Financial Independence: Sparking the FIRE for the Next Generation (2)

In our previous post Financial Independence: Lighting the FIRE for the next generation (1), we considered the question: “If you can do it all over again, what will you do, or not do? If you can pass some inspiration to the next generation looking for financial independence, how will you light their FIRE?” In many ways, the path to good personal financial management is not difficult, and really revolves around a few core tenets, such as managing:

1. Emergency funds
2. Insurance
3. Savings and investments
4. Getting on the property ladder
5. Debt

In fact, the next generation are much luckier, with a lot of the advice now having gone mainstream and being easily available from the web and other sources without having to pay someone to learn about it. Pretty much anyone can reach Financial Independence by following what is widely preached about personal finance, even if they do not know the intricacies of finance and various financial instruments. However, the two main hurdles really are:

1. Trying to do it all by yourself – as we discussed previously when considering Emergency Funds and Insurance, many things in personal finance are easier to do as a household unit which can self-insure individual members, so don’t reject help!
2. Personal behaviours – even if we know all there is to know about personal finance, it is hard to avoid all sorts of deviations from the roadmap. For example, splurging on the latest gadgets, cars and experiences and hence not being able to save enough, succumbing to FOMO and YOLO mindsets and ending up losing a part of the money stashed away

While the previous topics of Emergency Funds and Insurance touched on how the family, or financially independent parents in particular can help their children get started on the path to FI or FIRE, the latter three topics of savings and investments, property and debt management will touch more on the personal behaviours that matter. Let’s start sparking the FIRE for the next generation!

Sparking the Fire for the next generation

Savings and Investments

Let’s talk about the core of personal finance and FIRE: Savings and Investments.

A. Savings

Savings is probably the key to FIRE, by a long shot. Although investments, stock picking, asset allocation and the power of compounding are usually the main topics of discussion when talking about FIRE, none of these make FIRE possible without savings. Part of this “myth” about the power of investments can be found in the usual chart trotted out to promote investing – how $100,000 a grow to $1 million over the course of 40 years at a return of 6% per annum, if only you invested early enough!

Why Invest? Compounding $100,000 to $1 million over 40 years at an annual return of 6%

While there is nothing wrong about this chart, anybody who has saved and invested their way to FIRE can tell you that it is not an accurate depiction of what really happens. Investing and compounding $100,000 to $1 million can happen in real life if you have that amount to invest right at the very beginning, and if you can refrain from touching any of the capital gains or dividends over 40 years. What usually happens is that people save and invest over their lifetimes, a little at first, when they earn a small amount, and more and more as they grow older and start earning more.

But this also means that the vast bulk of their savings invested have less time to compound through investing, as these savings only happen later in life. So when comparing their lifetime savings versus the invested amount, even after 20 years, more often than not, the investment amount is only somewhat larger than the cumulative amount of savings.

Cumulative Savings and Investments over 40 years

As can be seen, most of the gains from investing over simply saving for FIRE come only after the first 20 years. Thereafter, the gains can be quite large, but for most people who are aiming for FIRE, the objective is to be able to retire early after 20 years of work! So they are unlikely ever to see the gains from investments that the earlier chart promoted!

Let’s take a look at how large this perception gap is, by comparing the ratio of the portfolio investment amounts versus the cumulative amount of savings over time, firstly using the lump sum investment approach of $100,000 at the start, and then using the actual pattern of savings and investment over a lifetime of earnings.

Ratio of investments to cumulative savings over time at an annual return of 6%

Elapsed Time	Lump Sum Investment	Savings + Investment
After 5 years	134%	111%
After 10 years	179%	119%
After 15 years	240%	134%
After 20 years	321%	148%
After 25 years	429%	163%
After 30 years	574%	178%
After 35 years	769%	193%
After 40 years	1029%	218%

So, after 20 years of saving and investing, instead of the 3X we expect our savings to have grown through constant investing, it is more likely that all we have is being 50% up over the amount saved. And that is also if we constantly reinvested all the dividends too. Which is probably also why many of us end up going for high risk and speculative investments. And also why saving will be more important than investing.

At the end of the day, our ability to FIRE relies more on savings and luck, than on investment. And the only way to accelerate saving, is to earn more

B. Investments

Hence, saving hard will be the key to how quickly we can get to FIRE. And the ability to save hard is largely based on how much we can earn, otherwise, there is a real danger of saving too hard when we earn less, and just ending up making ourselves miserable (see here). There is also the danger of saving too little when we earn more, what is known as hedonic adaptation (or the hedonic treadmill) of our lifestyles to income.

