How current economic changes impact retirement safe withdrawal rates

Recently I’ve really started to notice the impact of inflation on daily spending. Have you?

At first, it was just 1-2 things. Then it was a handful. Now it seems like everything is noticeably more expensive. (Assuming it’s even in stock in the first place.)

Gas. Groceries. Takeout. Toiletries. Utilities. Car maintenance. Healthcare/supplies. Pre-school. Appliances.

Everything seems to cost more and you just can’t buy as much with the same budget anymore.

This got me wondering about how recent macroeconomic changes over the last 6 months might impact retirement safe withdrawal rates and asset allocations.

The macro changes I’m referring to are: Inflation at a 40-year high. Stock valuations doubling since their pandemic lows. Interest rates that are scheduled to increase a minimum of 3 times this year.

In these times, what should investors and retirees be doing to defend their portfolio values and retirement security?

This week, I asked my friend Karsten Jeske (aka “Big ERN”) to help us make sense of all that is going on right now in terms of macro trends…and what it all means for safe withdrawal rates and asset allocation. We had a wide-ranging, nearly 2-hour(!) discussion full of insights and tips that you won’t want to miss.

We discuss:

Major recent macroeconomic changes that (early) retirees may want to factor into their retirement planning
What new safe withdrawal rate % retirees should consider right now
Whether investors should potentially update their asset allocation given current macro trends
Whether he believes asset prices are overvalued right now
Alternative assets (like cryptocurrencies) and their merits / concerns
How much cash he believes is advisable to hold right now

Have you (or are you) planning to make changes to your asset allocation or safe withdrawal rate in light of recent macroeconomic changes? Let me know by leaving a comment!

How current economic changes impact retirement safe withdrawal rates (HYW085)

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Andrew Chen 01:22
My guest today is Karsten Jeske, also known in FIRE communities as “Big Ern,” which is an acronym for the blog that he writes extensively on, called “Early Retirement Now,” where he blogs about early retirement financial planning.

I’ve had Karsten on the podcast a couple times now, where we’ve talked about topics like safe withdrawal rates, sequence of returns risk, and asset allocation. He’s probably most well-known in retirement planning circles for his detailed analysis of safe withdrawal rates.

Well, with recent inflation and stock market valuations reaching historical highs, I wanted to bring Karsten back on the podcast to share insights on how early retirees and soon-to-be retirees should potentially consider adjusting their expectations in terms of SWRs. And maybe adjusting their portfolios, too, in terms of asset allocation. Because the last couple of years have seen some pretty significant macroeconomic changes.

Karsten has a lot of expertise in this area. He holds a Ph.D. in economics. He is a Chartered Financial Analyst. He has taught as an economics professor at Emory University; and he’s worked in economist roles at the Federal Reserve Bank of Atlanta, as well as the Bank of New York Mellon, in the Asset Management group, in San Francisco.

Oh, and he is also an early retiree who FIRE’d at the age of 44.

…So, I’m really excited to have Karsten back on the podcast today to share his insights on macroeconomic trends and their impact on early retirement planning. Let’s jump in!

So, we’re here to talk a little bit about safe withdrawal rates and portfolio adjustments, given all the macro changes that have happened since we last spoke. First, though, by way of intro, you’re probably best known for your research on safe withdrawal rates. But for those who haven’t caught our prior episodes together or just aren’t familiar, what is your background, broadly, when it comes to early retirement planning and wealth management research?

Karsten Jeske 06:21
I’m a former economist from the Federal Reserve. I did that from 2000 to 2008.

Then, between 2008 and 2018, I used to work for Bank of New York Mellon, Asset Management. I did that for 10 years.

And then 2018, I had enough, in multiple ways and senses of the word. I saved enough money to retire early, and that’s what we did in 2018. The funny thing is I actually found the FIRE community after I was pretty much already done with my FIRE preparation, so I didn’t even know that that movement existed until I was almost ready to retire myself.

Obviously, I’m a math geek, a finance geek, an economics geek. I like spreadsheets. I like MATLAB program, Python programming, and I like to do a lot of data analysis to see what are the risks of early retirement.

So, I wanted to see if there’s something out there that can help me gauge the risks and look at the tradeoffs. How much can we withdraw from our portfolio? How do you take a big portfolio, which is one dollar value, and how do you stretch this out into withdrawals over the next 50-60 years?

I didn’t really find too much interesting and valuable information out there, and I thought that maybe I have to do it myself so at least I know it’s done right. So I built my own little toolkit for simulating withdrawal exercises and simulations with past data, and then wanted to see, with my situation, what if I had retired in the 1960s or 1970s, in the not-so-attractive times to retire?

Everything becomes really easy if you retire in the early ‘90s and you have this big equity ball run. But the scary situations or the scary historical retirement cohorts would be something like 1929 or the 1960s and 1970s. So, the question is, with my personal situation, would I have survived some of these historical worst-case scenarios?

And what I found is that people would normally simulate retirement horizons up to 30 years (if you’re lucky, 40 years). And my concern was what if I have a 60-year horizon? Maybe I can’t retire at all.

There’s not a safe withdrawal rate at all. Safe withdrawal rate is zero. Sorry, keep working.

And I was actually positively surprised that what is normally considered a safe withdrawal rate, say, over 30 years was somewhere around 4%. You don’t have to reduce that a lot to stretch that into a 60-year retirement horizon.

Anyway, that’s what I started doing. And funny thing is I just had my five-year anniversary. Not the five-year anniversary of the blog, because I started the blog in early 2016, but my safe withdrawal rate series, when I started writing more seriously about the withdrawal math.

That’s what I started in December 2016, so that was just the five-year anniversary. And today, because we’re recording this on January 3rd, I just published the 50th post in that series. So, it has obviously grown.

I had material for a handful of blog posts back in 2016, but as this goes, one thing leads to another, and most of it because of feedback from readers, and interaction and comments from readers. People ask me, “Have you tried this, or have you tried that?”

And again, I’m not your personal research assistant, and people tell me something and I run the simulations for you. But if it’s something that I find interesting and exciting enough, a lot of my blog posts came out of that interaction and people asking me, “Hey, have you tried this?” and I say, “That’s a really good idea.”

Because a lot of the “solutions” to “This is how you don’t run out of money in retirement. Can’t you just do x, y, z?” And then for x, y, z, you can fill in all sorts of stuff.

What if you have a cash bucket? What if you include gold in your portfolio, or what if you have real estate in your portfolio, or what if you have flexible? Can we simulate some of that?

This is how the series has grown so extensively. I’ve chased down all sorts of rabbit holes of what people can and cannot do to alleviate some of that sequence risk. I haven’t found anything that completely convinces me that you’d never have to worry about sequence risk again.

But it’s been a good run, and it gave me the confidence to retire. Because sometimes people call me the Grinch of the FIRE community because I’m a little bit skeptical of the traditional 4% rule, so they think that I want to talk people out of retirement.

I actually have talked more people into retirement than out of retirement in the sense that I’ve done some case studies where people who thought they needed the 4% rule and 25x annual expenses, and then I did the math, and I found even if equities are very expensive, because you have some supplement or cash flows that are right around the corner…

Imagine you’re a 52-year-old early retiree, and you could draw Social Security already 10 years down the road, or you have a company pension, or any other supplemental cash flow. Once you factor that in, you can say that maybe in the future, you can reduce your withdrawals a little bit once that kicks in. You might even have a 5% or 6% withdrawal rate.

So, doing the analysis a little bit more precisely can actually go both ways, but it could increase your withdrawal rate if you find some idiosyncratic features and parameters in your personal life that would sustain a higher withdrawal rate.

For me, personally, when I retired, I looked at our supplemental cash flows, but it turned out that it’s too far in the future, and it’s also not that large. Our Social Security and a small company pension is probably not worth that much, so we were significantly under 4% in our spending target.

But then, of course, it was 2008, and the market has actually done really well since 2018. It turns out that that initial 3% was actually too conservative because our portfolio has now grown and we’re now withdrawing much less than even that 3% initial rate.

Anyway, that’s a little bit of my background, and my little claim to fame, and my little niche in the FIRE community.

Andrew Chen 13:44
Yeah, I remember that’s exactly how I found you. I was just searching around. I was doing some deep reading on safe withdrawal rates, and I was reading post after post.

