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.

How Much Is Enough?

Workers with a regular paycheck can afford to take some risks here.  If something happens, they can rest assured their future income will get them back on trap (but they’d better have long term disability insurance!).  Retirees don’t have this luxury.  They have no future stream of income to help mitigate their losses.  Younger retirees are even more at risk, since their nest egg will have to last much, much longer than the typical 70-something retiree.

So what’s a young retiree to do?  How big is big enough when it comes to you emergency fund?  There are two conflicting perspectives on the issue:

1. Young Retirees Can Least Afford To Gamble – Since a 40 year old’s portfolio must obviously last a lot longer than a 70 year old’s portfolio, the 40 year old can least afford to sustain heavy losses.  This would argue for a larger emergency fund, on par with the 2-5 year recommendation, to protect against the risk of having to sell an investment at an inopportune time.
2. Young Retirees Can Always Go Back To Work – The other side of the coin is that young retirees can always go back to work.  A 40-hour work week may be a terrifying proposition to a free-spirited 45 year old retiree, but he still has it a lot better than the 75 year old retiree.  The 45 year old is presumably well-capable of working for a living.  The 75 year old?  Maybe not.  Semi-retirees will have a huge advantage here.  Since they never totally left the work force, their skills are probably a lot sharper than somebody who’s spent the last 5 years traveling for a living.  This would argue for taking on more risk and using a full- or part-time job as a backup plan.

A Third Factor…

As I’ve written before,  most young retirees invest for cash flow rather than total return because they have different goals and different criteria for success.  Cash, in most cases, is the lowest-yielding asset class, often earning negative real returns after taxes.  For this reason, I advocate young retirees holding a much smaller emergency fund than is typically recommended:  something on the order of 12-18 months’ worth of expenses seems about right.

Holding too much cash will impair your cash flow to the point of making early retirement impractical, if not downright impossible.  Going back to work may sound unappealing, but I would consider myself very fortunate to have that option.  There are also a few other alternatives such as part-time (rather than full-time) work, starting your own business (perhaps a franchise), and various passive income opportunities.  The point is, early retirees have a large capacity to take on risk.  I think it wise to take advantage of that.  It should pay off more often than not.

Active traders use many tactics in an attempt to micro-manage their finances:

• Trying To Time The Market – To successfully time the market, you’ve got to guess right twice:  when to get out, and when to get back in.  I’ve never met anyone who could do this consistently.  I’ve also never met anyone who’d met anyone who could.  I doubt such a person exists, but even if she did, it’s probably not you.
• Selling Covered Calls – Selling covered calls is an interesting strategy to try to increase the cash yield of a portfolio, but in the end is fatally flawed.  The problem is that it skews the risk/return ratio downward.  If a stock you sell a covered call against performs well, it will likely get called away from you and you’ll lose out on any additional upside.  No problem there, it was a risk you willingly took.  The problem is, covered call strategies do nothing to protect your downside.  You can still lose it all.  Capping your upside without limiting your downside is not a good deal, in my opinion.
• Chasing Top-Performing Funds – Following top-performing actively-managed funds is a national past-time.  It’s no wonder why, the media needs active funds and the excitement they bring to sell magazines.  Picking a winning actively-managed fund is an incredibly difficult task because the top-performing funds for one year have a habit of showing up on the bottom of the list in subsequent years.  Buying and selling funds in an attempt to beat the market is the surest way to below-average returns.

How Early Retirees Should Invest

I’m a firm believer in passive investing.  Index funds have lower expenses than their actively-managed counterparts and subsequently tend to out-perform them handily over long periods of time.  You can’t control how generous the market will turn out to be, but you can control how much of your return goes to your broker and to Uncle Sam.  For a primer on passive investing and portfolio construction, check out William Bernstein’s The Four Pillars of Investing: Lessons for Building a Winning Portfolio

What Constitutes A “Safe” Return?

