If you are close to retiring early or have already jumped the fence, you face a series of financial problems:
Suddenly the money you have is all you will ever have and if you'll lose some or all of it, you will have to get back to work. And getting back to work will be hard after having been out of your job for a long time. Thus, when you start to think about investing, you might be overly concerned with risks: Putting all your money into stocks is risky, but putting it into the wrong apartment house can drive you into bankruptcy, too. Banks themselves could go belly up, and sometimes even entire states… So what should you do?
And as soon as you really have retired, you will notice that your life - lifestyle, interests, friends, passions - is changing faster and more than you would have thought. You have more spare time, you have different thoughts, fears and wishes than most of the (still working) people around you, maybe you'll travel more than before and learn to view the world from different angles. Retiring early is very different from just retiring at the usual age. It throws you out of the system in more than one respect.
Before you had stopped working, you could not know how long days can be. You will necessarily fill them with new activities and some of them will cost you money. Did you foresee that? If not, how constrained will you feel?
You'll need to conserve greater flexibility compared to ordinary retirees. If you buy an apartment house it would be better to continue to live nearby. But how can you know where you'd like to live 20 years from now? You might even want to live abroad, at least for some time. (Which is an important consideration; you'll need to think about currencies…)
It is very hard for a 40 year old to think about the next 40 years. And probably early retirees do not even want to know too much about the future. If they had preferred stability, they could have continued to work, staying inside of the usual system.
Thus, when it comes to building a portfolio suitable for early retirees, consideration #1 must be flexibility.
Consideration #2 is safety. As early retirees rely more on their own capital and less on regular pensions, the conservation of their capital is highly important, if they want to avoid getting back to work some day.
On the other hand, a 40 year old can digest more volatility of returns than a 65 year old. So part of the overall capital can be allocated to opportunistic investments that might need a few years to play out.
In other words, we need a smart mix of opportunity and stability.
My personal decision was for a mix of cash/bonds and stocks. No real estate (besides the house I live in), no investment funds, no index funds.
Considering the possibility that one day I might want to live in a different country and in general I intend to travel a lot, I need to be sure that my money will maintain its purchasing power not only in my home country but even abroad. Hence I invest in a mix of international stocks, while overweighting my home country's stocks.
Generally speaking, the cash/bond component should be large enough to cover about 3-6 years of expenses. The stock component's dividend yield should cover at least half of your yearly expenses. This means that you'll have to take half of your expenses either from the cash pile or from realized stock gains. So the cash/bond component acts like a buffer: Sometimes you use some of it to cover expenses or to profit from exceptional opportunities the stock market may offer and every now and then you fill it up again with gains from your stock investments and dividends.
However, the buffer should never ever go below 3 years of expenses. Just like the stock component, I would split it in two segments: Flexibility/opportunity and Safety/stability.
In the cash/bond part, flexibility means cash. I would recommend holding at least 2-3 years of expenses as cash in a few different banks. The opportunity segment is allocated to bonds with rather short durations. With this part one can play around a bit, but I would never chase for yield. Always remember the safety imperative.
The stock component mirrors the same basic principles: A bit more than half of it should be allocated to stable income stocks and the rest can be invested more opportunistically.
How much money do you need to retire? Don't do it, if you need to beat the market in order to be able to cover your expenses. You should do fine with less than average returns. Hence I would say that your overall capital should cover about 25 times your annual expenses, so that a 4% return after taxes and inflation is all that you need to achieve.
When choosing your stocks, try to keep in mind the flexibility & safety concept even for the opportunity segment. As you'll need inflation protected income for the rest of your life, focus on pricing power. There are stocks that have some "antifragile" characteristics. "Antifragile" is a concept developed by Nassim Taleb and characterizes objects that actually benefit from being subjected to stress. Not only do they resist, they even benefit. Applied to businesses, this means that there are companies that can profit from recessions, stock market panics or general disorder. As retirees basically depend more on a stable economic environment than other people, investing in antifragile businesses can be a smart way to manage this problem. In good times they provide stability and bad times bring about nice opportunities.
Hence for the opportunity segment I would choose stocks like Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) or Jardine Matheson (OTCPK:JMHLY), i.e. robust conglomerates that are managed by value investors that will likely profit from market dislocations.
The following table from Berkshire's annual report shows the defensive character of Warren Buffett's holding:
Only in two years there was a small loss in book value per share and in both years Berkshire still did much better than the S&P 500.
Jardine Matheson grew book value and earnings throughout the recession:
Another possible series of stocks includes all companies that run massive buyback programs and/or have demonstrated in the past that they will accelerate repurchases when prices go down. Examples are: DirecTV (DTV), Deere (NYSE:DE), IBM (NYSE:IBM). By investing in these businesses, market dislocations will cause your part of the pie to increase without spending new capital. With EPS increasing right through the great recession and its financial segment growing earnings even in 2008/9 one could also consider IBM to be in the antifragile camp as well.
The stability component of the stock portfolio can be invested in the usual suspects: Coca-Cola (NYSE:KO), Nestlé (OTCPK:NSRGY), Wal-Mart (NYSE:WMT), Sanofi (NYSE:SNY), Johnson & Johnson (NYSE:JNJ) and other income stocks. If you are a very enterprising investor, you can mix the opportunity and stability parts of the stock portfolio by investing in smaller companies with superior business models that have a good chance to deliver nicely growing dividends in the future. Recently I have written about some of them: Admiral plc (OTCPK:AMIGF), United-Guardian (NASDAQ:UG), Fuchs Petrolub (OTC:FUPEF), BBA Aviation (OTC:BBAVF). In many cases these companies' profitability is protected by the small size of their niche markets which they dominate. Most have good pricing power, i.e. inflation should not concern their shareholders too much.
Admiral plc is a British car insurer with very low cost ratios and, through special reinsurance arrangements, extremely low capital requirements. This provides a competitive advantage to the company and allows high payouts to shareholders.
United-Guardian produces and sells cosmetic ingredients and other personal care products, pharmaceuticals, medical and health care products and proprietary specialty industrial products. The company can be characterized as a "supernichist". A supernichist's market is so small that it becomes unattractive for competitors (besides the fact that several patents protect the product). This built-in moat also gives United-Guardian good pricing power.
Fuchs Petrolub AG is a German lubricant manufacturer that operates very close to its 100,000+ customers, which it mostly serves directly. Frequently products are tailored to clients' specific needs, which makes these products hard to substitute and provides above average pricing power.
BBA Aviation plc is a provider of aviation services and aftermarket support to operators of business and general aviation, military and commercial aircraft. In all its segments it operates in the position of a monopolist or inside an oligopoly, which gives the company excellent pricing power. The Aftermarket Services segment typically does well during economic downturns, as businesses tend to overhaul older aircraft to keep them in service for a longer time, while the low asset intensity and flexible cost base of the Flight Support segment helps to moderate the impact of recessions.
If you just have the minimum capital and still want to retire early, try to be patient. Choose the right stocks for you, wait for the right prices to buy, build your portfolio and don't try to speed things up. I know, it is tough. You could leverage your returns a bit and maybe double your capital in little time and then feel safer. But remember: If you lose a larger part of your capital, you will need to work again. And over the long run, good stocks will go up anyway. Time is the friend of the good business, as Warren Buffett says. If you don't believe that over the long run high quality stocks will do fine, you should not retire and invest your money in the stock market in the first place. Probably you will feel better with other investments like real estate, or maybe consider keeping on working at least for a little while.
Disclosure: I am long OTCPK:AMIGF, BRK.B, DE, DTV, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.