I read a good article recently on how to construct an Ivy League fund using exchange-traded funds (ETFs).

The original article was for American investors. Here’s how British readers can do the same thing.

But why would you want an Ivy League style fund?

Well, the endowment funds of Ivy League universities like Yale and Harvard have historically achieved excellent returns, with less volatility than an index tracker.

Their success is partly because of special opportunities we can’t easily replicate, such as access to good hedge funds.

But they’ve also done well because of asset allocation, which we can copy with ETFs.

The model we’ll be following is that of David Swensen, who is Yale’s fund manager. (I’ve previously sung the praises of Swensen’s book Unconventional Success, which is well worth reading).

Swensen had posted an average return of 16% a year for 21 years, as of 2006. This makes him the best university endowment manager in the world.

Swensen’s Ivy League portfolio via UK ETFs

In place of the U.S. ETFs, I’ve selected from the Barclays iShares range of London-listed exchange-trade funds.

Each ETF’s stock market ticker is given in brackets.

The Swensen model portfolio

• Domestic Equity (30%): FTSE 100 / FTSE 250  (ISF / MIDD)
• Emerging Market Equity (5%): MSCI Emerging Market Equity (IEEM)
• Foreign Developed Equity (15%): FTSE Developed World (IWXU)
• Property (REITs) (20%): FTSE EPRA/NAREIT UK Property (IUKP)
• U.K. Government Bonds (15%): FTSE UK All Stocks Gilt (IGLT)
• U.K. Inflation-Linked Bonds (15%): £ Index-Linked Gilts (INXG)

A few thoughts on this ETF portfolio

The Ivy League ETF portfolio has some clear advantages to UK investors:

• Well-diversified
• Cheap to run
• Liquid
• Very simple to set-up
• Easy to rebalance

Would I put my money into it right now? Well, I haven’t done so, which answers the question.

Partly that’s because I’m foolish, and do risky things like invest in small caps.

But also I think equities look really good value at the moment, whereas I suspect Government bonds are still expensive, although maybe not in a bubble anymore.

The whole point of asset allocation is you ignore these sorts of hunches, however, so that’s something to keep in mind.

As the original ETF Database article says:

Several Ivy League endowment managers have consistently beat the market by a large margin, with billions of dollars at stake. Of course, this is made possible partly because many investing instruments are available to larger institutional investors that retail investors cannot access. But according to these managers, the trick for individual investors isn’t active trading: it’s better asset allocation.

As a simple asset allocation goal to aim towards over the next few years, I think the Ivy League endowment portfolio via ETFs has much to recommend it.

Update August 2010: I’ve now written a second article on the Ivy League portfolio, modifying it in light of its past performance and some further comments by David Swensen.

Remember to take professional advice if you need it before making any investments.

Further reading:

1. Swensen’s Ivy League portfolio revisited
2. Hedge funds lag the simplest portfolios
3. How to create your own cheap, simple and secure Guaranteed Equity Bond

This is a guest post from Tim who authors the Psy-Fi blog, an excellent take on psychology and finance.

Making money from stocks is easy enough if we can defeat the main enemy – ourselves. There’s no getting around the fact that us humans are subject to lots of biases and psychological quirks that combine to destroy our investing returns.

The first line of defence against this is to recognise the problem.

Here are seven psychological quirks to look out for.

1. Overconfidence and optimism

Most of us are way too confident about our ability to foresee the future, and overwhelmingly too optimistic in our forecasts.

This finding holds across all disciplines, for both professionals and non-professionals, with the exceptions of weather forecasters and horse handicappers.

Lesson: Learn not to trust your gut.

2. Hindsight

We consistently exaggerate our prior beliefs about events.

Market forecasters spend a lot of time telling us why the market behaved the way it did. They’re great at telling us we need an umbrella after it starts raining as well, but it doesn’t improve our returns. We’re all useless at remembering what we used to believe.

Lesson: Keep a diary, revisit your thinking constantly.

3. Loss aversion

We hurt more when we sell at a loss than we feel happy when we sell for the same profit. But stocks don’t have memories – decisions on whether to buy or sell should always be independent of your buying price.

Lesson: Ignore buying prices when deciding whether to sell.

