But This Doesn’t Have To Be You!

Poor little Johnny followed the conventional wisdom of saving 10% of his income year in and year out for retirement using such traditional retirement accounts as his 401k and even a Roth IRA.  Now this is excellent advice, and I definitely recommend you save at least 10% of your income every year for retirement, although I think it should be more like 20-30% of your income just to be safe (some might disagree).  Nobody is telling you not to save money, because compound interest is indeed the 8th wonder of the world.

But there’s a better way, or at least a complimentary way that, coupled with diligent savings, will help you reach your goal of early semi-retirement decades earlier than you would otherwise be able.  It is not inconceivable you could reach the point of being financially capable of quitting the 9-5 world permanently within 5 years of implementing this plan.  How?  It’s simple:  set aside 10% of your work efforts to income-generating side products in addition to saving the regular 10% of your income for retirement.

Tithe Your Earning Power To Compound Your Results

It is often said a person’s earning power, that is, the ability to earn an income, is by far the biggest asset anybody has.  This is entirely true, but what this doesn’t tell you is that you can magnify your earning potential several times over working for yourself rather than somebody else.  This means finding a low-maintenance side gig and banking the earnings.  This is what Tim Ferriss refers to as a muse in his book The Four Hour Work Week.  If you do it right, you can net an additional $15,000-20,000 per year per muse, each requiring only a few hours per week (or month, if you choose wisely) to maintain.

Your muse doesn’t have to be in an area you’re particularly interested in, although that will certainly help keep you motivated.  It doesn’t have to be something you want to turn into a full-time business someday, although that’s great, too (J.D. at Get Rich Slowly did it, and seems to be doing very well for himself as a result).  It’s simply a matter of recognizing a good passive income opportunity when you see it, and taking action.  As it turns out, taking action on an obviously slam-dunk idea is the hardest part for most people.  That is why they continue grinding away at the 9-5 until they get their golden watch:  they are all talk.  But not you.  You’re going to take action.  For ever 10 hours you spend at work,  you’re going to spend at least 1 hour building an alternative source of income (click here for 40+ alternative income ideas and resources).  I chose creating not-really-passive online income using niche sites as my muse, but yours could be literally anything.  Get out there an explore to find out what works for you.

It Adds Up Over Time

Let’s try a different sort of math, but one that is related to all those “if little Johnny saves X% of his salary every year he will have $Y at age 65.”  Instead of saving 10% of his income, let’s assume he spends 10% of his working hours  on side projects that generate an extra $1,000 per month by the end of the year, a number that is extremely doable if you work efficiently, although you will doubtless start out a bit slower as you learn the ropes of your chosen business.  At the end of 5 years, you will be generating approximately $60,000 per year of extra income with a time investment of only 10-15 hours per week.  What’s more, you could probably double or triple that number if you worked more (careful though, we don’t want to create another full-time job for ourselves) or invested a little money to help spur growth.

At this point, you can probably afford to tell your boss what he can do with himself.  Or you can continue working for a few years, pocketing the extra cash flow or reinvesting it in your businesses until you feel ready to quit your job.  The point is, it’s entirely up to you.  And tithing just 10% of your working hours got you there in 5 years instead of 40.  Now that’s what I call compound interest!

Check out Tim Ferriss’s 4-Hour Workweek for more on how to get out there and live the good life now.  Tim goes through some specifics you can apply to your own situation.

Places To Retire For Under $1,500 Per Month

Thailand

It’s true some of the larger cities can be quite expensive, especially if you insist on having all the luxuries you took for granted back in the states, but there are a number of places in Thailand where $1,500 still goes a long way.  It won’t get you a beachfront condo, of course, but I’ve been told it’s possible to get a decent (if small) apartment in the $100-150 per month range, especially in the northern part of the country.  A beer at a bar will cost you less than $1 and a decent meal might only run you a few dollars more.  Great food, sun, the beach, a friendly people on an affordable budget.  Doesn’t get much better than that.

Costa Rica

Costa Rica is one of the safest and most prosperous nations in Central America.  Over half the surface area of the country is protected as a natural sanctuary, and tourism is Costa Rica’s most important industry.  As such, there are plenty of English-speaking ex-pats in the area, and many people in the more tourist-oriented areas will speak decent English.  Costa Rica is known for its lush rain forests, diverse wildlife, and beautiful beaches.  Not the cheapest country on the list, but it’s quite possible to live a decent lifestyle on $1,500 per month outside of the major cities.

