EngFI2022

28 Apr, 2022

Posts

Picking The Right Investments

You have a 401-k an IRA and or a brokerage account but how do you pick from the thousands of investment choices available? It doesn’t need to be as complicated as it may seem.

There are plenty of choices: cash, money market accounts, government bonds, CD’s, short and intermediate term bonds, large-cap stocks, REIT’s, mid-cap stock, high-yield bonds, small-cap stocks, foreign stock, micro-cap stock, commodities, options, futures, limited partnerships, alternative investments, IPO’s, etc. Rest easy knowing you can reliably build wealth by focusing on US corporate stock within a single index fund.

Allocation

The first step will be to determine your allocation of investment types based on: 1) your goals, 2) risk tolerance and 3) timeline. If you need help with your allocation, check out my post on “Investment Risk” https://www.1engineeronfire.com/?p=358. Once you select an appropriate allocation you can then start looking at your investment choices.

Employer Plan

Many people do the majority of their investing via their employer’s plan. Within that plan you will have limited options but most plans cover the basics. A safe bond option, a number of stock options and typically some balanced or target date funds.

If you are a set-it and forget-it investor a balanced fund may be for you. They are often called a target retirement 2030, 2040, 2050…fund. They are a mixture of stocks and bonds based on a retirement date corresponding with the name. These funds will automatically balance the stock bond allocation based on your retirement year. I find these funds a bit conservative so dig into the details and see if the allocation mix suits your goals. Typically, these funds have a higher expense ratio (fees) because they are doing the rebalance work for you.

If you want to be more involved in your selection select from the stock options. There will often be a S&P 500 fund, Russel 2000, NASDAQ, Blue Chip, Large cap, etc. These funds attempt to mimic various stock indexes. When the names get confusing just go to the research page and do a little digging. You are looking for pure index funds or Large, Mid, Small or Micro cap funds. You could easily just pick the S&P 500 fund and get ~500 of the largest US stocks. Or make a mixture of the other funds say 30% large cap, 25% mid cap, 25% small cap and 20% international. Your goal is to diversify among the various stock classes. If your allocation is anything but 100% stock you need to mix in the appropriate amount of bonds. With this plan you will need to rebalance annually to maintain your proper stock to bond allocation.

Self-directed Accounts

If you have your own IRA (Roth or traditional) or brokerage account (taxable) your choices are virtually endless. You can invest in individual stocks, mutual funds, bonds, etc. Today’s index funds from mainstream companies are available to you at the click of a button as well as individual stocks. The data indicates consistent investing in a simple US stock index fund like Vanguard’s VTSAX or Fidelity’s FSKAX or FZROX will match market returns with the lowest fees. This is the investing strategy at the heart of the FIRE community.

If you are inclined to pick individual stocks, the data indicates you will underperform the index funds over time. But if the urge to “play the market” is strong, allocate no more than 10% of your holdings to this venture. You may catch the next rising star or buy the next Netflix the day before it drops 35%! The thing you have to ask yourself is “Are you smarter than Warren Buffett? The data suggests otherwise.

Advisor Accounts

What about advisors? Investment advisors used to be the only way the average investor could buy stocks. Now with online brokerage we can buy stocks without an advisor. A good advisor can provide valuable advice, at a cost. A bad advisor will make himself and his company rich at the expense of your portfolio. Typically, an advisor will charge 1% of your invested funds annually. That 1% gets charged whether you win or lose! Large firms, like Fidelity or Merrill Lynch, have significant research teams analyzing the markets. Their advisors have instant access to that research.

I suggest starting simply on your own with a Fidelity or Vanguard account and just buy a broad market index fund. Once your assets reach over $100,000 you may find an advisor may offer some value. They can offer other planning services and keep you on the right track in down markets. I started investing on my own and when my family and professional life became complicated, I realized I wasn’t paying enough attention to my investments. That is when I moved a portion of my investments to an advisor. At that point in my life the 1% fee was worth the advice and gave me some confidence that I was on the right track. Now in retirement, I have a proven plan in place and I may eventually reduce my portfolio share with my advisor.

Keep it Simple

As I look back on my 35 years of investing, I realize it could have been simplified. I was buying mutual funds chasing last year’s returns essentially ending up with 25 funds that made up the whole market. I did well because I unknowingly created my own index fund made up of many individual funds. The problem was, even my low-load funds had high fees compared to the modern index fund. This is why the simple index fund is so right for so many investors. These low expense (fee) index funds invest in good US companies. Companies that don’t measure up automatically fall off the index and new growing companies are added. You as the investor don’t need to perform individual company research attempting to pick the winners. You can invest that time into the things you enjoy!

Conclusion

Buy the index fund or build your own version within your employer’s plan.
Invest in a target date retirement fund if you are a hands-off investor.
Use the same strategy within your self-directed accounts knowing you have more choices.
Invest in the best low-cost index funds from proven brokerage firms.
If you must pick individual stocks, do so with no more than 10% of your assets.
Use a good advisor based on your situation but understand the cost.
Keep investing and enjoy the returns of good US companies!

1EngineerOnFIRE

EngFI2022

26 Apr, 2022

Posts

Investment Risk

On 20 April 2022 I happened to look at my stock app and I did a double take when I saw Netflix (NFLX) dropped 35%! This was a real reminder of individual stock risk. Many people think of stocks as risky investments, this Netflix drop would support their case. I would like to explain basic investment risk, how to mitigate risk and how diversification and allocation can help to reduce investment risk.

What is Investment Risk?

Per Merriam-Webster, Risk is: The chance an investment (such as a stock or commodity) will lose value. Warren Buffet’s #1 rule of investing is “Never Lose Money”.

Investments Types by Risk

Low risk investments – Cash, Money market accounts, Government bonds, CD’s, Short and intermediate term bonds.

Medium risk investments include – Large-cap stocks, REIT’s, Mid-cap stock, High-yield bonds and Small-cap stocks.

High risk instruments include – Foreign stock, Micro cap stock, Commodities, Options, Futures, Limited Partnerships, Alternative Investments, IPO’s, etc.

