a structured approach to achieving financial independence
overview
It goes without saying that earning positive returns on one's investments is a key factor in achieving financial independence. However, whilst much focus tends to be on maximising returns on an investment portfolio, in actuality the more structured approach sees the focus shift to maximising returns subject to the amount of risk that is appropriate for a given situation.
Moreover, and this is a subtle but important extension of this point, when one has a specific objective in mind, the optimal investment structure is one that aims to provide the required rate of return in order to meet that objective (no more, no less) whilst minimising the risk for that given return.
Stated simply: if an investment portfolio requires a rate of return of 5% per annum over each of the next 20 years, for example, in order to grow to a size sufficient to meet the required financial independence objective, the investments that should be selected are those expected to see the portfolio generate a return of 5% per annum at the least risk possible.
In the world of investment selection, it is possible to have two alternative assets to choose from, both of which have an expected return of 5% per annum but each possessing a starkly different risk profile. Likewise, it can be tempting to go for a higher risk alternative in the hope of earning a higher return – but does the portfolio need to be subjected to this risk, if the objective can be reached without?
A higher return, all else equal, is always going to be preferable, but increasing the likelihood of reaching the objective is arguably better still. Once that objective has been reached it may be possible to sequester part of the portfolio into high return seeking initiatives, but in such a manner that even if those were to prove loss-making, financial independence (the main objective) remains intact.
Under a structured approach to achieving financial independence, all portfolio investment choices are undertaken in a manner that aims to maximise the likelihood of achieving that end objective, as opposed to simply seeking out the highest return possible at any risk.
understanding risk
The thing about risk is that even though higher risk often means higher return, it is vital to understand what this actually translates to in practice.
Any prospective return on an investment is fundamentally an expectation based on some set of probabilities. Therefore, greater risk comes with the characteristic of a greater dispersion of return outcomes. This is most clearly illustrated in the diagram below. Whilst the expected return is seen as increasing as the risk increases, the portfolio is being subjected to a greater dispersion of potential outcomes. Importantly, note the increasing size of the distribution that falls under the expected outcome as one moves along the expected return line.
The aim of having a structured approach to an investment portfolio being managed with a view towards providing financial independence (or even standard retirement goals), is that you want to obtain the required rate of return whilst making as narrow as possible the range of possible return outcomes that may occur. This will indeed have the consequence of capping the degree to which the portfolio may outperform to the upside, but it also has the advantage of, as best as possible, managing the extent to which the portfolio underperforms – that is, managing the downside.
The Steps
Risk management and increasing the likelihood of achieving the desired outcome are very important aspects of investment management and should be taken into account when choosing investments on the path towards financial independence.
The approach has the following steps:
Step 1: Calculate what level of income is required for financial independence. This is a highly personal decision and needs to be given careful consideration. A common way (but certainly not the only way) to estimate this number is to examine the last 3 to 5 years of expenditure behaviour. The larger the data set available for understanding spending behaviour, the more informed will be the decision. Also, do keep in mind that allowance will need to be given for inflation - that is, whatever the chosen number is in today's dollars, it will need to be adjusted to the time when the objective of financial independence has been reached, be it 10, 20 or 30 years hence.
Step 2: Calculate how much capital is required in order to generate this income level over the course of your life expectancy from the point at which financial independence is achieved. For conservative estimates, it is best to assume moderate rates of investment return on the portfolio during the time in which it is being drawn down. The 4% rule is a common approach but do examine a range - perhaps 3% to 7%. To help with estimating this number, a tool is available here.
Step 3: Gain insight into your current financial situation. This will entail creating a balance sheet of all your financial assets and liabilities to understand the net position as of today.
Step 4: Calculate what rate of return is required in order to grow your current wealth to a level that is able to generate the desired level of income. This step can be confronting depending on the other parameters chosen. It will highlight how much risk the portfolio will need to be subjected to in order to achieve the desired outcome. In many ways, minimising this number is a key step to increasing the likelihood of reaching your goal. As the diagram above illustrated, higher expected returns come with the price of ever increasing dispersion of outcomes. In other words, for higher required portfolio returns there will be a larger dispersion of outcomes to the downside for any such asset that is expected to provide that higher return.
Step 5: Find and invest in assets that provide this required rate of return at the least risk possible. This is arguably the hardest step of them all. Some will pay for the services of a financial adviser (or similar) to have them find suitable investments. Alternatively, options such as index funds are available - this means accepting whatever the broad market return is and hoping that it associates strongly with that return obtained in Step 4. Property is also a popular choice but should be assessed with the same rigour as any other investment. To help assess the return potential of an investment property, a tool is available here.
Step 6: Ensure that the whole structure is set up as efficiently as possible in terms of cash flow, tax etc. This aspect of financial independence is often overlooked, but is worth the time taken to have it structured optimally. For coverage of the importance of cash flow management see here.
Step 7: Stay the course and be disciplined. The payoff will have been worth it!
closing remarks
What is important to realise from these steps (and will become apparent to those who investigate) is that there are underlying relationships that hold that allow for a deep understanding of the actuality of planning for financial independence.
All else equal:
The more time one has to reach a given portfolio size, the lower will be the required rate of return. Starting early pays huge dividends down the line. It is said "do something today that your future self will thank you for", and starting early on this path will be one of the greatest gifts that you can give your future self. This can also be considered when setting up trusts for children, in that a small amount saved commencing at birth will amount to a sizeable fund when the child grows to a young adult.
Inflation is a quiet enemy to maintaining the purchasing power of income that is being produced, and forgetting to allow for this can lead to problems down the line.
Efficient and targeted spending habits are critical. Enjoy yourself, but arguably look to allocate expenditure on those things that will yield the greatest utility.
Please contact info@financialactuality.com to discuss further.