After five years of early retirement, I realized I made a serious mistake that cost me between $500,000 – $1,000,000. Let me tell you what happened so you don’t do the same.
When I left Corporate America at the age of 34, I thought I was done earning more money for good. Below is the income budget I put together in 2012 to support us for the rest of our lives. Expenses are not listed because we’ve never spent more than we’ve made. But perhaps I’ll do a thorough analysis in a future post.
Our base case retirement income scenario was to make $78,000 gross or $54,600 net a year in passive income and live a simple life back in Hawaii for the rest of our lives. If things went really well in the stock and real estate markets, we calculated an optimistic annual passive income scenario of $117,600 gross and $94,080 net.
At the time, we were probably spending about $100,000 a year to live in high cost San Francisco. By moving to a paid off house in Honolulu, we’d have no problem living within our means with a child on a much lower income.
But if we did have a problem living on less or wanted to live it up more, we had fallback options through Active Income and Bonus Income. These were also divided into Base Case and Blue Sky with $15,000/month and $50,000+/month gross totals, respectively. It’s always fun to dream about what could be.
If you’re wondering about the line items in the Bonus Income column, those are all the things I already had, but didn’t count on to make anything extra. For example, my Rich Hot Spouse was there to provide the love she has always provided. Anything more and I classified it as utopia. Aww.
Today, more than five years later, we still live in San Francisco and I’ve done all the things listed in the Active Income chart. Although my income grew in retirement, I did NOT change my investment risk profile. This was a major mistake because a major bull market ensued.
Early Retirees Should Invest With More Flexibility
If you retire early, know that you have the ability to make more money than you could ever imagine working a full-time job. This surprise is the biggest reason why the fear of running out of money in early retirement is completely overblown. If you have the wherewithal to retire early, you have the wherewithal to lock down your expenses or make a killing pursuing a dream.
From the years 2012 – 2014 I was stuck with a “4% mentality.” In other words, if all I could earn was 4% a year on my retirement nut, I’d be happy because at this rate, I’d never touch principal. By not touching principal, I could leave some money to people in need after I die.
Because of my complacency and fear of having to go back to work, I proceeded to invest much more conservatively than I should have. As a result, my public investment portfolios comprised of stocks and bonds underperformed the S&P 500 by several percentage points per year. For reference, the S&P 500 was up 13.5% in 2012, 29.5% in 2013, and 11.4% in 2014.
Yes, I know I shouldn’t compare a stock/bond portfolio only to the S&P 500, but I like to compare my performance to the top performing asset class of the two to feel the pain.
Despite my public investments comprising only ~25% of my net worth, I was still unable to invest aggressively like a 28 year old who has only seen a bull market. I kept reminding myself of the Asian Financial Crisis of 1997, the dotcom bubble of 2000, and the housing implosion of 2008-2009 as reasons to stay conservative.
Lesson #1: Just because you close your eyes doesn’t mean the world can’t see you. When investing, try to think beyond your own financial situation. The stock market doesn’t care if you are retired. What it cares about is corporate growth and profitability. There are always companies to invest in which because of different phases in their growth cycles can offer much greater returns. Projecting your own financial situation onto other investments may adversely affect your returns.
In Spring 2014 a catalyst for change happened. My 7 year, 4.1% yielding CD was finally coming due and I had to put the money to work. Originally I was going to just reinvest the proceeds in another 7-year CD, but the best 7-year CD rate I could find at the time was about 2.2%. Disappointed, I decided to look elsewhere.
After seeing Blue Sky income growth, I realized that my base income assumption of $78,000 – $117,600 a year in retirement had been too conservative. Thus, I decided to do a 180 and aggressively leverage up. Specifically, I took on a $1 million mortgage to buy a $1.24M fixer upper in Golden Gate Heights while already carrying a $1 million mortgage for my primary residence.
Think about how egregious this move was from a risk management perspective. What I did was akin to buying $1.24M of one stock on $1M margin. If the stock went down 20%, I’d be wiped out. I suddenly believed I was some invincible hot shot who couldn’t miss. Yet I had no job, just a belief that my online business would stay at an elevated level.
