Last week, we dove headlong into the wonky but uber-crucial topic of retirement safe withdrawal rates.
My conversation with Karsten Jeske, PhD – a former professor, Fed economist, quantitative finance researcher, and early retiree – focused last week on sequence of returns risk and how to estimate your safe withdrawal rate in early retirement.
Our conversation was so action-packed that I had to break it up into two episodes, so this week we continue our discussion and focus on how to mitigate sequence of returns risk during early retirement.
- How to adjust your withdrawal rate and rebalance your portfolio in response to market conditions
- How to critique the common advice that the returns risk in the first 10 years of retirement determine success or failure in all retirement
- Why sequence of returns risk is a “zero sum game” between retirees vs. savers, and why investing strategies for these two groups should therefore inversely mirror each other
- Concrete actions investors can take, during their accumulation phase and during retirement, to reduce sequence of returns risk
- How early retirees can use rental real estate to reduce sequence of returns risk
- What is the lowest historical safe withdrawal rate that entirely eliminated sequence of returns risk
- How coronavirus might impact your safe withdrawal analysis and early retirement prospects
What actions do you plan to take to fortify your safe withdrawal rate? What other questions about safe withdrawal rates and sequence of returns risk do you have? Let me know by leaving a comment when you’re done.
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Links mentioned in this episode:
- Early Retirement Now Safe Withdrawal Rate Series
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:22
Last week, I had Karsten Jeske on the podcast to talk to us about safe withdrawal rates and sequence of returns risk in retirement. We talked a lot about the concepts and theory behind these ideas.
This week, in part two, we continue our conversation and discuss mitigation strategies for how to reduce our exposure to the sequence of returns risk so that we can have more confident withdrawal strategies in retirement, especially for those of us who are thinking about early retirement.
I hope you enjoy today’s conversation. Here it is.
When I think about early retirees who are planning essentially up to two back-to-back 30-year retirements, when you analyze these historical scenarios, if we were to take the exact approach that you just said, look at the situations where history dealt you the worst hand, and if your safe withdrawal rate still works under those scenarios, you’re pretty defensible.
What is a historically low enough safe withdrawal rate? I’m sure it’s lower than 4%, but that would, for all practical purposes, eliminate the sequence of returns risk.
Karsten Jeske 02:32
You would probably not eliminate sequence of return risk. So to answer your main question, if you were in the lower 3%, I think I once did a calculation.
If you had retired in 1929 and you have a 60-year horizon, and no additional cash flows, you never get any Social Security, any pension, nothing, a little bit over 3%. I forgot whether it was 3.15% or 3.25%. That would have seen you through 1929.
There was another bear market in 1937. Through the Second World War, there were a few more recessions afterwards, all the way to 1989. It would have lasted through the crazy 1970s, double digit inflation.
A lot of people sometimes say that I’m an eternal pessimist and I try to talk people out of early retirement, and I’m way too conservative and way too pessimistic. Actually, that is a very hopeful message because it means that I had suspected that there are some retirement dates where no safe withdrawal rate would have been safe, where you could have withdrawn zero, or even withdrawing 3% every year would have eventually wiped out your portfolio.
No. All you have to do is you lower your withdrawals from 4% to 3%, and you would have been safe, even during the historically worst episodes.
Unfortunately, from 1965, we don’t have the data all the way to 2025. But remember what I mentioned earlier. If you look at the time windows, what matters first for your safe withdrawal rates.
We have 55 years’ worth of data, and the last five years have very little impact on your safe withdrawal rates. So actually, that 3.1% or 3.2% rate is probably also going to be safe for the 1965 cohort.
It’s amazing that you don’t even have to reduce your withdrawals by very much. Going from 4% to 3%, that is a 25% drop in the amount you withdraw every year. So it is a substantial reduction.
You listen to people like Suzie Orman. I don’t know if you remember that interview where she effectively said if your retirement is twice as long, you need twice as much money.
That’s obviously not true because that means she doesn’t understand the time value of money. Because if you do exactly that thought experiment that you said, that 60-year horizon, that’s basically two 30-year back-to-back windows.
