Portfolio 10

Retiring Early Using Indexing Strategies

Portfolio 10

On a recent rainy day perfect for book browsing, I found myself cruising the investing and personal finance section of my favorite super-sized 50,000-title Barnes and Noble. Years ago, I developed a rule to help my search for good investment books: ignore anything with the phrases "How To…" or "Million Dollars" in the title. From painful experience, I learned that book titles like How To Make $1,000,000 Day Trading or Building A Million Dollar Stock Portfolio In 3 Months lack common sense and are hazardous to your wealth.

However, on my recent bookstore stroll, I spotted a paperback book (not as expensive as the hardbacks) with the title How To Retire Early & Live Well With Less Than A Million Dollars. I bought the book and read it because the title contained the phrase "Less Than A Million Dollars". The title seemed more humble, more realistic, less full of exaggeration than the nearby hardback titles blaring "Make A Million Dollars…" and "How to Get Rich…."

I discovered the book wasn't written specifically for index fund investors, but it contained solid arguments supporting index-investing strategies.

Gillette Edmunds, the author, retired at an early age in 1981 with $500,000. He decided to invest this nest egg and support his family with the profits and earnings from his investments. The book is a practical instruction manual on how to retire early with a small nest egg.

Although he doesn't stress indexing in the book, Edmunds favors many strategies used by index fund investors to grow portfolios.

For example, Edmunds emphasizes finding "dirt cheap methods" of implementing investment strategies. Throughout the book, he worries about high commissions and fees while buying or selling many different types of investments. This fretting over commissions (over time, they take a big chunk out of investment profits) leads him to favor index funds when buying or selling stocks. He writes, "Most investment geniuses become average investors over twenty to fifty year periods," - a powerful argument in favor of index fund investing.

Another bit of Edmunds wisdom: "You do not need to outperform any market to live off your assets. With the proper asset allocation, all you need is to stay even with the markets." Edmunds makes a strong case that it is very difficult to beat any market. So if you can't beat 'em - join 'em. Don't worry about guessing which individual heavy-commission investment is going to outperform the market next year. Buy the market; buy the index that consistently tracks the performance of the market year after year after year with very low commissions and fees. Over the long haul, the index fund investor will come out ahead when compared to the investor trying to pick individual investments that will beat the market.

To implement this strategy, Edmunds suggests an unusual asset allocation. He reports in 1996 the typical U.S. investor split his investments 40% U.S. stocks, 30% U.S. bonds and 30% cash. He feels the 40/30/30 allocation is a prescription for disaster. When U.S. stocks do poorly, U.S. bonds likewise lose value, and cash investments don't generate enough return to keep up with inflation. Edmunds recommends allocating investments between 3 to 5 non-correlated asset classes (he says holding less than three asset classes is hazardous). He argues that U.S. stocks are overvalued and suggests U.S. stocks and bonds should make up one-third or less of any investment portfolio. He suggests an investor hold two-thirds or more of an investment portfolio in 2 or 3 of the asset classes listed below (in addition to the one-third or less of the portfolio in U.S. stocks and bonds):

  • Foreign stocks
  • Emerging market stocks
  • Foreign bonds
  • U.S. real estate
  • U. S. oil and gas

 

In order to spread risk over each of these asset classes, Edmunds suggests considering foreign stock and bond funds plus foreign emerging market funds. Although volatile, the performance of these funds does not blindly follow U.S. stocks and bonds and these asset classes are cheap compared to U.S. stocks and bonds. In some cases - like emerging markets - good indexes (or index funds) do not exist for the recommended asset class, but there are index funds available for asset classes like foreign stocks.

Edmunds recommends investors buy several individual properties for the U.S. real estate portion of their portfolio. However, many investors don't have the knowledge or time to manage real estate investments. A more practical way for investors to purchase real estate, Edmunds says , is through a Real Estate Investment Trust (REIT). He says REIT's "tend to be steady, solid, boring long-term investments" that typically return 10% per year. According to Edmunds, ownership of individual real estate properties or REIT's is an important component of any investment portfolio.

And finally, Edmunds feels U.S. oil and gas companies and properties will get more and more expensive in future years. Because most people can't afford to buy oil or gas wells, sector funds in the oil and natural gas industries can round out the non-correlated-with-U.S.-stock-and-bond portion of an investor's portfolio.