Belize

Belize is home of the 2nd-largest coral reef in the world behind Australia’s Great Barrier Reef.  As such, it’s a mecca for scuba divers, snorklers, and a popular cruise ship destination.  Even better, English is the official language of Belize (most everybody speaks Spanish as well), making it an easy transition for ex-pats who don’t speak another language.  The cost of living here is similar to Costa Rica (for similar reasons).  It will probably cost you around $300 per month for a decent-sized apartment outside of Belize City.

But that doesn’t mean you can’t be both an index investor and an income investor.  It just means you’ll have to slice and dice your portfolio a bit, tilting more towards higher-paying value stocks (being sure not to take on too much risk as a result).

Income Investing With Index Funds

As a general deal, value-oriented stocks (that is, stocks with a low price relative to the underlying company’s earnings and book value) tend to pay higher dividends.  Slam dunk, right?  Just buy all value stocks and call it a day!   Not so fast.  Most of these value stocks are cheap for a reason: the market doesn’t expect them to fare as well as higher-priced stocks.  Still, there is ample evidence the market has a tendency to undervalue the potential of many of these value companies.  The famous Fama/French value premium states that investors can rightly expect a premium in exchange for owning value stocks, albeit at the (assumed) cost of  taking on a bit more risk.

Two Value Index Funds With Good Yields

As usual, you don’t have to look too far past Vanguard for your index fund needs.

• Vanguard Value Index Fund (VIVAX, 2.22% yield, 0.26% ER) – The Vanguard Value Index Fund is a mainstay of slice n’ dice portfolios everywhere.  Owing to all the recent dividend cuts in the financial sector (a popular sector for value-oriented funds), VIVAX doesn’t quite have the same yield advantage over the Total Stock Market Index Fund (VTSMX) as it normally does.  Still, this fund should regain much of its old poise as the financial sector continues to improve and dividends continue to be raised.
• Vanguard Small-Cap Value Index Fund (VISVX, 2.25% yield, 0.28% ER) – Like the fund above, the Vanguard Small-Cap Value Index Fund is a classic choice for small-value tilters.  If there’s one thing that’s more powerful than the Fama/French value premium, it’s the small-cap value premium.  Since small-cap value stocks tend to be among the market’s lease favorite securities, their appreciation potential (and yields) are even larger than average.  Small-cap value stocks tend to deliver the best risk-adjusted returns of the Morningstar style box over long periods of time.  Like the Value Index above, VISVX’s yield has been hit hard by the recent financial crisis.  Look for this one to recover nicely.

Don’t Forget REITs!

Value stocks aren’t the only place to find above-average yields in the stock market.  Real Estate Investment Trusts, or REITs, offer all the advantages of investing in real estate without the hassle of managing any properties yourself.

• Vanguard REIT Index Fund (VGSIX, 4.31% yield, 0.26% ER) -  Due to special tax rules requiring REITs to pay out at least 90% of their net income to shareholders, REITs typically yield far more than most other types of stocks.  Real estate can be a great source of steady, inflation-adjusted cash flow without taking on too much risk.  I would caution against devoting more than 20% of your portfolio to this particular asset class, though.

Traditional Retirement Investing Model

The traditional model is to invest for maximum long-term growth of capital with an equity-oriented, aggressive investment portfolio (David Swensen’s Unconventional Success epitomizes this strategy).  Income generated from the portfolio is a secondary consideration.  In fact, many would argue that the ideal portfolio wouldn’t generate any taxable income at all so as to avoid the drag of taxes (the tax-advantaged nature of 401k and IRA accounts aside).  The idea is to generate a sufficiently-high net worth to give you a large enough margin of safety so you won’t run out of money even if you have to chip away at your principal for a long period of time.  For investors who start early and save diligently, this approach is more than adequate to meet their needs.

Early Retirement Investing Model

The early retirement model focuses on cash flow rather than net worth.  Since those of use who choose to retire before age 40 can’t possibly accumulate the amount of wealth as somebody with the advantage of another 20 or 30 years of compounding (unless we have an exceptionally-high income), we must make due with a much smaller asset base.  Where a 3-4% yield might be acceptable to your average run-of-the-mill 70 year old retiree, early retirees need to do better.  Unless you’re okay with living a very spartan lifestyle in retirement (some are), you portfolio will need to throw off at least 5-6% of its value in cash every year.  What’s more, that income stream will need to grow at least the rate of inflation every year in order to preserve your portfolio’s purchasing power.