Some hedonic adaptation of our lifestyles and spending to higher incomes later in life will definitely set in, regardless of how hard we try to avoid it. And this is where investments come in. Even if investments play a secondary role in getting us to FIRE, it is still an important role. A target to aim for may be to eventually save 50% of of our earned income over our lifetime, and then double that amount through investment. Such a target also recognises that investment returns are not that easy to come by.

As an example of how hard it is to achieve relatively moderate investment returns over time, consider what Warren Buffett said in the Berkshire Hathaway shareholders’ letter of 2005. The Dow Jones started on January 1 1900 at 66 and ended the century on December 31 1999 at 11,467. If we expected the same rate of return over the next 100 years, the Dow Jones will end on December 31 2099 at an astonishing level of 2,011,011! At this point, when the Dow Jones just ended at 33,147 for 2022, it is almost impossible to even imagine that magnitude of gains.

But what is more astonishing is that to get to a level of more than 2,000,000 by the end of 2099, and to repeat the returns achieved over the last century, the Dow Jones has to have an annual compounded return of … only 5.3%! And even though the Dow Jones is now almost 3X the level it started this century 23 years ago, it has only had an annual compounded return of 4.7% so far. This tells us a couple of things about investing for FIRE:

Typical long term returns to investing, even aggressively in stocks, will be in the mid-to-high single digits. Any product or service which offers double digit returns is unlikely to be achieved in practice

This is important, because there is a general lack of understanding about what realistic rates of returns to investing are. If we set our expectations too high, we will be disappointed by how slowly our investments grow. And in the worst case, we may then opt to pursue highly speculative “investments” (think of cryptocurrencies and meme stocks) in an attempt to boost investment returns. Not that it is impossible to make a fortune doing so, as many people have proven over the last few years. But just as many people have tried and ended up with less than what they started off with after these few years as well. Fortune, it seems, favours the lucky, rather than the bold.

The example of the Dow Jones is quite interesting in a few other ways. Let’s look at how it may compound over time based on the historic rate of return in the last century and the rates achieved so far in this century:

How the Dow Jones may grow over time based on different rates of return

	At 5.3% return	At 4.7% return
Start of 2000	11,467 (actual)	11,467 (actual)
End of 2019	32,296	28,462 (actual)
End of 2039	90,723	72,186
End of 2059	254,849	180,878
End of 2079	715,894	453,230
End of 2099	2,011,012	1,135,671

As we have seen earlier, the benefits of compounding returns are not apparent until at least 20 years have elapsed. If we are able to look back from the vantage point of 2039, after 40 years, we will no doubt be astounded that the Dow Jones has gone up 9X, or even 3X after 20 years in 2019, but to the one who is investing, it will seem to move at a snail’s pace. So an incredible amount of patience is needed for investments to help someone reach FIRE. And if this person is the Type A or impatient sort, it would far better to focus his/her energies on earning and saving more instead.

A second interesting observation from this table, also discussed in the same shareholders’ letter, is how a small change in the rate of return, from 5.3% to 4.7% in this case, can cause the final outcome after 100 years to differ by 100%! Warren Buffett mentions this in passing when he talks about the fictitious example of the Gotrocks family and their Helpers:

• In the long run, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn
• Suppose all businesses are owned by a single family, the Gotrocks
• Now, let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions
• After a while, most of the family members realize that they are not doing so well at this new “beat- my-brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.”
• At the end of the day, the Gotrocks still own all of the businesses; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of the businesses minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. 

So fees and commissions do add up, and the obsession over minimising fees in investing is real! And even if if the fees and commissions look small, say 0.6%, as we have in the projected returns of the Dow Jones over 100 years, they add up and eventually these fees and commissions can end up being half of your wealth!

Investing is truly like watching paint dry – you will not see any significant gains until at least 20 years is past! And if you are paying a lot in fees and commissions, it will take a lot longer!

Conclusions for now …

Looks like there will have to be a third instalment of this series on sparking FIRE for the next generation to cover the last 2 topics!

But for now, let’s think a bit about what we have discussed. Investments are usually considered to be crucial for achieving Financial Independence and FIRE, thank to writers like JL Collins. However, a much bigger part of the road to FIRE is really about savings, and in turn about earning more to sustain a high level of savings. Without high earnings early in your career, FIRE will be hard to achieve without at least 20 to 30 years of working for a living (and investing). That would be the minimum amount of time for investing to do its work.

Of course, it is also perfectly possible to achieve Financial Independence and FIRE through investments. Many have done it this way. But this requires taking on higher risk, and more than a good dose of luck. It is just as likely that this path does not work out! A look at the Forbes list of the richest Singaporeans show that only 5 of them gained their wealth through investments (see here also). More often than not, fortunes are gained through business and simply earning more.

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