Most finance books use the word retirement in their title. “How to Retire”, “Retire in Style”, or some variation thereof. I have intentionally not used that word in my title, and I haven’t used it a ton in the book. That’s because my experience with advising people rarely centers around a specific desire to retire.
Most Americans are not looking to just wake up one day and quit working. I find that most people who “retire” tend to continue working, if nothing more than part time. There is something cosmic about work. It even shows up in the Garden of Eden as Adam and Eve both worked. It’s good for you, and most people who give up on work permanently tend to decline, physically and mentally.
At the very least, older folks tend to manage their investments closely, and follow what they invest in very closely. I think that’s very important as it tends to keep people healthy, engaged, and mentally sharp.
For those reasons, I tend to use the word “liquid” instead of “retirement”. What I mean by that phrase is one’s income from investments produces enough cash to meet one’s living expenses. At that point, a person can do whatever they want, and any income they generate can be used to purchase more assets that will produce even more income.
The first step to thinking about how to become liquid is understanding the difference between growth and income. The relationship between the two must be taken into account, and your investment philosophy can and will change over time. Let’s explore these two.
Growth is the increase in the price of an investment, should someone buy that asset from you. If you buy a stock for $10, and it increases in value to $20, you’ve gotten growth of $10. Growth is a long term benefit, and you shouldn’t count on any investment to grow over a short time frame. For instance, I can’t tell you what an S&P 500 index fund will do next year. However, I am pretty confident that it will grow 8% to 10% over the course of the next 20 years. Maybe a little more, hopefully not a little less, but it should be in that range.
Income is the cash an investment produces for you on an annual basis. When I rent out a house to a tenant, I make perhaps $200 per month, after my mortgage and all expenses are paid. If I divide the cash that goes in my pocket by the value of that asset, I get my income yield. Different assets have wildly different income yields (and growth rates). Usually, rental properties will produce between 6% and 10% of income. I say usually because there’s certain rentals that will produce less, generally very expensive properties in great neighborhoods. Sometimes properties have an even high yield, generally for “value-add” properties. Stocks produce dividends, bonds produce a coupon, etc.
When you add your growth rate and income rate together, you get your total return on an asset. For instance, you might assume a S&P 500 index fund would earn 8% growth and a 2% dividend for a 10% total return. Maybe a rental property earns a 6% income yield and is in an area where real estate typically grows 6%, for a 12% total return.
At all points in your life, you need to be concerned with your total return. For instance, since municipal bonds don’t grow (at the end of the term you get back your principal), you just get your income yield, and the total return is pretty low. Therefore I don’t like the idea of investing in bonds.
That being said, you can’t ultimately live off growth, without having to sell off assets. If you do that, you won’t have the asset any more, and it won’t produce any more income for you. {Insert cliche about killing the goose that laid the golden egg here}. You need income to produce cash for you, and at different points of your life, this need for cash will be different.
When you’re young, and still working, it’s fine to invest solely in assets that produce growth. You don’t need cash, and you’re not going to need to use the cash that your investments produce. In fact, I often find that the income produced by my investments, particularly real estate, gets left in cash, doing nothing for me for months at a time. This is particularly true if I forget to move cash over into my brokerage account and buy stocks.
I’ve also found that my real estate that produces less income tends to grow faster. For instance, my real estate in Austin, TX doesn’t produce as high of a yield as my rental in Little Rock, AR. However, it does grow significantly faster. At my age, 42, I’d rather have the growth.
However, at some point in your life, you’ll need your investments to produce cash. How much depends on your lifestyle needs. Hopefully you’ve saved enough where the income from your rentals and dividends from your stocks will pay for your lifestyle. However, it may be necessary to exchange more growth oriented assets for income assets in order to meet your living needs. With real estate, this is pretty easy, because you can just 1031 exchange into a higher income piece of real estate. With stocks, you may have to sell in order to buy real estate to accomplish the same thing.
It’s important to understand growth vs. income, and how that affects your portfolio. You’ll need to understand how much income you’ll need to meet your living expenses, and if your current portfolio will meet your needs at some point, or if you’ll ultimately need to convert assets into a higher income producing asset. What you don’t need to do is sell growth assets to just buy bonds. You can get the same income yield with assets that also grow, particularly if you invest in real estate.