Efficient Investing: Key to Financial Independence

This is the magic of compounding returns. You might want to be on one of the upper lines, wouldn't you?

This is the magic of compounding returns. You might want to be on one of the upper lines, wouldn’t you?

The downshifting equation and your way to financial freedom is as follows:

Passive returns + Income from Job = Spending + Savings

Thus your way to increasing independence from the grind in the job-tread-mill has two main components:

  • Efficient Spending
  • and efficient investing.

Spending control in the form of frugal living decreases your actual need for money (right side of the equation) and gives you more room for high savings in the beginning of your downshifting journey.

Later on, passive returns will increase steadily and the need for savings will reduce once you have a meaningful stash accumulated. As frugal living will obviously continue, poof!, the need for income from a job will reduce accordingly!

And this is what we want.

As an advocate of the middle way, Woodpecker works on all variables at once, thus I started reducing need for work early on when passive income was already nice but way from enough for complete retirement. But how you play the variables is up to you. The important thing is to build a stash and to control spending.

The post today is about investing

Disclaimer: I am not a financial advisor. This post displays only Woodpecker’s opinion. Please do your own research prior to investing.

The magic of investing lies in compounding returns.

Small gains in the beginning pile up to huge returns over long time thanks to compounding.
However, the magic of compounding very much depends on the interest you can earn on your capital.

E.g.:
1.000 EUR invested 50 years ag would yield 12.000 EUR today at 5% return p.a.
But it would yield 19.000 EUR today at 6% p.a. and 31.500 EUR today at 7% p.a.

A general rule of thumb is the 70-rule: Divide 70 by the annual percentage return, and you will get how many years it takes to double your investment. E.g. with 7% it takes 70/7=10 years to doubly your investment etc.

Achieving a high return p.a. is absolutely mandatory and will make the difference between getting rich, or just get along well. Every percentage point is important!

Your aim should be a yield of at least 4-5% p.a. after taxes, the more the better. Thus, investments like “save” government bonds, saving plans from your bank, most life insurance products drop out immediately in todays low-interest-rate environment.

In the long run, the best bet probably is the stock market.

Let me summarize the advantages of stocks over other investments:

  • Siegel’s constant, stating that stock markets in the long run yield about 7% gain p.a. after inflation. No one knows if this holds true in the future, but it shows the outstanding robustness of stocks in the past. Why should that change?
  • Stocks are assets, tangible values. No counterparty risk, no default risk involved. You own part of a company, a factory, arable land, a tanker, whatever. This things will be there even after an inflation, a budget crises etc. A huge benefit over all debt investment (as bonds).
  • Low transaction costs. Thanks to online trading and passive funds, you can invest cheaply, transaction costs can easily stay way below 1% for a buy/sell-roundtrip. Buying real estate in contrast, at least in Germany will cost ou about 5%-10% a round-trip.
  • Diversification. You have a whole universe of investments at hand, you can spread out your capital in different countries, industries etc. Again very difficult with the (in Germany currently) so-en-vogue real estate.
  • Dividends. Stocks generate dividends. Up to 4-5% only from dividends (plus price increase) are easy to be found. This makes stocks much more attractive than e.g. gold. See above example what magic this few percentages of dividends alone can do to your stash.
  • You can learn, as you will do multiple transactions. Unlike real estate, if you are into managing your stocks yourself, you will learn and improve by the dozens of practical transactions you will do over the long run.

Consequently, Woodpecker is invested 85% in stocks and was for almost all the past. There has been many stressful years in the last decade as a stock investor, but 2013 was great, and overall return of the last ten years was around 7% p.a. in Woodpecker’s portfolio, including dividends and after tax and costs.

The few other things about stock investments and it’s challenges:

  • Volatility can be stressful. After a few swings you will get cooler, but the first and second crash in your portfolio is likely to make you uneasy and giving you some bad nights. As the famous investor Kostolany said: “Stock profits are pain and suffering money. First comes the pain, then comes the money.” But remember, we are here for the long run, the marathon. The long-term return is what counts, and typically this is great in stock markets.
  • Stock markets are quite high these days. I can really not make any recommendations here. Only that I would bet everything, that in 20 years from now, markets will definitely mark even much higher. What happens in between is not seriously to be predicted (see bullet one). Forget about all the experts. Fact is, no one knows. Stocks could crash next year, but they might continue to rally as well.
  • Stock picking is a difficult art that takes a lot of time. If you want to do it yourself, there is no way around value assessment, digging numbers, reading reports, reading books on investment, on history, on mass psychology and on anti-cyclical behaviour. You will not outperform the market without putting a lot of work into it, even if you are smart. Remember, there is a lot of other smart guy out there in the market and some of them work like hell. If you don’t have fun digging numbers and reading reports, you’d better go for a passive investment in the form of an ETF (exchange traded funds).
  • If going for an ETF, this is already much better than normal funds, as typically managing fees are much lower. They should be below 0,5% or so, as our example above shows how much a lower yield due to fees will eat into your long-term returns. The ETF should fully backed by stocks to avoid counterparty risk. At it should be diversified, e.g. on the EUROSTOXX or some other broad index. And dividends should go to you or get reinvested.
  • Get a cheap depot and always check on unnecessary costs. Keep the number of transactions low to reduce costs. Always remember you are in a marathon. What happens during a week, a month, a year, is none of your concern.
  • Read here a former post about some behavioral guidelines on investments.

