General Financial Ignorance

In my previous post I mentioned an article about a 30 year old who planned to retire at 35 with $1,000,000 (AUD) invested.

When you go public with your financial independence plans I guess you have to expect some criticism. Some of the replies to the Facebook article about Pat’s plan were just plain incorrect though.

I am a little worried about the general financial ignorance that these people displayed but even more concerned with the complete confidence they showed in expressing their opinion publicly.

You should always be ready to learn something!

So, in the spirit of improving everyone’s financial literacy I have grouped some of the most *ahem* interesting replies and will now hope to shed some light on them!

The “He didn’t think of inflation” crowd

“Haha. If he thinks one million is enough to survive on good on him. He’s in for a rude surprise though when he finds out $40k isn’t worth the same in thirty years.

“Like to see him live on $40k in 30 years time.

“Has he taken inflation into account? $40k in 2018 is a lot different to $40k in 1998 and will be a lot different to $40k in 2048.

“What an idiot! $40k is going to go a long way in 20 years! FR’s

“If your “investment” vehicle doesn’t beat inflation and taxes, then you ultimately lose. 40k today will have far less buying power in ten years, significantly less in 30. This sounds like a “mattress stuffed with money” plan.

“40k pa may not be enough by the time he is 60yo

“Yes he maybe free financially when he takes that step but he will always be tied and governed by renting somewhere and the exorbitant prices he could face in time. Living on 40k over potentially the next 50 years may not amount to much at all with factors like inflation…”

So this one kept popping up again and again.

Thankfully this is very easy to explain.

$1,000,000 generating 4% per year creates the mentioned $40,000 income per year.

However the average return on an investment like this in the draw down stage (that is, when you are getting an income from your investment) would be something conservatively around 6% p.a.

So what gives? If you can earn $60,000 on $1,000,000 investment per year why doesn’t Pat live on that instead?

The extra money above the $40,000 is reinvested so that each year you are financially independent your income increases in line with inflation and the consumer price index (CPI) among the other various increases to the cost of living.

By the time Pat reaches 60, 80 or 100 his investment won’t be generating $40,000 per year, it will be making much more than that.

He has stated that he has absolutely taken into account inflation (the gradual reduction in the buying power of your money) just like anyone who intends to be financially independent must do. Simple!

The “straight line” crowd

“$1m at $40k a year is 25 years. Not a very long time… What happens when you turn 60 and the money runs out??

“So if he wanted to retire at 35 on 40,000 a year that would only take him to 60

Perhaps these people have only ever had a bank account that doesn’t pay interest!

Truthfully their calculations are correct $1,000,000 / $40,000 = 25 years of an income.

Except that this money is invested and making money.

Let’s use the ideal first year of return as an example.

We have $1,000,000 invested and it makes a return of 6% p.a. which means we made $60,000.

We spend $40,000 to live so that at the end of that first year our investment is now $1,020,000. ($60,000 – $40,000 = $20,000 which is added to our original $1,000,000).

We actually haven’t reduced our principle investment (the original $1,000,000) at all. Quite the opposite, it has increased by $20,000!

This is important because it means that in year 2 if our investment again returns 6% we will make $61,200 (or $1,200 more than the previous year) which also happens to be 2% more than the previous year. This 2% increases just about cancels out the average long term inflation rate so our money maintains its buying power!

The “I could never survive on $40,000” crowd

“Ahh the ramblings of a millennial who has no idea what the future holds….guess no wife or children then. My family spends about 20k on food alone each year. Try need 3x the amount to manage a family comfortable – thats without the smashed avos and living in an affordable city.

“I would like to see his comments on this plan and how its worked out when he is turning 50. $40,000 isn’t much to live off no matter how little you spend on items of choice. It is also necessary people to work and pay taxes for our schools and medical systems to survive. Oh and I guess he isn’t have any children either.

You can absolutely live a healthy, fulfilling and satisfying life on $40,000 (AUD) per year!

I suspect there are many people that raise families on this income even in developed countries as well.

Financial discipline is a skill that takes hard work to maintain. When you really take a look at the things you need to survive you will find that they are actually a pretty small part of your entire cost base (assuming you have no huge medical costs and a reasonable income i.e. $40,000AUD and above).

How you choose to spend all of the remaining money you make is ultimately up to you but I would love to take a look at this crowds Nitty Gritty Details and figure out exactly where all that money is going. I suspect that with a couple of tweaks they would easily see it is possible.