The kicker, of course, is just what you mean by the word “safe.”  Stocks will likely return 8% or so going forward, but are stocks safe?  Not by a long shot.  You might consider investment-grade long-term bond mutual funds to be more or less “safe,” but they are currently yielding more like 5 -6%, not 8%.  And that ignores the issue of credit risk, which is even affecting the perception of government bonds around the world, these days.  If by safe you mean no or little risk of principal in real inflation-adjusted dollars, long-term bonds are not “safe.”

Tilting towards short-duration, high-quality bond funds (from the Morningstar bond style box) fares you no better, since short-term yields are still paltry.  And it’s quite likely short-term bond yields are below the rate of inflation, guaranteeing you negative real returns if you invest today.  If you define safe as there being a minimal chance of not reaching your financial goals, short-term bonds are not “safe.”

What about real estate?  As we’ve seen, the notion that real estate is a “safe” investment or a “sure thing” has been turned completely on its head.  Property prices can and do fluctuate like crazy, sometimes dropping off a cliff.  The Vanguard REIT Index Fund (VGSIX) currently yields just under 5% and will likely appreciate 3-4% per year going forward (averaged over a very long time horizon), but REITs certainly can’t be considered to be a “safe” investment, at least not by themselves.  REITs do have their advantages over direct investment in rental properties, however.

Investing Is Risk

Now we come down to it:  to invest is to accept risk.  There is no such thing as an absolutely “safe investment,” although some investments carry very low amounts of risk (Treasury Bills, insured immediate annuities, FDIC-Insured Certificates of Deposit, etc).  The basic idea of Modern Portfolio Theory is that risk and return are intimately related.  By taking on more risk, you can expect to earn a higher rate of return in compensation (sometimes, not always).  To ask for a “safe 8%” or a “safe” anything is to ask for a free lunch.  Unfortunately, the market doesn’t give out free lunches.  To devise an intelligent investment strategy is to find the place where your willingness to take risk meets a high probability of earning sufficient returns to meet your financial goals.  If you find the amount of risk you must take to reach your goals is more than you’re comfortable with (a common occurrence), you’ll just have to save more money.  There is no free lunch.

*All facts and figures are accurate as of 1/11/2010

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.

Saving A Million Dollars Is Simple As Pie

You don’t need to win a game show, the lottery, or rob a bank.  What you do have to do is understand how the wealthy to be that way and duplicate some of their habits.  Wealth that is earned slowly is wealth nevertheless, therefore each person has the opportunity to make choices that build wealth.  Here are a few tips for everyday people that can lead to a comfortable if not wealthy lifestyle.

Stop spending money!

Who’d have guessed spending less money would be the first step toward building wealth?  It makes sense, yet we as a society can’t seem to spend our money fast enough.  In fact, we spend our money before we even make it and wonder why we can never get ahead.  Most millionaires in this and other countries live a very modest lifestyle (check out The Millionaire Next Door and The Millionaire Mind both by Thomas Stanley if you don’t believe me) .  They understand you cannot possibly build wealth if you spend all of your earnings.  With that in mind, think about each dollar you spend.  Will this product really improve my life?  It it a good value or could I spend my money more wisely elsewhere?  If you spend money needlessly, even if it is just a few dollars here and there, you are wasting opportunities to save money.  And due to the miracle of compound interest, you aren’t just spending $4 on that mocha latte, you’re spending every dollar that $4 could have earned were it invested properly.  It adds up at a mind-boggling pace.

Start saving for retirement right now!

If you don’t already have some form of retirement plan in place you cannot afford to waste another minute.  This is true regardless of your age.  If you begin saving for retirement (be it in an IRA, 401k, taxable account, or other investment vehicle) when you are young you can contribute less over your lifetime and end up with a much higher balance than those who start ten, twenty or thirty years later.  Conversely if you wait until your 40′s or 50′s you’ll have to start saving a huge portion of your income to make up for lost time.  A person in their early 20′s could conceivably retire with one million dollars if they make it a point to max out their retirement accounts every year until reaching 30, even if they never contribute a dime again after that.

