The stock market is booming this year, and at the time of writing the S&P 500 is up a healthy 16% YTD. Along with it, most portfolio balances are reaching new highs. This has put a lot of otherwise smart investors in a very good mood.
Euphoric might be a good word for it.
As portfolios continue to reach new all-time highs, I’m seeing a ton of new folks declaring retirement dates on social media (Twitter, Facebook, etc). And it worries me.
Is now really the best time to pull the plug on your job(s) and “go for broke” with this early retirement business?
We must not forget the volatile nature of capital markets! Don’t just make plans based on the good times — make plans for days when times are tough. Quitting your job during the middle of a booming market (potentially a bubble market) could be a very bad idea…
The Moving Truck
To illustrate this point further, imagine your family has just purchased a beautiful new home in the suburbs. It’s a decent drive away, and you’ll need to drive all your boxes and furniture over in a moving truck.
To get the truck to your new home, you’ll have to cross a river. There are several different bridges on which you can cross.
Being an astute and careful truck driver, you know the truck has a vehicle weight of around 13,000 pounds when empty. The nearest bridge can hold a maximum capacity of 15,000 pounds. On the surface this seems like it won’t be a problem, but we must remember the moving truck will be full of boxes, furniture, and other items from your household.
The contents of that moving truck with cargo could potentially be 2,000 pounds. There’s also the potential for it to be heavier by several thousand pounds, or lighter than 2,000 pounds. You just don’t know!
Would you risk driving that moving truck over the 15,000 pound bridge, hoping your cargo weighs less than 3,000 pounds? (It’s also worth imagining that the bridge is a rundown U.S. bridge, which adds to the uncertainty.)
Or, would you spend the extra hour and drive to the next bridge with a maximum capacity of 21,000 pounds? Personally, I’d spend the extra hour to go over a safer bridge.
The Market Is An Unknown
Clearly, the answer to the moving truck question has a lot to do with your personal risk tolerance, and your ability to estimate the weight of the cargo. Most people will have no skill at estimating the cargo weight, so it makes sense to take extra care when choosing which bridge to drive over.
Just like the weight of that moving truck, the true value of your portfolio is an unknown variable too. We all know that markets continuously cycle between boom and bust periods. The value of your portfolio is going to more or less follow those market cycles over time as well.
Today it could be at a peak, but tomorrow is anyone’s guess!
Historically we see that bear markets have an average loss of 34%. The biggest recent downturn was the 2008 crash, with a 57% drop in the S&P500 (peak-to-trough).
Knowing these big swings can happen, why would you want to retire with numbers from a booming bull market? Well, you wouldn’t, not without some significant and careful planning!
How Much Do You Actually Need In A Bear Market?
Imagine you’ve set your retirement number at $2 million with a 4% withdrawal rate. Those assets (and withdrawal rate) should provide a comfortable $80,000 a year in retirement spending. Fantastic! You can now give your evil boss the middle finger and retire comfortably for the next 50 years, right?
Unfortunately the unexpected happens, and the market crashes by 50% next week. Woops! If you keep spending $80k/year it’s going to be a failure under most simulated market conditions.
Now your portfolio is only valued at $1 million. If you still believe in the 4% rule, and are willing to adjust your withdrawal to match, this leaves you with a mere $40,000 per year to spend until the market recovers. Some serious belt tightening is required.
For most people, this is nearly impossible. Lowering your spending by 50% is a very difficult proposition! Most people could perhaps cut a few thousand dollars out of their budget by eating-out less, cutting-off a few subscriptions, and maybe traveling less.
But cutting by 50%? That’s really hard to do! Nobody wants to live off cat food and rice in retirement! And is it really worth retiring if all you can afford to do is stay at home and watch Netflix?
I’ve said it once, and I’ll say it again — Don’t retire on the bare minimum! Discount the value of your portfolio and spend less than 4%… so that when the bear market actually begins you’ll be a comfortable position.
Discount Your Portfolio
Don’t get me wrong, it’s perfectly OK to be excited when your portfolio reaches a new high. I get it! Congratulations! But the fact of the matter is, a bad bear market can easily come along and clobber your portfolio.
So how much should you actively discount your portfolio by when calculating retirement numbers?
I suggest using the median CAPE ratio relative to current the ratio as a method to determine this. You can find the current market CAPE ratio here.
Right now the current market CAPE ratio is at 37.6, and the median CAPE is 15.85. To find the discount, simply divide the median by the current CAPE ratio:
15.85 / 37.6 = 0.42
This means the median is only 42% of the current market value! This will be our discount rate.
(Note: Technically a CAPE 20 would work here too, but let’s be conservative and use the median.)
Next, it’s time to decide on a more realistic withdrawal rate than the 4% rule. We’re living longer and retiring earlier than the Trinity study ever imagined, so it’s time for an update. Many experts recommend using less than 4%, and I think they’re right. Market conditions have changed since the days of the Trinity study, and we must adapt. EarlyRetirementNow has a good post on this subject, where he argues a safe withdrawal rate of around 3.25% – 3.5% will likely survive 60 years. (Although its worth noting his assumptions have inflation at rates much lower than where they are today.)
To keep things simple (and safe), let’s use a safe withdrawal rate of 3.25%. If we use our earlier portfolio value of $2 million, we now can calculate the following discounted annual budget:
$2,000,000 * 0.42 * .0325 = $27,300 annual budget.
Can you live off that? Admittedly this is something of a worse case scenario, but it could happen.
If you don’t plan on cutting your budget to poverty levels during the next recession, I suggest reversing the equation and working backwards from your minimum annual budget (in this case let’s use $60,000 as the budget floor):
$60,000 / .42 / .0325 = $4,395,604 portfolio value
To maintain that $60,000/year budget in a terrible bear market, you would need $4.4 million in today’s dollars. In most years your spending can be significantly higher than $60k.
Punching these numbers into cFireSim (making sure to set the $60,000 budget floor), we get a 100% success rate, with the lowest annual spending of $61,059 and the highest at $648,783.
Most of the simulated portfolios finished above the $4.4 million starting point too.
This is exactly what we want to see in a strong inflationary environment, where prices are continuously rising. That $4.4 million (or whatever you have left) will have significantly less buying power in 50 years! We need to keep up with inflation even in our elder years!
You certainly don’t want to feel the budget squeeze as you age; you want live a life that gets a little bit better every year. Proper discounting of today’s elevated market values makes a huge difference in the final outcome.
While these are all hypothetical numbers, it makes sense to think carefully in scenarios where there big unknowns exists (like higher inflation rates, and bubble-like market values).
The future is always uncertain, and bad things happen. Sometimes this means planning to have a little too much, rather than too little.
I’d much rather drive my portfolio over a bridge that can hold it, and have plenty of room for error. I’m not a big risk taker when it comes to providing for my family.
That said, my discount rate might seem too conservative for folks willing to risk it and retire on less. It’s perfectly OK to be a risk taker, but need I remind you that in 2009 the stock market did actually retreat to the Shiller PE median following the Great Recession. I’m not making this stuff up! It did happen, and likely will again at some point.