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The 80/20 Way to Early Retirement

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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.

If you enjoyed this article please visit Can I Retire Yet? to learn more or get the RSS feed for it here.

Posted on June 1, 2012.

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5 Responses to “The 80/20 Way to Early Retirement”

  1. Thank you to Darrow for the mention of my calculators. I noticed that Lazy Man editorialized Firecalc over my own calculators mentioned in this article. I really encourage you to examine my writing on the subject explaining the dangers of the backcasted approach. Some of that work is even being published in academic journals reviewed by Phd’s on the subject. This is a serious issue that has put many retirements in danger of failure. The backcasted approach is “old-school” and a bit out of date. If you would like to link to those posts you are welcome to add them yourself but I didn’t feel comfortable linking within a comment. Hope that helps.

    • Lazy Man says:

      Todd,

      How about a guest post summarizing your writings on the dangers of backcasted approach? You can email me at lazymanandmoney (at) gmail [dot] com.

      I looked at your Ultimate Retirement Calculator and it seemed to ask the “Desired annual retirement income.” Isn’t this backcasting in the Wikipedia definition of the sense:

      “Backcasting starts with defining a desirable future and then works backwards to identify policies and programs that will connect the future to the present.”

      ?

  2. Backcasting as commonly used in retirement planning and specifically retirement calculators has to do with historical assumptions – particularly market returns as built into Firecalc. The common misconception is to use the past 100+ years of U.S. historical return data and believe it has some applicability to the future. It doesn’t. For example, since Firecalc was first built the actually real time data since then has produced results that are out-of-sample and historically unprecedented. More advanced modelling has demonstrated return expectations for recent years at roughly half the lowest end expectations implied by backcasted models like Firecalc. It is an extremely dangerous model to apply and should be avoided if financial security is your objective.

    • Lazy Man says:

      I see what you mean now and I agree with you completely. For years I’ve suggested that the growth in America can’t be assumed in an increasingly global economy. Maybe in 2006 or 2007, I was using historical assumptions when estimating returns, but since then I’ve started to go away from them. That said, I think there should be some assumptions in growth of capital over time. Even your Ultimate Retirement Calculator has a “Annual Interest Rate you expect to earn.”

      You can use FireCalc without any historical assumptions. There’s a page of “Your Portfolio” that allows you to adjust with “consistent annual market growth” and “random performance” along parameters that you can adjust.

      I can see your point that it might be dangerous to have the historical assumption as the default. I would certainly prefer to make changes to the calculator if it were mine, but it’s still the best out there in my opinion.

  3. First off, just to clarify the point in your previous comment, every retirement calculator requires a return on investment assumption. The calculation cannot be made without it. It is simply a necessary part of the math. The key is not whether or not the assumption is made, but how you make it and what you do with the output resulting from it.

    Obviously, I respectfully disagree with your preference for Firecalc since it existed before I ever had my Ultimate Retirement Calculator programmed. I wouldn’t have wasted my time if I thought an existing resource had the necessary functionality.

    But blog comments are not an appropriate venue to go into detail. It would really require a guest post on the issues surrounding the use and misuse of retirement calculators to properly explain (as you previously suggested). We can take this offline and decide where to go with it. Thanks.

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