I was like, “Oh, wow, this is really in-depth.” So, folks, you should definitely check out the series.

I remember that you have spreadsheets that you can download, right? I’m not sure if I recall this anymore, but was there a website software tool, like Portfolio Visualizer or cFIREsim, that you’ve made as a result of this?

Karsten Jeske 14:09
No, these are all external providers. I have a Google sheet, and I post that, I maintain that, I add the most recent asset returns to that. I think, right now, the asset returns probably go to either the third or fourth quarter of 2021.

But you still have to download that sheet and do your own calculation. I haven’t made a business out of this yet. For example, what you could do is you could just transform this into some kind of a JavaScript and make that into an app, or have this as a standalone website.

Right now, it’s a spreadsheet. And it has some advantages and disadvantages. It’s obviously not quite as consumer-friendly and user-friendly as some of these very nicely designed apps, but the nice thing is all of my formulas are right out there.

There’s nothing hidden, there’s nothing protected in the sheet. You can see all my formulas. You can see the returns I’m using.

I have actually a pretty extensive return series. I have the equities, bonds, 10-year bonds, the 10-year U.S. Treasury benchmark bond. I have the short-term cash rates, so the 3-month T-bill rate.

You can use the Fama-French factors, the small cap, and the value of a growth factor. I have gold. And if that’s not enough, you can also feed in your own custom series, if you want to.

For example, if you want to bundle some kind of an active strategy and simulate your own returns that are packaged into an active strategy or any other strategy, you can package that too, and run this with your own custom series. And because it is a spreadsheet, you can then copy and paste the simulation results and move that into your own personal spreadsheet.

So, in that sense, it takes a little bit more work on the end user. But once you’ve mastered this, it’s definitely a very nice tool, and it has a lot of different ways to play around it.

For example, I started running a lot of this as big MATLAB programs. I think, in the beginning, it was useful because I wanted to loop over every single possible combination of parameters, over different lengths of the retirement horizons, over different stock-bond weights.

That back then, I had to do via MATLAB, because at one point, I had to loop, and if you counted all of the different steps in the loop, I think I simulated six or seven million different retirement cohorts, so every cohort with all the different combinations of parameters.

But the funny thing is everything I’ve been writing recently that I publish on my blog, where I publish simulation results, is usually derived off of that Google sheet. That’s really how useful that sheet is. And if I can write 5000-word blog posts with that…

If you want to do a quick and dirty run of your own retirement case study, you can certainly do that with that Google sheet.

Andrew Chen 17:53
Yeah, so we’ll definitely link to that in the show notes. That’s a super useful resource.

What do you think about the other publicly available tools like cFIREsim? Are they valuable?

Do you use them, or have you checked them out before? What’s your assessment of them?

Karsten Jeske 18:11
cFIREsim was the first one I found, and I initially worked with that and tried to write some blog posts based off of that, because I think you can also export some results from cFIREsim. But very quickly, you reach the boundary of usefulness of some of these apps.

I think the most concerning problem with everything else out there is that, at least everything I’ve seen so far, they do annual simulations. They do just one single start date, and then you withdraw the entire annual withdrawal on December 31st or on January 1st.

The biggest concern with that is that in something like 1929, the peak was in September 1929, so if you simulate around the 1930s, you get a much higher safe withdrawal rate. Because you either do the December 31st 1928 or the December 31st 1929, and you don’t capture this market peak.

Because between the previous year-end, you had some huge run-up in the stock market, and then you already had a pretty big drop from that big market crash down to the end of the year. So you would then miss probably one of the worst times to retire, and you would artificially increase your safe withdrawal rate that way. So, I’d feel a little bit troubled by that.

And then the other thing I’ll feel troubled by, and I think this is basically the background of the people who wrote this. A lot of them are more the techy people, the IT engineers.

They run these simulations and say, “Oh, wow, I found there’s only a 2% chance of running out of money in retirement. This is fantastic. I’m going to run with this.”

Of course, what people then don’t understand is it’s not really a probability to begin with. It’s a historical ratio. It’s not really quite 100% a probability, but let’s call it a probability.

But if you call it a probability, it’s an unconditional probability. And it’s unconditional because there were tons of times when you don’t run out with the 4%, there are tons of times where you don’t even run out with the 6% safe withdrawal rate, but those were all the times when equities were really cheap and bond interest rates were very high, which is very much unlike what we observe today.

So, in that sense, what a lot of people call probabilities are really worthless numbers. Because if we want to calculate “probabilities,” we should do the probabilities conditional on where we find ourselves today. Otherwise, you would constantly make these mistakes where if equities are really expensive, then probably 4% might be a little too high.

But if you find yourself at the bottom of a bear market, then 4% would be insanely low. You’d probably go to 6%. So, you should condition your withdrawal math to your current market conditions.

I sometimes have the feeling that people who are outside of finance and economics don’t really appreciate these valuation issues, whereas when I talk to people who have a CFA charter, or econ or finance PhD’s, everybody speaks the same language and everybody realizes that we don’t want to take these unconditional probabilities like they do in a lot of these alternative simulation packages.

I certainly also report the unconditional failure probabilities, but then I also drill down what’s the failure probability conditional on being at the market peak, or being 30% below the market peak. And then you can see 4% might be a little bit shaky conditional on being at the market peak. But probably, if the market has already dropped by 30% and the CAPE is under 20, you would be crazy if you go below 5%.

Bring some finance into this because this is a very financial and very quantitative real world problem. This is not some kind of a statistics exercise where somebody pulls balls out of an urn. Or if it is, then you would have to understand there might be multiple urns, and if we consider the overall probability of all the urns, maybe the 4% rule has only a very small failure probability.

But if we only draw from the urn that has market conditions, like we find ourselves today with the CAPE above 30, actually almost 40, and interest rates really low, then probably you want to be a little bit more cautious.

So, these are all these things that were on my mind when I did my retirement calculations. I thought, before I “throw away” probably 20 more years of potential peak earnings in the finance industry, I want to be a little bit more certain about what I’m doing here and not do something based on “I read something on the internet, and then I retired.” It’s almost like this commercial with the guy who stayed at the Holiday Inn Express last night.

So, this is where I’m coming from. I want to do a more serious and a robust analysis of some of these issues.

Andrew Chen 24:20
It totally makes sense. So, again, we’ll make sure we link to that stuff because I think it’s important for folks to be able to see some of the rigor.

I definitely want to talk about some of these issues. Just before I jump in that, though, what are the big projects that you’re up to these days? What’s keeping you busy these days, other than the conferences?

Karsten Jeske 24:39
I’m still blogging. I’ve definitely taken down the blogging frequency. I only publish one or two posts per month.

But when I publish something, it’s usually something a little bit more extensive. It’s something like a 3000-, 4000-, sometimes 5000-word post, and it takes me a little bit longer to write that.

On top of that, I do a little bit of consulting; I work for a startup. No salary, but I would get some equity out of that, if that ever becomes valuable. It could also be worth zero, in which case, I work for free.

But I also do some number analysis, some economic forecasting. For example, expected returns or some processes that we’re trying to write and then market where, for example, equity bond and cash commodity expected returns would have to be determined. That was something I developed. I did some economic forecasting, so the GDP forecasts I did for them.

It’s a lot of fun. You don’t have to pay me for that. I find that interesting and intriguing and fascinating and worthwhile doing even without a salary, but if I make a little bit of money off of that eventually, that would be nice, too.

And then I just finished teaching a class in the extension program at UC Berkeley, and I taught Introduction to Microeconomics, of all things, which was actually one of my favorite classes when I was an undergrad, so I had a lot of fun with that last year. That has just wrapped up, and I’ll see if they want me back. I hope the students liked it.

A lot of these things evolved. I have to say that with the whole shutdown and you couldn’t travel much in 2020, I definitely took on some additional projects just to be busy, because if you’re cooped up at home much, you want to stay busy and involved.

Andrew Chen 27:01
Awesome. Let’s talk a little bit about what’s going on in the macroeconomic landscape right now.

Given all the havoc that the pandemic has wrought over the past many quarters, and the likelihood that we’re not so close to being out of the woods yet. At the time of this recording, Omicron is still raging.