Low risk investments historically do not keep up with inflation so we must look elsewhere to grow wealth. Many investors do not have the risk tolerance or knowledge for success in the high-risk category. For these reasons the smart investor will focus on the mid-risk category of US corporate stock.

According to NerdWallet the average annual stock market return is 10% https://www.nerdwallet.com/article/investing/average-stock-market-return. This is in line with the S&P 500 historic returns but a bit above the Dow Jones historic average return. Along with the compounding effect a 10% average return can help any investor grow wealth.

Company stock risk comes in two basic forms:

Systematic risk – Market risk or things that generally affect the market as a whole. Things like inflation, recession, interest rate changes, political factors, etc.

Unsystematic risk – Risk unique to an individual company. Examples would be Elon Musk making a bold statement to the news media affecting Tesla’s price or Netflix servers crashing causing loss of subscribers, Kodak not getting into digital cameras etc.

With this basic understanding of both basic stock investment risks, you can see the average investor has no control of either. So how do we reduce this stock risk?

Mitigating Investment Risk

If you invest 100% in Tesla stock and Elon Musk announced he believes in aliens and the tooth fairy the stock could fall to zero. You then lose 100% of your investment. But if you owned 50% Tesla and 50% IBM your total loss would be reduced to 50% because IBM didn’t fall. To reduce that even further spread your investing over more stocks.

So why not buy 500, 1000 or 3000 stocks and reduce your risk even further? When you buy an index-style mutual-fund you are doing just that. Now if Elon makes a crazy claim his share of your total becomes almost insignificant. You still share in the systematic risk of the market but unsystematic risk is minimized.

What do you give up when buying “the market” in large index-funds? You give up the highest returns if you had only owned the top performing stocks. You still benefit from their return but you have to average those returns with the lesser performing holdings.

So why not just buy the top performers? The data indicates even the best investors can not pick the top performers year after year. You can’t pick them either!

Diversification and Allocation

Diversification – spreading risk over a number of assets within a given asset class.

Allocation – Balancing the different types of assets classes based on goals, time and risk tolerance.

I’ve already discussed that owning an index fund buys hundreds or thousands of stocks. An S&P 500 fund like Fidelity’s FXAIX automatically diversifies (~500 stocks) your stock holdings within the large-cap asset class. If you were to own Vanguard’s VTSAX fund you would own over 4,000 stocks and cover large, mid and small cap asset classes.

If you have over 5 years to grow your wealth and a good risk tolerance, I think a 100% stock allocation might be just fine. But if you are near or in retirement or don’t like to see big value swings you should look into a different allocation.

If you have read about the 4% rule https://www.1engineeronfire.com/?p=57 you know to survive a long withdrawal period you need an allocation mix of stocks and bonds. The well-known “Trinity” study https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf can help you with allocation selection as well. For this you have to look at where you are, where you want to be and then honestly assess your risk tolerance.

The trick with any allocation is you need to stick with it. You can’t claim to be an aggressive 100% stock investor and then sell out when the market drops 30%. This will guarantee failure! You also need to understand $50,000 will only grow to about $103,000 in 10 years in a conservative 40/60 stock/bond portfolio. I like this chart I found at optimizedportfolio.com. At a glance you can see the average expected rate of return with various allocations.

The bars represent the best and worst one year returns for each allocation from 1926 thru 2019. One way to set your allocation is to look at the worst return (number at the bottom of the bar) and ask yourself if you can tolerate that amount of annual loss. For example, if you think a 25% loss in a single year would have you selling then you better not have more than a 50% stock allocation. If you have 2 decades before you need your money and you can ride out a 40% loss then you might be able to tolerate 90% stocks and can then expect 10% returns.

Of course, there are many variables and this is all based on past performance. Bonds are currently underperforming historical data so maybe add 10-20% more stocks to be a bit more aggressive. If you think you will exceed your portfolio needs, have a pension to fall back on or plan to supplement income with work I’d go more aggressive as well. If you are conservative and will have more than enough to meet your needs, stay safe and allocate 40% to 50% bonds. I would not recommend more than 75% bonds for the most conservative investor. It’s just too hard to keep up with inflation when returns fall below 7%.

What does 1EngineerOnFIRE do?

Throughout my working years my allocation was 100% stocks. I new I had strong investing discipline and would not sell in a down market. I dollar cost averaged monthly in my 401-k and bought IRA’s every year until I was well ahead of my goals. In the months leading up to leaving the workforce I did move ~10% of stock to bonds.

Now 2 years into retirement I’m slowly rebalancing to an 80/20 stock/bond allocation. I make quarterly withdrawals from my portfolio (3.1% annual rate). That 80/20 allocation should result in a 9.6% average return. Well above my 7% long term goal!

1EngineerOnFIRE

EngFI2022

19 Apr, 2022

Posts

The Love of Cars and Route 66

The Love of Cars

Growing up I had always heard the story of my uncle who bought a car at age 14. I wanted a car at age 14! When I was nearly twelve years old, I took on a paper route. Back then you could rake or mow lawns, shovel snow from driveways or get a paper route to earn money. Delivering ~60 papers every day I was earning about $20 / week. I saved most of the money, bought a really nice 10-speed bike and saved the rest for a car. Then I scoured the newspaper classified ads and eventually found my first car, a 1971 Chevrolet Chevelle.

That was a long time ago but cars have been in my blood ever since. I paid $350 for that Chevelle, learned to do body and mechanical repairs. That work ethic and having good goals led me to Financial Independence and allows me the time and resources to follow my dreams.

That Chevelle was upgraded to a Camaro and that Camaro to a Corvette. With any Corvette comes a huge connection to Route 66. That 1^st Corvette sparked the dream to drive Route 66. Now in our fifties we knew that classic Stingray would not meet our comfort and storage needs on a 5,000-mile trip. Financial Independence allowed us to by a modern Corvette greatly increasing the chance we would enjoy the trip. I set a retirement date and planned to depart for Route 66 just 2 weeks later.

Covid Steps In

Enter Covid-19. My planned retirement date was April 1^st 2020. Long story short I was convinced to work a bit longer to help complete a corporate reorganization so we postponed the trip. But hey, we had the car and the time so we set off on a trip to visit some out of state friends. Being Financially Independent allows you the ability to roll with the changes. In no way did we feel our retirement was ruined we just redirected our efforts to Covid friendly activities.