I will not go into more detailed investment strategies in this blog, nor will I disclose any individual stocks I prefer and the like. There is plenty to find in the internet. However, when reading around always ask yourself how independent that particular source is or if they serve other interests by their recommendations.

And never, ever, trust 100% in any recommendation! See them merely as inspirations and always put some own thoughts in any investment decision!

Cheers and happy investments in 2014,

Woodpecker

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6 comments on “Efficient Investing: Key to Financial Independence

  1. Klaus says:

    I ran across this blog by coincidence and it caught my attention so much that I was going through all posts during the holidays.

    Very well done, woodpecker! There is a lot of truth and value in what you write. Being in my late 40s and having focused very strongly on the job over the last 20+ years your reasoning really caused me to rethink priorities. There is a decision pending on what to do next in my life as I am about to exit my current job. And your blog has reconfirmed my thinking and will help me make the right decision.

    I didn’t see a lot of comments from others but I assume that there are more “silent” readers like me that love to come back regularily to see whether you added another thoughtful story.

    Thank you. Have a good 2014!

    • mrwoodpecker says:

      Thanks Klaus!

      All the best to you and your way forward! If you want drop an eMail or comment here later and let us know your decision and its impact in more detail.

  2. Teo says:

    Hi mrwoodpecker,

    Thank you for all your insightful thoughts.
    I’ve been following your blog for a few months now, having first reached it from a link from mrmoneymustache.com. I also live in Germany (not german) and your articles give me the very good point of view of a fellow European, on Financial Independence. I’m in my early thirties, working in software and I’m trying to follow the same ideas regarding frugal living. This is working for me at the moment, but the investing part is something that I’m not sure how to start. The only clear idea at the moment is that I’d like to go with ETFs to invest a monthly amount of money.

    I know that you do not give specific financial advice and that is fine, but could you please give a few points on what should someone read to start investing in Germany (books, blogs, articles, etc). What websites (again in Germany) should someone use to get into ETFs? The problem I have is that most of the info I find in English (my German is not at such high level to able to read investment info) is about the US/UK market and I have no idea where to start in Germany.

    Thank you very much for your blog. It is very inspiring.

    Cheers,
    T

    • mrwoodpecker says:

      Hi Teo,

      first of all, starting frugal living in your early thirties is very promissing. I only started to do this systematically since my mid-thierties, and still doing quite ok I guess.

      Converning investments, first of all you have to make a choice, if you want to do
      (a) active investing
      (b) passive investing

      (a) means you pick your stocks on your own. This is the way I am going, and, if well done, it allows you a certain outperformance of major indices. (Or unterperformance if you are less successful).
      But, (a) comes with A LOT of work, so better only do this if you really find fun in reading company reports, compare valuations, balance sheets etc. I for my part have some fun with this to a certain extend, but I guess most people don’t. If you don’t, better go down road (b), as outperforming the market is not likely if you invest only little time. E.g. I spend average 5 hours per week on my portfolio, average performance being around 5% higher then the DAX over the last 5 years.

      (b) means you just go with the flow. You invest in major markets and simply participate in the general upwards trend of stocks over the long term. Still you will suffer from time to time, when markets go down, but on the long run, stocks proofe quite superior compared to most other investments. And you will not have to make a lot of decisions.

      Concerning Readings:

      For (a), a great blog for stock evaluation is valueandopportunity.com. From there you will find countless links to other good blogs.
      A big chat-room in Germany is wallstreet-online.com.
      Recommended reading from my side: Warren Buffet, Kostolany (more on the story side, but good ones), o’shaughnessy (very number driven investment style), anything about “behavioral finance”.

      For (b) you really don’t have to read a lot. Pick two or three major indices in your area (e.g. DAX, EUROSTOXX, S&P500, whatever) and put up savings plans on max 3 or 4 ETF on them. Compare management fee, handling of dividends and costs at your bank. I’d do all online.
      I am at Comdirect and DKB, both offer good online conditions, but other banks probably as well.

      There is also more sophisticated allocation recommendations around for those investing in ETFs, I am no expert here as I go road (a), but I think most of it is overcomplicating things. Most big markets are very much correlated these days, so it probably is not too important how you allocate your money between major indices. The important thing it to start and to stay on track – even if chrash times come. And crash times will come.
      But sorry, I don’t know any particulat good reading concerning ETFs, as I work with individual stocks. Maybe you look at a forum like wallstreet-online.com.

      This is just my ideas, think it through, look for other opinions and then make YOUR decision. None can do it for you. And It is important that you feel good with your choice. Otherwise you will falter when the rough times come.

      Cheers, Woodpecker

      • Teo says:

        Hi Woodpecker,

        Thank you very much for your comments.
        I think for the moment I’ll try the waters with ETFs and as time passes and maybe i get more knowledge on the subject, I’ll try also different scenarios. I’m already a client of DKB, so I think I’ll try their online solution for this, thanks for pointing it out.

        Cheers,
        Teo

  3. […] you may have noticed, stock markets entered quite a run in 2013, obviously affecting Woodpeckers stock-biased portfolio in a healthy way. In fact, the Woodpecker clan’s investment stash increased by almost 25%. […]

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