4. Regret

Investment decisions should overwhelmingly be about risk, and risk implies a judgement, which may turn out to be wrong, often through bad luck rather than bad thinking.

Becoming overly focused on past decisions that have gone wrong without analysing whether the decision made was rational under the circumstances isn’t rational. Investing involves making mistakes and is often down to luck.

Lesson: Learn to live with mistakes.

5. Anchoring

Ten years or so of research have shown we have a nasty tendency to ‘anchor’ on specific numbers. Psychologists can change the results of simple estimation questions (for example, how old do you think Woody Allen is?) simply by posing an earlier unrelated question containing a number.

Lesson: Don’t get fixated on specific numbers, such as buy prices, stop loss prices or index values.

6. Recency Bias

We pay more attention to short-term events than the longer-term. So the effect of a short-term downturn in a company’s fortunes may be exaggerated, or we may simply assume that current market conditions will persist forever.

Lesson: Buy some history books, and look beyond the short term.

7. Confirmation Bias

We just love other people to confirm our decisions. And other people just love us confirming their opinions. In fact we could just get together and have a regular love-in but it doesn’t make for good investing. The only money you lose is your own.

Lesson: Make your own decisions; don’t worry about what others think.

Special bonus quirk!

As a bonus investment quirk, my all-time favourite is Myopic Loss Aversion. This is where investors can’t stand the sight of red ink in their portfolio – they avoid short term losses at the expense of long term gains.

Such people should be physically restrained from buying stocks. Let them play checkers with five-year olds or something they can always win at.

Conclusion

Many people who invest heavily in stocks tend to heavily exaggerate their own abilities and downplay the role of luck in stockmarket investment. Sadly there is a lot of random stuff in the market which we can’t control.

The easiest way of managing these psychological ticks is to invest regularly and for the long term in index trackers and avoid selling no matter what the circumstances.

Failing that – go take a course in weather forecasting. At least you’ll be more help than most market forecasters who can only tell you that you need an umbrella after it starts raining.

P.S. Woody Allen is 74. Most of you will have thought lower, unless you really knew the answer.

You can read more of Tim’s posts over on The Psy-Fi blog.

Further reading:

1. The 6 reasons small caps can supercharge your investment returns
2. The best cash investment rates deliver far superior returns
3. 7 ways to profit from other people’s folly

Even a modest passive income stream will bear fruit (Image by: Lindsay Haver)

It’s very easy to become disheartened when you first set up a side project with the aim of earning some passive income.

You might well only make a few pounds or dollars a day, even after weeks or months of work to get your passive income stream up-and-running. Most passive income projects fail to make even that.

But don’t be disheartened if you make only a small amount of cash. Passive income is the stuff of dreams, so it’s no surprise it’s hard to get hold of.

Even a little bit of passive income is worth a lot of money. Before I explain why, let’s remember how lousy it feels to be paid loose change for your efforts.

The little cheques that can crush your dreams

Reminder: Passive income is money you get without any extra work. Examples include interest on your cash savings, the income after costs on a property you rent out, or royalty fees on a book you wrote years ago.

Many of us have read articles online or heard stories from friends about how writing books, creating websites, licensing patents or any other route to passive income is the way to riches.

This idea that passive income will make you rich is… half-wrong.

Only the very lucky author, webmaster or inventor will make thousands overnight. And as this dawns on an eager new entrepreneur, he or she will often throw in the towel even before that first dispiriting $0.52 in passive income is earned.

I’ve already been through this with blogging, which I thought looked easy but as I’ve written turned out to be a truly terrible way to make money.

Blogging isn’t even properly passive; you need to continue writing to keep your audience entertained. (Luckily I blog about money because I love writing about it, not because I always love making it!)

Elsewhere on the Internet though, I’ve a project that is more ‘fire-and-forget’, and where the income is growing slowly from a small base. I could see it generating £5 a day by summer.

Now, you might think £5 a day is nothing to write home about.

So did I. But what I’ve come to realize is that even a trickle of income from a passive income stream is a rich thing to own, especially if you have more than one or two such income streams.

It’s all down to what you’d need to do to get that money elsewhere.