What macroeconomic shifts, if any, do you feel like have happened that are going to stick or linger for a while, that retirees and early retirees should factor into their retirement and financial planning? And if there are such shifts, what are they?

Karsten Jeske 27:39
We’re recording this in early January 2022, so keep that in mind. This is with the best of my knowledge as of today.

It’s really quite intriguing and amazing how well the economy has recovered, because the GDP has already reached a new all-time high. Imagine we take the Q4 2019 as the last quarter before the pandemic hit. I think the two-year growth for earnings was almost 40%, so definitely corporations are doing very well.

So, it already shows you that when the economy is just barely back to the old high, and corporations have grown by 40%, there’s probably been some distributional impact of the pandemic. If you just look at the overall average macroeconomic variables, everything looks hunky-dory and everything is back to normal, but there’s definitely been a redistribution.

It’s actually the kind of redistribution that you obviously don’t want necessarily from the societal point of view. It’s a redistribution from poor to rich. It’s a redistribution from small mom-and-pop proprietary companies to corporations.

Even within the corporate world, there’s a redistribution from smaller corporations to larger corporations. So, all of the distributional shift have all gone in a direction that…

Lucky for me because my equity portfolio increased, and I didn’t have to sweat anything about losing a job. I didn’t have to sweat anything about losing a business.

We did sweat a little bit because we had to homeschool our daughter for three months in 2020, so that was probably my biggest cost and headache and heartache, because the kindergarten was shut down for three months. But that’s pretty much the only cost that we really faced. But imagine, say, people who are single parents with kids at home, and they have a job where they can’t just help their kids with the help they need.

The nice thing is we live in a school district which is pretty well-run. This is why we actually moved here. We live in Southwest Washington.

Every kid, when they did the online schooling, they all got their own Chrome Book, so it’s not like we had to buy anything. We could have bought something, but it wouldn’t have been a big expense for us.

But think about the distributional impact. What if the school didn’t provide that, and parents have to buy laptops? Or imagine you were a single parent, and you have two or three kids at home, and you have to provide the laptop.

By the way, when our daughter was sitting in front of the laptop and doing that online schooling, it’s not like you can just leave the kid alone completely by herself and unsupervised. This is what first-graders would be doing. They will just be doing something else and not paying attention, so you almost still have to have an eye on our daughter.

So, this is obviously one of the big concerns. What will this do to society long term? There has been this shift and this rift.

Just to be sure, I’m a pro-free market capitalist. I’m not really lefty or anything. I’m definitely very much pro-capitalism.

But even then, you have to concede. Could this have negative impacts long term that we have this redistribution shift?

On top of that, we have big government deficits. We have inflation running rampant a little bit. Not as bad as the 1970s, but it’s definitely a lot higher than anybody would be comfortable with, at least long term.

Short term, you can always take that inflation spike. But this is not something that anybody would want to last much longer.

We can talk more in detail about inflation later, but one thing that surprised me is how long and persistent the inflation chart was. For example, if you look at what happens when the economy restarted in the second half of 2020, you had this one big boost. I think we had one GDP quarter that was 33% annualized.

It’s not 33% quarter over quarter. It’s a little bit less than that. It’s actually less than 10%.

It’s probably 7.5% or so, quarter over quarter. You annualize that, and it just came out at some fantastic 33% GDP number in the third quarter of 2020.

But then, GDP has more or less normalized again. So, I’m a little bit worried because I honestly thought that this inflation spike is going to last. It’s very short-lived, but it’s going to be the one spike when everybody wants to travel again in the spring of 2021, and then it will wear out and we’re going to go back to 2% or 2.5% inflation again.

It hasn’t happened yet. It’s almost this procrastination problem where people say, “Well, 7% is not all right now, but it will soon become better.” But if we keep saying this for a little too long, this is exactly how the 1970s inflation problem started.

So, the other things, aside from the distributional part, it’s a little bit worrisome. We have very high debt and deficit numbers, and that’s obviously not sustainable.

Not only is this going to be a problem on the inflation side. The government spent a lot of money to get the economy running again, but what happens if the government, at some point, stops, either because they have to or they want to?

Is this going to create maybe not a recession, but something like a mini-slowdown? Not a full-blown recession, but a bit of a mini double-dip recession.

These are obviously concerns on my mind. Overall, I’m still quite optimistic. I think this is all just going to work itself through the system, but it’s definitely something on the horizon, on my radar screen.

Andrew Chen 35:30
For Joe retiree and Jane retiree, should they be considering changes to how they’re doing retirement financial planning based on what is going on right now? Or is it more to be aware, over-index on being a little bit more conservative when you have that flexibility, but there’s no very specific actions to take?

Karsten Jeske 35:55
I’m obviously biased. As an economist, I probably have this bias saying that economics is the most important thing in the world, and everybody should listen to that. But sometimes I’m actually the opposite.

I think that we should also not fall into this temptation where we hear something on the news and then we say, “Okay, I have to throw out everything I was planning because x, y, z happened. And we have to completely rethink everything.”

The best example for that is it’s amazing how much things changed in just a little bit over a year. Because if you remember, in late 2020, we had very low inflation. And then all these people come out of the woodworks, and they say, “Well, if inflation is really low, that’s actually really good for retirees.”

And I thought it was a really horrible article written by Bill Bengen. He’s a hugely popular and hugely appreciated guy. He’s actually the inventor of the 4% rule even before the Trinity study.

If he’s speaking and writing, people would pay attention. Basically, he said, “If inflation is low, that means you have to make smaller cost of living adjustments to your spending, and that should help you if you’re calculating your safe withdrawal rate. So, all else equal, if you make smaller cost of living adjustments, that means your money should last longer.”

Then he went through all of this elaborate numerical analysis, and then he found we can raise our safe withdrawal rate from 4% to 5.5%, just because inflation is so low. And I looked it up; that was October 2020.

And I wrote a post to dismantle some of the…not even knowing how bad the inflation problem is this time around. Even if inflation had been moderate, I didn’t find this case very convincing, neither numerically nor economically. I think it’s Part 41 of my series that deals with that.

Long story short, I wasn’t a big fan of changing anything drastically back then in response to low inflation. And I don’t think we should do anything too crazy about high inflation.

Keep in mind, some of the best assets for inflation protection would be stocks, because where does the inflation come from? It’s corporations passing through inflation pressures and raising their prices, and corporate profits will be higher, and they will keep up with inflation.

Definitely, stock prices, they not only keep up with inflation; they keep up with inflation plus. Over the very long term, easily 5%. And actually, over the very long horizon, your stock returns keep up with something like CPI plus 6.5% or 7%. So, you have some sort of inflation protection.

Now, of course, what’s a little bit more worrisome is that we can’t really have 100% in stocks in a retirement portfolio. I think most people on the way to retirement can probably keep 100% equities almost all the way until the end, or maybe even exactly until the end. But once you’re in retirement, I think it’s a little bit too risky to have 100% stocks.

If it works out really well, it’s actually a great strategy. Actually, a lot of FIRE bloggers probably have 100% equities, but that’s because they can.

They probably have income from the blog. They don’t have to face the sequence of return risk of drawing down assets. Because if you do have a bear market right after you retire, you definitely have a much higher risk of failing.

So, I’m a lot more worried about your bond portfolio. It’s not so much the stock portfolio, but the bond portfolio. And if you look at the bond yields right now from government bonds, it’s something like 1.6% for the 10-year and 2% for the 30-year.

Over the next 10 years, I think the TIPS implied inflation rate is 2.5%, so you have a -0.9% real return on your bonds. With stock returns, I don’t think you’re going to have a negative expected return on stock.

The stock returns are going to be positive, at least in expected terms, and even in inflation-adjusted terms. But they’re not going to be that high either, because with the CAPE almost equal to 40.

So, my recommendation is I don’t think you have to do anything drastic with your portfolio, but you probably want to adjust your safe withdrawal rate. I wouldn’t necessarily say that now looks really too close to 1929. I think that we look closer to maybe the 1960s.

The big inflation spike wasn’t even around the corner; that took until the 1970s. There wasn’t even a huge -70% equity market drop ever in the 1970s or 1980s. It’s more of this prolonged period of…

Andrew Chen 41:39
Going nowhere.

