Planning for an early retirement is full of pitfalls that could put your timeline way off track if you don't course correct quickly.
If you plan to retire early, it compresses your window for saving and investing, and compounds any mistakes you make. Most people planning for a short career know the importance of saving and investing consistently, getting employer benefits like 401(k) matches or HSA contributions, and minimizing investment fees.
But some are probably still making silly mistakes that prevent them from reaching their goal of retiring early, and they don't even know it. Are you one of them?
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1. Investing too conservatively
If you want to retire early, you need to get aggressive with your investments.
The S&P 500 index historically produces a real total return of 6.5% per year; Treasury bills return about 3% annually even before taking price increases into account, and these days, you'll be lucky if they keep up with inflation.
If you want to grow your portfolio quickly, you need to invest in stocks. And you'll want to stay invested in stocks longer than most people with a normal career trajectory.
Since retiring early requires you to save more than average every month, your aggressive asset allocation is usually balanced by consistent cash coming in from new retirement contributions. So, while the stock portfolio may produce more volatility than a more diversified portfolio, you have new cash coming in every month that allows the portfolio's overall value to remain on a fairly stable upward trajectory.
The value of your future earnings can act as a ballast to your aggressive asset allocation as long as you're consistently contributing to your retirement savings.
2. Investing too aggressively (as you near retirement)
Some people have no problem putting 100% of their retirement savings in stocks, but they don't adjust their asset allocation as they approach retirement.
When you only have a few years left of work before your expected retirement age, you should start allocating some of your investments to bonds. Bonds are much better at holding their value than stocks, but they won't produce the same level of long-term returns. Bonds are for capital preservation.
Capital preservation is the name of the game as you approach retirement and in the first few years of retirement. This is the period when sequence of return risk is highest and could derail your entire plan.
As you approach the end of your career, the value of your future earnings is also lower and your portfolio balance is higher. As a result, your career no longer acts as an appropriate ballast to an all-stock portfolio.
A few bad years of returns in the stock market could mean you have to delay retiring. Or if you retire and the stock market tanks, it might mean you have to go back to work. You've worked hard to get this close, so don't let this silly mistake ruin your plans.
3. Not knowing how much you really need to retire
If you haven't figured out how much you need to retire, you may end up saving too little or (nearly as bad) too much.
Determining how much you need for retirement is as much art as science. It depends on how comfortable you are with risk, what you envision for your retirement, and how flexible you are with your spending plans. What it should all start with, however, is determining a budget for your retirement.
If you don't know how much you'll spend in a typical year in retirement, it's impossible to determine how much you need. So, tally up all your expenses. Remove the ones you won't incur anymore (less gasoline for your commute), add in the new ones you'll face in retirement (more travel and individual healthcare premiums), and come up with a rough idea of how much your life will cost.
From there, you could use the 4% rule. The 4% rule says you can withdraw 4% of your initial portfolio value from a 50/50 portfolio of stocks and treasury bills every year, adjusting for inflation.
But early retirees may need to be more conservative since they need their portfolio to last longer. On the other hand, they could be more aggressive with the knowledge that they can cut back on spending or go back to work if they see a significant drawdown in their portfolio. It's really a matter of how much risk you're comfortable with.
Determining how much you'll need to save to meet your spending needs gives you a number to shoot for. As you approach that number, you can get more conservative with your portfolio, and eventually, you can stop working and live off your savings for the rest of your life.