The “shares are too risky” crowd

“Cool idea… but anyone remember that little event that happened in 2008?

“How did you go after that recent share market crash? Might as well put it all on red

“Good luck surviving on $40K per year with a wife & family! What will you do when you lose your money due to the next big stock market crash?!

“I scrolled through the comments but I can’t find anyone else pointing out what I feel is obvious – the millions that were wiped off the AU and US stock markets in the last couple of weeks?? Does this not affect his plan? What about another GFC? I feel like it’s too risky”

“I knew a guy who did this, 18 months looking at the computer to make sure he was always getting the best, He said was easier to work and lower his portfolio so he could sleep at night. Market trends change when you’re asleep, and due to falls, he got up and worked to make back some of the losses, but when the market is all you have, it has to become your life, no retirement. Great idea, but it isn’t easy like this guy is making out.

“Property, like shares, is an investment. Both generally yield a return. Both generally increase in value over time. Generally speaking, shares yield a higher return. However, higher return equals higher risk. I think it’s a cool idea what he’s doing, but he’s really rolling the dice here. Best of luck to him. If the market crashes (again) I’m sure he’ll wish he invested his hard earned cash in bricks and mortar, or just kept it in cash. This is really more an article about living a low cost lifestyle – which I think is a great concept…

There is no denying that investing in shares carries a risk.

The same is also true for every other investment that I know of.

However, I think that a few people above have misunderstood how you can be invested in the share market and still earn an income despite the downturns.

One important factor is dividends.

Just like the rent a tenant pays a landlord a dividend is a portion of a company’s profit paid to a shareholder.

You may have heard of the term yield.

A shares yield is the percentage of a shares value paid back to a shareholder as a dividend.

For example, a share worth $100 with a 5% yield will pay a shareholder $5 in dividends over the course of a year.

This is often, but not always, independent of the overall price of a share. So this means that if you are invested in companies that have a strong record of paying a dividend with a high yield you can continue to make money despite the market’s overall performance.

The overall increase in the shares value is still a very important factor though. Should you find yourself at year 8 of your 10 year financial independence plan and there is another global economic crisis then I suggest the solution is relatively simple.

You just continue to work until the market recovers!

You can only make a loss in the share market when you sell at a loss. If you stay invested for the long term the chances are that you will make a considerable amount of money.

There is one other thing to mention. I don’t think that once Pat has achieved his goal of $1,000,000 he is going to continue to keep the money solely invested in shares. I suspect he will move this money into an investment that provides a much more consistent (but lower) return at a lot lower risk.

This effectively insulates himself from the share market crashes.

The “and the rest” crowd (I couldn’t neatly define these ones!)

“I couldn’t finish it because this man is a moron. You’re not financially independent if you’re renting. Also, the share market at the moment is  that’s why everyone is investing their money in property, it’s the investment with better returns and it’s safer than shares.”

“Financial independence means you have enough wealth to live on without working.” – Wikipedia.

Ignoring the property vs. shares debate (I intend to cover this at another time) if Pat is able to maintain his lifestyle purely from his investments then he has achieved financial independence. This is regardless of whether he is renting, paying off a mortgage or living in a tent in a national park.

“I will have worked for 10 years when I turn 23 in May, though I’m not hanging up my boots because I’d get bored living on bare minimum. I’ve saved very well, though I’d rather have that for when I actually have to retire and have f all super in comparison, because super doesn’t build interest.

Superannuation (the Australian equivalent of a 401k) can most certainly generate interest depending on what you are invested in.

If you superannuation isn’t growing in value above your compulsory contributions then you need to look into that straight away.

“Hope he budgeted for CGT on those shares

This is only applicable if he sells instead of using the dividends to live off of. Still, I am certain Pat has budgeted for this!

“4% ROI. Bit rubbish

This person has arrived at a 4% return on investment (ROI) from the $40,000 return on the $1,000,000 investment ($40,000 is 4% of $1,000,000).

As I said earlier this is what Pat intends to live off of, not what the actual return on his investment will be. Conservatively it should be expected that $1,000,000 would make an average 6% return or $60,000 per year.

SO in conclusion…

No matter how savvy you think you are with money there is always something to learn (I learnt about bond ladders just the other day!). Keep your mind open and you will be surprised at what ideas walk in.

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