November 24, 2023

How to Produce Investment Income Forever

One way to figure out how much wealth you need to accumulate to reach your financial goals is to determine how much investment income you want it to provide you per year.
A common rule of thumb is to withdraw no more than about 4% per year if you want your portfolio to last forever.
That’s not a perfect rule but it’s a good starting point.
In reality, your withdraw rate depends on what rate of return your portfolio delivers. If you have a portfolio invested entirely in bonds and treasuries that provide you a rate of return of 2.5% per year, and inflation is 2% per year, then of course you can’t withdraw 4% per year without reducing your principal.
If stocks only grow at 5% per year over the next decade, then the general rule of withdrawing 4% per year will be too aggressive, since inflation will be eating away your principal faster than it replenishes itself.
If you want your portfolio to last forever, then subtract the approximate inflation rate from your portfolio’s expected rate of return, and don’t withdraw more than the remaining number.
Max withdraw rate = Annual RoR – Annual Inflation Rate
So if your portfolio is growing at 6% per year, and inflation is 2.5% per year, then don’t withdraw more than 3.5% of your portfolio per year. That way, your portfolio will keep growing as fast as inflation to maintain its inflation-adjusted size, while you continue to withdraw 3.5% of it per year.
However, that approach doesn’t give you any margin of safety. If a market crash occurs and your investments temporarily lose 30% of their value, then your investment income may take a big hit. That figure should serve as an absolute upper limit, and ideally, you should keep it lower, especially since you can only estimate your forward rate of return rather than know it for sure.
So, stick to this to be safe:
Safe withdraw rate = Annual RoR – Annual Inflation Rate – 1%
One thing to keep in mind is that although the life expectancy at birth is less than 80 years on average, the life expectancy for someone who is currently 65 is about 85, according to the Social Security Administration’s actuarial data, give or take a year depending on your gender. If you’re 75, then your life expectancy averages into the late 80’s.
The overall life expectancy includes children who die young from health problems, teenagers that die from reckless driving, etc. Once you’ve already gotten to 65, you’re expected on average to hit 20 more years, and potentially far more than that if you live a healthy lifestyle.
Becoming too conservative with your investments is a risk of its own, because if your rate of return is too low, and you’re withdrawing 4% or more from it every year, you may run out of money. That’s why it’s important to adjust your withdraw amount relative to your expected rate of return, and try to plan your withdraw levels for it to last forever since you don’t know how many decades you may live after retirement.
3 Wealth-Building Examples: How to Get Rich
One of the most interesting things to me in my research is the type of words people use when they approach building wealth.
For example, far more people search Google for variants of “how to get rich” compared to “how to build wealth” or “how to become wealthy”. You would think that they’d be similar, but people usually phrase it the first way.
I think that’s because of the mind-set that many people have. “Getting rich” has short-term intimations, while “building wealth” sounds like something your grandfather did back in the day over blood, sweat, and tears.
Realistically, building durable wealth takes time. You can accelerate that process in multiple ways and build wealth quite fast, but it’s always critical to have a long-term outlook. People that make fast money and get rich swiftly often lose it just as fast as they make it.
For example, if you start an internet business and generate piles of cash flow, throw it at some sports cars and various gadgets, you could find yourself suddenly screwed if something in the marketplace changes, like your Google traffic, or advertising rates, or whatever the case may be.
No matter what you’re earning, the key is to put your earned money into reliable investments, like index funds, dividend-paying stocks, cash-producing real estate, and more.
And if you’re not earning a ton of money, you can still build serious wealth over time, and get rich eventually. This section will outline various fast and slow, modest and aggressive, ways you can build wealth.
Roth IRA example:
The current limit for a Roth IRA is 6,000 for people under 50. You get to put in after-tax money, and from that point on it’s never taxed again. If you make over 122,000 as a single-filer or 193,000 as a married couple, then you’ll be restricted from using this investment vehicle.
What rate of returns should you count on for an account like this?
John Bogle, the founder of Vanguard and inventor of the index fund, predicts based on current high market valuations that stocks will return about 5% per year over the next decade. McKinsey & Company forecasts 4-6% stock returns pear year over the next 20 years.
It’s impossible to say for sure how fast your equity investments will grow, but 130 years of historical price-to-earnings data from Dr. Robert Shiller agree with their estimates; high market valuations like today have resulted in poor forward-returns over the next 10-20 years at every point in history.
401(k) and Thrift Savings Plan (TSP) example:
With these types of retirement accounts, you can invest up to 19,000 and potentially also get an employer match, with no restrictions based on income. The 401(k) is commonly used by private employers while the TSP is the main investment vehicle for federal civilian and military personnel.
The money you put in is pre-tax, and is taxed when you withdraw from it. (Although nowadays, they also have Roth 401(k)s and Roth TSPs).
If the employer throws in another 5% of your salary, then even better. That’s what you get with the TSP, while 401(k) contribution matching will vary by employer.
Entrepreneurship example:
Suppose you took 100k, invested it to start your own business, and then managed to grow the equity of that business by 15% per year.
In reality, you’d also be receiving a salary from that business at some point, which you could be investing. And you might have business partners or early investors that affect your ownership percentage of it.
But generally speaking, to achieve very high rates of return over long periods of time, entrepreneurship in some capacity is the most reliable route, even if it is somewhat high risk.

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