I posit that most people can attain financial independence in less than 10 years and in less than 5 if they are truly determined. I also submit that many people are not willing to make the necessary changes.
By cutting all expenses to the bare essentials, I have been able to save approximately 60-90% of my net income thru grad school and my subsequent jobs with an average percentage in the mid eighties. Initially all this money went into a savings account. I mostly attribute this savings rate to reaching my goals this fast(*). My early fumbling into investing are certainly not something worth replicating but quite a few people have asked for it so here goes.
In retrospect going for the savings account turned out to be a semi-good idea since I avoided the 2001-2002 bear market. On the other hand I also missed the March 2003 rally. At the end of 2004 I was getting tired of earning 1.5% in my savings accounts. Since I grew up in country where investing in stocks was considered too speculative, I called my bank and told them that I wanted to buy some bonds. My bank directed me to some Baa-rated (as far as I remember) bonds from a company that was financing ships at 3% and I put down $20,000 or about a quarter of my savings at the time. I quickly realized that while $20,000 at 3% was earning $600 a year, the same amount in a savings account was earning only $300.
A light bulb went on and I thought that maybe I should start thinking about the return of investments and not just on increasing my investments by saving. Trivial, I know, but growing up in a financially conservative middle class, this was a big step.
Contrast and compare to the US where people grow up believing that as long as they put their money in the stock market they are almost guaranteed, nay entitled to get 10% returns on average if they just hang around for “the long run”.
Soon I made a program (today I would use a spreadsheet) to predict my net worth. When I plugged in my assets, the return on investment (ROI), and my monthly contribution, it would calculate my net worth for the next 80 years (I expect to live for quite a while). I put in “if”-statements such as “financial independence reached at 4% withdrawal”, “financial independence at 3% withdrawal”, “my first million”, “my second million”, etc. and the program would show which month I reached which stage. It was quite empowering to run the program. I probably ran it twice a day. I knew my net worth down to the cent. One aspect of playing with the program was the ROI. I already had substantial assets hanging around in a savings account earning a measly 1.5%. If I could get 3%, I would double my returns. What if I could get 5% or 10%?
At the time I was a young and enthusiastic scientist and pretty much ignorant about business and investments. Basically I was clueless. However, I was quite interested in geopolitics and demographic trends, so I called up my broker again and said I wanted to buy some stock in a company producing insulin (because people are getting older and fatter), a telephone company (I read that it was cheap on several investment sites), a wind power company (Because oil was running out) and a small cap holding company (I liked their dividend). Later I also got an airline company (Random investment newsletter). As you see pretty haphazard! So today when I see people buying some company because they think it’s cool, I try to remind myself about the way I used to buy shares. As luck would have it, most of these positions turned out to perform spectacularly (except the airline) returning more than 30% a year. I sold the airline (smart) and the wind company (stupid) because they were too volatile for me. Of course today I wish I had put all my money in those stocks and not just the fraction I did (about $30,000) at the time.
Making these investments increased my ROI. In my program I also had my average estimated monthly investment income as well as my average monthly expenses. Watching these two numbers converge by reducing expenses, saving money and increasing ROI was quite empowering.
One important lesson was than if you have $100,000 and a ROI of 5%, then spending 20 hours figuring out how to increase ROI from 5% to 6% is worth $1000 or $50 an hour. I was certainly not getting paid $50/hour in my day job. This meant that dealing with investments was now more profitable than my job, economically speaking. I decided that since I had saved the assets, I should learn how to invest them.