Karsten Jeske 41:40
Going nowhere. Your portfolio going nowhere, going sideways.

Bonds are getting hammered. Bonds are not too much of a diversifier because you have high inflation and a little bit of stagnation, which is bad for the stock market. So, I would be more concerned about that exercise.

But even if we have a repeat of what the 1965 or 1966 or 1968 cohorts went through, it doesn’t even turn out that you have to lower your withdrawal rate that much lower, below 4%. Probably 3.5% still seems pretty safe. It’s not that big a haircut you have to do to your retirement strategy.

So, if you were in this mode of, say, the FIRE community or the Bogleheads, I think probably a big share of the Bogleheads, they would say, “I want to have an equity index fund.” And then there’s a debate: Is it only domestic, or is it domestic plus international, and then have something like a bond fund.

And this is all index funds. So, if you’re in this universe where you restrict yourself to just that lineup of, say, Vanguard or Fidelity or Schwab index funds, there’s a little bit of the concern. What if we look like the 1960s and 1970s again?

I’m not saying that this is my forecast, but I would probably assign something like 10% or 20% probability that it could be like that. And I’m sorry, I don’t want to run out of money with the 20% probability in retirement, so I would like to hedge against that outside risk.

Now, the question is: Could you expand your horizon? Could you do something like real estate investments?

There are also some alternatives to bonds. For example, I dabble a little bit in preferred shares. They are a hybrid between stocks and bonds, so they pay a dividend, and it’s a much higher dividend.

You have much less upside potential because there’s a notional nominal value of each preferred share. It’s usually $25. You can’t really go much above $25.

Some are trading at something like $30, but that’s because their dividend interest rate is so high, so they’re trading a little bit above par. So, this is not like a Tesla stock that can go from $100 to $1000. There’s limited upside potential, but there’s also limited downside potential.

And I think I like a lot of these preferred shares because some of them have a real nice built-in inflation hedge in the sense that they have adjustable interest rates. In this world, it’s called “floating” interest rates. Some nice ones I found, I think the timing is really ideal.

They are fixed to floating. That means they’re initially fixed interest rates, something like 6% fixed interest rate, and then they are fixed until something like 2023 or 2024. And then they transform to floating.

And the floating is usually some kind of a benchmark interest rate, like the Libor rate. And then it’s something like Libor plus 4%. The nice thing about that, right now, interest rates are really low, and I enjoy something like a 6% interest rate.

Later on, who knows? If we have something like a repeat of the 1970s where we have double-digit interest rates and inflation rates again, that’s fine too, because then the Libor will also be higher, because then, at some point, the interest rates will be higher if inflation is higher.

You can do a little bit of shifting around, if you feel adventurous enough to do that. But as I said, probably equities, just the big equity indexes, they have some sort of an inflation protection built in. The question is what do you do about that safe asset bucket?

Sadly, it means that some of these preferred shares are also quite volatile, so they have a lot more equity exposure. So, if the equity market tanks by 10% or 20%, then some of these preferred shares will also go down. You also have to keep that in mind.

So, I don’t think that I would really do too much with the portfolio. I would more or less play around with the safe withdrawal rate.

Andrew Chen 46:53
When you mentioned the preferred shares, are you investing in individual companies or funds that hold preferred shares?

Karsten Jeske 47:02
Initially, I invested in an ETF. It was many different providers. They have ETFs.

I think the most liquid one is the PFF. It’s done by iShares. But I think that has something like a 0.4% expense ratio.

And after I saw that, I said, “0.4% doesn’t sound like much, but if we’re talking about something like a 5% yield, I don’t want to throw away 0.4% of that and have only 4.6%. So I could probably replicate that myself.” So, I looked at some of the underlying.

And then I also realized, “Maybe I don’t want to have the fixed rate preferred,” because that again has the problem: What if we have a repeat of the 1970s with the big inflation shock, and interest rates go up to double-digit? Then I don’t want to have a fixed rate 5% preferred share, because that would then lose out if we have an inflation spike.

But then I said, “Can’t I just selectively look at only the floating rate, or even better, the fixed to floating rate preferred shares?”

I have a post where I write about my option trading strategy, because I hold these preferred shares in my account where I do the options trading. And there’s one post last year where I give people a list. “These are the different preferreds that I hold, and these are all the fixed to floating.”

I think I have one or two that are relatively high rate. They are fixed, but they’re at a very high rate, so I was more comfortable investing in those. But I try to keep it to only the fixed to floating, which you can’t really do with some of these ETFs.

That’s actually another reason to do it by hand. The other nice thing is I can do some tax loss harvesting because I have this whole big palette of different shares, and then most of them have really substantial capital gains built in now.

Some of them were bouncing around at plus/minus zero, and once they dip enough below, I do some tax loss harvesting and buy a similar one for the next 30 days. And if that one goes down, I sell that one again and go back to the old one to avoid any wash sales.

So, there are at least three advantages to doing this by hand. You save the fees, you can pick only the ones that you like, and then you can do the tax loss harvesting on the individual security, and actually on the individual tax lot level. So, that’s what I’ve been doing.

But apart from that, it’s not like “Oh my god, I have to inflation-proof my portfolio.” No, I never went that route; I never felt that need. If I say that as an economist, it probably means something.

Andrew Chen 50:08
So you basically constructed the ERN preferred shares ETF.

Karsten Jeske 50:13
Right.

Andrew Chen 50:14
Then that means you have to actively manage it. Are you doing that with spreadsheets? And how often are you actually going in and tweaking?

Karsten Jeske 50:22
There’s nothing to tweak, especially a lot of them, I bought them many years ago, and these are all quality names. A lot of these shares, they are big financial corporations: State Street, Goldman Sachs, Morgan Stanley, Bank of America, Wells Fargo.

And once they have these huge capital gains built in, I’m just going to keep them, collect the dividends every quarter, and there’s really not much to manage. The only thing I have to manage is end of the year, but that’s what people do anyways.

They look at the different tax lots, and they check, “Can I sell anything at a loss?” and to get the tax write-off for the year. So I do a little bit of reshuffling.

Andrew Chen 51:14
But over a long stretch, it’s unlikely any of them are going to be in a loss position, right?

Karsten Jeske 51:20
Not in my personal case, because a lot of them are now trading above par. So, if you want a $25 notional share like that, you probably have to pay $26 or $27.

Some of them are actually above $30, which is crazy, because that means eventually they can be redeemed, and then you actually have a little bit of a capital loss. But the interest along the way is actually high enough that it compensates you for that.

My strategy is “buy and hold,” unless, at some point, I need the money, which I don’t really see myself needing the money. This account, probably over half of our annual budget is coming just from the dividends and interests that come out of these funds.

Another half comes out of the option trading that I’m doing on top of that, because I hold these shares as the collateral when I do option trades, because that’s all on margin. There’s nothing underlying. So, that is roughly 30% of our financial net worth.

With 30% of our financial net worth, we can actually manage our annual cash flow. And the rest of the portfolio, that’s all pretty much 100% stocks or real estate funds. I’m not even touching those; I just let that run.

Andrew Chen 52:56
So your allocation is 30% in the earned preferred ETF, is that right?

Karsten Jeske 53:01
Right, this is ETF. There’s some closed-end funds that hold muni bonds. That’s not inflation-protected, so I think they would get a little bit hammered if you have an inflation shock.

But I have the same problem again. Some of them actually have a lot of capital gains built in.

If I were to sell them now and invest in something else, I’ll have a huge tax bill from the capital gains. They would be long-term capital gains, so maybe eventually I might get rid of them.

In some way, it’s already water under the bridge. The Fed announced they’re going to do three rate hikes this year in 2022, three more rate hikes next year. They’re trying to be pretty transparent.

Even the timing has already pretty much worked out exactly so that by March, they’re going to phase out their bond purchases. And I think in the June, September, December meetings is when they have three rate hikes. Then they’ll have three more rate hikes every quarter after that in 2023.

And then probably you wait and see if that’s enough. Of course, if inflation comes in a little bit higher, they might step it up and do four and four. But in that sense, the damage has been done already.

We have priced in the rate hikes. It’s already in all of the curves. It’s visible if you look at the Fed Funds futures, the Eurodollar futures curves.

So, the rate hikes are already priced in by pretty sophisticated market participants. And even with that, I’m actually still ahead with a lot of these funds.

