YMOYL Chapter 9, Part 1: The Fatal Problem with Chapter 9

A reminder for readers: Casual Kitchen is running an in-depth, chapter by chapter review and analysis of the book Your Money Or Your Life throughout the month of January. Join us! You can buy YMOYL here, and you can find the first post in the series here.

Your Money or Your Life is a nearly flawless guide for dominating your personal finances. Seriously, all you have to do is read it, complete the exercises, and you will systematically accumulate money.

What YMOYL is not, however, is a flawless guide for dominating investing. Chapter 9 proves it.

The problem with Chapter 9 dates back to the book's first edition. When Joe Dominguez wrote it, he offered readers a deceivingly simple, one-size-fits-all solution for what to do with our money: invest exclusively in US Treasury bonds.

As we're about to see, this is a solution from another era--when interest rates were far higher--and it cannot be your only solution today. In its day, however, Joe D's idea worked, and it was so clean and simple that he could thoroughly explain it in just one chapter.

Which left the authors in a terrible bind when it came time to revise the book in 2008. It's not like they could shoot down Joe's idea and leave readers hanging with nothing to replace it: Sorry, but rates are too low in the current era to rely solely on Treasury bonds. Joe's idea won't really work any more. Too bad. Good luck transforming your relationship with money!

And so the authors tried to make Chapter 9 into a broader investment resource so readers could go beyond Treasury bonds for their passive income needs. What they actually created, however, is a crappy and superficial chapter that attempts to cram the entire investing industry into thirty-two pages. In other words, what used to be a simple chapter explaining Treasury bonds evolved into a messy chapter explaining everything. Badly.

Look, no book is perfect. And (up until the end of Chapter 8 at least) few books are as life-changing as this one. So, we're going take the good from Chapter 9, and we're going to learn from what it gets wrong.

Why Treasury bonds won't work
Okay. Let's first go over why it's a horrendous challenge today to fund a post FI-life exclusively with Treasury bonds. I'll explain with a quick example:

Let's assume your expenses are $3,000 a month ($36,000 a year) and you're living in an bygone era of 6% Treasury yields. How much capital in total will you need to be FI?

Remember our formula: Money x Yield = Passive Income, or M x Y = PI for short.

Then, plug in the numbers: M x 6% = $36,000 a year. Solve for M, and you arrive at $600,000 in capital needed to fund your post-FI life: $600,000 x 6% = $36,000.

That's dandy, except for the sad fact that we're not alive in an era of 6% Treasury yields. We're alive now, when the 10 year Treasury yields a paltry 1.6%, the 5 year Treasury yields a pitiful 0.62% and the 2 year Treasury yields a pathetic 0.24%. Even the 30 year Treasury, the US government's longest-dated debt instrument, yields a sorry-ass 2.58%. [Edit: Readers, these interest rate numbers are from five years ago (obviously), and it's instructive to see how they can change over even reasonably brief time periods. For example, right now in January 2017 the 10 year Treasury yields a slightly more attractive 2.44% while the 30 year yields 3.02%]

So how much capital does it take now, in an era of 1.6% Treasury yields? Once again, here's your formula: M x 1.6% = $36,000. Solve for M, and we come up with $2,250,000.

Yes, you read that right: $2.25 million. To generate thirty-six grand.

[Edit: Using today's numbers, we'd have M x 2.44% = $36,000, which means you'll need capital of $1.475 million. Quite a bit better. Also note how sensitive these numbers are to even small movements in interest rates when rates are especially low.]

A simplified way to think about it is this: if interest rates are roughly a third of what they were two decades ago, you're gonna need roughly three times the capital to fund the same level of expenses. Therefore, if you use Treasury investments--and nothing else--to fund your post-FI life, you're gonna need far more capital now than you would have needed back in Joe Dominguez's day.

So, what does this all mean? It means you're going to have to figure out a way to meet your needs differently. You will not be able to fund your post FI life with one single, easy investment solution like Treasury bonds. That solution was a historical artifact of Joe Dominguez's time, and it's simply not an attractive option in the modern era with interest rates where they are.

One last thought: if you're jealous of the readers who lucked out and discovered YMOYL during a high interest rate era, think again. Even those investors faced risk, and most of them had no idea it was coming.

What risk did they face? Reinvestment risk.

Remember, bonds eventually mature. Imagine if you were totally lucky, and you managed to buy a bunch of 30 year Treasury bonds back in 1982 when yields were at a scrumptious 11-12%. Well, guess what? Those bonds would have matured in 2012. Which means you'd get your principal back and have to reinvest it now at those days' crappy rates. Think about it. Even those investors were exposed to the risks of declining interest rates--they just didn't know it until much later.

The bottom line: the idea that there ought to be investments that pay juicy yields yet are free of all risk is a childish fiction. Everything has risk. It's time to grow up, embrace that risk, and find alternatives. That's what we'll discuss next week.

Coming Up: YMOYL Chapter 9, Part 2: Here's What To Do With Your Money: Alternatives to Treasury Bonds

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