What is the best investment strategy for early retirement? It seems like half of the information about early retirement is really about investment strategies. Consequently, I can skip most of that! Let me just mention two sources I find important:
- rikatillsammans.se, meaning “rich together”. A blog about investment and financial independence in Sweden. It is always important to know the specifics of investment in your own country. What investments are good from a tax perspective? What are the best investment platforms?
- The YouTube channel Common Sense Investing. It gives a lot of background on why global index funds are a reasonable investment. Also, why stock picking or market timing are bad ideas. Some videos have a Canadian perspective, which is of less interest. Watch out, though. It seems Ben Felix tries to subtly lure the viewer into factor investment tools provided by his company. But I could be wrong…
Personally, I am a conservative investor. Right now, most of my savings are used for repaying my mortgage loan. The rest gets invested in global index funds. Repaying my loan has a number of benefits:
- In Sweden, banks are willing to reduce the interest rate somewhat, once the loan has come down to 60% of the property’s value.
- It is a good alternative to buying bonds. Normally, bonds are seen as an important building block for a defensive investment strategy because of lower volatility. In the current situation, where interest rates are low and are expected to go up, bonds are likely not a good investment.
- It is an investment without additional risk. The performance equals the interest rate of my loan. In my case that is a bit below inflation. Not great, but better than a savings account.
- By reducing my loan-to-value ratio, I am reducing the risk of losing my property in the case of a steep drop in value.
What is important to keep in mind: With such a defensive investment strategy my expected return on investment is is very small. Remember the 4% rule? That assumes a full investment in stocks, which gives a higher return on average but comes with higher risks.
To get exposure to higher risk, and therefore higher performance, I invest parts of my savings in index funds. An index fund tracks a large stock index, such as S&P 500 or MSCI World. Instead of making active investment decisions, the fond manager simply buys the stocks included in the index. This is one of the easiest ways to diversify my investment, which reduces volatility. Furthermore, index funds are really cheap compared to actively managed funds. Combine this with the fact that very few fond managers beat the index consistently, and this becomes some kind of a no-brainer investment. Your bank advisor might not necessarily recommend you to buy index funds, because he will earn more himself if you buy the bank’s actively managed funds. However, if you search through independent investment advice, then index funds are currently the most common recommendation.
But if many people make the same investments, this can create a bubble, right? There has been some concern in that direction, most prominently from Michael Burry. Burry is the fund manager portrayed in the great movie The Big Short, who predicted the sub-prime mortgage bubble. So maybe Burry is right, and we are in for a massive crash? Most commentators say: Probably not. Yes, index funds pump a lot of money into large companies and neglect smaller ones. This might be something that active managers could benefit from if the increased trading fees to not eat the additional performance. But it is unlikely a cause for a bubble with risk for massive drops in prices. My personal view is that maybe Burry is using his prominent name to save the future of his industry: active fund managing.
Strategy over time
Another important point: How should we withdraw our money during retirement? The easy answer would be: withdraw 4% per year according to the 4% safe withdrawal rule. However, there are ways to reduce the risk from experiencing a major fall of stock prices after retirement. This sequence of return risk causes a reduction of your savings, which will impact the whole remaining retirement time. It is reasonable to start shifting money from stocks to more secure investments like bonds or fixed deposits.
After retirement, a bucket strategy can be used, as described here. Essentially, we sell stocks only during years with good performance. The withdrawn money is placed in two buckets with cash and bonds. Chances are high that those buckets will not deplete until another year with good performance refills them. It is important to realize that such a strategy reduces overall performance on average. But it reduces the risk of running out of money too early.
The safe bet
There is another way to reduce risk after retirement: buying the right insurance. An annuity, or single premium annuity, is a one-time purchase that creates monthly income until the end of life. The monthly rates can even be inflation-adjusted, i.e., increase slightly over time. The major disadvantage is that there will be no money left for your heirs. Also, you should make sure that you have protection against the insolvency of the insurer.