So, I’m not so worried about the rate hikes. I would be worried about rate hikes that go significantly beyond what everybody has already priced in. That would be the concern.

Andrew Chen 55:10
And what would that be? Is that like expectation plus 50 basis points or more?

Karsten Jeske 55:15
Yeah, inflation is so out of hand, we now have to raise rates 25 basis points every meeting, which would be two percentage points per year. Very quickly, we could be at 4% rates by the end of 2023. And that would definitely be a bit of a cold shower for everybody, for the bond market for sure, and probably also for the economy.

I used to work for the Federal Reserve, and I still have friends working there. They are trying to exude some sort of confidence that they have everything under control, but I think they’re probably sweating bullets a little bit.

For example, I looked at some of the numbers, and it looked like there was a bit of a lull period in the inflation numbers in the third quarter. I said, “Okay, maybe this is it now.”

So, we still have these very high inflation numbers from the spring of 2021, but once we roll them out and we are back to more normal numbers, this could all be done before everybody needs to get worried. But then, in the fourth quarter, everybody got slammed again.

You get these 0.8 month over month inflation numbers. You annualize some of these inflation numbers, so we are talking about double-digit inflation numbers. I think there was one at 0.9.

You get this resurgence in inflation. The most recent inflation number that we had was for the CPI for November. That was published in mid-December, which is the November number.

We’re expecting the December inflation number in the middle of January. I think it’s January 12th. It might be after this goes online.

But what people need to recognize is that if you look at these year over year numbers, basically what you’re doing is you take the previous months, year over year number, and then you kick out one month very way at the back end, and then you add one more at the front end.

And the numbers that we are taking out, next year over year number, we are taking out the December 2020 number, and we are adding the December 2021 number. So we are still taking out some of these very low inflation numbers. As of late 2020, everybody was worried about really low inflation.

So, we’re taking out these very low numbers, and we’re replacing them with very high numbers, so the year over year numbers will probably still go up for a while until…

Andrew Chen 58:24
April or so?

Karsten Jeske 58:25
Until April, and then we would be rolling out some of the really high numbers from 2021. And I hope at least that by April, we’ll have a little bit lower month over month numbers, and then at least the year over year numbers come down.

And then, hopefully, the Fed can breathe a little bit easy and say, “This is exactly what we expected. It’s still too high, so we’re going to start raising interest rates now to respond to this.”

But if that doesn’t happen, if we keep getting these 0.8%, 0.9%, 1.0% month over month numbers, then obviously, the Fed has to step it up a little bit. And I think that might be a little bit of a cold shower for everybody.

Andrew Chen 59:13
It’s not entirely in their control, because a lot of this is just consumer psychology, too. The Fed may have four months of patience, but consumers may be like, “Man, this has gone on a long time. I guess this is going to keep going on.”

Karsten Jeske 59:27
You can very easily shut down inflation. You cool down the economy. Paul Volcker did it.

There’s still a lot of big fans of Paul Volcker. I was working at the Fed from 2000 to 2008, and there were still some people that told me, “When I graduated from graduate school, when I was your age, that’s when Paul Volcker once visited.” And they were telling these stories about a cigar-smoking guy, and he’s one of the greatest heroes of economics and monetary economics.

So, there’s still a little bit of intellectual influence of Paul Volcker. And everybody knows the Fed can bring inflation under control by simply creating a demand side recession. We shut down the economy again, not by Dr. Fauci, but by whoever is in charge of the Federal Reserve, and that will have a cooling effect on the economy and on prices.

Now, if you look at some of the categories that had some of these huge inflation spikes, this would be new cars, used cars. It wasn’t even healthcare, because if you look at very long-term horizons, over very long horizons, usually inflation is 2% on average, and then housing and healthcare are usually 3%. Those are usually a percentage point higher than everything else.

But during this inflation spike, you look at some of the categories that had the big price spikes, they’re exactly the categories that satisfy the following property. Imagine somebody gave you $100,000 and told you, “You have to spend these $100,000 as quickly as you can.” What would you buy?

You wouldn’t buy gummy bears or anything like that. You would do the following: You would do remodeling of your house; you would buy cars (used cars, new cars); you would travel.

A lot of the price spikes came from rental cars. There was a shortage of rental cars. There probably still is.

So, why was there this big price spike? I think it’s because the government is basically just opening the floodgate and handing people money. And the nice thing is that there are a lot of people that actually needed that financial assistance.

Unfortunately, getting a stimulus check here or some child credit there, for the people who are really needy, that’s probably a drop in the bucket. But for every person who actually got some of this government stimulus, who needed it, there are probably 10 people who got the same amount of money, who didn’t need it, and flush with cash.

What’s the easiest way to get rid of a lot of money? You buy all of these durable goods, RVs, cars, boats, and travel. So, probably, if some of this largess is ending now, for example, this child tax credit, I think that’s already done as of December, so people won’t get any money in January.

So, it’s obviously bad news for the people who actually needed the money. That money is now phased out. The good news is (at least I cross my fingers) that this will take a little bit of this pressure off of prices.

And I would watch used car prices because that seems to be the first to respond. Everybody with a little bit of extra money, they’re going to run out and buy a used pick-up truck.

Because some of these used car prices were so insane. You had something like a 10% or 20% month over month increase in used car prices.

Sometimes you could even make out this is exactly the month when the stimulus checks went out. And this is no surprise. You had a big inflation spike then.

So, my hope is that, as painful as it will be for us to get weaned off of some of this government assistance, hopefully, we’ll also take care of some of this inflation problem.

Andrew Chen 1:04:20
I remember when we were first speaking about safe withdrawal rates way back. One of the key takeaways I had was maybe 4% is not the number, but somewhere between 3% and 4%. It probably won’t be less than 3%, you’re probably safe.

We’ve been talking about the current climate, inflation approaching 6% year over year, at least in the last few months. It’s the highest it’s been in several decades. At the same time, stock valuations are at all-time highs, CAPE of 40.

It sounds like you’re saying 3.5% is actually still probably okay for most people, even when you properly account for all these forces, to maintain retirement security. Is that right?

Karsten Jeske 1:05:06
Yeah. And I want to avoid talking about setting one single rate, because it has to be custom tailored. Think about the most bare bones, the worst possible worst-case scenario, where you have, say, a 50-year horizon, and you have no additional cash flows later on in retirement that you can rely on, as most people have.

I’m a little bit worried about some of the people that retire at age 27. They will have to wait until age 70 probably to get Social Security.

For most people who retire at age 40 or 45, there’s some Social Security around the corner. It’s not going to be zero. It’s not going to be as bad as some people want to make it.

But even if you assume, imagine a 50-year horizon and no additional cash flows, and you retired in 1965. Even then, you would have survived 50 years with something like a 3.3% or 3.4% withdrawal rate, or maybe even 3.5%. I have to look up the exact number.

Andrew Chen 1:06:18
But that’s burning down the principal all the way to zero, right?

Karsten Jeske 1:06:20
That’s burning down the principal to zero. And then, even if you retire maybe just three months before the all-time peak or three months after the all-time peak, it already looks a little bit better. It’s not quite as bad as the 1970s and early 1980s.

I would think that 3.5% is pretty safe. I think that the people who propose going below 3% or all the way down to 2%… There was one clown in the FIRE blogging world who said we have to go down to 0.5%.

Andrew Chen 1:07:05
That’s for shock value, though.

Karsten Jeske 1:07:07
That’s obviously a troll and shock value.

Andrew Chen 1:07:10
That’s clickbait.

Karsten Jeske 1:07:12
Exactly. So, I think that might be way too conservative. Even I wouldn’t go there.

Of course, there would be a way I would go there. If you say, “I need to have not just CPI adjustments, but I want to do something like CPI plus 1%, or CPI plus 2%,” then very quickly, you’d probably push your withdrawal rate even below 3%.

But if you are okay with CPI plus 0%, so you only keep it at CPI, which means it’s a little bit of a concern because everybody around you has some per capita GDP growth, and per capita income growth, and per capita consumption growth. So, you would be eroding away a little bit not your absolute purchasing power, but your purchasing power relative to your peers, your friends, your neighbors, your relatives.

