So, you’ve worked hard in high school and college, built your human capital, and are now starting a new gig that pays well with room to grow. Congratulations – but this is only the beginning. It’s now time to start building your investment portfolio – starting on day one. It is critical to start saving as early as possible. Why? Because of the exponential power of compound interest.

The Power of Exponents

Here’s the compound interest equation:

Value = Principal * (1 + rate of return)^time

See that little carrot looking thing next to “time”? That is an exponent, and it means that (1 + rate of return) is raised to the power of “time”, i.e., 1 year, 5 years, 10 years, 20 years, etc. – however long your money is invested and compounds over time. Here’s an example of the power of exponents:

• 10^1 = 10
• 10^2 = 100
• 10^3 = 1,000
• 10^4 = 10,000
• 10^5 = 100,000
• 10^6 = 1,000,000

An exponent is a powerful thing. While you need to:

• Invest a large chunk of capital and
• achieve a decent rate of return,
• time is the most powerful factor in investing.

Your investments will grow exponentially based on time – the longer the time invested, the larger your investments will grow. It’s the dollars you save and invest during the beginning of your career that will do the heavy lifting down the road, so start saving early. 

The Main Question

The main question: What size portfolio do I need to reach FI? The answer is surprisingly simple: about 25 times your annual expenses (the “25X Rule”). Notice this number has nothing to do with how much you earn, it’s simply based on your annual expenses. Later we’ll talk about the need to live well below your means in order to reliably build wealth and reach FI, and why keeping your expenses modest is the most powerful FI lever you can pull.

Where Does the 25X Rule (aka The 4% Rule) Come From?

The general rule of thumb is you can draw about 4% of your portfolio each year without significant risk of eroding your principal. Why 4%? Say your portfolio of 80% stocks and 20% bonds returns an overall 7% annualized and inflation runs 3% per year on average. That leaves about 4% per year in real (i.e., inflation-adjusted) terms that you can withdraw for living expenses without eroding your principal. And because 1/0.04 equals 25, you’ll need a starting capital of 25 times your annual expenses to reach FI. For example, if your annual expenses are $20,000/year that means you need to save and invest about $500,000 to reach financial independence ($20,000 times 25). Let’s look at some examples of the 4% Rule.

Predictable, But Risky – Fixed Withdrawal Rate from Portfolio 

Say you’re ready to retire, have $500,000 in a balanced portfolio of stocks and bonds, and want a predictable annual income. With the fixed withdrawal method, you would take out 4% of your initial amount ($500,000) to generate $20,000 of income for your first year of retirement.

Then you throw away the 4% Rule. Each subsequent year, you simply adjust the initial amount ($20,000) upwards for inflation. So if inflation was 3% during year one of retirement, you would withdraw $20,600 in year two ($20,000 x 1.03). If inflation was 3.5% in year two, the year three withdrawal would be $20,600 x 1.035, or $21,321. The main point is that you withdraw this amount regardless of what’s happening in the market. This method allows for a predicable annual income from your portfolio but is also risky in that during a severe market downturn, you may be withdrawing some of your principal. This method puts you at the mercy of the market’s sequence-of-returns. A poor run of returns in the early years of retirement, along with taking out a fixed amount to cover living expenses, is a bad thing, and could reduce your portfolio such that it won’t recover even with a subsequent bull market. I don’t recommend this approach because it leaves you too susceptible to chance.

Less Predictable, Less Risky – Flexible Withdrawal Rate from Portfolio

A more conservative method is to withdraw a certain percent of each beginning-of-year portfolio amount. This allows you to withdraw a slightly higher percent (between 4% and 5%) as compared to the fixed withdrawal method, but your annual income will fluctuate, so you’ll need some flexibility in your annual expenses to accommodate this.

An example – you’ve retired with a $500,000 portfolio. On January 1 of your first year, you withdraw 4% of the beginning-of-year amount ($20,000). During the year, however, your portfolio is down. Between the market decline and your withdrawal, the beginning-of-year amount on January 1 of year two is now $478,000, so you withdraw 4% of this amount ($19,120) to cover year two living expenses.

This method therefore adjusts your withdrawal amount based on market conditions, and reduces the impact of the market’s sequence-of-returns. Of course, this method also results in a fluctuating annual income, but reduces the risk of eroding your principal. This approach is an improvement over the Fixed Withdrawal discussed above, but we can do better.