What that tells me is that if I want to have a $40,000 a year retirement, maybe a million dollars is not enough. That is not going to last you through the absolutely worst events.
But maybe $1.3 million is all you need. The first million is going to see you through the first 30 years. And then the other $300,000 you’re not going to touch them for 30 years, so that will grow to about a million dollars and that will see you through the next 30 years.
So you don’t need twice the money to go through 30 years. I’m basically in the middle, between two groups of people that don’t understand amortization.
Suzie Orman says twice the retirement horizon, you need twice the amount of money. No, that’s not right.
But sometimes in the FIRE communities, you read that 60 years or 30 years, you need the same amount of money, because if you make it through the first 30 years, you’ll make it through the second 30 years. That’s not true either because over the first 30 years, you might make it, but your portfolio is so low at that point that you’re not going to make it through the next 30 years.
But if I had to pinpoint where I am, I’m definitely closer to the FIRE community and very far away from Suzie Orman because I’m saying that you have to reduce your withdrawal rate a little bit if you have a longer retirement horizon. But I was amazed by how little you have to reduce your withdrawal rate.
But in hindsight, of course, it makes sense because it’s a little bit like an amortization exercise, and for the years 31-60, you don’t really need that much extra money to hedge that part of your retirement.
By the way, for most people, it is probably safe to say if you do this 30+30-year window, think of it as during your first 30 years, you could draw down your portfolio all the way down to 25% because at that time, you will get Social Security. You will get pensions. Probably the last 30 years of your life, you might spend a little bit less anyways.
So it’s not like a 60-year retirement horizon. As a rule of thumb, I always say a 60-year retirement horizon is a little bit like a 30-year retirement horizon but with the 25% final value target because for most people, the second half of their retirement, they’ll have some other income sources from Social Security and pensions.
Andrew Chen 08:23
There’s a heuristic. I think it was first mentioned, or at least I first saw it, on Michael Kitces’ website that if you can just get through the first 10 years of retirement without getting hammered in your portfolio, then your risk of outlasting your portfolio basically goes away. Again, I think that analysis assumed a 30-year retirement.
But for early retirees who are planning this idea of two back-to-back 30-year retirements, how should they think about this 10-year heuristic? Should they take it literally so that no matter how long your retirement horizon is, what matters is literally the first 10 years?
Or should they think of it more as a ratio perhaps, meaning that if your 30-year retirement requires 10 years of non-bad returns or about a third of the horizon, then a 60-year retirement needs commensurately about a third as well, maybe 20 years of non-bad returns?
What’s the right way to think about that heuristic?
Karsten Jeske 09:15
That’s actually one heuristic I don’t really like. If you take this literally for the 60-year horizon, then you should say that you have to get through the first 40 years without getting hammered, and then the last 20 years, you basically go on cruise control.
So making it through the first 40 years, that’s not going to be a good heuristic for most early retirees. I don’t even like that heuristic for traditional retirees either.
The reason is that you solve one problem, you answer one question, but you raise another question that’s just as complicated, maybe even more complicated than the initial question. Because if it says you have to get through the first 10 years of retirement without getting hammered, well, what is hammered?
Imagine you start with a million dollars. What is your definition of getting hammered after 10 years?
Is that $500,000? Is that $300,000? Is it $800,000?
I can tell you with certainty that if after 10 years you still have a million dollars in real terms, inflation-adjusted terms, it’s effectively impossible to run out of money the next 20 years.
I did some calculations, and the question I tried to answer was a different angle, but I just looked at the results this morning. And this was actually something that would answer your question.
I asked myself. I simulated a 4% rule for every starting point over 30 years, and I look at what were the failures after 30 years and what were the successes after 30 years. But I look at not just the final outcome, but I also look at the stages along time.
And I wanted to see, among all the people that failed, what was the maximum portfolio value after 10 years that still made them fail after 30 years? Starting with that million-dollar portfolio, I found that there was a cohort that had still $800,000 left after 10 years and they still managed to fail.
And then likewise, among all the people that succeeded, what was the minimum portfolio value after 10 years that still made them succeed? Astonishingly, it was $300,000.