Route 66 Take Two

April 2021, we headed out on what my wife calls the world’s largest scavenger hunt. Our original plan was to be very spontaneous, drive no more than 4 hours/day and always with the sun at our back. We read the recommended guide books and had a list of sights not to be missed.

Route 66 starts in downtown Chicago and ends at the Santa Monica Pier in L.A. We’ve been to Chicago a number of times so that would be just a photo stop to start the trip. We grabbed the photo and we were off! Illinois does a great job of promoting the Route with good signage and plenty of things to see. I knew restored service stations were going to be one of my favorites and the one in Odell IL did not disappoint!

Our plan was to stay true to the old route as much as possible. There are actually 3 main routes. The original route established in 1926, the realignments that started in the 30’s and the modern highway that was the result of the Highway act of 1956. As you travel along you can often see remnants of the original route and the truck filled highway in the distance.

Traveling the old route, you soon realize there are so many treasures you would miss had you selected the highway. This trip made us appreciate the old bridges and small towns that made up travel prior to the modern highway system. Back in the route’s heyday businesses would use any form of advertising to draw you in to get a little of your business. In addition to neon signs be prepared to see dinosaurs, and giants along the route. The Gemini Giant in Wilmington is one of the many “muffler men” that have been restored and repurposed along the route. It was fun to search out some of the notable sights along the way.

As fans of architecture and engineering, buildings and bridges often caught our eyes. The Chain of Rocks Bridge crosses the Mississippi with a curve mid river! The rainbow bridge is just 500’ off the realigned route and fun stop. Iconic motels and neon signs can be found all along the route. Some open, some restored and some have fallen into disrepair.

As we traveled between must see attractions, we would come across something interesting and just stop and check it out. We planned our lodging 1 to 3 days in advance allowing flexibility. Typically making reservations from our hotel room as we planned our next day’s trip.

We planned a 4-hour max drive time based on google map. Google would route us down the highway so we were much slower on the old route plus stops. If we drive the route again, we would plan no more than 3 or sometimes only 2 hours / day. We found that our 4-hour plan took us about 8 hours to complete. Some stretches had plenty to see and some not as much. Being our first trip, we focused on the more iconic sights.

Our on-line research discovered that the “EZ 66 Guide” was the best driving resource for the trip. My wife and I each went thru the book with different colored highlighters and made a point to see anything we both selected. Everything else was optional and this turned out to be a great method for first time route travelers. I think if we were to travel the route again, we would pick a few favorites and spend more time in those places.

A few not to be missed attractions are the Start and End signs, the Chain of Rocks and Timber Creek bridges, The Blue Whale, Cadillac Ranch, Blue Swallow, El Vado and Wigwam motels, The Painted Desert and Petrified Forrest, Standing on the Corner Park, The drive to Oatman, Bottle Tree Ranch and the Santa Monica Pier.

Planning

Many people who travel the route say to plan 14 days for a one-way trip. We did it in a few less but planned almost as many days for the return trip thru Utah and Colorado then home. Some fly to Chicago and rent a car for the one-way trip. Any way you plan your trip you will find you could easily do it again and see completely different things.

If you have ever thought of driving Route 66 we highly recommend it. Set a date, make a plan and just do it! You will meet new people, see new things and experience a bit of mid twentieth century America.

1EngineerOnFIRE

EngFI2022

2 Apr, 2022

Posts

Talking About Money

Over my lifetime I have found people either talk too much about money or not enough. It’s rare people talk appropriately about money.

I have a theory:

People who talk a lot about money don’t have as much as they would like you to think. (They are probably broke but don’t know it)
People who don’t talk about money:
Come from a family who had little money or were poor money managers

They had plenty of money and didn’t want others to know about it.

I’d like to expand on my theory and explain what I believe is the proper balance.

Theory A

If you grew up in a home environment where money is tight you probably heard things like: We can’t afford that, Money doesn’t grow on trees, How much I make is none of your business, If we get a little extra money we can “X”, The car broke and I don’t know how we are going to pay for it, When you turn 18 you either get a job or move out, If I win the lottery I’ll…, Hourly wage or tax return money, etc.

Theory B

If you grew up in an environment where money was plentiful you might have heard things like: Not everyone can afford the nice things you have, I have to meet with my financial advisor, What college are you planning to attend? Did you see what the market did today? Where are you going for spring break? Let’s go to the lake house this weekend, John’s business had a great year, Net worth or income, etc.

Find The Right Room

Consider the saying “If you are the smartest person in the room, you are in the wrong room!” The same applies to money. If you want to be successful with money you should hang out people who have proven themselves successful with money. Their behavior will give you clues as to how you should act and what information you should divulge.

Weeding Out the Blowhards

According to my theory the people with money don’t talk too much about it. So how do find the right people to surround yourself and share advice? I was recently at a wedding reception where it seems everyone at the table was trying to out do the other. “I bought a new RV”, “I have a new boat”, “We just built a new house” and on it went until dinner arrived. I couldn’t believe all the hot air! But if you pay close attention, they give away little clues. “I received zero down on my RV loan”, “I’ll have my boat paid off next year”, “I’m looking at the new trucks when my lease runs out”. They were all broke and they just didn’t know it! They were trying to impress each other with borrowed money!

Look for the guy who sits quietly and just listens. Notice he isn’t talking about his possessions. He is probably well dressed but conservatively so. A luxury watch is sometimes a giveaway. When you ask him what he does / did for a living he will be vague. This may very well be the guy you want to get to know. Try to get him away from the group and learn more.

Appropriate Money Talk

When it comes to your spouse and kids, I believe an open honest learning environment is appropriate. Hold good discussions about your budget. Share with your kids the cost of running a household. The kids don’t need to know your full income or net worth but they need to see the process of good money management. It needs to be clear the details are not to be discussed outside of your home.

What is appropriate to discuss outside the home? If someone else brings up the topic feel free to discuss things like “We found a new budget app.”, “Saving for college is a priority in our house.”, “We like our financial advisor, I can introduce you.”. All indicate financial responsibility but don’t give away too much detail. Don’t discuss things like income, net worth, lavish spending, expensive vacations. Better to politely listen or downplay your experiences to avoid sounding boastful.

