For a long time, I wondered how we should withdraw money from an investment portfolio to cover living expenses and not hurt its growth rate at the same time. Given the end goal of financial independence is to live off investments, withdrawing too much money would deplete the investing capital and would force us to go back to work in case of a bear market.
Finally, a couple of days ago I found the answer.
Let’s elaborate on that a bit to make it clear.
The basics of an investment portfolio
During our working years, we should save money and increase our investing capital. That capital will be used to invest in various assets, diversifying our risk by buying into different markets.
Ideally, we should save at least 20% of our monthly income or better (50%) and use that to invest in stocks, real estate, bonds, metals and even in riskier assets, such as cryptocurrencies. If one market enters a bear phase, another might skyrocket at the same time, covering the losses.
Our goal is to have a big enough investment portfolio that returns enough money for us to retire in the future.
How much money do we need to retire?
We will need to track down our annual spending. I use a budget app for that, but a simple spreadsheet can work as well, as long as you are disciplined enough to update it often. Once we know how much we spend each year (and where!), we can calculate how much money we need to retire.
Multiply the annual spending figure by 50. That’s how much money you need to have in your investments to retire.
As an example, say I spend $20,000 per year. I need $1 million to call it quits and retire.
Now, say after years of saving money and building an investment portfolio, we finally reach that number. Then what?
Let’s talk about rates first
Typically, our investment portfolio is expected to have a growth rate. Like a bank interest rate.
If we put every saved penny into a bank account, we will make the bank’s interest rate. This is one of the safest bets we can make, hence the return will be minuscule and we will most probably lose money due to inflation, even if we shop around for the best rate.
By diversifying our portfolio as mentioned before, we can take advantage of bigger returns at the expense of a bigger risk of course. However, long term the US stock market is expected to have a 7% return. Even if we bought right before the 2008 financial crisis, we would still have made a hefty 153% return in 12 years by now!
Given we are not looking to pinpoint bottoms and ups, we are simply doing what’s known as “dollar-cost averaging”. We are in fact buying and holding for a very long term period. If we buy stocks, gold or a cryptocurrency every single month, we’re adding to our portfolio without trying to time the market. Remember, we are too busy working and besides, we are not experts in timing the market (even experts cannot)!
So, some assets will gain in value while others will lose. In the end, we expect our investment portfolio to have an average return rate of 4%.
Retiring and living off investments
We have a million dollars in investments. While it’s nice to watch the number increase by 4% every year on average, we do need to live in retirement. We are still spending money on food, home, and other necessities. Unless we polished our lifestyle, spending should have remained the same or increased just a bit every year due to inflation. For the sake of the discussion, we will assume it remains the same as if we retired tomorrow.
We need $20K to maintain our way of living. By withdrawing 2% of the investing capital every year, we’re guaranteed to never go back to work ever again. Even in the worst market conditions when our investments will lose 20% or more of their value, by withdrawing less than the expected average return we allow our investment portfolio to rebuild itself when the market turns.
If we feel it’s party time and we are entitled to burn more cash in retirement, things can get ugly.
Let’s say we increase our spending to $50K per year. We are now withdrawing more than the investments are expected to make annually. And while this doesn’t seem bad when stocks hit new highs, by the time the downturn comes, we’ll have a lot less money in our investment accounts to withstand the fall.
Yet, even if we survive, our capital will have been reduced so much that it won’t be able to grow sufficiently when markets start to climb. Even worse, our withdrawal rate will still hurt our capital, which by that time won’t be big enough to sustain our way of living. And even if we accept our mistakes and cut down our spending, our capital may be at $500K or lower, which means that a 4% average return rate won’t be enough to cover our expenses.
Eventually, we’ll run out of money in retirement years. Fail.
Recap (tl;dr):
Steps to living off investments:
- Save 20 to 50% of income.
- Dollar-cost average in various assets once every month.
- Track spending.
- Retire when the investment portfolio is 50X of annual expenses.
- Withdraw 2% or less than 4% at most every year.
- Live happily ever after.
Finally, what happens at the final curtain? If we are single, leaving a million dollars behind doesn’t seem logical. So, begin spending more close to the end and ideally die at zero. If we have a family, we probably want to leave that money to family members. After all, family comes first, right?
I wish I knew all that 20 years ago.
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