There was one cohort, their portfolio dropped in real terms, not just from bad performance, but also withdrawals. After 10 years, they had diminished their portfolio all the way to a little bit over $300,000 and they still managed to succeed in the end.
I guess it just happened so that that 10-year point was exactly the low point of the next bear market, and then you had a very rapid recovery, and they still made it through the next 20 years.
So you could then argue that if you look at the spot at 10 years, you have this limbo state between $300,000 and $800,000.
You can say that if you were above $800,000 after 10 years, everybody made it. If you were below $300,000, everybody failed. And then between $300,000 and $800,000, you had that limbo state.
Of course, it’s also a sliding scale. If you were at $800,000, you still had a pretty overwhelmingly good probability that you will make it the next 20 years.
But at $800,000, this is already where some failure probability creeps in. And at $300,000, pretty much for sure, you’ll run out of money, except for maybe one or two crazy lucky cohorts that made it.
Again, it’s a sliding scale. And then everything in between is in this limbo state.
Actually, I like that question. And it’s actually something that I’m going to write a blog post about that.
What is the point where you can say, “I’m out of the woods. I don’t have to worry about sequence of return risk anymore because the portfolio is so far beyond where it would have ever run out of money historically”?
Or what is the point where you can say, “Now we are down so much, we should really get scared about should I go back to work again”? Where is that point?
$800,000 is probably a little bit too conservative. Is it $700,000 after 10 years? Is it $600,000 after 10 years?
So there is no fixed cutoff. This is, again, the sliding scale. There’s no good heuristic.
And then on top of that, again, I don’t want to fall into the same trap, into the same mistake that I mentioned earlier. Imagine after 10 years, you are at $500,000 but you are at the absolute bottom of another bear market.
Then you could make the case, “I’m down to $500,000, but the next bull market is right around the corner. I would probably still stick it out because this is just temporary and it’s going to recover. The market overreacted.”
Or likewise, you could say that after 10 years, you had a very bad sequence of return event, and after 10 years, you’re down to $700,000. But that $700,000, you look at the stock market, it has been rallying a lot. It looks expensive again.
There’s another bear market around the corner, and you’re at only $700,000. Maybe that person should worry more about running out of money than the person with $500,000 after 10 years but is at the bottom of the bear market.
So it’s hard to make these sweeping cutoff statements. “If you’re above a certain amount, you’re scot-free. If you’re below a certain amount, worry a lot.”
You can’t make these kinds of statements in a completely unconditional way. It again would have to depend also on equity market valuations.
Andrew Chen 16:13
You mentioned in your blog that sequence of returns is a zero-sum game between retirees who draw down their portfolio versus savers who add to it, meaning if one side wins, the other loses. Can you explain more about this idea?
Karsten Jeske 16:28
Yeah. I basically made the following thought experiment. I looked at three investors.
One is a “buy and hold” investor. Put a million dollars in, let it sit for 30 years, and then look at what’s the final value of that million-dollar portfolio after 30 years.
The second investor is a retiree. This retiree has also a million dollars and then withdraws x amount of money every month. Let’s make it $40,000 a year or $3333 a month over the next 30 years.
And the third investor is a saver who starts with zero dollars and puts into his or her retirement portfolio exactly the amount of money that the retiree withdraws.
What you can see is that if you add the portfolio values over time of the retiree plus the saver, it has to exactly equal the “buy and hold” investor, not just at the final point but even over time.
I made the point once that sequence of return risk is, in some way, a zero-sum game. If the retiree manages to get lucky and get an internal rate of return of the portfolio over the 30 years that is higher than the “buy and hold” investor, then the saver has to have a lower IRR (internal rate of return) than the “buy and hold” investor.
Because they are on opposite sides. If one does better than the “buy and hold” investor, the other one has to do worse.
So I tried to make this point that savers and retirees are on the opposite side of this sequence of return risk. In one way, it is an acute mathematical observation. In another way, there’s actually a policy recommendation in this.
It means that if people could pool their risk, and you pool together not retirees all of the same age group, but what you want to do is you want to pool together retirees of different ages over time, there could be some pooling of risk.