When it comes to close friends it’s often difficult. When in doubt, it’s best to say less. Financial success comes at many levels and when people learn of net worth disparity it can only strain a relationship. On the other hand, the 401-k has made many more people “investors”. Now everyone is in the stock market and wants to talk about it. I’ve had many good discussions with friends and co-workers about investing. I prefer to answer their questions by referring them to credible resources.

If you work at it you will find like minded investors who you can share investment strategies. An investment club is a great way to share these ideas. In this environment you can talk openly in percentages, not hard numbers, and be on a level playing field. It’s worth the effort to find a like-minded group to discuss finance and investing. Hopefully you can learn something from the guy with the nice watch😊

1EngineerOnFIRE

EngFI2022

1 Apr, 2022

Posts

Financial Advice for Different Life Stages

On my birth date my father opened a savings account in my name with $100. I can honestly say I have been investing my whole life! I invested in myself, my marriage, my career, and my portfolio. Having a clear plan and being on track gives you confidence. That confidence must be perceivable to others as people have often asked my advice on a number of topics. I’ve made mistakes along the way but I’m hoping some of that advice might just help you to avoid those mistakes😊.

First Earned Money

For a grade school aged child with an allowance or birthday cash I suggest the following: Create a 5 envelope system as follows: 1) Savings 20%, 2) Long term goal 20%, 3) Short term goal 25%, 4) Church 10%, 5) Spending money 25%. Open a savings account and once the savings reaches a reasonable amount have the child physically hand the money over to a bank teller. Go to church and let the child place their own money in the offering plate. Let them spend their spending money on whatever silly thing they want. See my post about Teaching Kids About Money https://www.1engineeronfire.com/?p=173

High School Graduate

Assuming you have a job and money of your own first create your attitude money / emergency fund. For starters $1,000 will do but $5,000 with do a lot to improve your attitude😊. Continue to use the principles of the envelope system. Change the savings rates to focus on college savings and minimize spending. Your primary goal here is to invest in yourself. I might suggest 1) Savings 5%, 2&3) Combining long and short-term savings into college expenses 75%, 4) Church 10% and 5) Spending money 10%. Open an investment account with Vanguard or Fidelity and at the very least get it started with the minimum. Pick a local in-state university or trade school and live at home or with family. Do not go into huge student debt, go to work every hour you are not working on your studies. Graduate from school debt free!

College Graduate

Do not fall for the common financial traps of new job hires. Don’t buy a new car, don’t over spend on a fancy apartment, clothes, vacations. Yes, all your friends are doing it but they are broke and will continue to be. You are better than that and will soon be financially years ahead of your friends. Create a detailed budget https://www.1engineeronfire.com/?p=306 and put a priority on investing https://www.1engineeronfire.com/?p=302 so you pay yourself first. Learn about your employer’s 401-k and health care savings plans. Keep living like a broke college kid, you are used to it! Get the maximum match of your employer’s plan and invest every extra penny in low fee index funds. Thank your parents for all their help getting you this far😊

Getting Engaged / Married

Choose carefully! Your partner should be compatible not only socially but financially as well. A spender and saver do not mix! You both need common life goals. You are not only getting a spouse you are getting their whole family…forever! Don’t overspend on a silly engagement ring to impress other people. The same goes for the wedding. Have a nice party but stay within your budget with the cash you saved in advance.

Once you are married you need life insurance. Find a low-cost term policy if your employer’s policy is inadequate. Create an estate plan including trust, will medical and legal powers of attorney. These documents are not just for the wealthy they are for all responsible adults. Work together to create and follow a shared detailed budget. Budget a little spending money for each of you with no strings attached. No matter how small include an entertainment item in your budget. Review your budget regularly, openly and together! Calculate your FI number https://www.1engineeronfire.com/?p=306. and make a savings and investing plan and stick to it.

First Time Home Buyer

I live in the Midwest and a house and car are virtual necessities. I get that a condo or apartment in a big city appeals to many. Either way you need a place to live. Set a home purchase price based on your monthly budget and do not buy more house than you can afford (Max 25% of monthly take home). Have at least a down payment of 20% and an emergency fund of 6 months expenses before you even start looking. Shop for a 15-year mortgage.

Better to have the small house in a nice neighborhood than a big house in an average neighborhood. Your perfect house at age 28 looks nothing like your perfect house at age 50, you will move someday. However carefully you budgeted home ownership, you missed something😊. Modify your budget accordingly. Your need for life insurance may increase. Your estate plan will need updating. If this sounds expensive it is! But with a paid off mortgage, you can accelerate your investing and lower your FI number as your retirement housing cost will be very low.

Middle Age / Peak Earning Years

You should have found your life balance somewhere between minimalism and extravagance. Your portfolio should be on track to reach your FI number. It is critical you resist trying to keep up with the Jones’s. The Jones’s are broke, only neither you or they know it! If you are debt free you can enjoy life a bit more but stay on budget. Keep vacations, cars and other expenses in check. Just because you can get a loan for that sports car doesn’t mean you should! Paying cash for everything keeps your spending and savings in check.

Accelerate your investing and make sure the kid’s college funds are on track. If your income is sufficiently over your budget consider increasing your giving. Revisit your life insurance as policy’s may have run out or you may need changes. Review your estate plan.

Preparing for Retirement

Your FI number is in sight or you’ve already made it. Further investing is frosting on the cake. When the money is really flowing it’s easy to slack off on your budget and now is the time to really dial it in. It’s time to count every dollar like when you were starting out. I suggest performing an almost forensic accounting of your last 2 years of spending. This will give you complete confidence in your retirement budget. I would even consider categorizing items into Must have or Nice to have. This way you’ll know exactly what you can cut in a market downturn. Recalculate your FI number https://www.1engineeronfire.com/?p=306. Plan your upcoming lifestyle changes by reading “You Can Retire Sooner Than You Think” and Confirm your FI number calculations by reading “Can I Retire Yet” https://www.1engineeronfire.com/?p=232. You now should be self-insured and may not need life insurance, adjust as necessary. Consider your portfolio asset allocation and future withdrawal strategy https://www.1engineeronfire.com/?p=73. Make sure your health care coverage is in place. Consider setting up a charitable giving legacy. Investigate long term health care insurance. And once again review your estate plan.