Comparing side project income to interest on cash

At the time of writing, the best cash savings account is paying about 3%.

Interest on cash is the crown jewels of passive income because your money is totally safe and you don’t have to do anything at all to earn it. (We’ll ignore for now inflation that makes dividends better long-term, and the remote risk of losing money in a bank run).

Returning to my little web project, let’s say it does make £5 a day.

£5 every day adds up to £1,865 a year, which already sounds a lot better. (Remember, this is a fire-and-forget project, requiring at most a few maintenance tweaks a year).

Now how much would I need in cash savings to get £1,865 a year with interest rates of 3%?

More than £60,000, according to a quick play with my favourite compound interest calculator.

Small passive income streams are worth a lot

I don’t know about you, but the idea my passive income stream could soon be equivalent to £60,000 in cash was an eye-opener.

Of course, it’s not worth £60,000 in cash. My side project is to some extent dependent on Google and other Internet factors.

Similarly, if you write a slow-selling textbook on frogs or geography, say, eventually it will go out-of-date and your income will dry up.

A passive income stream from an investment in property is better, but even that will eventually require you to update your premises at some considerable cost (though that may be covered by price rises).

Cash in contrast is the ultimate liquid asset. Give me cash over web projects, any day!

But still, it does bring home how valuable getting £5 a day for doing nothing more really is. The minimum wage in the UK is around £5 an hour, so there are plenty of people working hard for 60 minutes a day to make what my little project could soon turn out rain or shine.

Crucially, a passive income of £5 may be easier for most people to achieve in the short-term than £60,000 in savings. If you’re trying to replace your salary with passive income, adding a couple of alternative income streams to the mix could cut down the scale of the challenge.

I wouldn’t quit my job to set up tiny passive income streams. But if you’ve got some spare weekends and fancy a project, it might be fun and financially rewarding.

Further reading:

1. What is your salary really worth?
2. Here’s a great way to boost your income in an hour
3. Bolton’s China trust is worth a small punt

I have just finished the The Snowball, the first biography Warren Buffett has cooperated with. It’s full of surprises, such as how Buffett had three leading ladies for two decades, and how his 1960s home was an accidental outpost of the counterculture.

But I’m more interested in how Buffett made his money. And while there’s few new facts about Buffett’s deals in The Snowball, the biographical format does put them into context. You get to see what makes him tick.

Here are seven interesting things I learned about Warren Buffett from The Snowball, and some ideas on how they can help your investing:

1. Buffett set goals young. (He really started, really young)

Buffet began obsessing over numbers as a child. He raced marbles with a stopwatch and calculated the lifespan of hymn composers when six-years old. He sold chewing gum at seven and Coca Cola when he was eight: the same year he began wearing a money-changer on his belt.

• His dad was a stockbroker. This gave him an early view of the markets
• At ten he was chalking stock prices at a local broker’s office
• The same year he visited the New York Stock Exchange, and was asked for a tip by senior Goldman Sachs partner Sidney Weinberg – an experience he never forgot
• His favourite childhood book was One Thousand Ways to Make $1,000
• At 11 he announced he was going to be a millionaire at 35, a seemingly crazy goal in 1941 (when a million really was a million)
• He filed his first tax return aged 14, having already made $1,000 (equivalent to around $12,500 in today’s money)

The takeaway: The power of compound interest takes years to work its magic. None of us has a time machine, so the main lesson is not to delay a day when investing for the future.

2. Buffett bought his first stock when he was 12-years old

Warren put everything his schemes had earned him into a stock, Cities Service Preferred, when he was 12. He also enrolled his sister, Doris.

Buffet was already learning how to hold shares through a slump

He paid $114.75 dollars for three shares, and watched the stock price fall from $38.25 to $27 a share. His sister Doris was not happy. When Cities Service went back up to $40, he sold. He made $5 a share profit, and got Doris off his back. After he sold, the stock rose to $202 a share.

Takeaway: We all learn the same lessons. Buffett’s business partner Charlie Munger says that because Warren started thinking about odds, stocks, and goals before he was a teenager, he’s years ahead of the rest of us.

I used to watch share prices rise and fall on the Teletext TV service when I was 11 or 12. At the same age Buffett was learning real-world lessons on holding shares through a slump and selling too soon.