In some way, from a policy perspective, this is actually a rationale to have company pensions.
I think company pensions have all sorts of problems in the sense that what if the company goes bankrupt, and what if they mismanage their pension fund? What if they do all sorts of crazy stuff with that pension fund where there’s some back door deals going on with money managers doing some crooked deals with the pension funds?
If you like movies, the movie Casino with Robert De Niro, what unions and pension funds can do to mismanage money. But taking that all out and looking at just the policy perspective of that.
So there is a rationale for people to pool their risk. And I don’t know if a pension fund is the ideal way of doing that because there are some principal-agent problems. The people that manage the fund, they might not make the right decisions because it’s not their money that’s invested.
But maybe we should have some kind of a FIRE pension fund where there are still people that are saving for FIRE and there are other people that are already in FIRE.
And because your sequence of return risk are exactly flipsides of each other, we should have some kind of a FIRE pension fund that shares the risk, that pools the risk of the people that are already retired that have sequence of return risk versus the people that are still starting out in their FIRE path.
And if they have a recession very early on in their FIRE path while saving for retirement, it could actually be good for them because they do the dollar cost averaging. So there could be a way for us to pool that sequence of return risk.
And I found that really intriguing. I never wrote more about this idea, but I thought that was an intriguing finding that we’re on the opposite sides of sequence risk and that we should, maybe could, find a way to pool that risk with different people in different stages of FIRE.
Andrew Chen 21:36
Yeah, that’s a really interesting idea. I guess it would also require a covenant by everybody participating to still play by the rules through thick and thin, because just a little bit of game theory here, if anybody breaks, then that hedge doesn’t quite work out.
Karsten Jeske 21:53
Oh, yeah. It can’t just rely on voluntary contribution because everybody will say, “I no longer want to be part of this because I realize if I drop out, I get more money.”
So it has to be a pension fund, or if people pool their money, there would have to be some paperwork signed to make sure that people don’t shirk on this.
Andrew Chen 22:14
You’ve previously written about real estate and its interaction with safe withdrawal rates. How can early retirees use rental real estate to reduce sequence of returns risk and just control their own retirement outcome a little bit better?
Karsten Jeske 22:32
There are a lot of people in the FIRE community that achieved FIRE through real estate investments.
And by the way, if you have only real estate investments and you don’t even have any paper assets, you don’t have a 401(k), you don’t have a stock portfolio, you can look at your cash flow and you say, “I have a million dollars’ worth of rentals, and after all costs, after allowing for vacancies and delinquencies and property taxes and insurance, I generate $40,000 worth of rental income.”
You could even argue that that rental income will go up with inflation every year, so this almost perfectly hedges your inflation risk in retirement.
So the point can be made that real estate is actually a really great way to live in early retirement without sequence of return risk because you don’t have these paper assets that sometimes on the way down, they overreact and you have to sell your paper assets at very depressed prices.
Now, we will see how all the landlords will make it through the 2020 recession because you hear already that delinquencies of rentals are up.
There’s some people calling for a rental strike, which means that not just the people that are cash flow restricted to pay their rent stop paying the rent, but even people who have the money, they just say, “Hey, I’m just going to stick it to my landlord right now.” How is that going to all work out?
So I think that rental real estate is actually a very viable and very valid approach to early retirement.
It has a few headaches because you have a million dollars’ worth of rental real estate equity, but it’s actually $5 million worth of properties and $4 million worth of mortgage. And until the mortgages are paid off, your rental properties are actually not really cash flowing very much.
So you have this very lopsided cash flow over time where, initially, when you still have the mortgage, there’s not a lot of cash flow that you can use for your own consumption. But then when the mortgages are paid off, your cash flow goes up to probably more money than you can ever spend in retirement.
How do you equalize these cash flows? I guess you could draw on some lines of credit.
I don’t think that my blog is particularly useful for the people that have only real estate and nothing else. But I definitely realize that there will be a lot of people that have, say, 70% of their portfolio in paper assets and then they have some real estate on the side too. How do they factor that in?
