When the topic of financial independence and its cousin F.I.R.E (financial independence retire early) became popular in the last few years, a big question was asked:
How would the early retirees fared when the market goes down?
Since the start of the year, the market has gone down 20-30% at various points.
I did not encounter people making a U-turn in their retirement plans nor do I seek out information on FIRE.
However, I had only heard of anecdotal evidences in articles that the fall in the financial markets was so swift that led some who wish to stop work or had stopped work to question the robustness of their plans.
The market fall would have reduced our net wealth such that these folks who aspired to be financially independent have to push back the date they pull the plug on their careers.
I think it is normal to feel less assured about our plans.
However, I do not think that it is necessary for your timeline for financial independence to get derailed.
If your original plan was sound, despite this fall, you would be relatively OK. The markets have been not too bad before this. Last year and in 2017 the market went up at least 20%.
But if you listen to some blogger or investment trainer’s plan, and decide to use that as your blueprint for financial independence, you might be in for some pain.
Some of their concepts are rather not thought out well. They violate a few fundamental axioms of financial planning.
In the context of this market fall, I can highlight 2 areas:
- A large part of the issue is that I think many are myopic in how they assess their returns, this drawdown versus the returns projection in their financial plan.
- Another issue is that their plan might not be very sound in the first place.
Let me give an example of the second point.
When You Speculate with a Short Time Horizon
Here is one very simple financial planning violation:
You are a high-income earner. You wish to stop work, get income in less than 5 years.
Is it a good idea to put 100% of your investable assets in a 100% equity portfolio?
We know that equities are volatile (this includes REITs and dividend stocks in case you do not realize they are equities as well) and it may take 5 to 10 years to capture the returns required.
This is pushing your money to take more risk when you do not have the time horizon for it. It is speculation that this would work out for you. Now, maybe you have to pay the price to push back the date of retirement to capture the returns.
A balanced approach would have fared better. The time horizon while boring, most often needs to be respected.
Now let us move on to the problem of not understanding investment returns.
Could You Be Financially Independent When a Bear Market Cut Your Portfolio by 40%?
In the end of 1992, you walked into your financial planner’s office.
You explain to her that your wife and yourself would like to see both of you have enough resources to retire when you are 50 years old (you are probably 39 years old at that point).
The financial planner works with you to find out how much income do you need in today’s dollars in the future. The financial planner asked how you would live your life if you are not working. What are the way of life you can accept, what are good-to-haves and what are absolutely-must-haves.
So both of you firmed up:
You can have a pretty satisfied living on $3000 a month. There are some things that both you will enjoy but you do not always need to have it. This should come up to $1,500 a month.
In total, that would be $54,000 a year. In 10 years time, at an inflation rate of 2.5%, they would need $69,125 a year.
To generate $69,125 a year for 40-50 years, it would be better to have a capital of $2.3 million at 50 years old.
With $2.3 million, your first year spending would be 3% of your capital. That is a pretty conservative initial withdrawal rate.
The planner explains that you need to deploy your wealth into riskier allocation with 100% weightage in low-cost global equities portfolio that tracks the MSCI World index. These are investments that can earn a rate of return typically of 6-7% a year.
But she thinks the write planning should be conservative. Instead of using a historical average rate of return of 6-7% a year, she used 4.5% a year.
If your wife and yourself can put in $50,000 a year for 10 years, at a conservative rate of 4.5% a year, you will need $1.09 million today (in end 1992)
You buy into the plan and decide to put $1.1 million into their portfolio, and contribute $50,000 a year for 10 years.
The 10-year period of 1993 to 2002 would probably be considered a period that is tough in terms of accumulating for financial independence.
In accumulation, you want a period of poor returns followed by a period of good returns. In this 10 year period, the returns were great for the first 7 years follow by 3 years where they cut your wealth in half.
The annualized rate of return for the 10-year period of 1993 to 2002 was 6.3% a year.
6.3% returns is rather decent.
However, investors are fixated on 6.3% that they may not understand that the actual returns have some serious ups and serious downs.
Here is a chart showing your actual portfolio value versus the projected portfolio value:
You need $2.3 million.
Eventually, you end up with $2.4 million.
In the last 3 years, your portfolio got shaved 40%. However, your plan is still intact.
You would probably be cursing and swearing at your adviser because at one point, your portfolio ended up with $4 million and she didn’t de-risk your portfolio.
I think that is the call of the adviser. There is no right or wrong answer. I would lean towards shifting part of the wealth to bonds if the financial independence amount is reached.
Here are the data:
They are less important than the chart I feel, but you would probably be able to appreciate how the actual portfolio value stacks up versus the projection.
Could You Retire at the Start of 1998?
You may have accumulated the $2.3 million in the fifth year. You could have sped up your financial independence.
But then in hindsight, knowing that your wealth is going to be shaved by 50% between 2000 to 2002 if you retire at the start of 1998, would you have a sustainable retirement?
Here are some things we know:
- At the start of 1998, the portfolio value is $2.5 million
- Based on the projected inflation rate of 2.5%, if you were to retire in 1998, you would need an income of $61,000 a year (lesser than $69k since you start off 5 years earlier)
- You need 5 more years of income, so you need your wealth to last 45-55 years instead of 40-50 years
We can work out your initial withdrawal rate: $61,000 / $2,500,000 = 2%
A withdrawal rate of 2%, by all standards, is pretty low.
Based on my studies, to last 60 years, if you want to take care of the worst-case scenarios, better to have an initial withdrawal rate of less than 2.8% or 2.5%.
- Great Depression
- The Spanish Flu and Depression of 1921
- High Inflation 1960s to 1980s
Your portfolio can be more balanced if you shift your wealth to more bonds instead of 100% equities.
The Last Word
What worked is not just about the returns in the market. It is sensible planning.
Here are some factors:
- Rationalize how much you need when you retire. If you wish for a safe plan, you need enough money. What is enough money is another matter altogether
- Have a realistic inflation rate
- Use a conservative yet realistic growth rate in your accumulation planning. If the portfolio do well, that is a bonus
- When things turned out better, know what we should do
- When things turned out not so good, know how to course-correct so that the goal is still intact
These are just some of the things I can think of.
You should also be aware that when people tell you the growth rate is 6-7%, also ask what is the time period. Think whether it went through some challenging periods.
Your annualized returns factor in good years and the poor years.
- The annualized return for 1993 to 2002 is 6.26%. That factors in a 49% plunge.
- The annualized return for 2004 to 2013 is 6.98%. That factors in a 40% plunge.
The challenge comes when the annualized growth rates are lower than your planning growth rate. That can happen. You just need to pivot accordingly. Usually, it involves choosing to live with less income or delaying retirement.
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