Genesis, it started on the back of an envelope

Our FIRE journey started with some basic assumptions and calculations on the back on an envelope. Then our project took shape, and things felt naturally into place over time.

Background story

Before I discovered the concept of FIRE, I was an ambitious person. I was always taking on new responsibilities which involved many travels primarily to the USA and across Asia. I was spending almost half of my time on the road or on a flight. My travels to the USA were very taxing because of the 12hrs time zone difference with Hong Kong.

Can you imagine sleeping during the day, and working at night? On average, it took me about 2 days for the jet lag to kick in. I could spend the first 48hrs with a normal local schedule but after that I would simply hit a wall and crash. I was aware of how my body adapted. With some experience, I became very acute and receptive to my body. I would work in my hotel room till I would feel sleepy, and within two minutes I would be in bed sleeping. As soon as I woke up, either after a one-hour nap or a 6 hours night sleep, I would just resume work till the next sleeping episode or till my alarm went off to start my day and the long list of meetings.

EUREKA !

With long hours of travels, my phone would usually download many emails, notifications and messages as soon as I landed. Having many pop-ups and unread were not new to me, except that for a trip to New York in October 2016 which was particularly special. It marked the genesis of our FIRE journey. By that point, Mama FC has been spending some time researching alternative ways to live the lives we were living, and ways to earn passive income so we could have better control of our time.

Indeed, as many of us who started a FIRE journey, we were unsatisfied with something. Something bugged us, created a void in us, burned our morale, or tired our bodies. Be it our professional situations, or our sense of being trapped and having no way out. That was a public holiday when Mama FC was reading up on news, and one Bloomberg article about early retirement caught her eyes. A spark appeared, an endless list of possibilities followed and our firecracker’s journey started right there!

Back of which envelope?

Mama FC went into the details and made a simulation at the back of an envelope. Well, close. It was the cover sheet of the Economist. Never mind, I digressed.  Here is what she sent me, a rough first iteration of our Fire simulation that eventually changed our lives.

You may try to make some sense out of it but everyone’s finances is different. For us, there are several currencies involved, and assumptions on mortgages etc. Mama FC had to guide me through the logic when I was finally settled in an airport taxi. She is a number person, and I only asked her one question- “Does this add-up?”. I didn’t need more to agree and go for it, right away.

It is after all, a math question…

So here we go, no fancy Excel spreadsheet with sensitivity analysis or online calculator (though all came later). This piece of paper had all we needed: simple calculations with a simplified Action Plan on the top right. We agreed that we will figure out the rest along the way. The excitement was at its climax. We felt like we found a treasure, a key to break free of the system that has slowly but surely swallowed us.

I believe most, if not all, people can begin their own version of FIRE journey now, not tomorrow, next week or next month. When you start from scratch, it is actually easy to make it simple. However, you will soon realize that sometimes it is in our nature to make things more complex: adding new assumptions, new scenarios, new investment strategies. 

Simplicity is the ultimate sophistication. Well said, Leonardo.

If you are intrigued, here is the math fundamental behind FIRE

The concept of FIRE is to reach Financial Independence and Retire Early. You can read it the relationship as this: If we want to retire early, then we need to be financially independent. Note though, the relationship is not a vice-versa one, which I will get back to another time.

To be financially independent means we do not again need to trade our limited resources, aka time, for things that sustain our lives and needs. How do we do that? We need to accumulate enough assets in our portfolio which are either appreciating in value that we can sell later, such as land which is a limited resource, or generating a yield that provides enough passive income continuously, such as a stock that distributes part of its income to its shareholders in a form of dividend or simply rental income. The amount of all assets we need to accumulate is our FI number.

Before reaching FI, we are in the first period called the accumulation phase because we are supposed to accumulate assets. After FI, we are in the second period called the distribution phase. In this phase, we are using the fruits of our assets to provide us with sufficient financial means to support our lifestyle.

How to calculate my FIRE number?

It is quite simple. Take your total annual expenses number (housing, food, transportation, taxes, children’s education, and anything that is essential to you) and multiply it by 33 or 25. Choose 33 if you are a conservative type, 25 if you are willing to be more flexible down the road during bad times. The resulting number is your FIRE number. So the higher the multiplier you choose, the bigger the resulting FIRE number. Thus the safer it is for FI to work out because you are in effect setting a higher saving goal for yourself.

Why 33 or 25? Are they magic numbers? It looks fancy, but it is simply the inverse of your chosen Safe Withdrawal Rate (SWR), which is the percentage you can withdraw from your portfolio ‘safely’ per year without dipping into your accumulated sum, over a long run.  

Is 3% the new 4%?

1/25 = 4% corresponds to the 4% Rule that you might have heard of before. A 4% SWR worked in the past, and will likely work again. However some failures did occur in the past, especially in an environment where assets are expensive. So what do I mean by failure ? Simply put, it means that you will likely run out of money before running out of breath.

To the same token, 1/33 = roughly 3% SWR corresponds to a more conservative withdrawal rate without failure (so far). And honestly, I would sleep much better that way. You might think that there is only 1% difference between 3% and 4%, so it is negligible. Not at all. Though it is 1% of your nested egg, it is a 33% difference in terms of how much you can withdraw and spend. So there is a significant difference between 3% and 4%.

