Look at the image above…
Imagine how waves gently and, then abruptly, hit the shore. If someone gave you a beach bed for you to rest on after sunset, where would you set the bed?
If you were a younger person in your 20s, 30s, and even 40s, you’ll probably feel safe if you put the bed as close to the water as possible.
You probably wouldn’t be too concerned if you see the tide going up because you’re strong and can quickly move the bed further away from the water.
Although it’s risky behavior, you like the action, so why not be closer to the water? You can tolerate the risk.
Now, let’s imagine that you’re over 65 years old.
Where would you put that bed?
Would you want to be as risky as your 30-year-old self, knowing that you no longer have the strength and agility to move it as quickly?
You would want to place the bed far enough from the water, so that you don’t get a surprise wake-up call from a wave in your face, with the possibility of getting drenched. (No offense to anyone over 65. My old man is 77 and he can move a mountain before a 30-year-old can upload a selfie to a social media channel.)
As we get older, our tolerance for risk decreases. The same happens with our investment risk tolerance. When we’re young, we take more risks in entrepreneurial activities or other investments because time is on our side. If we fail, we can get up and still be able to build a fortune.
However, as we get older, our financial mistakes can cost us dearly, since we might not have a long time horizon to make up for them.
Risk is something that we examine closely in our asset portfolio today because we will be retiring in a few years. The main difference is that while we’ll be in our early 30s/40s, our risk tolerance will be closer to that of a typical couple at the traditional retirement age of about 65.
But here’s the caveat: we need to live mostly off the dividends and capital gains, and not the principal, and make our assets last for five decades or so.
Approaching the finish line
We are only a few years away from reaching FI. We’re going to be busy over the next couple of years (when aren’t we?) transitioning to the fun lifestyles of early retirees and working on the stability of our portfolio.
And what is the single most important FI-related question that we’re working on right now to help us get there?
The question we’re working on is, what should our asset allocation look like upon retirement in order to make sure that we have a strong solid bed to rest on at that beautiful beach?
Amount needed to retire early
To be able to retire early, we need to have a certain amount invested in income-producing assets, and in turn, we should be able to safely withdraw around 3-4% of our portfolio to cover our annual expenses without depleting the principal too early.
How did we determine how much we need to have in assets, in order to consider ourselves financially independent and then be able to retire early?
Reaching financial independence is the time when we reach “25x our annual spending” in income-producing assets. We’re using the safe withdrawal rate as a guideline. We answered this question in more detail in this post: The FI Million Dollar Question: How Much Would I Need to Fund my Lifestyle Forever?
Asset allocation ingredients
Our income-producing assets today include bonds, stocks, and hard assets, such as real estate and short-term reserves.
An asset allocation chart is one of the most impactful visuals that I enjoy looking at, after net worth charts, of course, because it gives us a view of how our entire portfolio is invested. It’s a snapshot of how our assets are allocated.
Risk tolerance extremes
Some investments are riskier than others, and the riskier the investment, the higher the potential reward, and vice versa.
If you put your money in an FDIC-insured savings account with less than 3% interest a year, there is 0 risk, but then your money doesn’t keep up with inflation. This is a good risk-free vehicle to park your money for an emergency fund or for short-term goals.
If you put all your money in stocks, you might wake up one morning and find out that you lost a huge amount of your investment. You have to be able to stomach a 50% decline in your portfolio to be 100% allocated to stocks.
In that case, you might feel like you’re drowning, but if you do nothing, basically don’t sell while the market is low, the wave recedes and you go back to feeling safe at some point.
This loss is unrealized in this case, which means that unless you sell the stocks you own, you still own the same amount of stocks and have a chance to regain the losses when the share prices increase again.
You can balance the risk involved by implementing a sound investment strategy. You also have to consider your goals and investment time frame.
For example, we don’t put any money that we might need within the next five years in stocks because there’s a high chance that the investments could drop in value when we need them, and we don’t want to be forced to sell our shares when their price drops.
The growth-oriented investor
If we were to continue working the normal path to traditional retirement until we’re 65 and didn’t have any real estate investments, our portfolio, right now, would be mostly geared toward growth. We’d have a long investment time horizon and the ups and downs of the market wouldn’t matter to us.
Our investment would be heavily concentrated in stocks with an asset allocation of 80-100% stocks and 20-0% bonds.
The income-oriented investor
If we were a couple in our 60s, very close to traditional retirement, and without any real estate investments, we would be very concerned with the market performance and with taking on too much risk. We’d be looking to protect the accumulated money and also be focused on getting income from our portfolio to pay for our expenses.
Our investment strategy would have a heavy concentration of bonds with an asset allocation of 20-60% stocks and 80-40% bonds.
A traditional retiree would most likely have an income-oriented asset allocation.
The hybrid (growth and income) investor – this could be us!
After we got married, it was hard to see the big picture with our separate 401(k)s and other accounts.
Personal Capital does a great job of showing your combined asset allocation, but we prefer to use our own spreadsheet for now (see sample below with made-up numbers). It’s easy to update and gives us a complete picture of our asset allocation.
What will make our asset allocation different from a traditional retiree’s?
- We want a major portion of our portfolio to continue to grow since we’re young and plan to withdraw annually the least amount possible.
- We’ll need to keep a portion of our investments in our brokerage account that can support us during the first 5 years because we won’t be able to withdraw from our retirement accounts within that time frame. After 5 years, we’ll be able to withdraw through an IRA/Roth conversion ladder. This allows us to withdraw 401(k) funds before age 59 and 1/2.
- We expect to have real estate investments to generate income, so we won’t need to dip into our savings as much. However, in the future, we’re leaning towards real estate rental investments that’ll provide nice experiences for our guests, such as a vacation rental, instead of the traditional housing rental investments we have now with permanent tenants.
- We have a strong possibility of growing our assets after early retirement because we plan to stay active by doing enjoyable activities, and some hobbies might even generate income, such as consulting, blogging, etc.
- We’re not counting on social security income, but that would be a huge help if it’s still around by the time we reach traditional retirement age.
Where our asset allocation stands today
(Note: Unfortunately we used a WordPress plugin to show our allocation back then and we lost the data while transferring from Enchumbao to Crucial Wealth. We apologize that we can’t reproduce it.)
By seeing our entire asset allocation at a glance, we can determine where we need to rebalance. Our 401(k)s might indicate that we’re tilted heavily in one asset class, but our entire asset allocation tells a different story.
For example, our rental property generates a 10% average annual return after expenses. We expect to continue that trend, as we won’t get involved in real estate investments that don’t have the potential to generate at least that much of a return.
More fun work ahead
Financially speaking, this is what we’ve been up to lately–analyzing what our long-term position should be 2-3 years from now and making adjustments to shift our assets accordingly.
We’re reviewing different asset allocation models for stocks, bonds, and short-term reserves to see how much we should allocate to each asset class.
There’ll also be a shift in our real estate assets, as we prepare to sell our property over the next two years and explore some new exciting real estate opportunities abroad. The chips are slowly falling into place. We’ll continue to share our progress with you.
It’s amazing what can be accomplished by having a vision and staying focused. Anyone can take some time to quickly create a sheet of their net worth. We hope you’ll join us on the FI journey, and together, we can form an amazing community of early retirees!
What financial goals are you working on?
Risk disclosure: All investing involves risk, including the possible loss of principal. The material contained on this website is for discussion purpose only and should not be misconstrued as financial advice.