The last time I made such a move was back in 2007. Not only did I lose all my vacation property equity a couple years later, but I also suffered through a 50% income haircut as company bonuses were slashed. It’s funny how after a long enough period passes, we dismiss our mistakes.
With this new home purchase in 2014, I figured I could make up for my underperformance the previous three years by taking on leveraged single asset exposure risk, while already having three other properties in the SF Bay Area.
It was only through luck, some self-published propaganda, and a bit of foresight that Golden Gate Heights and the western portion of San Francisco turned out to be a region in high demand three years later.
Lesson #2: When you finally admit that your investment strategy was suboptimal, try not to go crazy by over-investing to catch up. Taking on leverage to invest, co-mingling funds, putting up safe assets as collateral for riskier investment, and aggressively inflating your lifestyle are the main reasons for financial destruction. Instead, slowly increase exposure through at least three tranches over a six month period. Just note that even if you reach an “optimal” investment allocation, there will always be people who make even more.
I’m currently in the process of de-risking in order to make sure I don’t lose all my gains. The three year double leveraged gamble feels like I went into a casino, found $30,000 worth of chips in a trash can, bet it all on black five times in a row and won each time. With these proceeds, I’m allocating a large chunk of capital towards 3% – 4% yielding, A-rated or better, tax free municipal bonds with 17 – 23 year maturity periods so that the money will be there to pay for my son’s college education and then some.
But here’s the thing. I’m going back to my same super conservative investing style despite my income now being able to easily make up for losses in riskier assets. There used to be a time when my investments made more money than my income. Not any more. Therefore, in a bull market with excess cash flow, I should take more risk.
Lesson #3: You need to talk to someone about your investment plan. Despite being an intelligent, rational human being, investing money is an incredibly emotional and sometimes completely irrational process. We are naturally guided by greed and fear to the point where we go from one extreme to another. Over the long term, talking to a parent, friend, spouse or professional can help you make better investment decisions. Make sure you properly explain your investment thesis to someone. If you can’t properly argue your case, then chances are high you are investing according to your risk tolerance.
The Biggest Error For Retirees
Poor risk management is absolutely one of the biggest financial errors early retirees make. We often bet too big when we aren’t supposed to, or invest too little when the opportunity is ripe. Steady recalibration is in order. I wish I could turn back the clock and realize in 2012 that just because I was jobless, didn’t mean that everybody else was in a precarious situation as well.
We need to set up an investing system similar to what I wrote in the post, A Better Dollar Cost Averaging Strategy. The problem is, even if you come up with an investing system that works for you, it still takes effort to follow your system!
For three months in 1H2017, I was too stressed to think about anything other than my pregnant wife and newborn. As a result, I neglected to take advantage of any stock market sell offs and follow my asset allocation objective of 50% stocks, 50% bonds for the year. Instead, I focused mainly on paying down mortgage debt and buying municipal bonds at par value because I didn’t have to think as much. I had already invested $250,000 in a real estate crowdfunding fund in January. My lack of focus has already cost me ~3% of performance compared to the S&P 500 in just half a year.
Automation is one of the reasons why so many people have done so well investing in real estate. Come hell or high water, some principal will get paid down each month. Automation is why I have no problems paying a marginal fee to a robo advisor. Life is always getting in the way, which is why renters who say they’ll simply “invest the difference” hardly ever keep up with homeowners.
If you don’t follow any of the three lessons above, then let me offer one catchall guideline for retirees when it comes to investing your money:
Invest 90% of your capital as if your life depends on it, because it does. For the remaining 10%, invest as if you were a 28 year old whipper snapper with your entire life ahead of you.
By following this guideline, you are protected from financial calamity while also potentially gaining exposure to higher performing assets that may supercharge your wealth in retirement.
Retirees, have you committed any of the errors I’ve made in this post? What type of financial errors or miscalculations have you made since retiring? For those who haven’t retired, have you not changed your investment risk profile as you’ve increased your income? I’ll be publishing my 2Q2017 investment review shortly so you can get a look at the numbers.