Why Index Tracking ETFs Are Still The Best Investments for a FIRE lifestyle
If you're a regular reader of this blog you will know by now that I will invest in just about anything if it looks like it will give a decent return. Since I started my FIRE journey I have invested in everything from Stocks & Bonds to Delivery Bikes & Cows!
If you take a look at our 2021 portfolio you will quickly see it's made up over 40 investments ranging from as little as R5,000 / $350 / £250 up to as much as R1,500,000 / $100,000 / £75,000 per investment and looking back at it now, it seems I have pretty much every sector covered from Healthcare to the Chinese economy!
We're just past the mid year point and I've been doing a thorough review of my portfolio as well as some of the experiments I started in January to look at what is performing and what is lagging to see if any adjustments are required.
If you're on a FIRE journey yourself or simply keep up to date on what's going on in the personal finance world, you don't need me to tell you that purist FIRE enthusiasts simply don't invest in anything other than low cost index tracking funds as their primary investment vehicle and most have a back-up find invested in a bond or money market fund in case of a bear (declining) market or a full on stock market crash.
The ratio varies but as a rule of thumb, most FIREites are somewhere between a 70/30 and 90/10 stock/bond ratio. That simply means that they put 70% to 90% of their investments in the stock market and 10% to 30% in the bond market.
The bond market is very low risk but relatively low reward. It tends to go up slowly in a straight line and depending on where you live it gives a return that is generally better than your average savings account. In South Africa, a bond market fund like the Sygnia Enhanced All Bond Fund has actually done really well in the last year and delivered a massive 14% return but that is slightly unusual in my opinion and for planning purposes I think 8% is a bit more "Normal" over the long term.
Bond funds are also fairly cheap with the same Sygnia fund mentioned above has a fee of 0.46% which is pretty good by South African standards. Early retirees are also obsessed with fees or more specifically not paying them, as over time, high fees ruin the magical effect of compound interest which is critical if your savings are going to keep you out of the rat race.
Then there's the stock market part and there is one simple choice if you want a quiet life and that is known as the Low Cost Broad Based Passive Index Tracking Fund.
Simply trips of the tongue doesn't it?
Well despite the fact that if you're an investing noob the title alone is enough to scare you into sticking your moola under the mattress, they are in fact probably the most simple of investments both to understand and to invest in if you use the increasingly more common ETF version (as opposed to a unit trust version).
So in case this is still pretty much Greek to you, let me quickly dissect what a Low Cost Broad Based Passive Index Tracking ETF is:
Low Cost - Somewhat obvious but it means it has a low management fee which is usually a charge applied to your returns and is a percentage of your investment. For example: if you invest 100,000 in a fund with a 1% fee, you will be charged 1,000 every year you hold the fund. You won't see it as a charge in most cases, it will be deducted from the profits you receive.
Broad Based - This means that the fund itself invests in a wide range of companies and for FIRE investing, the wider the better. Wide/Broad basically translates to low(er) risk. One of the most common Broad Based funds used by FIRE investors is the MSCI World Index ETFs which invests in around 85% of companies in stock markets across the world. Now you don't get a great deal broader than that! The reason this is important is that whilst you enjoy the returns of stock market investing, you don't have the risk of having all of your eggs in one basket (or company). A great example of why Broad Based investing is lower risk than investing in a company: Remember Toys R Us? How about General Motors? Pan-Am Airlines maybe? What do they have in common, they were all massive global companies we all grew up knowing and using that went bust almost overnight taking literally billions in shareholders investments with them.
Passive Index Tracking - This is super important. There are essentially two types of investment funds. There is "Active" which basically means there is a human being (known as a fund manager) who decides what to invest in, when to buy, when to sell etc. The second type is "Passive" which just invests into the market and then leaves it alone, no buying and selling or researching and stock picking. This is known as Index Tracking. Because you're not paying the MASSIVE salaries and bonuses of that fund manager and his team, Passive Index Tracking Funds are usually cheaper than Actively Managed funds.
ETF - Stands for Exchange Traded Fund. This just means that the fund is traded on the stock market the same as a company share. this means that anyone with a stock market trading account can buy and sell their shares in the ETF on the open market in real time without any form filling or raising of requests. This makes it pretty much accessible to anyone.
So now we've established what it is, why is it considered the best possible investment for early retirees?
Well pretty much for the reasons above, they are cheap, relatively low risk over the long term, easy to get into and out of and most importantly they give a great return that is almost impossible to get anywhere else without any effort.
