Welcome back to the newest installment of the Safe Withdrawal Rate Series. To go back and start from the beginning, please check out Part 1 of the series with links to all the other parts as well.
Today’s post is a follow-up on some of the items we discussed in the ChooseFI podcast a few weeks ago. How do we react to a drop in the portfolio value early on during our retirement? Recall, it’s easy not to worry too much about market volatility when you are still saving for retirement. As I pointed out in the Sequence of Return Risk posts (SWR series Part 14 and Part 15), savers can benefit from a market drop early during the accumulation phase if the market bounces back eventually. Thanks to the Dollar Cost Averaging effect, you buy the most shares when prices are down and then reap the gains during the next bull market. That has helped the ERN family portfolio tremendously in the accumulation phase in 2001 and 2008/9.
But retirees should be more nervous about a market downturn. Remember, when it comes to Sequence of Return Risk, there is a zero-sum game between the saver and the retiree! A market drop early on helps the saver and thus has to hurt the retiree. What should the retiree do, then? The standard advice to early retirees (or any retiree for that matter) is to “be flexible!” Great advice! But flexible how? We are all flexible around here. I have yet to meet a single person who claims to be completely inflexible! “Being flexible” without specifics is utterly useless advice. It’s a qualitative answer to an inherently quantitative problem. If the portfolio is down by, say, 30% since the start of our retirement, then what? Cut the withdrawal by 30%? Keep withdrawals the same? Or something in between?
How flexible do I have to be to limit the risk of running out of money?
That’s today’s post: Using dynamic withdrawal rate strategies, specifically CAPE-based withdrawal rules, to deal with the sequence of returns risk…
I have a confession to make! In the ERN family portfolio, we have almost no international diversification. We invest the bulk of our financial portfolio in U.S. index funds; FUSVX and FSTVX, which are Fidelity’s (lower-cost) alternatives to the Vanguard Admiral shares VFIAX and VTSAX, respectively. Our international exposure is in the low single-digit percentages. How come, you ask? How useful is international diversification, anyway? Jack Bogle, for example, claims that with a diversified U.S. equity portfolio you will capture pretty much the entire global economy already because U.S. corporations do business all over the world. That argument, of course, is not very convincing. Doing business abroad obviously means that you get some diversification, but it definitely doesn’t imply you get enough diversification from a U.S.-only portfolio. To see how flawed that “revenue from all over the world” logic is, keep in mind that Apple is generating revenue from “all over the United States” but nobody in their right mind would ever call for investing exclusively in Apple stocks as a good proxy for the entire U.S. stock market.
Let’s look at the chart below to see how the U.S. stock market is clearly not a very precise proxy for international stocks. It’s a scatter plot of U.S. monthly equity returns on the x-axis and global returns (both non-U.S. and all global stocks). World ex USA has only a 0.65 correlation with U.S. equities. If for most x-values the blue dots are scattered around the 45-degree line +-/10% or even +/-15% (monthly!!!) then we clearly don’t capture everything going on in the world with a U.S.-only equity fund. (Of course, the overall World index has a much higher correlation; the orange dots are closer to the 45-degree line, but that’s mostly because global stocks already include the U.S. with a weight of about 50%.)
So, diversification could theoretically work! Then why am I not more enthusiastic about international diversification? Very simple:
It’s less about whether diversification works. It’s more about when diversification works and especially when it doesn’t.
Today’s volunteer “Rene” (not her real name) was laid off earlier in 2017 and is now living off her severance package. She wonders if she has enough of a nest egg to simply call it quits and retire in her late 40s. And many other questions: if/how/when to annuitize any of her assets and what accounts to draw down first? So many questions! As I pointed out in Part 17 of the Safe Withdrawal Series, a safe withdrawal rate calculation has to be a highly customized affair and that’s what we’ll do today again. Let’s see what the numbers say! Continue reading “Ask Big Ern: A Safe Withdrawal Rate Case Study for “Rene””→
I don’t think anyone has recommended selling equities and running for the hills. I certainly haven’t, and I am probably one of the more pessimistic FIRE bloggers. Please don’t buy gold coins! Personally, I would never bet against the U.S. stock market. If you had invested $1.00 in large-cap equities in 1871, your investment would have grown to over $13,000 by July 2017, even adjusting for inflation. In nominal terms, to more than $260,000! How amazing is that?
So the good news is: Stocks have the tendency to go up, on average. The broad index not just recovered from every possible disaster we have ever encountered (2 world wars, the Great Depression, several financial crises, the Dot Com bust, 9/11, etc.) but rallied to reach one all-time high after the other. After every cycle of fear, we see a quick recovery back to economic fundamentals. But buried in the equity return chart above is one small piece of bad news; the flipside of the market bouncing back from disasters and returning to the trend is that stocks also underperform after long periods of above-average performance. And this is where Jack Bogle is coming from. He doesn’t forecast a new bear market – nobody can – but simply predicts a decade of underwhelming returns after the strong bull market over the last 8 years. How do you even make a forecast like that? That’s the topic for today’s post…
A few weeks ago I had the honor of talking to Jonathan and Brad over at the awesome ChooseFI podcast. Today, this long-awaited episode finally went online, so I hope everybody heads over to check out this podcast:
Almost everywhere in life, the word “active” has a positive connotation. An active lifestyle, an active personal life, an active participant in a discussion, etc. In contrast, “passive” stands for low-energy, dull and boring. Imagine setting up a friend on a blind date with a nice gal/guy who has a really great “passive lifestyle” and see how much excitement that generates.
But investing is different. Passive investing is the rage right now! It is a noticeable market trend in finance overall and the Financial Independence blogging world seems particularly subscribed to the passive investing idea. For the most part, I agree with the superiority of passive investing. But then again, not all active investment ideas are created equal. And that means that we are at risk of throwing out the baby with the bathwater!
Has the Personal Finance Passive-Pendulum swung too far? Are we willfully ignoring some useful principles from active investing for fear of shaking the foundations of the Passive Investing Mantra?
Take the following five examples of active investing. They all fall into different spots on the Futility vs. Opportunity spectrum:
Style investing, i.e., tilting the portfolio toward a theme such as dividend yield, small stocks, value stocks, low volatility stocks, etc., or a combination of them.
Allocation to different asset classes (e.g. stock, bond, cash, alternatives) in response macro fundamentals (P/E ratios, bond yields, volatility, etc.).
Changing the major asset weights over the life cycle, e.g., using an equity glidepath to retirement and even throughout retirement.
Setting the initial safe withdrawal rate in retirement and all subsequent withdrawal rates in response to changing market conditions.
It would be a mistake to apply the same passive investment mantra to all five aspects of personal finance. So, that’s what today’s post is about: Where should we stay away from active investments and where can we learn something from active investment principles? Let’s look at the five active investment themes in detail…