Welcome back from Thanksgiving break and Happy Monday! Today, the Handy Millennial would like to tell you a story. No, its not the Thanksgiving story, or the story of retirement. We already did those!
Today the Handy Millennial would like to tell you the story of three different incomes and what would happen in an extreme investment scenario: investing 100% of your income, or more poetically, what would happen if you invest like you have no expenses.
The utility of extreme examples
Now you may think to yourself that investing 100% of your income is absurd, and it is! But this is exactly the point. When we take an idea to its logical extreme, we can observe its merits, its pitfalls, and how we might go astray chasing the idea. You see, my dear reader, as people we are fallible, and one of our chief fallacies is that once we fall in love with an idea, we become more and more extreme about it. Thus it is useful to consider what would happen in the extreme.
Now as I stated, today’s extreme idea is investing 100% of your income. But that’s pretty vague, so let’s get specific.
- We choose an income, and invest 100% of the pre-tax amount.
- Each year of investing the income is incremented by the rate of inflation, just like the inflation adjustments you might receive at work.
- We invest for 40 years because the average college graduate joins the workforce at 22 and the average American leaves the workforce at 62.
- We experiment with 3 incomes, which happen to be the current (2017) tax bracket boundaries: $9,325, $37,950, and $91,900.
- For each case study, we begin with $1,000.
- To make things super easy, we will invest in the US Market only – 100% stock allocation.
- For each case study, we use a Monte-Carlo Simulator which uses historical stock market data.
Monte Carlo Simulation
Monte Carlo Simulator is a mathematical tool used to predict uncertain but mathematical events. So for example, we can use the Monte Carlo Simulator to predict casino winnings. As a side note, Monte Carlo is a major gambling city in Europe just like Las Vegas is a major gambling city in the US. Most mathematical methods of predicting uncertain events were actually invented to predict odds while gambling. Pretty cool huh?
This is the real Monte Carlo. Beautiful, isn’t it?
To perform its predictions, the Monte Carlo Simulator chooses random values where needed and then simulates the outcome. So for example, when simulating investing returns for yearly investments, as we are about to do, the simulator chooses an investment return and an inflation value, then calculates the return at the end of the year. This is repeated each year for 40 years (see above) and then repeated in total 1000 times.
The reason we choose the numbers randomly and perform the experiments thousands of times is because of something called the “Law of Large Numbers.” This is a mathematical law which tells us that if we were to choose an unpredictable (random) number thousands of times, the set of outcomes will tend to certain distribution which inherently describes our random number. As an example, this as selecting numbers from a distribution described by the bell curve. So in effect, the Law of Large Numbers tells us that such random choices will tend to be predictable in aggregate as the number of choices we made grows to infinity.
The key here is how do we choose random parameters? Well, we use past market performance to learn what these parameters might look like. In this case, we learn about market return and inflation.
Now you might say that this isn’t fair. Because, well, you do not believe that the market will perform as well in the future. However, the Handy Millennial challenges you to consider the following:
All compound interest/ investment articles choose a single return rate and a single inflation rate – usually the mean. The Monte Carlo Simulator will look at all market returns, including great periods for investing such as the Great Depression and the inflationary 1970s. You are free to look at its top return choices (the market returns that beat 90% of the cases) or its bottom return choices (market returns that were beat by 90% of the cases). This is your choice, but the Handy Millennial is betting you will look at the FANTASTIC outcomes :).
Now that you know a little bit about the method, we will use our trusty tool PortfolioVisualizer.com to run our experiments. Feel free to put in your own numbers and enjoy!
Case study I – making $9,325
In the first case study, we are all PhD graduate students who earn $9,325 per year. We start with $1,000 saved, and we invest 100% of our income for 40 years. (Note here that we stayed in graduate school for 40 years – a real doom’s day scenario for every PhD student.)
Here is what we find:
And the percentiles correspond to the lowest 10%, lowest 25%, etc. etc. on this bar chart:
Now these charts are eye popping to say the least! The absolute lowest simulated return is $1,300,000. That’s right, feel free to read that again – that’s a 7 figure number. I did not adjust for inflation because I did not want to mix the discussion of purchasing power into these experiments. However, note that just obtaining median performance (half of the experiments are better, half are worse), our poor graduate student would end up with $7,488,132.
Now if you’ve followed along with the Financial Independence posts in the FIRE community, you would realize that this means that that our lowly graduate student can now withdraw $300,000 for life and never exhaust his stash! Amazing.
Before the Handy Millennial gets too deep into what this means, let’s look at our next 2 experiments.
Case study II – making $37,950
In the second case study we have a median US couple. What does this mean? Well the median US couple earns $57,230 per year. Here we are choosing the 15% tax bracket income. So for example, let’s say this couple actually paid their taxes and rent but nothing else. In essence, let’s squint really hard and pretend that they are investing 100% of their income. (They are eating Ramen and sitting alone in their living room like the poor misers everyone thinks that the FIRE community is.)
What would they have?
And the bar chart showing you all the possible outcomes is:
Holly Smokes! I need a smoke break… a coffee break… anything really. Is this possible or is the Handy Millennial pulling my leg?
No my dear reader, there are no shenanigans here. The lowest possible outcome is $5,000,000. This means that the lowest possible 4% Safe Withdrawal is $200,000 per year! It’s worth repeating… PER YEAR!!!