And keep in mind, this is just a rough estimation. So many events can happen in life, good or bad. Some factors are somewhat within your control (having children, their education, healthcare, the place to live, your lifestyle). Whereas others are not (inflation, taxes, market returns, accidents). To me, these 25 and 33 numbers represent different milestones. The 25x transforms the FIRE plan into reality, the 33x offers some peace of mind.

How much should my investment return be?

Shouldn’t my investment return match my SWR and I would be good to go? In theory yes. Yet we need to be aware of one thing that could derail our path while being extremely hard to predict- Inflation. 

Inflation does not directly affect the SWR calculation but it affects our life by reducing what we can purchase with the same money allowed by the same SWR. Most of us in the developed economies have been living for the past three decades in a mild inflation environment (1-2% range), which is barely noticeable. However, more recently, inflation has spiked in many countries post-Covid and amid the war in Ukraine, eroding significantly the purchasing power of the money that we have accumulated. 

Sequence of Return Risk (SRR)

Another critical component of success for early retirees is sequence-of-return risk (SRR), or sequence risk. You can think of it as the sequence of which any ups and downs of the financial market take place. Is it up-up-down, down-up-up or up-down-up? Even if the average percentage change is the same, the sequence of them happening can make a huge difference.

Although markets generally go up over time, markets experience ups and downs in one direction for some periods that can extend to 5 to 10 years. A market downturn is fantastic during accumulation phase as you are buying more assets at a discount. However, a prolonged market downturn has a negative effect if you are in distribution phase, especially if it happens at the beginning of your retirement. Indeed, your portfolio can shrink to a point where you may not recover before the next bull market. Thus it is very important to have a strategy to mitigate the effects of SRR. Although it sounds far away if you are beginning your FIRE journey, you will have time to look into this in more details later on. I shall provide more information in a future post.

The spectrum of potential returns

Considering these factors, it is important that the return on investment exceeds your withdrawal rate. The yield (or return) of your portfolio can widely fluctuate depending on the assets present in your portfolio. Without going into what constitutes a portfolio (see post “What is the best way to structure your portfolio”), let me share with you how I view the spectrum of potential returns:

-1,000,000% return

meaning you owe more money that you actually invested. It can happen if you make investment without properly understanding the underlying risks behind. For example, with leveraged products, you are borrowing money to finance your investment. A home mortgage is a good investment if you can repay your loan payments. It acts as a multiplier of return yet it is also a double-edged sword. It magnifies your gains if you are financially savvy or lucky, but it also magnifies your losses if the market is not in favour.

I always like the saying that “The market can stay irrational longer than you can remain solvent”. Similarly, if you are shorting an asset, meaning selling it without owning it because you are betting on the asset value to go down, your exposure becomes almost unlimited. Indeed you will need to buy this asset on the settlement date of your short position, whatever the price of this asset will be. And of course, you can combine both by leveraging shorts. Unless you are triply sure what you are doing, and aware that you may lose much more than you actually invested, please rethink before trying it.

-100% return

Meaning you lose everything you have. It is a better outcome than above, but it will take you a long time to reach FIRE if you have to restart from ground zero. To avoid this, please stay away from the Get-Rich-Quick fantastic opportunities that you would likely find on Facebook, Youtube, your mailbox or investment advice from your new ‘friend’. Another saying, “If it is too good to be true, it probably is”.

0-2% return

In a bear market environment, it would be a fantastic performance. However, in most conditions, it won’t be enough to sustain your lifestyle, unless you have a large amount of money and just plan to live off by depleting your capital, i.e. the FIRE number you have achieved – which is indeed an option for some if you do not plan to leave a legacy.

2-8% return

It might seem meagre considering all the stories of people making millions in no time. Actually, this range represents the most common, or at least most commonly expected, return that investors are targeting. The higher the return, the higher the risks and the volatility (ups and downs). With this return expectation, there is usually no capital protection, nor guaranteed yield.

If you are into corporate bonds, you may find some corporate high yield bonds with 8% yield. However, it may come with a much higher risk of default in debt repayment, be it in the periodic coupon payment, or the principal. It happened to us once when we were tempted to buy a corporate bond that gives 8-9% yield. Though the amount was small, lessons were learned. High yield bond sounds nice, no? A bond that gives high yield. It gives out higher yield because it is usually a sign it cannot borrow elsewhere with cheaper rates. You probably have heard of its moniker, corporate junk bond, which is definitely a form of marketing rebranding.

10-30% return

It looks very attractive and must include some non-trivial risks. Any opportunity offering a return on investment in that range without risk is a scam. I would say, try to stay away from it. You may be in need of fast money, and someone promised it to you. Again, if you are sure of what the risks are, don’t miss the opportunities. Else, you will likely be disappointed and will likely lose whatever you put in, which brings you back to the -100% return category.

Above 30% return

You enter the territory of gambling odds or pure scams. If the sum you invested is just play-money which you are ready to lose for the experience, go for it. Else, stay away.

Do you have your envelope, your FIRE number estimate, and how much you are aiming for your investment return? Everyone follows a different journey but I did learn a lot by reading posts of other bloggers. My next posts aim to help you start your own journey, and more specifically:

• How to save money and for how long?
• What is the best way to structure your portfolio? 
• How to choose a good ETF?

How did your journey start? Did you discover it by browsing websites, or by discussing it with a friend already on the journey? Do share your story here, and the stories around you. Thank you.

Image credit: pixabay.com