Maybe then you want to be a little bit more cautious. But if you’re fine with CPI plus 0%. I have a hard time justifying less than 3%, that’s for sure.

Andrew Chen 1:08:24
And undergirding all this, as a reminder, is what kind of asset allocation?

Karsten Jeske 1:08:30
Something like 75/25. Back in the old days, people said 60/40. I think 60/40, or even 50/50, because 50/50 looked really great during the Great Depression.

I wouldn’t want to do 50/50, or even 60/40, because with negative bond yields, that’s probably a little bit too risky. And 75/25.

You might even have a little bit of real estate in there, either through direct investments or through funds. Maybe you can go even a little bit higher that way.

But if you want to restrict yourself to stocks versus bonds, I found that 75/25 gives you a little bit of the sweet spot where you don’t want to have too much in equities. Because if you have a repeat of, say, 1929, you’re going to get really hammered if you don’t have enough bonds.

On the other hand, something like a repeat of the 1960s, 1970s, or early 1980s, if you have too much in bonds, bonds were not really a great diversifier at that time. And stocks didn’t even drop so much during the 1970s either. So, 75/25 stocks versus bonds seems to be the sweet spot.

Andrew Chen 1:09:59
Right now, other things being equal, is that type of allocation what you would recommend presently? Or what are potential asset allocation changes that investors should consider given current macro trends?

Near zero rates, they’re definitely going to start rising. Stock valuations, it’s crazy to say, having more than doubled since March 2020. Real estate prices in many places having increased 20% or more, year over year.

Should we be changing the way we think about asset allocation and certain asset prices potentially being overvalued?

Karsten Jeske 1:10:36
Yeah, everything is overvalued. But then again, that is the whole idea of looking at historical simulations. We were overvalued in 1929, we were overvalued in the 1960s, and we were overvalued in 2000.

So, my view is that if you hedge against some of these historical worst-case scenarios, we should be okay this time around.

Andrew Chen 1:11:05
Just for historical perspective, right now, the S&P 500 PE ratio is about 30, the CAPE is about 40, the inverse CAPE is about 2.5. Where does that put us in a historical context, relative to where those numbers have been historically? Just so folks understand.

Karsten Jeske 1:11:26
We can talk a whole hour about the S&P, and the CAPE, and the different PE ratios. Shiller publishes his sheet, and maybe his research assistant is not working on this anymore, but the last time I checked, I think it’s still the outdated numbers from September. And the earnings numbers he’s using to calculate the CAPE, they only go until June.

Which is not a huge problem, because if he takes the 120-month average and he’s missing a few months at the end, it’s not going to be that much of a problem. But it would certainly be a problem, for example, if you just calculate the simple PE ratio, the way people normally do it is they do the trailing PE and they look at the most recent four-quarter aggregate earnings number.

There’s still some people who are floating around the Q2. If you’re lucky, you get the Q3 number. Q4 numbers haven’t even been coming out yet.

But you can look at some of the estimates. Dow Jones S&P, which is the index provider for the S&P on their webpage, they have not just the realized and finalized earnings numbers. Because Shiller waits until the earnings numbers for the quarter are finalized, so that’s why there’s this huge lag in the earnings numbers.

S&P, they also have the earnings estimate for even the fourth quarter. They even have the earnings estimate for the first quarter. We haven’t even finished three days of the first quarter of 2022, we already have an earnings estimate for the first quarter of 2022.

That might be a little bit of hand-waving, but I can tell you that the first quarter earnings numbers, they’re not going to be deviating too much once they are all released over the course of the next few weeks and months.

So, if we calculate the four-quarter earnings numbers for Q1-Q4 of 2021, I think we get aggregate earnings in the S&P of somewhere around $191. You set that in relation with the S&P price index, and it’s actually under 25.

If I play with the numbers a little bit and I take a lagging number for the 12-month earnings, then I can make it 30, which would sound insanely high, because the 30 is not the CAPE. The 30 is the 12-month trailing earnings. That would sound definitely very overvalued.

25 is not very nice. It’s a little bit scary, but at the same time, it’s not wildly overvalued either. So, it’s an expensive equity market, but I wouldn’t be running for the hill.

I don’t know if there is even an earnings multiple where I would say, “From now on, we even have negative equity expected returns.” I don’t know how high that CAPE or how high that PE ratio would have to be before I would say, “Now we have either negative equity expected returns, or a negative equity premium.”

You sell your equities, you put it in cash, and then you make more in expected terms with the equity portfolio. We’re nowhere even close to that.

We still have a positive equity premium. We’ll make money equity over cash, and certainly equity over bonds. In expected terms, we’ll make more with equities than with bonds and with cash.

So, I think we’re still in an okay position. That’s what I’m saying. We should compare this to the historical, potentially worst-case scenarios for past retirees.

I don’t quite see how we would be worse than 1929, or how we would be worse than the 1960s and 1970s. If something changes, I’m going to post it on my blog, if my views change. But I don’t quite believe that yet, that it will be worse.

There are obviously challenges: a lot of debt load, talking about the redistributional challenges, but I think there are also some positive things on the horizon. For example, this whole artificial intelligence and the productivity gains that people were poopooing.

I have poopooed that for a long time, but I can actually see that some of these new technologies that will increase productivity, it will eventually hit. It’s not going to hit overnight. It’s not like the internet, or information technology in general, made everything more productive overnight.

It waited until everybody said, “This was just overblown. This will never make us more productive.” That’s when all the productivity gains happened.

It happened with IT in general. That was already around since the 1970s. It took probably until the 1990s until we saw the productivity gains.

The same with the internet, and the same will be true with some of this machine learning and artificial intelligence, self-driving cars. And I think there will be some productivity gains.

Not saying that this will suddenly create 10% GDP growth every year, but I think there might be a little bit of a bump in productivity growth and we can milk this. And maybe the stock market, much smarter than all of us, has already priced that in.

I was mentioning, for example, the S&P earnings numbers. If you look at the yearend, 2021 is $121, and I think the forecast for 2022 is already over $200. I think it’s $211 in earnings over the 2022 calendar year.

So, instead of going 12-month backward-looking earnings, you go the 12-month forward-looking earnings. And then look at some of the earnings forecasts and the growth forecasts for earnings. Definitely, it’s priced for perfection, but I don’t think we’re in any kind of irrational territory here.

It’s not like the late 1990s with pets.com or anything like that. It’s definitely more fundamental, and there are some real productivity stories and productivity gains to be had, hopefully. That’s my positive spin.

But then again, if I were to retire today, I would still hedge against that worst-case scenario, which means, very likely, you will have a very comfortable retirement, where later in retirement, you will notice, “I can actually increase my spending now.”

Andrew Chen 1:19:31
You would just do that by lowering your safe withdrawal rate, but priced to perfection, as you mentioned. I think what I’m hearing, please correct me if I’m wrong, is that all asset prices are expensive, everything has an elevated risk of declining right now, but what else are you going to invest in?

So, the thing that you can do is control your safe withdrawal rate. I think that’s the gist of it, right?

Karsten Jeske 1:19:55
Yeah, exactly. And this is the crazy thing: that you go from a 60/40 to a 75/25.

It’s not despite the high equity values. It’s almost because everything is so expensive. If we had cheaper equity valuations, 2% inflation and 8% bond yields, I would be 100% bonds.

So, why take a chance if I can have a 6% safe withdrawal rate? It’s actually almost because everything is so expensive. You almost have to take a little bit more risk to make it through the next 30, 40, 50 years.

Because the simple math is if you have a zero expected return asset, and you have a 50-year retirement horizon, you can withdraw 2%. So you almost need to increase your risk exposure and hope that we have some kind of…

They used to call it the “Greenspan put,” and then they called it the “Bernanke put.” Now they call it probably the “Powell put.”

I think that probably policymakers would come to people’s assistance. If the market drops again by 50%, 60%, 70%, it’s not going to be like during the Great Depression where the Federal Reserve is going to say, “Not our problem; your own problem. Maybe you’ve invested in stocks.”

“We don’t care about your wellbeing. We want to be an independent central bank. Bad luck.”

I think that definitely policymakers have felt it easier to come to the assistance of investors. I wouldn’t exactly call it a put option that they provide, but I think there is going to be… Just look at what happened during the pandemic.