Author Gillette Edmunds presents considerable "food for thought" in How To Retire Early & Live Well With Less Than A Million Dollars. His goal is to guide the reader toward retirement with a nest egg of $500,000. His advice: invest in 3-5 asset classes, don't depend too much on U.S. stocks and bonds, and use index funds to help spread risk across each asset class. Hard to ignore advice from a retired investor who has successfully lived off his $500,000 portfolio for nearly 20 years.

 

In his book How To Retire Early & Live Well With Less Than A Million Dollars, author Gillette Edmunds discusses several index investing strategies. Contributing writer Larry Putnam used several ideas from the book to construct this quiz. See how many of the questions you can answer correctly. Answers provided at bottom of page.

1. How To Retire Early & Live Well is about:

(A) Retiring early using day-trading profits
(B) Retiring early and living off a $500,000 nest egg
(C) Retiring early after accumulating $2,000,000
(D) 10 Steps to successful investing

2. According to Gillette Edmunds, in 1996 the typical U.S. investor had an investment allocation of what percentage of U.S. stocks/U. S. bonds/cash?

(A) 80/10/10
(B) 60/30/10
(C) 50/10/40
(D) 40/30/30

3. Which asset class or classes closely follow the rate of return on U.S. stocks?

(A) U. S. real estate
(B) Foreign stocks
(C) Foreign bonds
(D) All of the above
(E) None of the above

4. Over the next 20 years, Gillette Edmunds, the author of How To Retire Early & Live Well believes:

(A) Prices for U. S. bonds will beat inflation
(B) Prices of U. S. stocks will increase faster than foreign stocks
(C) Prices for Real Estate Investment Trust (REIT) shares will increase faster than U. S. stock prices
(D) Oil and gas sector funds will decrease in value

5. Which of the following index-investing characteristics does Gillette Edmunds favor in his book, How To Retire Early & Live Well?

(A) Paying high commissions for mutual fund investments
(B) Buying "momentum" stocks that are moving higher in price
(C) Buying a sector fund that is not correlated with U.S. stock prices
(D) Using "technical analysis" to select the best stocks to buy


6. Which asset class does Gillette Edmunds feel will return an average of 14% over the next 20 years?

(A) emerging markets
(B) U.S. stocks
(C) U.S. bonds
(D) U.S. real estate

7. The author believes investors should do the following:

(A) beat the market
(B) time the market
(C) buy the market

8. How To Retire Early & Live Well:

(A) guarantees the reader will be able to retire early by following the author's ideas
(B) states that an investor must have a nest egg of $1,000,000 before retiring
(C) suggests investors diversify into non-U.S.-stock-and-bond correlated asset classes
(D) requires you set up an electronic trading account with a broker

Answers

1. B is the correct answer. Gillette Edmunds retired nearly 20 years ago and has successfully lived off his $500,000 nest egg ever since.

2. D is the correct answer. Edmunds feels U.S. stocks and bonds are currently overvalued and the average investor gets a puny return on the 30% sitting in cash accounts such as checking, savings, and money market funds.

3. E is the correct answer. None of these asset classes, including U.S. real estate, closely follows the return on U.S. stocks. Gillette Edmunds argues investors should hold no more than one-third of their investments in U.S. stocks and bonds and two-thirds or more of their investments in asset classes like U.S. real estate and foreign stocks and bonds because they do not blindly follow U.S. stocks and bonds.

4. C is the correct answer. Edmunds also likes REIT's as investments, even though they are "boring" because prices do not correlate with U.S. stocks and bonds.

5. C is the correct answer. The book suggests purchasing oil and gas sector funds to diversify an investment portfolio.

6. A is the correct answer. Although volatile, Edmunds feels emerging market stocks will outperform all other asset classes over the next 20 years returning 14% per year, on average.

7. C is the correct answer. The author suggests index funds allow an investor to diversify investments broadly an entire market or sector. Purchasing a REIT or oil and gas sector fund allows the investor to diversify broadly across market sectors.

8. C is the correct answer. Gillette Edmunds is trying to get investors to think differently - that there is a strong possibility U.S. stocks and bonds will not have very high rates of return over the next 20 years. He urges investors not to rely so heavily on U.S. bonds and equities and to consider buying other asset classes to spread their risk.