So here, I think there is a real need for a very careful safe withdrawal analysis because you could be one of these landlords, you still have a mortgage on your property, and your rental property is not really paying you a lot of cash flow right now, but then once the mortgage is paid off, then you go from roughly breaking even to making a ton of money from your rental because your rental is paid off.
How do you factor that into your withdrawal rate? The “Trinity study” doesn’t give you any guidance on that.
So it again looks a little bit like this pension or Social Security consideration. You have to frontload your withdrawals a little bit from your paper asset portfolio.
You withdraw from your paper asset portfolio initially while you still have the mortgage, and then once the mortgage has paid off, now you have better cash flow from your rentals. Now you can reduce your withdrawals from your paper portfolio.
What kind of an impact does that have in your overall safe withdrawal rate analysis? I have a toolkit where you can run your own safe withdrawal rate analysis and you can basically put in the supplement or cash flow.
You can have a mortgage. You can have Social Security at a future point. You can have your rental income.
The rental income, the cash flow could be really low initially. It could be negative initially potentially. And then just at this future point, the mortgage has paid off and then you have a nice cash flowing property.
So this shows you that you have this great need to do your safe withdrawal rate analysis on a personalized basis. You can’t just take an off-the-shelf safe withdrawal rate.
I once made an analogy. It’s like requiring everybody to wear 10-sized shoes. They will be too tight for some people and too loose for other people. It might be a good starting point, but invariably the 4% will be too tight or too loose for other people.
I like the idea of rental real estate as a hedge. First of all, as a diversification, obviously.
You don’t have all of your eggs in one basket. It’s not all in paper assets. It’s not all in equities.
I personally invest in rental real estate. Not my own rental real estate, but it’s through some private equity funds.
We’re so far very happy with the returns. There’s diversification. There’s some cash flow benefits from that.
Of course, you could always argue with rental real estate, you could have lost a lot of money in 2008 and 2009.
The people that did this properly, they knew what they were doing and they would not go into too much leverage. The people that didn’t buy at the top and they didn’t have to sell at the bottom, at FIRE sale prices because they didn’t get the financing or they couldn’t refinance their mortgage.
Most people that do real estate, they have been around for many years and decades, and they made it through 2008 and 2009. For example, the private equity funds that we use for our real estate investments, they all did very well during 2008 and 2009.
For example, multifamily rental real estate did relatively well in 2008 and 2009 because everybody who lost their house had to move somewhere. They had to move to apartment buildings.
So we will see how it goes. This year, I’ve already gotten some notices that delinquencies are up, but a lot of people are working with management.
They said, “Look, it’s just a cash flow problem. I’m waiting for my unemployment benefits to come through. And tenants want to pay.”
But definitely, I think that what people have to keep in mind is that even though rental real estate is not 100% correlated with the stock market, it is definitely correlated with the economy. You will have more delinquencies. You will have potentially more vacancies if the economy is in a recession.
So don’t consider rental real estate as some 100% safe asset either. They have to keep in mind that there’s still some volatility there.
Andrew Chen 30:35
Although I like the comparison to supplemental cash flows like Social Security, where the bulk of your cash flow comes from right after the mortgage gets paid off, similar to how Social Security gets paid out when you hit a certain age, except that in rental real estate, there’s perhaps even less political risk because you can guarantee that once the mortgage is paid off, people still need a place to live.
And as long as you bought in a geographic area that doesn’t totally go down the drain, that has some staying power because there are good jobs and strong local economy, then you’ll probably be able to secure good renters even after your mortgage is paid off. So I like that comparison a lot.
In one of your posts, you mentioned that the return profile that you exactly want to avoid is high returns during the early accumulation years followed by low or even negative returns in your late accumulation years. And then in retirement, it’s the opposite.
This is the sequence of return risk thing that we were talking about earlier. You want to avoid low returns early in retirement that are then followed by high returns in your late retirement years. So they’re mirror images of each other.
Is the right way to think about that in the same vein as that zero-sum intuition that because when you’re adding, your portfolio gets amplified in exactly the opposite way that somebody who is drawing the portfolio down? Is that the right way to think about that?
