was also a time of being constantly barraged with gloom and doom in the news.  I was holding a balanced portfolio of index stock and bond funds.  My asset allocation significantly shifted because of the rapid decline of stocks.

I normally checked the balance of my accounts several times a week.   However, I was very nervous about going online to see the carnage during this time frame.  I kept telling myself …  ”This is a perfect time buy stocks, don’t look at your account balance now”.  My neighbor told me that he could not take the pressure anymore.   He sold all of his stock investments and went to cash.   He wanted to wait to get back into the market when it stabilized.  I really questioned his decision.  Especially since he was 100% in stocks before the crash and only about 10 years away from retirement.

I needed to return my asset allocation back to the desired state.   So, I held my breath and completed the required rebalancing.   I sold bonds and purchased stocks to make this happen.  I initiated multiple purchases.   I will highlight a few …  I was able to buy the Vanguard Total Stock Market index ETF (VTI) in the high 30′s.  I also purchased the Vanguard REIT Index ETF (VNQ) in the 20′s.   Looking back, the purchases in 2009 look like home runs today.    VTI is trending in the mid-70′s this week.    The latest quote for VNQ shows it in the mid 60′s.   So, both ETF’s have more than doubled over this time frame.

I focused all of my additional contributions during the “fear in the street” time period to stocks.   I started to realize this was a “once in an investing career lifetime” opportunity  to purchase stocks at fire sale prices.   So, my stock allocation during this time frame was more aggressive than normal.  After the recovery, I settled back into my normal asset allocation.

The rebalancing and aggressive purchasing during the stock market lows allowed my account balance to recover faster than expected.   I feel very fortunate to have been able to stomach the purchasing of additional stock shares during the turmoil.   Looking back, it has paid tremendous dividends and has helped in the journey to achieve financial independence.

The US Census data shows the median household income declined 1.5% in 2011.   The median household income in 2011 was $50,054 compared to the prior year results of $50,831.  Please remember this data is always behind.  That’s why you do not see the 2012 results.

I was recently thinking about the following question:

What size of nest egg is required to achieve passive income  at the median household level?

Assumptions

1. Required Income: $50,054 per year
2. Annual Withdrawal Rate:  4% (my estimate – feel free to use your own withdrawal rate)
3. No pension or Social Security payments
4. No part-time work.

To receive $50,054 in annual income with a 4% annual withdrawal rate, a total nest egg of $1,251,350 is required.    This amount is derived from dividing the $50,054 by 4% (.04).   If you increase the annual withdrawal percentage, the required nest egg declines.

If financial independence is achieved, an individual may decide to not work anymore.   This could reduce the amount of expenses incurred.   A few examples include no more saving for  retirement, a reduction in commuting costs and reduced taxes.    However, there are other situations which may increase expenses if a person is no longer employed.   It could include the possibility of increased health care costs and an increase in travel expenses (Hello Hawaii !).

It’s important to consider the definition of median as in “median household income”.   It technically means the middle value.   Approximately one-half of the group is lower and one-half of the group is higher than the median.    This translates into a lot of US households  living on less than or greater than $50,054 per year.

If you are receiving pension and/or Social Security payments, please feel free to subtract the total annual income received from the $50,054.   This will allow you to reduce the total nest egg required in the calculation.

Happy New Year !

It’s been a good year for my stock investments.   I know  this because my asset allocation (60% stocks/ 40% bonds)  is out of balance.   This means either my stocks went up, bonds went down or a combination of both.   In my case, the primary driver for the asset allocation shift was the growth in my stock investments.  The stock portfolio represented greater than 60% of my nest egg.

I previously made a decision to rebalance investments twice a year.    The first rebalance occurs mid-summer close to my birthday.    The second rebalance happens the last week of the year.   I completed the rebalancing process this morning.   It was a little over an hour to bring the investment allocations back in line to the desired 60% / 40% split.   I sold some stock index ETF’s and purchased bond index ETF’s.  In addition, I adjusted my US/International/REIT stock allocation split back to the desired state.

Rebalancing is an important exercise for investors.   It’s amazing how asset allocations can change quickly over time.   An allocation can rapidly move to a place that is outside of your desired risk tolerance.

Example

Let’s say Pete is striving for a 50% stocks / 50% bonds asset allocation.   His portfolio balance is $10,000.   Goal state for this asset allocation is $5,000 in stocks and $5,000 in bonds.   However, the portfolio now shows a $6,000 balance in stocks and $4,000 in bonds (60% stocks / 40% bonds).    To bring this back in line, Pete will need to sell $1,000 in stocks and purchase $1,000 in bonds.   This will bring his asset allocation back to the desired 50/50 split.   Pete will be selling a percentage of his stocks after the increase in value.   

I’m a huge fan of rebalancing investments during the year.   The primary reason is it drives the right behavior.   My goal is to buy low and sell high.   The rebalancing I did today allows me to sell a portion of my winners (stocks) and buy bonds.

A difficult question to answer is how often to rebalance.   If an investor rebalances too frequently, there is a possibility that stocks may continue to go higher and he/she may lose out on the additional gains.    If an investor does not rebalance enough, the asset allocation can become way out of whack.   I have decided rebalancing twice a year is the optimal frequency for my portfolio.

One measure of success in a career is the hourly wage that is earned.   The majority of us begin our working life at a less than desirable pay rate.   I still remember being 16 years old and making minimum wage at a popular fast food restaurant.    If all goes well, the hourly wage can increase over the years as we gain more experience, education and knowledge.

There are several ways to achieve financial independence in life.   One common path is to invest money over a working career.   The majority of us will invest in a combination of stocks, bonds and cash based on our risk tolerance.   The investments may be in the form of retirement and/or taxable accounts.

Let’s say you have diligently invested over your life-time and are ready to retire.  One difficult question to answer is what percentage of income can be withdrawn from a nest egg each year without running out of money.  A quick google search of this question will provide many different opinions.  One answer that comes up frequently is an initial withdrawal rate of 4% with future increases for inflation.

There is an exercise that can be completed that will provide a different perspective on financial independence.   This can be completed no matter where you are on the financial independence journey.   The first step is to add up all of your investments and savings to understand your total nest egg.    Multiple the nest egg by an annual withdrawal percentage you are comfortable with.  This will provide the annual income provided by the respective nest egg.   The next step is to take the annual income and divide it by 52 weeks.   You can then take the weekly income amount and divide it by 40 hours in the week.    This will provide you with an estimated hourly wage the nest egg will provide.    This is passive income that does not require your labor.   You don’t even have to leave the house to receive this income.   The one caveat is investment returns are volatile and do not always go as planned.

Example

Donna is 65 years old and has a nest egg that totals $400,000.    She is going to assume a 4% withdrawal rate which provides an annual income in the first year of $16,000.   If you take the $16,000 annual income and divide it by 52 weeks it provides a weekly income of $307.69.    The last step is to divide the weekly income of $307.69 by 40 hours which provides an hourly income of $7.69.   Very Nice !

Another way to view the hourly wage is to also factor in pension payments, social security payments or any other passive income sources.   Good luck on your financial independence journey !