They had extraordinary Fed meetings between meetings. They just had the meetings over the phone and, basically overnight, reduced not just the current interest rate to 0%, but then also said that “Our forecast for 2020, 2021, and 2022, is all 0%.” So we almost commit to a 0% interest rate.

Apparently, they are going to follow that forecast because we do project rate hikes now for 2022. But back then, everybody was so scared, and they said, “This is so out of left field. We’re going to do whatever it takes to keep financial markets afloat.”

So, maybe we can take something like 75/25 equity versus bonds now. It used to be more like the 60/40 is the traditional balanced portfolio, but bond yield is so low, we probably have to take on a little bit more risk, which, as I said, maybe the equity risk isn’t even that bad anymore with some Federal Reserve assistance there.

Andrew Chen 1:23:23
If you were holding 100% equities right now, knowing that bond yields are so low, the Fed has already made transparent that they intend to increase rates, and they will not be shy about increasing them further if they see inflation is just not tempering, is it wise to move from 100% equities to, say, 75/25, knowing that? It seems like there’s only downside for fixed income investments.

Karsten Jeske 1:23:52
Yeah. And again, if you’re not retired yet, be my guest. Be 100% equities.

That’s what I did, and it worked really well for me. And even if you have some short-term volatility, you use the dollar cost averaging. Some of my best investments were putting money in, no questions asked, automate your investments at the bottom of the market in March 2009.

I’m a little bit worried about 100% equities in retirement because, if you go look at 1965 to 1982, that would have been a really bad experience. And again, bonds were not too much of a diversifier.

Diversification basically means one asset goes up, the other one goes down, and then we have a negative correlation, like we had during most recessions. Stocks go down, and bonds go up.

Bonds still had a little bit of diversifying properties during the 1960s because both stocks and bonds went down, but bonds didn’t go down as much as stocks. So, it’s still better to have 25% in bonds instead of 100% in stocks. Even though everything went down, 25% of your portfolio went down a little bit less than the stock market.

It’s not a very comfortable feeling of diversification, but it helped at least a little bit. So, I’m not sure I can, with a clear conscience, recommend 100% equities.

For example, I have 100% in riskier assets. Most of the portfolio, 70%, is in stocks, a little bit in real estate, private equity funds. And then that option trading plus preferred shares plus muni bond funds, that’s about 30%.

If I calculate something like an econometric and statistical factor model, it’s actually a relatively low equity exposure. And if I just look at pure correlations and betas of that 30% portion, once I reassemble the whole portfolio and I look at the statistical attribution of that, it also looks like a 75/25 portfolio: 75% risky assets, 25% looks something like bonds or cash.

And the reason why I’m doing all of this complicated stuff with the option trading and the rest of the portfolio, it’s not just 75/25, but I have a little bit of alpha on top of that. That’s the other thing that comes out of the statistical analysis. I think that I actually add a little bit of extra return that I wouldn’t get if I replicated this with just a pure stock versus bond portfolio.

But anyways, even I am not taking on 100% stock exposure. I don’t want to lose one for one. If the stock market goes down again by 50%, I don’t want to lose exactly 50%; I want to lose a little bit less than 50%.

But then again, a lot of FIRE bloggers and podcasters, they are claiming they’re retired, but they still have 100% equities. It may work for them because they have the extra cash flow.

But if you have the flexibility and you say, “I have 100% in equities. I don’t want to invest in bonds. If it doesn’t work out, I can always go back to work or do some little consulting contract to supplement the income.”

And you say, “I want to have 100% equities. I want to stay away from bonds.” I think that’s maybe not a bad idea.

But if you don’t really have the ability to work regularly, there’s some early retirees, they’re on sailboats or something like that. They can’t just say, “I can always be a Starbucks barista or a Walmart greeter.” No, you can’t because you’re on a sailboat somewhere in the Pacific.

And you have this budget. If you don’t make your budget and your 100% stock portfolio goes down, maybe you want to be a little bit more cautious.

But I think some early retirees will have the flexibility to maybe do a little consulting contract here and there for a few months a year. If it doesn’t work out, I think it wouldn’t be a bad idea to forego the bonds.

Andrew Chen 1:28:52
I think what I’m hearing, and please correct me if I’m wrong, is that if you are at the cusp of retirement or in retirement, you have no other hedge, no other income source, it’s probably a little bit riskier to be 100% equities. And so, if you are, you might be better served to go 75/25, let’s say, even though you know that bonds also face this interest rate risk, and rates can only go up, and the Fed has already signaled their intentions.

But if you have some other hedge, you own a rental property, maybe you can easily do some consulting work or whatever, then knock yourself out. Maybe 100% equities is exactly the right tradeoff given the riskiness of bonds right now. Is that essentially a good…?

Karsten Jeske 1:29:37
Yeah. Bonds don’t really have any risk in the sense that if you buy a 10-year treasury bond right now, and I think the yield as of today is something like 1.6%, you are going to make exactly 1.6%.

Andrew Chen 1:29:54
But you have to hold it to maturity.

Karsten Jeske 1:29:55
You have to hold it to maturity. But then again, even if interest rates go up along the way, the value of that bond goes down. But then also the reinvestment interest rate that you get after that is higher, so there is some compensation for that.

The other way, which is actually the cleaner comparison, is you don’t look at the 1.6% yield of one fixed bond, because, for example, if you buy an ETF, if you buy the IEF, which is the 7- or 10-year treasury ETF (I think it’s iShares), they keep rolling these bonds. They sell the ones that drop out of that time window, and then they buy the ones that roll in.

Andrew Chen 1:30:44
So you always have a blend.

Karsten Jeske 1:30:45
You always have a blend, and it’s always basically a fixed maturity. It’s hard to do exactly only the benchmark bond, probably even monthly trading, certainly quarterly trading, to keep that exactly at the benchmark bond. That expected return may or may not be 1.6% because you have the impact from the duration effect.

I did some of this in my consulting gig. What is the expected return of that rolling the 10-year benchmark bond for the next 10 years? Right now, in the interest landscape that we face, that’s probably a little bit less than 1.6%.

It doesn’t have to be less. It varies over time. But right now, you’re probably closer to 1.4-1.5% expected return if you do that rolling thing, because you have to balance.

If the yield goes up, you have a negative impact on your returns from the duration. But then higher yield also means higher income in the future. But normally, the duration impact is a little bit higher than the impact from higher interest rates.

So, if you do that rolling experiment with the 10-year, it’s probably even less than the 1.6% yield right now. And that has to do with how quickly the Fed is going to raise interest rates. So, that is definitely a concern.

But it’s 1.4%, and it’s going to be slightly negative real yield. But at least you can be sure that if there’s some other blow up in 2023 or 2024, another pandemic or something like that, and the Fed then has to lower interest rates again to zero and announces a bond purchasing program, and that yield goes from 1.6% to 0.6%, then you’re golden again. So then, your stocks go down by 30-40%, but your bond portfolio goes up by probably around 8-10%.

So, it’s really a tradeoff. If everybody knew how the next recession is going to look like, if the next recession is going to be something like a demand recession, it’s another pandemic that lowers everything, lowers growth and lowers interest rates and lowers inflation, then bonds are a really good diversifier.

But then again, what happens if we have something like an overreaction of the Fed? Or not overreaction. First of all, an overreaction of inflation, and then that causes the Fed to…

I think Paul Volcker already passed away. Paul Volcker wouldn’t call this an overreaction. We’re already way past the curve potentially.

If this 6-7% inflation were to take hold, we are still at 0% interest rate, so it’s not really an overreaction. It sounds scary. If this doesn’t come down on its own, and we have something like a wage price spiral where inflation settles in at 7% and just stays at 7%, we would actually need something like a Fed Funds rate that’s higher than the inflation rate to bring that under control.

You can’t just fight 7% inflation rate with a 2-3% Fed Funds rate. So, it has to be the increase of the inflation rate plus a little bit more to bring inflation under control. There’s a little bit of fancy monetary policy arithmetic involved in that.

That’s obviously the risk, right? Bonds could really get hammered there if that were to happen. And then maybe you are better off with 100% equity portfolio.

At least you take a little bit of a bath short term. But long term, at least everything is going back to normal. First of all, stocks are a bit of an inflation hedge anyways because corporate profits will eventually catch up with any amount of inflation, and so will the price index.