You’ll only discover whether you have the stomach to invest through a bear market or whether you’ll be sucked up by the next property bubble by being an active investor. Start with small sums, sure, but don’t delay that start.

3. Buffet lied, shoplifted, and played truant as a kid

This one was a real surprise. As a teenager Buffett revealed a wild streak. He says:

“We’d steal stuff for which we had no use. We’d steal golf bags and golf clubs. I walked out of the lower level where the sporting goods were, up the stairway to the street, carrying a golf bag and golf clubs, and the club was stolen and so were the bags. I stole hundreds of golf balls.

“I made up this crazy story for my parents – I told them I had this friend, and his father had died. He kept finding more of these golf balls that his father had bought. Who knows what my parents talked about at night.”

Takeaway: Even Buffett had to learn to be Buffett. I don’t know about you, but I found this heartening to read. Together with discovering that Buffett was a shy child who enrolled himself in Dale Carnegie’s public speaking course, it made him seem more human.

It’s easy to feel you haven’t got what it takes to make money. Some are born special, you might conclude. But Buffett’s history shows that even the world’s richest and most admired investor had to iron out his kinks.

Buffett’s history also makes me proud to be an outsider. Many of my college classmates entered the city or became management consultants, and have earned six-figure salaries for a decade. When property prices were booming, I’d sometimes wonder if I’d made the wrong decision by deciding to go it alone – even though I know that working a nine-to-five in an office and answering to some buffoon of a manager would kill me.

Discovering Buffett made being his own boss a top priority puts me in good company. I also suspect the unusual structure of Berkshire Hathaway grew out of Buffett’s non-confirming mentality.

4. Buffett is a businessman first, investor second

You’ll often read that Buffett evaluates stocks as if he’s buying the whole business. What I realised after reading The Snowball was Buffett doesn’t do this because he’s an investor who thinks like a businessman. Buffett is a businessman who is also an investor.

• Buffett ran multiple businesses while still a student: He sold refurbished golf balls, peddled stamps to collectors, ran a network of pinball machines when he was 17, owned a tenanted farm, and managed a 50-strong paperboy route
• He dealt hands-on with strikes and turf wars at newspapers from The Washington Post to the Omaha Sun
• Buffett didn’t just buy, hold and drink Coca-Cola – he engineered the replacement of its CEO
• With all the new businesses, from See’s Candies to GEICO, he added everything from their stock level reports to weekly sales projections to his endless daily reading
• Berkshire Hathaway is far from a simple holding pen for Buffett’s investments. He’s used his business acumen to produce an intricate money-making machine which takes cash from its subsidiaries and the float from its insurance businesses and reinvests it at higher rates of return, multiplying his returns

Takeway: Buffett’s success will never boil down to filters or ratios. Investors who try to ape him simply by reducing his methods to dubious cashflow projections or buying any old listed household name when its stock price falls 20 per cent will never replicate Buffett’s success. (Okay, rounding down roughly nobody is ever going to replicate Buffett’s success, but you know what I mean).

Buffett’s record suggests investors should spend as much time reading about business and management as they do calculating P/E ratios. The trouble is, all manner of financial ratios are available at a touch of a button. Buffett’s sense of business value is far harder to emulate.

5. Buffet makes mistakes

He really does! I was even more heartened by Buffett’s stinkers than by his golf ball robbery.

Some classic Buffett cock-ups include:

• Him and his friends spending $25,000 in 1957 on four-cent Blue Eagle stamps that the US government was about to take out of circulation. By securing and controlling the supply, they destroyed any chance of the stamps becoming valuable. His partners in the caper were still mailing him with postage paid for by sheets of the stamps decades later.
• He bought The Buffalo Evening News in 1977 and had lost $10 million within three years by becoming embroiled in a price war and a fight with the unions (though it later became very profitable)
• Buffett’s firm Berkshire Hathaway is living testament to his biggest mistake – spending millions to gain control of a doomed textile manufacturer
• Buying into Salomon Brothers in 1987 for $700 million eventually plunged him neck-deep into the Wall Street culture he so despised, when its rogue traders and poor management threatened his reputation and fortune

Takeaway: Mistakes happen even to the best of us. Sadly, having read The Snowball cover-to-cover I haven’t found a Buffett blunder to rank with my own worst investment (an iffy company called Homebuy that went bust overnight). But I saw plenty of examples where Buffett dusted himself down after an investment misfired and tried to learn from what went wrong.

