Valuation-Informed Indexing #402
By Rob Bennett
Early retirement is an option for millions of Americans. The reason is that our economy is more productive than it was in earlier days. In a less productive economy, each hour of labor produces less of a financial return. So in earlier days it was a rare thing for someone to be able to produce enough wealth to be able to retire at age 60 or at age 55 or at age 50. Today, there are lots of people who can pull it off if they make the goal of achieving financial freedom early in life a high enough priority to help them resist enticements to spend their increased productivity dollars on good and services that offer them less in the way of personal fulfillment than breaking free of the need to work to pay the bills.
I would like to see more people become aware of the possibility of achieving financial freedom early in life. So in earlier days I wrote only about how to develop effective saving strategies and ignored the investing issues that have become my focus over the past 16 years. I learned that ignoring the investing side of the story is ultimately impossible. Those who become effective savers with the aim of achieving early retirement must invest their saved money effectively to achieve the goal. And following the conventional investing advice of today stands a good chance of causing them to wish that the thought of achieving financial freedom early in life never occurred to them.
I was an active poster at a Retire Early discussion board at the Motley Fool site starting in May 1999. I had lots of fun talking things over with some of the most effective savers in the world. I never posted about investing in those days. I had doubts about the raging bull market that was being widely celebrated at the time. I realize now that it was that bull market and the false ideas that it put in people’s heads about how much wealth they had accumulated that led many of my friends to believe that early retirement might be a viable option for them. I realize today that those people were being misled terribly and I regret my decision at the time to refrain from speaking up about the doubts I held as to what the bull market of the late 1990s represented.
It represented a con. Not in the way that we usually think of a con. I don’t believe that there were people who were deliberately tricking other people. I believe that as a nation of people we were all tricking ourselves. During the insane bull market of the late 1990s, we told ourselves fairy tales about the possibilities that had become opened to us as a result of the rapidly rising stock prices of those years. Some of us put lots of effort into telling the fairy tales. Others of us were reluctant to do so, probably because of some sort of common-sense-based intuition telling us that money that seems to come from nothing is not real and does not last. But of course we played a role in letting the craziness get so out of hand just as important as the role played by the big-time promoters of it. I regret today that I did not speak up more strongly. I was a coward. All of the many cowards who tolerate bull markets play a big role in the process by which they get so out of hand.
I can show you with numbers how bad things got in those days.
The Buy-and-Holders have a rule that they use to tell aspiring early retirees when they have saved enough to be able to hand in their resignations from their corporate jobs with little fear that the decision will ever come back to bite them. The rule is called “The 4 Percent Rule.” The rule was cited in thousands of newspaper articles published in those days. It is not cited as often today but it is still around. If you run a Google search on the term “The Four Percent Rule,” I am confident that lots of material both dated and new will turn up.
The idea is that someone contemplating retirement can be assured that his portfolio will not be reduced to zero within 30 years so long as the amount that he needs to take out of it each year to cover his living expenses does not exceed 4 percent of the starting-point portfolio balance. A retiree with a portfolio balance of $1.5 million is ready to retire so long as he does not plan to withdrawal more than $60,000 per year in retirement (that’s 4 percent of $1.5 million). The rule is promoted as a highly conservative approach to retirement planning. Afterall, the average long-term stock return is 6.5 percent real. A 6.5 percent rule would permit an aspiring retiree who requires $60,000 to live on to retire before his portfolio balance reaches $1 million. To tell the fellow that he needs to wait until his balance reaches $1.5 million appears on first impression to be a belt-and-suspenders approach.
Say that you are an aspiring retiree who in January of 1996 holds $700,000 in your account. You look at this 4 percent rule being pushed by most of the experts in this field and you see that you are $800,000 short of what you need to finance a retirement that permits annual withdrawals of $60,000. “Oh, well,” you think to yourself, “”early retirement was a pretty dream but it does not appear to be a viable option for me.” For the next four years, you give up on the goal, spend all of your earnings on fun stuff and save not one additional penny.
Then you happen to do a quick check on the status of the crazy dream in January 2000. Lo and behold, the stock market has produced a return of 126 percent over the four years. You had less than half of what you needed to retire safely in 1996. But four years later, after saving not one additional penny, you have $1.58 million in your account, more than the $1.5 million needed for a “100 percent safe” retirement, according to the 4 percent rule (one study that was cited daily at the discussion board I frequented in those days used that precise phrase without irony). By magic, you went from being a guy with nowhere close to enough to one with more than enough to do so with perfect safety.
Lots of my friends fell for it.
I don’t believe that those retirements were “100 percent safe.” Most of the gains of those four years were the product of irrational exuberance. Not of anything with genuine economic significance. Adjust for valuations (as Shiller’s Nobel-prize-winning research shows you must) and you learn that the safe withdrawal rate for those planning to retire in January 2000 was 1.6 percent, not 4 percent. Do the math properly and you learn that the fellow retiring at that time with $1.5 million and plans to spend $60,000 per year had only a 30 percent chance of seeing his retirement account survive 30 years.
What a funny joke!
I believe that we can do better than the investing advice that has become popular during this long, crazy bull market. I believe that we can do a lot better. I believe that lots of the people whom I helped save more effectively were hurt in serious ways when they were misled into thinking that they had saved enough to retire safely when they had not yet done any such thing. That’s why today I focus my efforts on the investing side of things.
Rob’s bio is here.