They are in essence the ultimate passive income provider for people with savings.
And the obvious next question is: what kind of returns can I expect?
Personally, we absolutely need a 9.5% return on our investments to prevent the need for work income but I aim for 12% and so far (over the last 5 years of focussed index investing) that's been pretty achievable. If you look at the historic returns for some of the more popular indexes you can see average returns pretty consistently between 10% & 12% going back decades. My personal favourite index is the S&P 500 and if you look at the returns for that, you start to see why a passive investment in it makes sense:
S&P 500 Annualised Index Returns (July to July):
1 Year - 36%
3 year - 17%
5 Year - 17%
10 Year - 14%
25 Year - 10%
50 Year - 10%
100 Years - 10%
And there's some pretty hefty stock market crashes, wars and even global pandemics throughout all of those timeframes. Even if you take the lowest return at 10%, that's still more than we need, so why invest anywhere else? The answer for me probably lies somewhere between, adventure, excitement, stupidity and greed!
And with the magic of compound interest, you can make some serious money if you're willing to squirrel the cash away and not touch it. Let's say for most people, the FIRE journey from the first day of saving to pushing the button. That rate goes a long way when you look at the compounding affects over 10 years.
Let's take a pretty average example, you're 30, you decide you want to retire at 40 and you've got R250,000 already in savings and you can afford to save R25,000 by living super frugally. If that feels too much or too little, change it to whatever you fancy, it's all relative.
If I simply take that R250k and buy an S&P 500 tracker and then save an additional R25,000 every month for 10 years. I'll invest a total of R3,250,000. BUT if I get the 14% return the S&P 500 gave over the last 10 years, and let's face it, no miracles happened that I can remember in that time, that investment would be worth: R7,630,183
Yep, that's a profit of R4,380,183 or, if you used your own numbers, a profit of 135% on top of your starting investment.
All for doing nothing more than clicking a few buttons once a month to invest your savings.
Then think about it from the perspective of after you retire, you can leave that investment sitting for the rest of your life getting a 10% return year after year. You obviously have to take inflation over time into account but simply, that R7,630,183 that you saved over 10 years is going to give you a R763,018 return every year for doing nothing which is R63,584 per month, which is actually pretty close to my current living expenses for Mrs H, Winston and I.
And that is why, like 99% of the FIRE community, we have most of our net worth in Low Cost Broad Based Passive Index Fund ETFs.
And finally, why is it better than almost all of my other investments?
Well if you've been watching the stock market or in fact the global economy in general over the last year or two, it has not been all over the shop! I've seen returns on some investments of 100% last year, only to see that drop to -50% returns this year, you can't live like that! Well you can, if you want to retire, not sleep and sit in front of graphs and spreadsheets all day managing your money in the fear you might be back at work in a few years time.
I've got some boring (Cattle being a great example. like watching paint dry) and some thrilling investments (Crypto makes you feel alive!) but none constantly move forward month after month and give me the feeling my money is working hard, invested in some great companies and will feed me into my old age. And I don't need to check on it, it's been doing that for 100 years and yes there will be a crash and yes there will be volatility but I've got over 50 years of investing left and for the last 100, they gave 10% and I need 9.5%. That peace of mind when you're living off your savings at an early age is, as a famous credit card would say; Priceless.
If you're beginning your FIRE journey and don't know where to start on choosing a index fund or what different options are around. Have a look at my magnificent 7 ETFs, they've served me well so far and although there is a lot of variation in them, it will give you a good view of my thought process when I picked them close to a year ago now and so far they've given me an annualised return of around 27%. I'm not suggesting you copy my portfolio (in fact none of this is financial advice, you should do your own research) but if I were looking for a few Index Tracking ETFs to get started based on what I know today, I would pick the Vanguard Total Stock Index ETF (VTI), The Vanguard S&P 500 ETF (VOO) and the Vanguard Mega Cap Growth Index ETF (MGK). They are simply my favourite funds (And I am not sponsored by Vanguard, although if they're reading; I would love to be hahaha) and I am pretty sure they will play a large part in my portfolio for the rest of my life.
Hopefully this helps someone, I'm living proof that it's all a bit bewildering figuring this stuff out once you've committed to saving for early retirement. I made some howlers of investments that probably added a year to our pre retirement savings journey but I guess that's just school fees and it was all worth it in the end.
Until next time, keep living