Focus On Sustainability

I know what you’re probably saying:  “but Kyle, reaching for yield is dangerous!”  And you’d be correct.  Many times, investments with high cash yields pay so much simply because they are so darn risky.  Case in point, junk (or “high yield”) bonds.  Private real estate partnerships can pay handsome dividends, but you could also lose your shirt.  Stocks offer a good shot of making lots of money in the long run, but you stand a dangerously-high chance of losing half your investment in any given year.  Clearly, choosing investments merely for the yield is not the answer.

What About Bonds Or Annuities?

By the same token, some investments typically used to product reliable streams of income (high-quality bonds and immediate annuities, for example) aren’t workable for most early retirees.  Bonds are great sources of income, but offer no inflation protection on their own (and those that do, such as TIPS, have unfavorable tax properties).  Immediate annuities, meanwhile, can be bought with inflation protection but their yields are ridiculously low for investors not at least 55 or 60 years old.  Even though long-term bonds currently yield enough to live off of (just over 5% currently), inflation would eventually seriously impair your purchasing power.

What About Stocks?

Vanguard’s Total Stock Market Index Fund (VTSMX) currently yields about 2%, which is far below our desired cash yield.  That said, stock dividends tend to rise with inflation over the long term (despite setbacks like in 2008).  Held for a long enough period of time (say 15-20 years), the income generated from a diversified portfolio of stocks will likely far exceed the income from a portfolio of bonds.  Thus, stocks certainly have a place in your portfolio.  The only question is, how much?

What About Real Estate?

Real estate is a pretty attractive investment from an early retirement perspective.  Rental properties generate decent cash returns (often in the 6-8% range) and rents typically keep pace with inflation.  A well-managed rental property in a decent part of town can pay off handsomely.  And thanks to banks’ willingness to lend money to property owners (even now), a relatively modest amount of capital can generate a tidy monthly income, at least compared to most other asset classes.  If being a landlord isn’t your cup of tea (it sure isn’t mine), there’s always the option of buying Real Estate Investment Trusts (REITS) and letting the pros do the dirty work.  REITS yield less (currently a bit below 5%), but they require a heck of a lot less work to maintain.  Due to real estate’s favorable investment characteristics (at least from the early retiree’s perspective), move real estate near the top of your list.

Putting It All Together

I’m not gonna lie, these are tough times for income investors.  High-quality investments are yielding well below their historical averages and high-yielding investments are decidedly lacking in quality.  Realistically, the best you’re going to do right now without risking your capital in speculative high-yield investments is in the 4-4.5% range.  Asset allocation is a very personal thing (here’s my Roth IRA allocation) and there are no one-size-fits-all rules.  My motto has always been that when in doubt, split the difference.  Putting 1/3 of your portfolio in each of the above asset classes:  1/3 in bonds, 1/3 in stocks (both domestic and international), and 1/3 in real estate is as good a starting point as any.  Just remember, the goal is to find the right balance between current income, inflation protection, and long-term growth of capital.  While early retirees need to focus a lot more on income-generation than most other investors, the same principals apply.

Cash Flow Is King

When somebody says “Cash Is King” they’re generally referring to the fact that no asset has value if it can’t be converted to cash.  Or perhaps they’re referring to the ability of cash-rich investors to take advantage of those rare golden opportunities the market so rarely delivers.  But I say, Cash is not King.  Rather, cash is the prince to the real king, Cash Flow.  Which is better, having cash or having the ability to reliably generate an endless stream of cash on a regular basis?

That’s why net worth is such a misleading number.   In the net worth paradigm, a million dollars in the bank yielding 1% (for $10,000 in annual income) is more valuable than $500,000 in a diversified portfolio yielding 5% (for $25,000 in annual income).  But is it really?  That measly 1% payout won’t even keep pace with inflation, whereas the 5% will.  What’s more, that extra $25,000 in annual income brings with it far more options than the $10,000 payout.  You could very well choose to use $5,000 of that money to supplement your income and still save twice the amount of money you could afford to save with the 1% payout.  Even better, the higher-yielding portfolio won’t take long to overtake the larger bank account.  You could also choose to save it all, or none.  The point is, you have options.

You Can’t Spend Net Worth

Unfortunately, you can’t spend net worth.  Or rather, you can but unless you’re extremely wealthy you will eventually have to worry about running out of money.  But cash flow has an interesting property:  so long as you spend it conservatively, perhaps reinvesting a bit of it just to be safe, it will never run out.  Cash flow gives you the freedom to live your life how you want to live it, not having to slave away at a job you hate just to pay the bills.  And that’s worth far more than adding a digit to your net worth, at least to me (not that I’d turn down a million dollars if you offered).