Ok ok, let’s get to case study #3 because we can feel the temperature rising here.
Case study II – making $91,900
Now here we have your average graduate school educated professional in their first year after school. Side note: Stay in school kids… don’t read too many articles about Bill Gates, or Buffet, because they are already billionaires. Education matters, especially in the US.
Now our young professional for some reason decided to skip the BMW and the 12th floor loft in center city and is instead driving his old beater and living outside the city. He therefore gets to invest his entire salary of $91,900 per year. Let’s see what happens.
And the individual experiments summarized in this plot are:
Wow! So the lowest possible outcome is $15,000,000. That’s $600,000 for life at a 4% withdrawal!
What does this mean for you?
Well my dear reader, it means that you are already rich. Scratch that, you are wealthy! Because what this chart shows you is that over time, as you trade your time for money, and invest that money into places that let allow it to grow, you will end up very, very wealthy.
What’s that? You can’t imagine how $9,000 per year could become $1,300,000 or $5,200,000? Well why the heck not?
Reason #1: It’s just math and I hate math.
Is it because it’s math? If so the Handy Millennial has some news for you.
Please stop using your smarthphone, your car, your TV, your computer, electricity, and while you are at it, please do not consume any perishable food, or drink any water. Why not? Well my dear reader, all of these systems work on mathematical models:. That cool new iPhone face detector? A math algorithm. Your car running? A math algorithm. Your TV playing Real Housewives? A math algorithm.
Are you starting to see the point? All modern advancements are built on mathematical algorithms that are carefully designed and tested. So it’s time to pay attention and understand the math algorithm that is predicting your future.
Reason #2: I don’t have $91,900 to invest per year.
You don’t have that kind of money? Well sure, but look, you fell into the trap. Which trap? The comparison trap! You looked at the Handy Millennial’s post and you looked at the BIG Number. Don’t do that. Remember that first, Rome wasn’t built in a day, and second, you don’t need to live in Rome.
The Handy Millennial would guess that somewhere between your employer’s retirement match and your contributions you could scrape together at least $9,000 per year. No? Fine, let’s say that you work minimum wage and you save just 2 hours of earning per week, about $15. After 52 weeks you would have $780. Which doesn’t look like much until you put it in our trusty simulator and find:
Now this point here is quickly devolving into the usual post about saving lattes and such. The point here is not to badger anyone or make anyone feel guilty about their lack of income. The point is to show you that the math works and that you just need to trust it!
Reason #3: I don’t need $1,000,000 to be happy.
What’s that? You don’t need money to be happy? Well sure, that is a fair point. One does not need things to be happy. In fact, it has been proven over and over again that gratitude is the best recipe for happiness. If you are happy with what you have, then you will be happy. If you want more, then you will always be unhappy.
So sure, when you reach your savings goal you might splurge and buy yourself a nice car, or a nice watch, or fancier noodles, but that was never the point. The point of accumulating wealth is:
- To buy more time with the people you love.
- To buy time to see more of this beautiful world.
- To protect you and the people around you from the unexpected.
- To protect yourself from events in life like permanent disability.
- To give you options when life is taking them away!
Reason #4: But you need to live NOW!
Yes you do! The Handy Millennial wholeheartedly agrees with this. We never do know when it will all be over. Actually, this is the reason to save to begin with! (See reason #3 above). So please go ahead and buy yourself a car that is safe and reliable, rent a home that isn’t rat infested, go on vacation once in awhile and recharge your batteries.
But this advice, and the advice on most personal finance sites, can be reduced to the following 3 points:
- Spend with a plan in mind. In this case, decide on how much you want to save. Spend the rest.
- Spend with a purpose and spend longitudinally in time.
- Avoid temptation! Marketing is clever and good, but you are better! Right?!
A useful visualization: Death by 1000 cuts
Because you are already wealthy, or more accurately, your future self is already wealthy, you only need to do one thing – protect your wealth from death by a 1000 cuts. My grandpa used to say, “If you bring it in by the truck-full, but lose it through a pinhole, you will always be poor.”
I like to visualize this in terms of water. Think of your future wealth as a pool being filled with water through a hose. But on the way to the pool the hose is leaking from tiny cuts in 1000 places.
- Big cable bill? Cut #1.
- Excessive phone data splurge? Cut #2.
- Luxury car lease payment? Cut #3.
- Credit card interest? Cut #4.
- 30 year mortgage interest? Lengthwise Cut #1.
- Unexpected/desired house upgrade? Axe to the hose, lengthwise Cut #2.
- But it was on sale! Cut #5
Eventually your pool is getting filled with drops while the sun is drying everything up twice as fast. You get the picture.
In conclusion, my dear reader, what the Handy Millennial did in this post is use the scientific principle of extreme examples to analyze the effect of saving and investing. By looking at some really big numbers over some really long time periods, we learn what the potential of the investing action is. We can therefore be: 1. motivated to save, and 2. motivated to stay the course through the ups and downs of the markets.
And in conclusion, the Handy Millennial would like to ask you to apply the principle of extreme examples to your life. Think of a problem that you are facing – what would happen in the extreme case? Is it really as bad as you think it is? Or, on the flip side, is it as good as you think it is?
Often times, by using this method you will find that what you felt in the immediate sense is totally different when observed through the long term lens.