Retirement

Congratulations you made it! With all your planning, the decision will be easy and stress free. I suggest a quarterly withdrawal strategy. This will keep you in tune with your investments and budget as you work out any minor adjustments. Hopefully in a year you can give yourself a raise. After a few years, and you have proven your plan is bullet proof, move to an automated monthly withdrawal. Fully enjoy your new lifestyle activities and giving back. Plan every day ahead of time so the time does not slip away. Of course, review and update your estate plan. Start a business, volunteer, travel, spend time with the grand kids or maybe even start a blog😊

1EngineerOnFIRE

EngFI2022

31 Mar, 2022

Posts

Do I Really Need a Budget?

I’ve read a number of blogs lately about how people claim they don’t need a budget. They don’t like budgeting and just track their spending after the fact. I understand, people don’t want to spend their time going over boring numbers. Worse yet the numbers might suggest you should actually change your behavior!

Read on to learn: 1) Why your budget is a key part of your financial independence (FI) foundation, 2) How to calculate your FI number, 3) Why it’s important to start investing now.

You Need a budget

If your goal is to be financially independent you need a budget. Without a budget you cannot responsibly manage your money. You need to properly manage your money so you can maximize your investing. Trust me even multi-millionaires have a budget. In the book The Millionaire Next Door most, if not all of the millionaires interviewed said they have and stick to a budget! You need a budget to calculate your FI number.

Your Financial Independence Number

Sure, FI is about freedom and spending time doing things you enjoy with people you care about. To earn that freedom, you need passive income to cover your expenses. To do that you need to know your FI number. Old school retirement was defined as working for a single company for 30 years. After that they gave you a gold watch, a pension and you moved to Florida in the winter. Not anymore! Today you need to look out for yourself. The good news is now you can work where you choose when you choose but only if you plan accordingly.

The traditional rule for a 30-year retirement is you need 25 times your annual expenses to avoid out living your money. See my post on the 4% rule https://www.1engineeronfire.com/?p=57 . Don’t forget taxes, we need to pay Uncle Sam and the Governor. We’ll use 20% for our tax calculation. Now we have all the variables to calculate our FI number.

This FI number is an estimate and doesn’t take in account social security or any other income. It should be a target to help get you started. As you refine your budget you will also be able to refine your FI number. Example: Monthly budget = $2,666 x 12 = $32,000 / 0.8 (20% tax) = $40,005 x 25 = $1,000,125. Your FI number would be $1 million.

It’s All About Time

Unless you are planning to sell your upstart tech dot-com for many millions you need to start investing today. As you can see from the above calculation you need ~$1 million for every $40,000 of pretax income. For the average American saving $1 million seems like a daunting task. This is where the power of compound interest comes in. This will be the most powerful tool in the investment toolbox.

With your FI number and a solid budget in hand you can calculate the time to FI. Start by subtracting your monthly expenses from your monthly income. Anything left over can be invested. Better yet include investing as a top budget priority and eliminate all frivolous expenses to increase your investing.

Time matters! The path to $1,000,000 can be reached in many ways. With an average return of 9% here are four examples:

$214/month in 40 years, $547/month in 30 years,

$1,498/month in 20 years, $5,178/month in 10 years

As you can see starting sooner makes a HUGE difference in the calculation. The FIRE community has aggressive examples where individuals maximize their income, minimize their expenses allowing them to maximize their investing. This is how a blogger can claim to be retired at 37 after a 13-year career. Most of us will find a balance investing what we can in our younger years and ramping up as we earn more. The key is to squeeze every dollar out of your budget and assign it to investing as soon as you can!

Get Started

Establishing a budget does take a little work. Suck it up and just do it. Just list your expenses largest to smallest. Start with the easy ones that come every month like mortgage / rent, food, utilities, transportation, phone, etc. Next consider irregular expenses like insurance, property tax, medical, etc. Then consider the oddball items that always pop up like birthday presents, technology, clothing, hair care, tax prep, etc.

Your list will not be perfect. You will need to modify it over time but that is ok. Now fill in the dollar amount. If you have last years history great, use it to come up with monthly averages. If not, don’t stress over it and take your best guess. When next month rolls around make changes as necessary. Congratulations! you now have a budget.

What does 1 Engineer On FIRE do?

I still use MS Excel to create my monthly budget with every detailed expense. I track around 40 individual expenses. It’s what engineers do😊. I update the budget at least annually using inputs from last year’s expenses. It sounds like a lot but I just spend about an hour annually and a few minutes as needed throughout the year.

I automate all regular payments and use an app for irregular expenses like restaurants, car repair, travel, etc. I use a simple phone app called Accounts II. Every month on the 1^st I pay myself by adding the monthly budgeted amount to the app. At any time, I can look at my app and see if I have money left to spend. A little trick to help develop your budget is to plan a slush fund to fill in the gaps as you are developing your budget. As your budget becomes more refined you can lower the slush amount and put that toward investing.

Conclusion

You really do need a budget. At first it takes a bit of effort but it becomes less over time. You can’t calculate an accurate FI number without an accurate budget. Without an accurate FI number, you are likely to fall short on savings and significantly delay your retirement date. Good luck budgeting!

1 Engineer On FIRE

EngFI2022

28 Mar, 2022

Posts

Start Investing – The Basics

What is a 401-k, 403-b, IRA, Roth IRA or Brokerage account? Where do I invest my saved dollars now that my budget is in order? What choices should I make in my company 401-k? I’m maxing out my 401-k and wonder where to invest next. How do I buy an index fund, stock or bond? Like most things knowledge is power and you want your investments to be as powerful as possible!