Virtually all Buffett’s purchases of major insurance companies seem to have gone awry in the early years, for instance, and yet it’s by reinvesting all the cash thrown off by these companies that Buffett has maintained Berkshire Hathaway’s incredible growth rate.

The moral is to not despair when an investment turns out badly, but try to figure out what you can takeaway from it, as well as what you can salvage the situation.

6. Buffett considered quitting investing in his early 30s

In 1969 Buffett wrote to his investors that he was going to close their partnerships:

“I know I don’t want to be totally occupied with outpacing an investment rabbit all my life. The only way to slow down is to stop. I am not attuned to this market environment, and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.

“I do know that when I am sixty, I should be attempting to achieve different personals goals than those which had priority at twenty.”

Takeaway: What can anyone learn from this but humility? I already knew before reading The Snowball that Buffett wound down his partnerships in 1970 because he thought the market too over-valued to deliver an adequate return for his investors. That move alone would seal Buffett’s place in history among value investors, even if he had retired.

Of course, Buffett didn’t retire. He is still compounding his investments at an average rate of over 20% a year, nearly four decades later.

7. Buffett treats becoming the world’s richest man as a game

I couldn’t even begin to quote examples from The Snowball showing how Warren Buffett is in it for the scorecard, not for the payday: the entire biography is a testament to it.

No sports cars or private islands for Warren Buffett – even when he eventually bought a corporate jet he called it ‘The Indefensible’. For decades he bought suits from the everyman outfitter nearest his office, and his biography frequently mentions (and has photographic evidence of) his favourite threadbare jumper. And famously, his main residence is the first house he bought in 1961.

From setting that goal aged 11 of becoming a millionaire by 35, Buffett seems to treat investing as an intellectual challenge. He probably learned this from his great mentor Benjaman Graham, who seemed more bothered by being right than being rich, and for whom investing was just one of several high-end hobbies.

Buffett’s ‘inner scorecard’ helped him save and reinvest his money early on

Unlike Graham, however, Buffett really cares about every penny. From ‘Buffetting’ a few cents off the price he paid for stocks to demanding his friends sell him shares they’d bought in companies he was interested in, right up to his close personal friendship with his rival for the title of world’s richest man, Bill Gates, Buffett really wants to have the biggest snowball.

If you were to say there’s something rather peculiar about chasing money as a means to an end, I could certainly see your point. But when the recipient chooses to leave virtually all $62 billion of his winnings to charity, it’s hard to complain. I’d rather have Buffett as the world’s richest man than the Salomon traders who almost destroyed his reputation.

Takeaway: Spend less than you earn and reinvest the difference in the stock market. Buffett may have lived a remarkable life, but that central practice is something we can all aspire to.

Beyond that, I don’t want to get too moral. I’m happy to live below my means, but can I honestly say I’d be happy with Cherry Coke and a steak from the local shop if my means were sufficient to buy up The Maldives or launch me into space? Unfortunately I’m not qualified to comment.

I do think my attitude is closer to Buffett’s than to the more visible of the cityboys I’ve seen in London over the past few years, for whom cash is flash. Also, Buffett’s self-containment from materialism – he calls it his ‘inner scorecard’ – undoubtedly helped him save and reinvest his money early on, and got his investing career off to a flying start in his 20s. You have to accumulate before you can speculate. Good luck rolling your own snowball.

I can’t recommend The Snowball enough for anyone interested in business and investing. Obviously, anyone interested in Warren Buffett should buy it too, but I imagine you’ve all got two copies already (one for your library and one for your bathroom). The book is seemingly always discounted at Amazon (click through for the latest price at Amazon US or at Amazon UK) so there’s no excuse. Except, perhaps, it weighs a tonne, so you might put your back out while reading it.

