Investing For Early Retirement: Stocks, Bonds, Real Estate, Or What?

Investing for early retirees and investing for regular retirees are two completely different pursuits requiring two completely different approaches.  Strategies appropriate for one goal don’t necessarily translate to the other.

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.