History of Retirement Accounts

Large companies like banks and railroad companies started offering pension plans near the turn of the 20^th century. The Internal Revenue Act of 1921 helped spur growth of pensions by offering an exemption for corporate contributions. Labor unions pushed for pension plans and by 1950 about one half of private company workers had pensions. Some of these plans started to fail and the government stepped in and the defined-benefit plan slowly gave way to the defined-contribution plan (401-k, 403-b, etc.). Today’s employee is likely not to have a defined-benefit plan (your father’s pension) and needs to look after their own finances for retirement.

Account types

Just like a simple bank savings account “holds” your cash a 401-k, IRA or Brokerage account holds your investments. Each account has its own rules under the IRS tax code. Many employees have access to an employer sponsored 401-k or 403-b account. An IRA (Individual Retirement Account) is for any individual regardless if their employer offers a plan. A brokerage account is a taxable account with no special retirement rules. All these accounts are basically buckets to hold your investments.

401-k, 403-b Accounts

401-k and 403-b get their names from their designation in the IRS tax code. The 403-b account is essentially a 401-k but for non-profit organizations. The key benefits to a 401-k account are 1) You invest with pre-tax dollars, 2) Funds grow tax free, 3) Employers often offer matching funds. Primary drawbacks are 1) Withdrawals are taxed, 2) Withdrawals are penalized prior to age 59 ½ years of age (with few exceptions), 3) Contribution limits

IRA Accounts

Founded in 1974 as part of the governments Employee Retirement Security Act (ERSA) the IRA was meant to offer tax-advantaged savings for employees who didn’t have a pension and provide a tax-deferred account for terminated employees with qualified plans (rollover). Advantages 1) Funded with pre-tax dollars, 2) Tax free growth. Disadvantages 1) Taxed withdrawals, 2) Withdrawals are penalized prior to age 59 ½ years of age (with exception), 3) Low contribution limit, 4) Phased out tax advantage based on income, 5) Required minimum distributions after 70/72 years of age.

Roth Accounts

To further complicate things there are Roth versions of both 401-k and IRA accounts. The big difference is a Roth account is funded with post-tax money. Advantages 1) Contributions can be withdrawn tax and penalty free after the account is 5 years old, 2) Funds grow tax free. 3) No required minimum distributions 4) Conversion provision from traditional IRA. Disadvantages 1) Low contribution limit, 2) Phased out tax advantage based on income.

Brokerage Accounts

A brokerage account is a bucket that holds cash and investments with no tax advantages. Pros 1) No limits on contributions, 2) No limits on withdrawals. Cons 1) No tax advantages. A brokerage account can be held with a traditional advisor like Fidelity or Merrill Lynch or through an electronic account like e-trade or TD Ameritrade.

Funding Order

So now you know the different buckets to hold your investments but which ones do you fund first? If you have an employer 401-k with an employer match you should at least contribute enough to get the full match. This is your best return on your investment dollar. It’s like getting free money! If you have both a traditional 401-k and a Roth option I suggest you use the Roth if your income is low and income taxes are not a concern. If you are in a high tax bracket you may want to use the traditional 401-k to reduce your tax burden.

After you receive the full match or don’t have a 401-k / 403-b I suggest funding a Roth IRA. If you have saved enough to maximize the contribution limits of these accounts invest in your brokerage account. Each account has limits and rules beyond the scope of this article but the internet offers all the details.

Investment Selection

If you are a set-it and forget-it investor look for the index fund or balance fund choices in your employer’s plan. Index funds may be called total stock, S&P 500, Russel 2000, Dow Jones, etc. A balanced fund will often have a retirement date like 2030, 2040 fund. Or you can pick a balance of large cap, medium cap, small cap and international funds.

The options for your IRA are almost infinite. Since you are just getting started I suggest we just stick to Index funds. It may seem too simple but a fund like Vanguards VTSAX of Fidelity’s FZROX or FSKAX is all you need. What matters most is you start investing now. As you increase your investing knowledge you can easily change your asset mix.

Let’s Get Started

For your companies plan simply set a meeting with your Human Resources department. Ask for all the information on their plan and any forms you may need to get started. They will probably refer you to a website to get you set up.

For an IRA go online and pick a broker. I use Fidelity for my online accounts and I have a Merrill Lynch broker. If I were starting over today, I would probably use Vanguard for my online account. If you feel uncomfortable starting online call one of their 800 numbers and set up and appointment with an advisor.

It’s really that easy! The online process will walk you through the steps to get started.

Look at my Favorite Book post https://www.1engineeronfire.com/?p=232 for investing ideas and for upcoming articles on picking funds that are right for you.

1EngineerOnFIRE

EngFI2022

21 Mar, 2022

Posts

My Favorite Finance / Investing Books

Over the years I’ve read plenty of books on personal finance and investing. They all have something to offer, some more than others. Depending on where you are on your financial journey different books will speak to you differently.

Buried in Debt or Just Starting Out

If you are just starting out and or buried in debt Dave Ramsey’s Total Money Makeover is a great place to start. This book will help you set a budget, kick debt to the curb and start saving. Dave’s plan uses his proven “baby steps” to get your financial life in order. 1) Create a $1,000 starter emergency fund, 2) Eliminate all debt, 3) Fully fund a 3-6 month emergency fund, 4) Invest 15% for retirement, 5) Save for your children’s education, 6) Pay off your home early, 7) Build wealth and give back. I found Dave’s radio show after I was well on my way but found it a great reference for helping others. Dave has a great way of simplifying issues and removing emotion to help people make their own decisions. This title is my recommendation for anyone living paycheck to paycheck or struggling with debt and needs a plan to turn their financial life around.

Ready to Start Investing

Are you self-motivated and ready to start investing but don’t know where to start? JL Collins’ book The Simple Path to Wealth may just be the best no nonsense book on investing ever published. Jim’s path to investing led him to create a blog to document his learnings to someday share with his daughter. The blog content evolved into this wonderful book on how to invest simply and get back to the things you enjoy. Jim is a firm believer in index investing and the Vanguard approach. I suggest watching a few online interviews of Jim and then read his book. His blog jlcollinsnh.com is full of great information but the book is better organized to help you get started. While Dave Ramsey’s tone is that of a father trying to set his wayward child right, Jim Collins is like your knowledgeable uncle hoping you learn from his experience! This book is my number one recommendation for anyone ready to start investing.