Further reading:

1. The Warren Buffett hedge fund that wasn’t
2. How did Warren Buffett get rich?
3. 5 ways to invest like Warren Buffett (from the man himself)

Most of us get into investing because we want freedom, whether it be freedom from the office, from traffic jams or from the drudgery of a mortgage. We want to be free from having to work for a living.

Why then are money-motivated books called things like The Millionaire Next Door or Secrets of the Millionaire Mind? A million isn’t what it used to be, but it’s still more than most people require for financial freedom.

What many of us are really looking for is a replacement for our salary. The number on your pay check is therefore the number you need to beat.

If your salary arrived in your bank account no matter what you did, wouldn’t you be free? You could quit work the next day, if you wanted – or you could get a more enjoyable or meaningful job, work for charity, or do a dozen other more fulfilling things instead.

This post explains why and how I focus my investing on growing my annual passive income stream to replace my income, rather than concentrating on my net worth.

Note: If you’re an American or European investor, please do keep reading. The principles of good money management are international! Just mentally swap the £s for your currency and scale up or down as appropriate.

Why target income instead of capital?

Generating a sufficient income to replace your salary is going to require some serious capital. There’s no escaping that fact.

But I believe there are some subtle benefits in targeting income rather than a capital sum when making your investment plans:

• Replacing a salary is a more tangible goal for many people. Having £1 million sounds like winning the lottery. Generating £25,000 a year sounds more feasible. We only achieve what we truly believe we can achieve.

• Better investment decisions. If you’re shooting for the stars, you’re liable to trip in the gutter by taking too many risks. If you’re building a portfolio of income producing assets, you’ll take a more measured view, reinvesting dividends over time and not being scared out by blips in asset prices.

• Asset allocation. There are plenty of income producing assets (I list a few below). By buying different ones as and when they appear cheap, you’ll build up a nicely diversified portfolio as well as buying more income bangs for your investment buck. Aiming for a capital sum could encourage you to chase whatever sector is currently hottest and likeliest to come crashing down.

• Reduce portfolio churn, taxes and dealing fees. This is a great hidden benefit. If you buy shares in a company with an 8% dividend yield, you should never need to sell it provided the income keeps coming in (and ideally rises with inflation). That means no extra fees for your brokers, and no capital gains tax (or, in the UK, stamp duty) for the tax man – and so more money for you to compound over the long-term or to spend later.

What assets produce income?

Plenty of assets grant you regular cash payments in return for holding them. They range from the very safe (cash), through bonds and property, right up to the very risky (such as out-of-favor small-cap shares that may or may not double in price, or cut their dividend, or go bust).

Other assets such as gold and other commodities, mining shares, and tech stocks typically don’t produce much income. Instead you hope for a capital gain.

In rough order of riskiness (and so higher long-term income as a reward), you could consider the following assets for your income portfolio:

• Cash
• Government bonds
• A private or state pension (if you’re old enough)
• High grade corporate bonds
• Junk bonds
• Regular savings into an equity-income investment trust or fund
• Investing in a stock market index-tracking fund (the UK FTSE is currently paying over 5%)
• Investing in a commercial property fund
• Buying residential property to let out (but remember you’ll need to pay for its upkeep, and property may well be in a bubble right now)
• Creating a high-yield portfolio of good dividend paying shares (arguably not actually that risky over the long-term, provided you can ignore the fluctuations in capital)
• Overseas property
• Exotic and specialist income plays (like Prodesse, the mortgage-backed security investment trust I bought)
• Investing directly in small private businesses for a share of the profits

These are just the pure investments – there are other options. For instance, you might create a second income stream, especially if it’s based on a hobby you’d enjoy doing once you’ve quit work.

How much income do you need?

You tell me? Seriously – another benefit of aiming to replace your salary through a passive income stream is you should know roughly the figure required, rather than going after the rather nebulous idea of a million pounds, dollars, or whatever your currency of choice is.