Karsten Jeske 32:08
Right. For example, if you had started saving for FIRE right around 2009 at the bottom of the stock market, I think from March 8, 2009 to March 8, 2010, you had a one-year rolling window where the S&P returned about 70%.
It’s not a calendar year return. I think the highest calendar year returns were around 30% in 2013 and 2019. But there was one rolling 365-day window where you had a 70% return.
If you had just started out at that time, the 70% didn’t really make you a lot of money because maybe you invested $1000 a month. Of course, the first $1000, that made you $700 return. You would have been better off if the 70% return happened right at the end of your accumulation phase.
As I said, there’s that flipside between retirees and people saving for retirement. If you start saving for retirement, and during your first year you make 70%, I’m not saying that’s bad. I’m just saying that I could have waited a little bit longer until I’ve actually gotten my first $100,000, and then I get the 70% return.
I’m not saying it’s bad. I’m just saying that it could have been even better if that big growth in equity prices had happened a little bit later.
For example, I just want to give you two other anecdotes. I got my first job in 2000 out of grad school, right at the peak of that stock market. And then I moved from the Federal Reserve to the private sector in 2008.
It wasn’t quite the peak, but it was still close enough to the peak and then you had the next bear market coming. So I was really lucky that I had very bad returns during these two points where I first started making contributions to my savings.
And then in 2008, where I started making even larger contributions to my savings because I moved from the government sector to the private sector. I had more money to spend and more money to save.
So I was one of the winners of sequence of return risk because I started right around the time when the market has completely tanked. I lost a little bit of money in the beginning, but then mathematically, that was good for me.
Actually, potentially psychologically, it might not be good for you because I’m pretty sure there are tons of people who got so psychologically scarred from either the 2000 to 2002 or 2003 bear market and the 2007-2009 bear market. They said, “I sold all my stocks. I’ll never touch stocks again.”
I was always the other way around. I said, “Stocks are on sale. I’m just going to keep buying and I will come back again.”
So from a mathematical point of view, you are better off as a saver if initially you have low returns and then it snaps back when you already have a little bit of nest egg on your side.
Andrew Chen 35:58
You write about how the ideal allocation then is holding as much equity as possible during the early accumulation years and then transitioning in the later accumulation years to a greater share of fixed income, and then doing exactly the opposite in retirement, starting with more fixed income early in retirement then transitioning to a greater share of equity in the later retirement years.
So the ideal return profile, if you had to sequence the returns in an ideal way, is low returns early in accumulation, high returns late in accumulation, and then the inverse in retirement, but you have a large share of your holdings in fixed income precisely when the market is rallying.
I understand the hedge principle of not being so exposed to equity, but that also means that you don’t capture in the upside during those rallies?
Karsten Jeske 36:55
Oh, yeah. Again, it’s purely a hedge.
It’s an insurance where if you start retirement, maybe you want to go not far below a 60/40 portfolio, somewhere between 60/40 and 75/25. 60/40 means 60% stocks.
What I use in my simulations is 40% 10-year U.S. Treasuries. And then maybe on the upside, you can go to 75/25.
And again, it’s purely a hedge. If you are lucky and the stock market keeps rallying right around your retirement date, you gain a little bit less.
So you could have made the case, “You just should have stayed 100% equities and you would have made even more money,” which means that in retirement you probably would have made so much money that you’re going to end up with millions and millions of dollars when you die, which is a nice thing.
But again, it’s purely a hedge because if it goes against you, then you definitely don’t want to be 100% equities throughout your entire life, because at 100% equities, definitely the safe withdrawal rates would be even below 3%. They would be probably closer to 2% than 3% if you do the 100% equity approach.
Now, of course, it could also go wildly in your favor. Then it’s your choice. Do you want to still withdraw the same?
If it goes in your favor and the market keeps rallying and you had 100% equities, forget about 4%. Then you can probably withdraw 5-8%. Or you keep withdrawing your 4% and then you’ll have tens of millions of dollars left over after 60 years.
But that’s not really the issue here. The issue is do you want to hedge the downside? And hedging the downside, it’s definitely better to have some diversifying assets right around the time you retire.