Another great read for someone ready to start investing is from John Bogle (the founder of Vanguard Group). His book The Little Book on Common Sense Investing is a straight forward approach to index investing. John is considered the father of the index fund. He created Vanguard as an investor-owned company to provide low-cost alternatives to existing mutual funds. Since Vanguard is investor owned there are no company stockholders looking for profit therefore lower fees. Vanguard offers a number of fund options and John suggests a few different fund allocations based on your desired involvement level. Anything from a few index funds to a buy it and leave it balanced fund. Watching a few interviews of John, you can tell he believes in the data behind index investing and truly wants to help the individual investor succeed. Warren Buffet said “Jack did more for American investors as a whole than any individual I’ve known”. If you have your budget in order and are ready to invest, this title is my number two recommendation.

The Active Investor

If you want to pick individual stocks Ben Graham’s The Intelligent Investor should be your investing bible. Ben was Warren Buffet’s instructor and mentor. This book is not a light read but it lays down the foundation for successful stock selection. The bottom line is there’s a lot of work to properly analyze a publicly traded company. The book considers a company’s stock price, unique place in the market, management team, balance sheet and corporate health in detail. The due diligence required for successful stock picking is not to be taken lightly. The book even recommends if you don’t have the time just buy an index fund, anything else is just speculation. Additionally, the book provides the foundation of investing that gives valuable perspective of why so many stock pickers and fund managers fail to beat the index.

I listened to the audio book Unshakable by Tony Robbins. He discusses the different types of investments and associated fees. He uncovers many of the fees built into actively managed funds and promotes index investing as a core strategy. Tony also covers different asset classes, diversification and allocation. He talks about a “core and explore” strategy for investors who want to be more engaged than simply buying an index fund. I’m not sure if it was the writing or the voice of the audio book but I found Unshakable quite motivating. It was interesting to hear his take on alternatives to index investing.

Planning to Retire

Can I retire Yet by Darrow Kirkpatrick is my number one pick for anyone considering retirement. Like me Darrow is an engineer and his wife is an educator. These similarities had me immediately interested! The book covers Darrow’s data driven approach to determine if he was financially ready to retire. It also covers his straight forward but effective investing and withdrawal strategy. This book confirmed my own calculations and gave me confidence that I was financially ready to retire. It also alerted me to the fact that I had not created a solid retirement withdrawal strategy. I still check into the blog at www.caniretireyet.com and find it a valuable resource.

I found You Can Retire Sooner Than You Think by Wes Moss not only informative but entertaining. Wes was inspired by the movie The Pursuit of Happyness starring Will Smith. Wes wondered what a happy retiree looked like. Wes shares the results of his national retiree survey and the results are very interesting. Wes discusses the numbers needed to retire but more importantly his survey results speak to the human side of retirement. Things like how many hobbies or activities make a retiree happy? How many sources of income make a retiree comfortable? Even what brand of car happy retirees drive. Wes has put out a number of podcasts on www.wesmoss.com and he does a great job of explaining how you can retire sooner than you think. I consider Wes’s book a must read for anyone considering retirement.

Conclusion

If you are just starting out, have money to invest, don’t know where to start or are considering retirement there are books to help you along the way. These 7 books are at the top of my list when asked for recommendations.

1EngineerOnFire.com

EngFI2022

7 Mar, 2022

Posts

Teaching Children About Money

It had been some time since we had the lesson about pennies, nickels, dimes and quarters. Back then you could get 5% from a savings account. Our son had his own savings and 529 accounts but he didn’t know about them. I taught him that if you let the bank store your 20 nickels, they would give you one “free” nickel at the end of the year. He seemed to like that idea and wanted in on the deal.

The Money Machine

Some years later, my son was about 9 or 10 riding in the back of the car, he informed me he wanted a Nintendo Game Cube. I told him we couldn’t afford to buy him whatever he wanted. He quickly replied “Just go to the money machine.” From his prospective this made perfect sense. For his whole life he watched his parents pull up to an ATM machine, push a few buttons and walk away with cash.

It was then I realized it was time to have a serious talk about money. I told him it was his mother’s and my job to go to work and earn money. Our money was put in the bank and we took it out to pay for our house, food and clothes. He had an important job too; it was to do well in school and be a good citizen.

The System

When we arrived back home, we got out the basket he kept his money in. He had a few dollars from doing chores and some birthday money. I told him he needed to manage his money so he could buy his own game console and the cartridges to go with it. I told him he needed to divide every dollar he earned into 5 categories.

I explained 10% was for the Church, 15% needed to go for Savings to never be touched. 25% to a Long-term goal like a game cube. 25% to a Short-term goal like a game cartridge. The balance, 25% was for Spending money like a book from the school store or a candy bar.

Motivated by the desire for the Game Cube he spread his money on the table and counted. He then retrieved 5 envelopes, one for each category. In his own handwriting he labeled the envelopes and their percentages. He got out the desktop calculator and went to work. Not knowing how to exactly divide the money, I suggested he round up on the savings and long-term and let the spending money envelope be a little short.

After devising this system, he was all about filling the envelopes. He wanted to get paid for everything. His mother and I had to inform him there were some jobs that were expected just for being part of the family. He would not be paid for cleaning his room, clearing the table etc. He could however propose extra work that would go beyond basic chores. These extra chores were often overpaid to encourage his efforts😊

A Parent’s Reward

After each sizeable “payday” he would get out the calculator and divide the earnings. Once the savings envelope reached a worthwhile amount we went to the bank and he made his very first savings deposit. This was a teller window event with passbook and all! The first time he placed his own earnings in the church offering plate you could just see him beam! The system worked, he was motivated to earn and taking responsible actions with his money. He eventually bought the Game Cube and was flush to buy the necessary cartridges.

The Teenage Years

We were lucky, our son didn’t crave designer clothes, money for weekly movies or high-cost sporting gear. Our focus was on education and he knew his job was to get the best grades possible. He knew this would allow him to attend any university he selected. About the time he turned fourteen I made him an offer. I proposed any money he could save toward a car I would match before he turned sixteen. I assumed he would save around $1,000 and we could find a $2,000 beater to get him through high school. I was wrong, he saved $2,000 and we started shopping for a $4,000 car. Living in a rural farming community a $4,000 car stood out as one of the nicer in his school parking lot!