Whereas bonds, you take a bath like that, that will never come back. That’s really water under the bridge if you take a big cold shower like that.

Andrew Chen 1:35:53
What percent cash or cash-like investments do you think is advisable for investors to be holding right now? Do you recommend near zero?

Karsten Jeske 1:36:01
Yeah, I have pretty much zero, and that’s because, at least right now, just the cash flow every month is from trading options and the dividend and muni bond income. I don’t think I have a lot of cash lying around just useless.

Actually, before I wrote the safe withdrawal rate series, I wrote a lot about emergency funds, why I never had an emergency fund while I was working. And it goes back to the idea that when the stock market is making more than cash, I don’t really see the cash plus maybe the 0.1% that you’re making.

Or even when your money market account makes 2%, I don’t view this as a 2% gain. I see this as a 3% loss relative to making 5% with the stock market.

Some people will say that I was a little bit gutsy with that move. It definitely worked while I was accumulating.

Now, the advantage of cash is that it depends what kind of recession you think the next recession is going to be. Is it going to be a demand side recession where the Fed has to slash interest rates and start bond buying programs again?

Then, in that case, your cash investment is some sort of a diversification. It doesn’t go up when your stocks fall, but at least it doesn’t go down either. So, the cash is basically making whatever policy rate plus a little bit more, whatever your bank offers you for your money market. Or maybe you shop around a little bit, or you churn these intro offers where you do 2% offer here, and then once that expires, you go to some other company.

So, doing the cash as in, say, money market or other short-term instruments would be a good investment if you believe that the next recession is not going to be another pandemic. It’s not going to be another global financial crisis. It’s going to be a repeat of 1973-1975 or 1981-1982, where we have inflation, the Fed has to step on the brakes really hard, like under Volcker in the early ‘80s.

So, it’s going to be poison for bonds. It’s going to be bad for stocks. Maybe not as bad as another Great Depression, but bad enough for stocks that it hurts, and then no diversification from bonds.

Now, if you had invested during the 1960s and 1970s and 1980s in just short-term cash, you would have done a little bit better. So, it depends on what kind of recession are you trying to hedge against.

Andrew Chen 1:39:35
Do you invest in any other asset classes right now for refuge or growth potential? There are some asset classes, like crypto, that have done spectacularly well, but they also don’t have a ton of stability or accessibility. Are things like that, or private startups, etc. still in the realm of you can put some play money there but don’t bet too much?

Karsten Jeske 1:40:01
So far, I haven’t even put any play money in crypto. I think I like the returns I’m making with all my other investments. If that ever changes, I’ll write something about it.

But I haven’t felt the need to do anything crypto. But I can definitely see the lure of it.

Andrew Chen 1:40:28
Do you consider that investing, or do you consider that just pure speculation?

Karsten Jeske 1:40:32
It’s obviously pure speculation. For example, if I invest in a stock, there’s a company behind it, there’s capital, there’s land, there’s intellectual property behind it.

It creates profits. Part of the profits are paid out as dividends. Part of the profits will be kept as retained earnings, and hopefully invested in something profitable and to grow the company internally and endogenously.

I don’t quite see what is the equivalent of that, of a cryptocurrency. There is obviously some kind of a value there because time and effort and electricity and computing power was invested in solving some math problem to create this coin, or this Bitcoin, or whatever the other coin is. But there’s nothing fundamental that makes this grow, so the only growth potential is really that you find a greater fool to pay more for the coin when you sell it.

I could also see some sort of appeal for it in the sense that there’s some liquidity. You could store some value in something. And there’s probably some privacy advantages.

Some people say you don’t have to pay taxes on your crypto gains. Actually, you do.

Andrew Chen 1:42:14
We have to move to Puerto Rico to do that.

Karsten Jeske 1:42:23
I could see the appeal, but it hasn’t really moved me yet to do anything. I can tell you, for example, I have about $2000 in my checking account right now. That is the cash that is sitting there, doing nothing.

I used to run a much tighter ship when I was younger, and I didn’t quite have as much money as I have today. But right now, whether it’s $2000 or $200, and I put the other $1800 in the stock market, it wouldn’t make a big difference for me.

So, I don’t think that crypto really competes with my stock investment or my real estate investment. I think crypto competes with my $2000 in my checking account.

Andrew Chen 1:43:19
That’s interesting.

Karsten Jeske 1:43:21
If my Wells Fargo checking account had an option, you have one account that’s in dollars and another one is in crypto, if I suddenly started having the need to pay my bills in any kind of cryptocurrency, I can write a check not in dollars but in crypto, and I get money in income that’s paid in crypto, and then it goes into my Wells Fargo crypto wallet, then I can see the appeal of crypto for me.

Because crypto compared to holding dollars, I could see the appeal. One is dollars is just being melted away by inflation. But I don’t quite see how crypto would ever compete with, say, a real estate investment, or a stock investment, or even a preferred share.

The preferred share, there is some capital at Goldman Sachs. And that’s working for me. And the people working for me are working hard in making profits.

So, if I have to rank it, real investments, stocks. After that, it’s crypto. And after that is cash, as in dollars cash in a checking account, in my wallet.

Crypto is better than cash, but I don’t really see that crypto is better than stocks. If I had moved all my money into crypto a few months ago…

Andrew Chen 1:45:01
Hindsight is always 20/20.

Karsten Jeske 1:45:02
But there are some people who mortgaged everything, their houses, and their mom’s house, and grandmom’s house, and their credit cards, and put that in crypto.

Andrew Chen 1:45:12
It sounds extraordinarily volatile.

Karsten Jeske 1:45:15
They look really golden now. Who knew that this is how it’s going to work out? It could also just go down again.

Because as I said, the fundamental value, I don’t quite see that. Because in terms of the value of an asset, you do it either with earnings or through dividends, you do a spreadsheet, you do the net present value of all of these future earnings or dividends, and there is your value. And then you compare it to the value of the asset.

If it lines up, then it’s a good investment. If it’s undervalued, even better. If it’s overvalued, it’s not so good.

But I don’t really quite see what is that cash flow out of crypto. There are some people now who have their crypto, and then they lend it out. It’s basically like securities lending.

For example, you can own Tesla stocks, and then you can make a little bit of extra yield because your broker can lend it out to people who want to short that. That kind of securities lending apparently exists also for crypto.

Maybe that’s the solution. I think there’s some exchanges where they pay you some sort of an interest on your Bitcoin holdings. It’s probably more of the major cryptocurrencies, the ones that are used by some hedge funds for some arbitrage strategies.

Andrew Chen 1:46:56
Maybe I should do an episode on this because people keep asking about it, like “Can you do an episode on crypto?”

It does seem like the market cap of this is starting to become a little bit too big to ignore. It’s something like two trillion dollars. Certainly, most of that is Bitcoin and Ethereum, but still.

Karsten Jeske 1:47:13
Yeah, you’re comparing that to the U.S. money supply. You can’t really compare it to the M0 money supply. You have to compare it to something like the M2 because it also includes some electronic money.

It’s more than just a few percent. It’s something like 10% of the U.S. money supply. It’s quite extraordinary.

But even if you say crypto has value, because it is a store of value and it can be used as a transaction, it’s not going to get even close to the number of transactions that are done in the United States dollar. If you calculate all the transactions that are made in cash, in ACH, in wire transfers, in credit card transactions, it has to be in the billions every day. I don’t quite see how Bitcoin or crypto gets even close to that.

But maybe. Ten years down the road, who knows?

Andrew Chen 1:48:19
Who knows? Karsten, this has been a delight, as always. Again, a really good, stimulating, meaty conversation.

I might have to break this up into two episodes, but I loved it. It’s been great. I always love mind-melding with you and getting your thoughts on all things safe withdrawal rates and macroeconomics, so thank you so much for taking the time to chat with us.

Karsten Jeske 1:48:41
Thank you. Thank you for the invitation.

Andrew Chen 1:48:42
We’ll make sure we link to all this stuff in the show notes. Thanks so much. Cheers!

Karsten Jeske 1:48:45
Thank you.

Andrew Chen 1:48:46
Bye.

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How current economic changes impact retirement safe withdrawal rates (HYW085)

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