Here’s an example income portfolio. Say you’re currently earning £25,000 as a salary. You might replace that salary with a portfolio containing the following income-producing assets:

• £25,000 in cash, yielding £1,250 per annum
• £35,000 in government bonds, yielding £1,250 per annum
• £100,000 in a corporate bond ETF, yielding £5,500 per annum
• £50,000 as a deposit in two well chosen buy-to-let properties together yielding £3,000 per annum after expenses and mortgage interest
• £200,000 in a high-yield portfolio, yielding £10,000 per annum
• An online eBay hobby business you build up over two to three years, which generates £4,000 per annum after costs

Adding all that up, you’d need £410,000 to replace your current salary. Still a huge sum, but not insurmountable. Remember, most of these assets should go on producing income forever (with ups and downs), so you’d have a fair-sized pension on quitting work, too.

With an income strategy you’re like the famous old Southern gentlemen – you try NEVER to sell your capital, you only live off the income.

If I was at all young (say under 50), I wouldn’t try living off £410,000 for the rest of my life, even if I didn’t touch the capital. It’d be more sensible to aim to replace your salary plus 25% extra, and to reinvest the excess, to give yourself a margin of safety.

On the other hand, if you’re an adventurous type you may decide not to save any more money once you’ve left work and started drawing your investment income. You’re currently saving and investing a chunk of your current salary, remember – this money could go on living instead. In that case you’ll need less income than your current salary to live on. Risky, but each to their own.

You’ll also want to take into account tax differentials between different asset classes. Dividend income is tax-free for lower-rate tax payers in the UK, for instance, so you may find you ‘take home’ more than you did when working!

Savings and salary working together

While you’re still saving and building up your income portfolio, the income-producing assets you’ve already bought will contribute money that you can use to buy yet more income.

For instance, if you’ve already got a £100,000 share portfolio, then dividends could add £5,000 to your income buying war-chest every year. It’s yet another example of compound interest working in your favour.

Never forget inflation

Won’t you need more than your salary in 10 years time, due to inflation?

Good point. You’ll need an income that is keeping up with the inflation rate to maintain your purchasing power – or better yet, increasing with wage inflation, to keep up with the neighbors.

• It’s certainly possible to achieve an inflation-proof income with shares and property, since over the long-term dividends and rent will likely keep up.

• You won’t want to hold too much cash or government bonds, since the income produced will usually hardly cover inflation, and will need to be reinvested.

• You’ll need to reinvest a significant portion of your corporate bond income, too (perhaps 30-50%, if you’re getting say 6% a year on it and inflation is around 2.5%) to stop its value being eroded over time.

In terms of the target income required, it will definitely rise as you save towards it. Concentrate on the riskier assets such as shares and property in the early years, since the income they produce should also go up over time. Like this, in practical terms your target isn’t racing way from you, and you’ve more time to ride out volatility.

Incidentally, if you’re trying to achieve financial freedom by saving cash alone, you’re doomed unless you earn millions. Surplus income from an ordinary job almost certainly won’t be enough to enable you to save enough to make up for the corrosive effects of inflation, even in if you stash it ALL away.

Escaping from the rat race does not come cheap, and I’m not about pretending that it does.

To return to our example of replacing a £25,000 salary with passive income, if I invested mainly in shares and rental property and only diversified the portfolio into fixed income such as bonds in my final years of saving, I’d plan on investing around £7,000 a year into shares for 25 years, assuming a pretty aggressive inflation-adjusted annual return of 7%. (Handily, £7,000 is just under the annual ISA limit in the UK, so I could keep all my savings safe from the taxman).

I’m a money saving ninja, and that would be a tough but achievable goal for me. But it will be too much for many people – which is why most people you know will still be working at 70. If you want it enough, you’ll find a way (I’d suggest creating a second income stream is an ideal way to start).

On a more positive note, if you can increase your annual savings as your salary goes up over the years, you’ll bring down the time it takes. Bonuses, inheritances, and wins on the horses can all be deployed to buy you a bit more of that precious salary-replacing income.

Do what works for you

Some people will respond more readily to ambitious targets such as ‘making a million’. For them, the salary replacing strategy is going to sound too pedestrian. That’s fine, whatever works for you.

I hope however that the idea of investing for income to achieve financial freedom has at least struck a chord with some of you. And I’ll look forward to receiving a postcard from you mailed on a working day from some dream location in a couple of decades’ time!

Further reading:

1. 10 good reasons to retire early
2. Do you want to retire early enough to save 75% of your income?
3. Companies paying dividends early to beat higher UK tax rates