After turning sixteen he wanted to get a part time job. He had the car and good grades so we encouraged his pursuit. I’m not sure he still used the 5-envelope system but I didn’t worry about his finances as long as he was saving. His account balance was growing and his spending in check.

Attitude Money

This is when we discussed Attitude Money. I suggested he never let his bank account balance drop below $5,000. At first, I could see he wondered where I was going with this concept. I asked him “Doesn’t having $5,000 in the bank make you feel good?” He smiled and agreed. I said if your car’s transmission failed and cost $2,500, it would be a bummer but you could maintain a good attitude because you had the money to cover it. I suggested he might know some people whose life would be thrown into complete chaos if faced with such an unexpected expense. He understood.

He bought into the concept and kept his attitude money through his time at university. We agreed to split the cost of tuition and he paid for every other term. During his senior term he came to me a bit concerned. He told me he didn’t think he had enough money to cover tuition. We went over his finances and I learned he had more than enough to cover the costs. What was the problem I asked? He said he wouldn’t have his full attitude money when he graduated! I knew then he was going to be just fine😊

1 Engineer On FIRE

EngFI2022

2 Mar, 2022

Posts

Managing Withdrawals In Retirement

I didn’t realize it but I had reached my minimum Financial Independence number in 2016. I was planning a 2020 retirement date and still had some financial house keeping to complete. We were making double payments on a 15-year mortgage. Our budget still needed refinement before I could confidently calculate my final FI number.

It was about this time I realized my investing focus had always been on accumulation and I had little knowledge of withdrawal strategies. It seems everyone writes about saving, investing and how to acquire wealth. But few write about what to do when you reach your goal. My guess is there are more people needing coaching in the accumulation phase😊

Top 5 Withdrawal Strategies

A quick internet search of retirement withdrawal strategies results in five common strategies. The 4% rule, Fixed dollar, Fixed percentage, Systematic and The 3-bucket strategy. As an engineer I sometimes like to get lost in the numbers and simulate untold options. In the end a much simpler approach seems to always win out.

If you want to dive into some advanced strategies, I suggest looking into Darrow Kirkpatrick’s January 4^th, 2016 post in Money.com. I’ll be discussing the top 5 simple strategies here.

The 4% Rule

The 4% rule has been discussed in my earlier blog and has been the gold standard of investment professionals for years. Trying not to oversimplify you start your first year of retirement by withdrawing 4% of your 50/50 stock/bond portfolio. You rebalance annually and in your second-year withdrawal no more than 1.02 x your last year’s withdrawal. The added 2% gives you a raise for inflation. The research indicates a high success rate of a 30-year retirement never depleting the portfolio.

Fixed Dollar

In a Fixed Dollar strategy, you simply withdrawal a fixed dollar amount like $40,000 annually for a set number of years. At some time during the set term, you reassess your plan and adjust accordingly. Very convenient for budgeting but doesn’t account for inflation or principal growth or erosion. You may run out of money or live below your portfolio’s potential.

Fixed Percentage

Using a Fixed Percentage strategy, you withdraw a fixed percent of your portfolio total. If you select 4% of a $1m portfolio you would receive $40,000 your first year. Without any growth your next year’s withdrawal would be $38,400 (($1m – $40,000) x 4%). If you received 7% growth after year one’s withdrawal you would have a second year withdraw of $41,088 ((($1m – $40,000) x 1.07) x 0.04). The advantage is an easy annual calculation (Total portfolio x 0.04 = Withdrawal). Disadvantages are irregular withdrawal rates and no long-term protection against running out of money.

Systematic Withdrawals

A Systematic withdrawal strategy is favored by some dividend investors. You plan to withdrawal only dividend and interest income from your portfolio. You never touch the principle and your portfolio is left to your heirs or the charity of your planning. Your income will vary by market performance. A very conservative approach that could be used with retirees who’s pension and social security cover most or all of their basic needs.

3-Bucket Approach

The 3-Bucket Approach gives a bit of security and still allows for the potential of growth. Bucket one, for near term needs, will hold typically 3-5 years of cash. Bucket two is invested in 5-8 years of fixed income securities and bucket 3 holds the remainder of your portfolio in equities. As you pull cash from bucket one you refill if from growth from buckets 2 and or 3. This takes a bit of management but gives you security from a downturn in the market. In a lean portfolio it may leave the equity allocation too low for adequate long term growth.

What’s Best For You

No one strategy is right for all. Taxes, market valuation, required minimum distributions and other considerations muddy the waters. You may find a mixture of strategies works best for you or a more complex method altogether. I find the simple solution if often the most elegant. That way I can spend more time spending time with the things we enjoy.

1 Engineer’s Strategy

Here is what I have done so far. Being somewhat conservative I left work with a portfolio value of 35 x my gross annual budget. I guess that’s Chubby FIRE in today’s FI world, only requiring a 2.8% withdrawal rate. At two years prior to retirement, I moved 5 years of income to bonds within my 401-k. The balance of my 401-k, my IRA’s and other investments remain invested in 100% stocks.

The year I turned 55, I “separated” from my company and then qualified to use the rule of 55. This allowed me to withdraw penalty free from my last employer’s 401-k. I rolled the remaining balance of my 401-k into a mix of low-cost index funds. I currently take a quarterly withdrawal from the 401-k bond fund.

During the second ½ of 2020 and all of 2021 it was like magic! I would take out my quarterly withdrawal and by the next quarter the account balance had grown back. My other investments continued to grow as well. The “Money Making Machine” was alive and well!

The 1 Engineer on FIRE withdrawal strategy is simply to continue to make quarterly income withdrawals from my bond fund. Maintain 5-7-year bond buffer in good markets (the average bear market lasts ~4.5 years). In bear markets I may tighten my budget belt (reduce or eliminate lifestyle budget items) and draw down my bond fund allowing my equities to recover.

Conclusion

So, I guess I have a Modified 2 bucket strategy!

What do you think? Do you have a withdrawal strategy?

1EngineerOnFIRE.com