Guest Post: northSaver’s Story part 5

This is a guest post (5 of 5) from a member of the retirejapan community. You can find northSaver on the forum.

Part 1: What is Early Retirement? 
Part 2: Laying the Foundation
Part 3: The Principles of Early Retirement
Part 4: How to Save for Early Retirement

In the fourth article I explained the first two points of how to achieve early retirement, which are:

1.  Reduce your monthly living expenses as much as you can
2.  Eliminate high-interest debt as fast as you can

In this final article, I’ll expand on the third point.

3.  Invest your savings wisely

As well as property, we have built up some cash savings that we invest in a couple of ways using low-cost funds. Much has already been written on this subject, so for the sake of brevity I’ll only explain the two portfolios that we currently use. The important point to remember is that the funds you invest in must be low-cost. This means that the annual management fee charged by the fund manager should be less than 0.5%. Vanguard funds are very good in this respect, but there are others too. These funds are low-cost because they are passively managed, rather than actively. The managers use your money to simply buy and hold, rather than trying to time the market by buying low and selling high (or vice versa). This may sound ineffective, but research shows that low-cost passively-managed funds outperform most high-cost actively-managed funds over the long term. So which funds do I invest in?

Stock and Bond Portfolio

We currently have about half of our cash in a balanced 60% stock / 40% bond portfolio. The stock funds are mostly US and UK index trackers, with a couple of higher risk funds (biotech and emerging market) thrown in for spice. The bond funds are similar – mostly low-risk, low-yield. The bond funds don’t perform as well as the stock funds over time, but they have the important job of tempering the volatility of the stock funds and ensuring that you don’t lose too much in a stock market crash.

In the short term (a few years) this portfolio will go up and down, but in the long term (a few decades) it should return about 9% per year on average. This is before inflation, of course, but even after inflation you should get close to 7% per year. So it’s better than a bank account, but also riskier over the short term.

It’s important to keep this portfolio balanced to the original allocation of 60% stocks and 40% bonds. If you don’t, then over time you’ll become over-leveraged in stocks, which will be costly when the market finally corrects itself. It’s generally OK to rebalance the portfolio just once a year, if the allocations are skewed by 5% or more.

Unfortunately, I use high-cost mutual funds to achieve this portfolio because I’m still locked into my 15-year savings plan. I’ve calculated that it’s worth keeping them, rather than paying the high early-surrender penalties and switching to low-cost funds, so I’ll just grin and bear it for now. Needless to say, my high-cost portfolio has sadly not returned 9% per year over the last 11 years!

Permanent Portfolio

The other half of our cash is in something called a Permanent Portfolio, which historically has produced almost the same returns as the stock/bond approach, but with less risk. This means that the bad years aren’t as damaging as the stock/bond portfolio’s, and the good years aren’t as thrilling. Over time it all evens out and the returns from both portfolios are similar.

The allocation is simple: 25% stocks, 25% bonds, 25% gold and 25% cash. You can probably see right away how conservative this approach is. You never lose money on the cash, and the other three tend to even each other out because they are fairly uncorrelated. It’s a wonder this portfolio makes any money at all, but it does – year after year. A study has shown that in the last 40 years (1974 – 2011) it has returned an average of 9.3% per year. The same study showed that a 50% stock / 50% bond portfolio returned 9.5% in the same period. What’s more, the Permanent Portfolio only had three losing years in all that time, the worst one being -4.1% in 1981.

Again, it is important to rebalance the portfolio every year to maintain the 25% allocations. The above performance figures assume that this has been done.

I use just three ETFs (exchange traded funds) to achieve this portfolio, all traded on the London Stock Exchange. For ETF buffs, they are: Vanguard FTSE All-World (VWRL), Vanguard UK Government Bond (VGOV), and iShares Physical Gold (SGLN). I bought them using a US-based discount brokerage firm called Interactive Brokers.

So that just about wraps it up. There are other good ways to invest too, such as peer-to-peer lending, REITs (real estate investment trusts), and even bank accounts when the interest rate is high. What’s more, rental property is usually a good hedge against inflation because you can increase the rents accordingly. But don’t forget that on the path to early retirement, the investing part is not so important. It’s far more important to spend less and save more. Investing your savings wisely will get you there a little faster, that’s all. Thank you for reading my small series of articles, and I hope your path to early retirement is short and pleasant!