The following article is a guest post from Darrow Kirkpatrick. He is a software engineer, author, and investor who achieved financial independence and retired early at age 50. When he's not outdoors rock climbing or mountain biking, Darrow is writing about saving, investing, and retiring sooner at Can I Retire Yet?
Want an essential tool for navigating modern financial life? Understand and internalize the famed "80-20 Rule" also called the Pareto Principle. It's named after Italian economist Vilfredo Pareto, who observed in 1906 that 20 percent of the citizens in his country controlled 80 percent of the land. (Things haven't changed much: today the top 20% of Americans control about 85% of the country's wealth.)
The 80/20 rule is about causes and effects: it tells us that just 20 percent of the effort in any endeavor produces 80 percent of the results. How does this apply to your personal financial life, particularly to financial independence and retiring early? Simple. Expect that 80% of your progress toward retirement, that is 80% of your net worth, will come from 20% of your focus. Identify those high-leverage focal points, and you'll be on a fast track to financial independence.
Sadly, many financial plans flip the 80/20 rule around, overloading you with data and complexity that you simply don't need. In truth, you can build a secure retirement by focusing on just a few essentials during most of your career. The other details are simply dwarfed by those few key factors that make or break the entire analysis...
A few minutes with a good retirement planning calculator will quickly identify the essential factors in your own retirement equation. They come down to four variables: how much you make, how much you spend, the return on your investments, and what gets taken away by inflation. And those four variables reduce to just two main factors: your savings rate, and your real return on investment. I've found that Financial Mentor has some great calculators for playing with all of these variables. [Editor's Note: I personally like the retirement calculator at FireCalc.]
So, how do you maximize your savings rate — the percentage of income you save versus spend? Frugality is a great place to start, but it only takes you so far. You also need to focus on income — creating wealth. And here's the straight scoop: you can't build wealth in the stock market, except over extremely long time frames using money earned elsewhere. There are really only three avenues for most of us to create wealth, and those are a high-paying career, business ownership, or rental real estate. If you want to build wealth faster, then orient your life in one or more of those three directions, ASAP.
The second key retirement factor is the real return on your investments: that's total return minus the inflation rate. This is huge. No other factor related to your paper assets is as important for retiring sooner. All the other little variables that can occupy you when trying to predict a perfect retirement "number" pale in comparison to the real return on your investments. The reason for this is very simple: the compounding of returns over many years multiplies small differences into enormous sums!
Predicting or controlling your real investment return decades into the future is impossible. But you can look at history to get some sense of the possible range. Over the last century the Dow Jones Industrial Average returned an average in the range of 9-10% annually, however many experts think it will do worse going forward. You can use a simple inflation calculator to get a feel for what inflation does to the value of your dollars over time. [Editor's note: Inflation over the last century has been around 3.5%. I subtract that from my expected returns. So if I think an investment is going to 8% long term, that's 4.5% after inflation. It also wise to take out investment expenses and taxes (if the account isn't tax advantaged) as well. Though there is some debate about the 3.5% inflation number, it is accurate enough for this exercise.]
But even Ph.D. economists who study these subjects for a living, can’t reliably navigate these numbers even one year into the future. So how can you maximize your real return? Leverage the most important factor that you can control — investment expenses. Minimize your costs by choosing only funds and ETFs with expense ratios less than about 0.25%. Another factor you control is your asset allocation. You can reduce inflation's bite by holding inflation-protected assets, such as TIPs, commodities, and real estate.
In the end, the truth is that retirement planning is a bet on an essentially unknowable future with major variables that just can't be predicted in advance. So sweating minor details, focusing on the 80%, is a foolish exercise. Skip the complexity. Instead, build your financial independence by focusing on the 20% that truly matters — maximizing income, reducing expenses, and protecting against inflation.
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