Change jobs

Are we recommending you switch employers every other year?  Certainly not, however, employer loyalty can only get you so far.  If your paycheck does not reflect your value, quit.  Do not settle for less than what you’re worth.  The job market is iffy right now, but that does not mean nobody is hiring.  Evaluate your skill set and what you can bring to the table and find an employer who is willing to pay for the value you add to their company.  Increasing your income is imperative to live comfortably and continue to fund your savings.

These are just three of the ways you can begin growing your million dollar nest egg.  You should also try to own your own home and avoid spending money on big ticket items that depreciate quickly (used cars are a better deal).  Are there things in your life you could do without in order to retire a (multi-)millionaire?  For most people, the answer is yes.

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).

Penalty-Free Early Roth IRA Withdrawal Techniques

There are a number of IRA early withdrawal exemptions applying only to very specific conditions, such as in the event of permanent disability or first-time home purchase, but what we’re after is a more generalized method of getting at our money without any strings attached.  There are two such cases I know of…

Roth IRA Contributions Are Always Penalty-Free

Since Roth IRA’s are after-tax accounts, you can always withdraw your contributions without penalty.  For example, say you’ve contributed $30,000 to a Roth IRA over the years and, thanks to generous market returns, it is now worth $50,000.  You are allowed to withdraw $30,000 (the amount you contributed) at any time for any reason, no questions asked.  You won’t owe an early withdrawal penalty or even income taxes.  Every dollar you withdraw beyond the $30,000 you’ve contributed, however, will be subject to both the penalty and regular income taxes.

Substantially Equal Periodic Payments

Substantially Equal Periodic Payments (SEPP) are an inflexible way to tap into your IRA before regular retirement age.  The rules are simple:  you must agree to take substantially-equal payments every year for 5 years or until you reach age 59 1/2, whichever comes last.  Once you decide to start taking SEPPs you are not allowed to skip a payment or change your mind, or you will owe a penalty on previous withdrawals.  The annual distribution you are required to take is not decided by you;  rather, it is based on your life expectancy.  There are actually three specific methods used, each resulting in slightly different amounts:  the amortization method, annuitization method, and Required Minimum Distribution (RMD) method.  See Investopedia’s article on the subject for more details.

Why Do We Work To Begin With?

Ask a man on the street why he goes to work everyday and he will answer “to earn a living.”  He works to earn money for the things he needs in life, or so he would have you believe.  Truth is, he probably works far longer than he needs to merely to earn a living.  Most people could easily afford to put a roof over their heads, nutritious food on the table, and live happy, meaningful lives for a small fraction of what they currently spend on trinkets they think are needs but that are really just wants.  From this perspective, you don’t need nearly as much money as you think to live well.  Does cable tv really improve the quality of your life?  Does that new Cadillac really make you happier than a used Civic would?  Doubtful

How Much Is Enough?

Using the conservative rule-of-thumb that you shouldn’t withdraw more than 3% of your portfolio per year if you want your money to last indefinitely (perhaps more if you invest for income, but let’s keep things simple), you’d need approximately $600,000 to retire on $1,500 per month.  If you use the more conventional 4% safe withdrawal rate, you’d only need about $400,000.  Could you accumulate $400,000 in 10 or 15 years if you really wanted?  I’m willing to bet you could.  You’d have to cut out most luxuries and move to a cheaper part of town, but you could live pretty well and still save a tidy sum.

So depending on your needs, you could retire comfortably with between $400,000 – $600,000, which is far less than the $1 million – $2 million figure usually thrown around.  It simply requires adjusting your lifestyle.  Is there anything wrong with wanting to retire with $4 million and live a life of luxury?  Certainly not, but it’s important to realize the difference between a want and a need.  People tend to forget the difference.