Let’s Build a Bridge – Flexible Withdrawal with Three-Year Cash Cushion

I think the best approach is the above flexible withdrawal method coupled with a three-year cash cushion. How does the cash cushion work? On year one of retirement, set aside three years’ worth of expenses (net of other passive income streams, interest, and dividends) in a short-term bond fund or a money market fund. This three-year fund is there to avoid the need to sell stocks during a market downturn. Count this three-year fund towards the bond/cash allocation of your portfolio. An example: let’s say that after interest and dividends, you need an additional $15,000/year from your portfolio to cover expenses. A three-year fund would be $45,000; this is your cash cushion. If the market does well that year, sell $15,000 of your stock/bond funds to pay expenses. If it doesn’t, just draw from the three-year cash fund until they recover. Once they do, sell some stocks and/or bonds to replenish your cash cushion back to three years of expenses. Your overall asset allocation should guide whether to sell stocks or bonds. Again, this method is designed to minimize the need to sell stocks during a market downturn.

The risk here, of course, is that the market takes longer than three years from the start of a bear market to recover. As we will discuss in this post, since 1926, the average recovery period of bear markets has been 3.3 years. But some of the more severe market declines, such as the 2007-2009 bear market, have taken up to five years, sometimes more, to recover to the pre-decline highs. If this bothers you, build a bigger cash cushion – say, five years. But remember that this cushion won’t be earning much, just sitting there in case of emergency. So there is a real opportunity cost for having too much cash cushion.

Some Assumptions

The 25X Rule assumes you’ll maintain the same general standard of living in the future. But it also assumes you’ll never earn another dollar and ignores Social Security. It also ignores pensions and inheritances, if they apply. So, if you include these, and/or have plans to work part-time, start a small, low-risk business, or just make some occasional walking around money, your 25X number will be smaller.

Slipping In or Out of FI

If you’re currently at FI but anticipate a future increase in expenses – want to move to a more expensive city, currently single but want to get married and have kids, or just want to increase your standard of living (big house, new cars, etc.) – then you’ll need to build more capital in order to equal 25X your higher expenses. So be careful: if you’ve reached FI, you can slip out of it if your annual expenses start to creep. But the good news is that, if you’re not at FI yet, you can slip into FI just by lowering your annual expenses.

Consistency, Persistence, and a Long-Term Perspective

In the beginning, saving enough for FI can be daunting. It’s like looking up at a mountain top looming over the trailhead and thinking “I’ll never make it.” But with enough time and steady walking up the trail, you’ll eventually find yourself at the peak (and be sure to enjoy the scenery along the way). The key is consistency, persistence, and a long-term investing perspective.

Deduct a set percentage – as much as possible – from each and every paycheck directly into your investment accounts. Increase this percent over time as your career grows. In the early years, the money in your portfolio will be mostly the dollars you save from your income. But over time an interesting thing happens: your investment gains will start to equal or exceed the capital you save and invest. At this point you’ve hit critical mass, with both your savings and investment gains powering your portfolio’s growth. You want to hit critical mass as soon as possible, so start early. There will be down years where the market tanks and you lose money. It’s inevitable and you need to be mentally prepared for the occasional declines. The key is to stay the course and do nothing different.

A Parting Thought on Market Fluctuations and Investment Costs

Based on the market’s historical return, a balanced portfolio of stock and bond index funds will likely return around 7% annualized over the long term. But your actual yearly returns will fluctuate a great deal around this annualized number. You must be able to handle these fluctuations and weather the inevitable, temporary down markets in order to reap the rewards of long-term investing. We’ll explore this later.

Just as important, you must also keep your investment costs as low as possible. Why? The 7% return is the market return. Your personal return – what you use to pay the rent and buy groceries – is the market return minus your investment expenses. This distinction is critical. If you pay an advisor 1.5% to manage your money, and he puts you into mutual funds with an expense ratio of 1.5%, that’s 3% right off the top. Now let’s say inflation runs at 3%. If your advisor makes you 7%, your personal rate of return net of fees and inflation is only 1% ! (7% – 1.5% – 1.5% – 3% = 1%). So, John Bogle, the founder of the investment company Vanguard, isn’t kidding when he says, “Costs matter!”. They do, more than most of us realize. Always remember: you pay rent and buy groceries with the market return minus taxes, investment costs, and inflation.