Since I was interested in (macro)economics, I was quite concerned about the systemic risk of index funds. This was probably fueled by my initial bear market experience from the sidelines. An economy can crash and bring down an index while individual sectors and companies will be doing quite well. Yet whereas my home country has maybe a few hundred listed stocks, the US has close to 10,000 which is quite a mouthful. Thus I wanted to go with mutual funds. I got my suggestions from various authors at financialsense.com. I then downloaded the prospectus and read about the manager’s philosophy. If I agreed with the manager, I invested in the fund. I have never picked a fund based on historic returns. Rather, I pick from the conviction that I am right and that the rest of the world crazy as it may be will eventually come around to see things my way even though it may take years. In other words I pick investments based on fundamentals, not trends. I can modestly claim that my predictions usually turn out to be true even though I don’t know whether it is because I’m really right or because of random chance 🙂
My investment story turns out to be complicated by the fact that I was learning more rapidly than the market was moving. Thus within a year I started pulling money out of the funds to start a broker account. I read tons of 400 page books about how to use options to manipulate the return structure. During that year (2006) I matched market returns but at half the volatility and covered my living expenses three times over. In other words, I did as well as the S&P 500 but at half the risk. I also demonstrated (to myself) that it was possibly to turn potential gain into instant cash.
(*) For the math geeks consider this: Saving 70-80% means spending only 20-30%. If expenses can be covered by extracting 4% from savings and investments annually, one needs to save a total of 20-30%/0.04 = 500-750%. Without considering compound interest, this will take 500/80 = 6.25 years or 750/70 = 10.7 years(*) . There are two important conclusions here. First, the 10% difference between 70% and 80% makes a big difference in the estimated time it takes to gain financial independence! Second, compound interest will play only a minor role. It would move the retirement date to 4 or 5 years instead of 6 years. The standard recommended 15% savings rate results in 25 years. This is not a coincidence as this is also comparable to the time most people spend working before retirement. For such a long time compound interest does make a difference. Finance geeks would want to use a financial calculator and use PV=0, i = 8% (or whatever ROI you think you can get), PMT=-0.70 (or however much you’re saving), FV = (1+PMT)/0.04 = 0.30/0.04 and then solve for n. If you have no clue what I am talking about, you might want to find out 😉
Doing covered calls is a nightmare when it comes to filling out tax returns though. Besides, since I could never get the timing right, covered calls did not make any extra money for me. It was time to learn again. Therefore I started reading financial statements and began to learn methods to estimate the value of a company. In particular I started reading financial statements of companies that were not followed by Wall Street. Wall Street is mainly run by banks and big (pension) funds. First, this means that they need to invest billions of dollars which naturally restrict them to the largest companies. Second, if you are in charge of a big pension fund there is more job security in going along with everybody else than being the sole contrarian. If it turns out that you were wrong and they were right, you will surely get canned. If it turns out that you were wrong and they were wrong, you’re safe (who could have known, right). Finally if you are right and they are right, everybody wins. This also means that everybody shares the profits and losses. Conformist portfolio managers with this attitude are essentially charging money for nothing. Since conformity is a common human trait (if I had a dollar for every time I’ve heard “normal people” as a justification for some action) this explains is why index funds are generally superior. There are, however, managers that don’t follow the crowd and they can make outsized returns. Thus my present (2007) strategy is to buy undervalued companies that are generally hated by the market and wait for a turnaround. Once the tide of conformist managers and the blind indexers that follow them come around, I expect to be at the front of the wave. This might happen in 2009 or maybe I even have to wait until 2011. Who knows? Crowds are fickle.
Things have changed a lot since I started. I remember celebrating when my investment went up by $2 – “Honey, I earned $2 on the stock market today!”. These days my portfolio sometimes fluctuates by a paycheck on a daily basis and gaining or losing four digit figures is not a big deal anymore – “Oh, by the way honey, I lost/made $5,000 last week”. I sleep well at night.
Today I look at myself as “Me, Inc.” instead of “Who Cares, Inc.”. My day job would thus be a way of generating a consistent alpha (time based performance), but much of the my income performance is beta (market based performance) related. Taking control of my own investments has essentially turned investing into a second job for me. I can earn more managing my investments than I could taking on a second (minimum wage) job. This is also why I no longer need a “real job”.