And then the question is if the market tanks, then you could argue that you move into equities over time. You use something called a glide path back into equities to capture the rally that will obviously come eventually. Every bottom of the bear market so far has seen a nice strong recovery again.
Or you could actually say that you keep that 60/40 or 75/25 forever just for peace of mind. And if it goes well, you might as well keep the 75/25.
So you do this glide path back into equities only if you find yourself in a big bear market where you would effectively then just withdraw money out of your fixed income portfolio and you would keep the equities untouched. And you can do that for a number of years until you run out of money in your fixed income portfolio.
And then you would never touch your equity portfolio. And then that will eventually recover, obviously.
Andrew Chen 40:21
Earlier, when you said a 3.15% to 3.25% withdrawal rate is low enough to virtually, if not eliminate sequence of returns, at least make it more or less irrelevant. Roughly speaking, what type of split between stocks and bonds was that assuming?
Karsten Jeske 40:44
I think for that, I assumed a 60/40. And again, I don’t want to sound like this will eliminate sequence of returns because if you pick a safe withdrawal rate of 3.2%, you still face sequence of return risk in the sense that if the market just turns out really horribly, you don’t run out of money.
But if the market is actually really strong early on in your retirement, then you can say, “That initial withdrawal rate that I picked, that was way too low. I can now walk up my withdrawal amount.”
If you do these failsafe calculations, in the worst possible case, you just make it. And in the not so worst case, it just means that either you have a ton of money left over when you die or you could actually walk up your withdrawals and give money to charity, give money to kids.
You might be so rich. They might name buildings after you at the university.
So I’m not saying you can eliminate sequence of return risk. You still have the sequence of return risk. Only it’s between making it and making it really nicely.
The other thing I wanted to say is that, of course, this relies on historical simulations. You still have a failure probability, and the failure probability is that you would fail if the future is significantly worse than what we’ve had in the past.
It doesn’t mean that that’s a 100% safe withdrawal rate. You can never even be 80% sure that the future is going to be as good or slightly better than the past.
There could also be a possibility that the future might be significantly worse than the past. We don’t really know what kind of probability to assign to that.
When I talk about failure rates versus success rates, and failure probabilities and success probabilities, sometimes I mix them up. What I really mean is these were the rates in historical simulations.
Does it really translate one for one into probabilities? It depends on your assumptions. Is the future going to be worse or not worse than what we’ve seen in the past?
Andrew Chen 43:15
For folks thinking about FIRE right now, how has the way we should analyze our early retirement prospects changed in recent months? Coronavirus has exploded.
When we compare pre-coronavirus stock market highs, where valuations were really very expensive, versus now, the economic damage and stock market corrections that have happened, how should we be adjusting, if at all, our assessment of early retirement prospects now compared to previously?
Karsten Jeske 43:47
First of all, it’s astonishing that the market isn’t even down so much. We’re recording this on May 17th. We have recovered quite nicely from the low point on March 23rd.
It’s astonishing how in light of all of this macroeconomic uncertainty, the market hasn’t dropped by more. You could say that the drop in economic activity is for sure worse than we saw during the Great Recession. It’s probably not quite there at the level of the Great Depression.
The pace is definitely really bad, but at least there is this prospect that once states start reopening and people realize that everybody just wears a mask to go out. It’s one of these 80/20 Pareto Principle things.
Maybe the lockdown helped a little bit with keeping people out of the hospitals. If we discontinue the lockdown but we’re just careful about what we do, maybe that’s all we needed in the first place. And if that’s the case, then definitely the economy is going to jump back relatively quickly.
So in that best possible outcome, you could argue that maybe this is a recession extremely deep, but it lasted only really two months. The recession might already be over. In terms of growth, May is already slightly better than April.
A lot of people make this dramatic argument where they say, “The economy is not going to jump back to where we were in January over the next two months, so this has to be really bad.”
Yeah, it might be bad, and the recovery is definitely going to take longer than the two months that it took on the way down, but at least there are signs of some growth out there. There might be some states are reopening now in May. More states will reopen in June.
I liken this to we are going from being hit with a two-by-four over the head to being hit with only a two-by-two. It’s still awful, but even something slightly less awful than March and April is already growth. So you might have probably the shortest recession on record, and then recovery after that.
