When you first learn the premise behind the FIRE movement (financial independence, retire early), you start to wonder: how do I invest differently for FIRE? How can I earn enough passive income to cover my living expenses?
Strap in, and get ready to punch the accelerator on your retirement planning.
Different Needs, Different Risks
While many of the fundamentals remain the same as traditional retirement planning, people who want to retire young could be retired for more than half a century. They face different risks, have different needs, and in some cases need to invest differently.
Here’s what you need to know before we tackle actual investments.
A Quick Overview of Safe Withdrawal Rates and FIRE
If you’ve ever heard of “the 4% rule,” you understand the premise behind safe withdrawal rates.
Planning for retirement, you need to know how much you need to save as a nest egg. And in order to know how much you need to save up, you need a few other numbers.
First, you need to know how much income you want from your investments in retirement. In other words, how much do you need to cover your living expenses? Second, you need to know how much you can safely pull out of your nest egg each year.
The 4% rule asserts that you can safely pull out 4% of your nest egg each year in retirement, with almost no risk of running out of money within 30 years. For example, if you have a $1 million retirement nest egg, you could safely withdraw $40,000 per year to cover your living expenses.
You can invert that math to calculate how much you need to save for retirement: if you live on $40,000 per year in expenses, you can multiply that by 25 to reach your target nest egg using a 4% withdrawal rate (100% / 4% = 25) of $1 million.
“But,” critics point out, “early retirees will probably live for more than 30 years in retirement!” Thankfully, in most historical scenarios, a 4% withdrawal rate would have left your nest egg intact far longer than 30 years, and in many, the nest egg continued growing indefinitely.
However, for anyone who wants more certainty, financial planner Michael Kitces demonstrates mathematically that a 3.5% withdrawal rate would leave your nest egg intact forever, at least in all historical scenarios over the past century.
And sure, a zombie apocalypse or alien invasion could always destroy worldwide financial markets in the coming decades, upending all your careful retirement planning. But a century’s worth of historical returns is as close to a certain prediction as you can get.
As a final thought, think carefully about your living expenses post-FIRE. Read up on the concepts of lean FIRE versus fat FIRE — it might just make you rethink some of your current expenses as well.
The FIREwall Against Sequence Risk
Another core retirement concept is sequence of returns risk, or simply sequence risk. It posits that once you retire, it’s not just your long-term average returns that matter in keeping your nest egg intact, but also the order or sequence that they hit your portfolio.
More specifically, sequence of returns risk is the risk of a market crash early in your retirement, when it does far more damage than a market crash later in your retirement.
That’s because the longer your nest egg grows post-retirement in a bull market, the larger it becomes (obviously), and the better it can withstand a sudden drop of 30% or worse.
Think of it like momentum for your money: the more momentum you get out of the gate, the more powerful a shock would have to be to halt it in its tracks.
The minority of historical scenarios where portfolios ran out of money in 30 or 35 years? They all involved a market drop early in retirement.
But early retirees have a secret weapon to battle sequence risk: they can go back to work if the market crashes in the first few years of their retirement. That’s a lot easier for 40-year-olds to do than 70-year-olds.
In my experience, however, it’s usually a moot point anyway.
Most People Work Post-FIRE
The image of sitting on a beach sipping margaritas for the rest of your life is how marketers sell the notion of FIRE. But I don’t know a single person who reached financial independence and actually did that.
Every person I know who has reached financial independence at a young age has gone on to do something else. Inevitably something fun, something rewarding — and something that generates at least a little income.
Many people blog about their experiences, or start podcasts, or sell online courses, all aimed at helping others achieve the same success. Some continue investing aggressively to grow their portfolio of income properties or other high-yield investments. Others take their dream job at a nonprofit to help save the world.
It takes a certain degree of discipline and motivation to achieve FIRE. Fundamentally lazy people — the kind who would happily sit on a beach all day sipping cocktails with tiny umbrellas in them — often don’t have the gusto to achieve FIRE in the first place. This means financial independence rarely means actually retiring early.
For that matter, you could always work a part-time, laid-back post-retirement job for fun and some extra money. I’d love to pour wines at a local winery; my mom plans to continue her current side hustle of tutoring kids.
Some FIRE devotees refer to this concept as “barista FIRE” — the ability to retire with a fun full- or part-time job rather than grinding it out at your 9-to-5 day job.
One of the most common questions I hear about FIRE is “How will I pay for health insurance without employer coverage?”
At traditional retirement age, Americans can go on Medicare to replace their employer coverage. Early retirees don’t have that option.
Fortunately, you have plenty of options for health insurance without employer coverage. Even so, you do need to budget for it in your post-FIRE annual expenses.
Investment Strategies for People Pursuing FIRE
So, people who reach financial independence and possibly retire early have slightly different advantages and risks than those who retire in their 60s. But does that translate to a different investing strategy?
