This article explores two common investment approaches used by those pursuing Financial Independence, Retire Early (FIRE). While the FIRE movement emphasizes earning more, saving more, and investing better, this article focuses on the investment aspect. Two general approaches will be discussed, along with their pros and cons.
Understanding Financial Independence
Financial independence is achieved when your investment returns cover your living expenses. This means generating enough investment income to exceed your expenses, allowing you to redesign your life and pursue other goals.
Method 1: Exchange Traded Funds (ETFs)
This method involves allocating your assets to a globally diversified, balanced portfolio using ETFs.
Building a Diversified ETF Portfolio
For beginners, two diversified ETFs can be used:
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Vanguard Total World Stock Index Fund (VT): Represents global equity markets.
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Vanguard Total World Bond Fund (BNDW): Represents global bond markets.
A common allocation strategy is a 60/40 portfolio, allocating 60% to VT (stocks) and 40% to BNDW (bonds).
Backtesting and Performance
A five-year backtest of a 60/40 portfolio using Portfolio Visualizer yielded an approximate return of 8.94%. The standard deviation is low, indicating lower risk. The maximum drawdown (potential losses) was around 20%. The expense ratios for these ETFs are around 0.055%, making it a low-cost strategy.
Improving Your ETF Strategy
You can potentially improve performance by researching:
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UCITS ETFs: These are ETFs traded on the London Stock Exchange, domiciled in Ireland, which can reduce withholding taxes.
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Accumulating ETFs: These ETFs automatically reinvest dividends, avoiding withholding taxes and allowing for faster compounding.
Withdrawing Money From ETFs
When you need money, consider taking out a percentage of your portfolio annually. A proposed withdrawal rate is around 2.5% of the portfolio's value. If your portfolio is worth $1,000,000, you can take out $25,000. Adjust the amount annually based on portfolio growth.
Pros and Cons of the ETF Approach
Pros:
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Highly diversified: Your money is spread globally.
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Low cost: ETFs have very low expense ratios.
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Decent returns: Achieved without stock-picking efforts.
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Low risk: Evidenced by low standard deviation.
Cons:
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Not entirely passive: Requires selling ETFs when withdrawals are needed.
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Less emotionally satisfying: May not provide the same psychological benefits as other strategies.
Method 2: Dividend Investing
This method involves buying individual dividend-paying stocks.
Building a Dividend Portfolio
The goal is to select 20 to 60 stocks that pay a dividend of at least 5% annually. Look for stocks with sustainable free cash flow and a low payout ratio, indicating higher quality dividends. Examples include REITs (Real Estate Investment Trusts) and bank stocks.
Backtesting and Performance
A 10-year backtest of eight REITs in the STI (Straits Times Index) yielded around 7.85% annually, with a standard deviation of 15.4%. Three bank stocks yielded higher returns of 13.42% but with a higher standard deviation of 16.7%. Splitting your investment between REITs and banks can help balance performance.
Fine-Tuning Your Dividend Approach
Fine-tuning requires more financial knowledge:
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Screening Stocks: Select stocks based on low volatility, higher payout ratios, or high free cash flow.
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Financial Statement Analysis: Understanding financial statements helps in selecting quality dividend stocks.
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Screening Software: Utilize software to identify suitable dividend stocks.
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Manage Brokerage Fees: Although a local CDP account is necessary for Singaporean investors, you can cover back the brokerage fees through reinvesting in the next dividend payout.
Reinvesting Dividends
When building a dividend portfolio, reinvest at least half of your dividend into buying more stocks. Reinvesting half of a 6% dividend yield is similar to withdrawing 3% of your portfolio annually.
The Psychological Power of Dividends
Dividends are emotionally satisfying as regular payments appear in your bank account. This encourages persistence and psychological defense during market downturns, ensuring you stay invested.
Pros and Cons of the Dividend Approach
Pros:
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Emotionally satisfying
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Encourages staying invested
Cons:
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Requires more monitoring and stock selection.
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Dividends can occasionally underperform.
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Requires doing more drilling.
Conclusion
Both ETF and dividend investing can be effective strategies for pursuing FIRE. The best approach depends on individual preferences, risk tolerance, and financial knowledge. ETF investing is a safe and effective strategy, but it may not be as emotionally satisfying as dividend investing. On the other hand, dividend investing is an emotionally powerful strategy, but it requires a lot of drilling.