But if I were to retire right now, I would be very cautious with my safe withdrawal rate because it seems quite unusual that the market hasn’t dropped by much. And I think the market is still quite expensive.
We went from a CAPE ratio of over 30. It’s still at about 27 or so. That’s still very expensive in historical comparison.
So the market hasn’t really gone down by enough to say that everything is good again in terms of valuations. It’s still quite overvalued.
Again, my assumption is not as rosy as the economy went in the tank for two months, and then in the next two months, we’re going to dig out of this and everything is going to be back. No, I’m not saying that.
I’m actually saying something like the economy went down for two months, and it’s probably going to take about two years until we even reach the old high. But it just means that we lost about two years’ worth of growth and then we keep going from there. That’s actually not so bad.
That would justify roughly losing two years’ worth of growth in the stock market. That’s about a drop of 15% in stocks, which is roughly where we are.
So in that sense, in that best possible scenario that I described, where we start digging ourselves out of this mess over the next two years, I think that the stock market is actually justified to be where it is right now.
But there’s some downside risk. What if some other critter comes back next year that’s more virulent and more deadly? We’re going to have the same mess again next year.
Are we going to have a shutdown now every year during February, March, April, May season? That would be really bad for the economy. It would be very bad for the stock market.
Andrew Chen 48:56
What is your own asset allocation right now given the current environment? How do you expect it might change, or not, as you look into the future, given everything that’s happening?
Karsten Jeske 49:08
My asset allocation is we have about 50% equity index funds. 36% is my option trading strategy. That might be a topic at some other time.
I do an option trading strategy. I sell put options on the S&P 500 index. I do that three times a week: Monday, Wednesday, Friday.
It’s not day trading. It takes me anywhere between a few minutes to maybe half an hour, three times a week, to do that. I sometimes do that on the ski lift on my Android phone.
There’s not much to it, but it has been very profitable. It’s also relatively stable income, so that’s why I like that. So there’s 36% doing that.
And then we have 11% real estate. I mentioned that briefly earlier. That’s the private equity real estate funds.
And then we have about 3% is cash. Very short term, risk-free instruments, money market CDs, or simply just cash sitting in the account.
Interest rates are so low now. It’s not making a big difference. So that hasn’t really changed much.
I’m always looking out for some real estate opportunities, not for me personally. I don’t want to become a landlord. I don’t want to deal with the management of this.
But I’m definitely looking for opportunities to raise that real estate portion. We’re working with two different providers from the Bay Area.
It doesn’t mean that the real estate is all invested in California. There’s a lot of properties in California, but also other states, all the way to Virginia, Utah, Washington, Arizona, Texas.
I like the diversification there. And I like that they manage it and I don’t have to get my hands dirty.
I could definitely see myself increasing that maybe to 20% and I take a little bit of money out of the option trading over time.
Andrew Chen 51:27
Well, Karsen, this has been a really delightful conversation. I’ve had so much fun. It was really good analysis and understanding how you think about this from an economist’s point of view.
Where can people find out more about you and your work?
Karsten Jeske 51:45
I’m at earlyretirementnow.com. It’s all one long word. I’m on Twitter too, but you can find everything on the blog: the contact information, my Twitter handle.
If you want to see the parts of the safe withdrawal rate series, at the top of my site, there’s the main menu. Click on the safe withdrawal rate series.
That’s a landing page where I have a quick description of all the different posts that I wrote so far and what to read first, because you don’t want to read it all in the sequence that I wrote it because these are just my crazy ideas over the last three and a half years. You probably don’t want to read it in the same order that I wrote it.
There’s some guidance on who should read what and when. But there’s also the list of all the 37 or 38 posts that I have so far.
Andrew Chen 52:45
You could turn that into a book, for sure. But we’ll link to the series in our show notes so folks can have easy access to it.
Karsten, thanks so much again for taking the time to chat with me today. I know we went way over, but really valuable content for our audience, and I look forward to sharing it with them. Thank you so much.
Karsten Jeske 53:03
Andrew Chen 53:04
Cheers. Take care.