Yes — but only to an extent.
Beware of Bonds
In 1981, U.S. Treasury bonds — essentially risk-free investments — paid over 15% interest. In 2021, they pay around 1.5%.
Which is actually lower than the CPI inflation rate. In a very real sense, investors are actually losing money on Treasury bonds in 2021.
It doesn’t take a math whiz to realize that if you invest money at 1.5% interest per year, and you withdraw it at a rate of 4% per year, you’re going to run out of money.
All of which means that bonds don’t work so well for people pursuing FIRE, at least in the perpetual low-interest environment we’ve seen throughout the 21st century so far. That presents a problem for retirees because bonds have historically provided stability to protect against the volatility of stocks and sequence risk.
Good thing you don’t have to worry too much about sequence risk, as outlined above.
All that said, bonds can still serve a role in your asset allocation as someone pursuing FIRE. Consider investing in municipal bonds that offer tax-exempt returns at the federal, state, and local levels.
For high earners in particular, the tax savings can boost the effective yield you earn, making them a viable investment to add stability to your portfolio.
Stick with the Fundamentals for Stocks
But most people pursuing FIRE use index funds and low-cost exchange-traded funds (ETFs) to diversify their portfolios and gain exposure to thousands of stocks, investing in the market as a whole rather than trying to pick the next Netflix.
Over the long term, the S&P 500 index has returned an average of 10% annually.
I recommend at least one large-cap U.S. fund, one small-cap U.S. fund, one international developed countries fund, and one emerging markets fund. As you learn more, you can branch out, but just those four funds make an excellent foundation for your stock portfolio.
Stick with a robo-advisor until you reach a high net worth, and then consider switching to a human hybrid advising model. By saving yourself the hefty fees charged by traditional investment advisors, you can reach financial independence years earlier.
Include Real Estate in Some Form
As a real estate investor myself, I can assure you that not everyone should invest directly in real estate. Only consider it if you have a passion for it, and plan to invest in properties as a side business.
For the average person, you’re better off diversifying into real estate through more passive means. Try one of many indirect ways to invest in real estate, such as real estate crowdfunding investments like Fundrise, Streitwise, and Groundfloor.
While you can easily invest in publicly traded real estate investment trusts (REITs), and they do provide excellent liquidity, they come with several drawbacks. Most notably, they move with too much correlation with stock indexes to provide any real diversification benefits.
In my own investment portfolio, I use real estate as a stand-in for bonds. My real estate investments provide strong income yields with far more stability than the stock market. They don’t offer the same liquidity, but I don’t need liquidity from my real estate investments. My emergency fund and stock investments offer plenty.
And if you do decide to invest in real estate directly, you can score some excellent tax benefits to boot!
Minimize High-Risk Speculation
It seems like everyone has a grungy cousin who made $100,000 on Dogecoin speculation or the like. But that doesn’t mean you should go out and put all your savings into cryptocurrencies or other speculative investments.
I have a little money in Bitcoin, Ethereum, and other crypto assets. Emphasis on “little” — I set aside no more than 5% of my portfolio for fun money investments and speculations. It would annoy me to lose it, but it wouldn’t break me.
If you feel the need to show off how smart you are by picking stocks or speculative investments like fine art or cryptocurrencies, go for it. But only do so with a small percentage of your total assets.
Which, come to think of it, is no different than how everyone else should treat these investments.
The Role of Tax-Sheltered Accounts
Most people who pursue FIRE aim to optimize their taxes to lose as little to Uncle Sam as possible. Think of taxes as leakage — lost money leaking out of the well-oiled machine you’re building.
Yet tax-sheltered retirement accounts don’t let you withdraw money until you reach 59 ½ — which hardly helps you if you want to retire at 40. So how do you resolve that dilemma?
First, you can invest in both tax-sheltered retirement accounts and taxable brokerage accounts. Your real estate investments can also generate ongoing income for you, outside of your retirement accounts. You can lean on your taxable investments before reaching 59 ½, then start tapping your retirement accounts.
Read a more detailed exploration of how to maximize tax-sheltered accounts for FIRE as you plan your own early retirement.
For example, I don’t pay for life insurance or long-term disability insurance, and I invest the money instead. My family’s 60% savings rate means that we could financially survive losing one parent’s income. It also means we’ve built a thick nest egg in just a few short years of getting serious about FIRE.
Strange and wonderful things happen when you start saving 40%, 50%, 60% of your household income. It starts compounding on itself and taking on a life of its own. Neither my wife nor I earn a large annual income, but by keeping our living expenses low we’re on track to reach financial freedom within six or seven years of taking it seriously.
If you’re interested in the nuts and bolts of FIRE, take a deeper dive into the math behind extreme early retirement. You’ll be surprised at how simple it is — and how fast you can achieve it.