Foolishness of the 4% rule

[Deleted User]

Algorithms do have a leg up on human emotions. Whether they can predict anything or not is highly doubtful but at least they do no harm.

Either the “bucket” or the fixed percent allocation strategies are good in my book. Whatever is easier to buy into will work. 

Thrugelmir

Linton said:

Deleted_User said:

michaels said:

Any strategy where you change the mix between cash and equities depending on some perception of whether markets are 'high' or 'low' is 'timing the market'.  Most of the literature suggests that trying to time the market is as likely to lead to underperformance as overperformance - may be more so as it involves extra trades.

It does not matter what you call it.  The problem with “timing the market” is that humans were not designed for it and normal human emotions  lead to bad investment timing.  This fundamental problem could at least hypothetically  be mitigated by having a strict algorithm make decisions for you.  And using the cash wedge during market downturns does not result in extra trades.  

The main problem is that its hard to execute this strategy.  When the sky is falling and your cash is the only thing holding value, will you really be able to deplete this one resource that is working for you? I think its much easier if you have sufficient DB income to cover the bucket of your basic needs and the cash bucket is only there for contingencies. 

The problem with predicting the market is deeper than humans not being designed to do it.  There cannot be an algorithm that could make optimal investment decisions for you no matter what the economic circumstances for the reason that Michaels gives - the use of any such algorithm will invalidate its own prediction.

Whether the market is random is difficult to prove. It probably isnt completely so in the short term as there seem to be momentum effects. However the best approach is in my view to assume that it is and so dont worry about it - treat it like the UK weather.  You need an asset allocation that you can live with no matter what the circumstances and keep to it through the good times and bad. In dealing with the weather you have appropriate clothing in your wardrobe that can deal with most things.  Just like the situation with the weather you have to accept that your wardrobe will not be able to protect you from the real extremes.

Even the weather has probabilities. It's not completely random. Weather doesn't materialise from nowhere. Rain although forecast isn't always a certainty. Sensible people will take an umbrella with them as insurance though. Those that don't keep up with events, or are unprepared by nature, are more than likely going to get a good soaking at some point of time. Luck only lasts so long. 

MK62

Audaxer said:

MK62 said:

If you look at your example, instead of starting with 50k in cash and 200k invested, if you started with 25k in cash and 225k invested, after 3yrs you'd have £281k......if you took the other 25k cash then, you'd be left with 256k rather than 250k.......so the opportunity cost would have been 6k.
Of course, at the start you could not know markets would rise 25%.......

Yes, but if these 3 years had been negative and shown a 25% loss overall, and you had used up your £25k cash buffer, you would be left with investments worth £168,750 and no cash buffer. If you were looking to continue now with the same income, you would be starting at around £8,600 which is 5.1% of your current investment value. It might still be okay, but I'd be a bit concerned and I would think I needed to lower my withdrawals. 

That's why I'm thinking that if you can afford it, it's better to have cash to cover the first few years income as well as a cash buffer.

Which is exactly why people use a cash buffer approach in the first place......to protect against having to sell in a falling/fallen market.

Fair enough, if the downturn lasts long enough, it might outlast your buffer.....but even so, you'd still be in a better position than if you'd used no cash buffer at all.........but you do have to accept that there is an opportunity cost involved if markets rise.

But you pay your money and take your choice........for me, the cash buffer approach is worth the relatively small opportunity cost it might entail.....but then at my stage, it's more important to me to avoid losses than realise gains.......I accept that might not be the same for everyone though......

[Deleted User]

Loosing 100k always hurts more than the satisfaction from gaining 100k. 

MK62

Hmmm......depends - once into the withdrawal stage I'd agree, but 10/15 years ago, for example, I used to see downturns as something of an opportunity, even though, on paper at least, they appeared to cost me money.........losing 100k, even on paper, would concern me far more today than it would have back then.....relatively speaking of course!!

bostonerimus

MK62 said:

Hmmm......depends - once into the withdrawal stage I'd agree, but 10/15 years ago, for example, I used to see downturns as something of an opportunity, even though, on paper at least, they appeared to cost me money.........losing 100k, even on paper, would concern me far more today than it would have back then.....relatively speaking of course!!

At the nadir of the pandemic markets my investment paper losses were scary multiples of $10^5 and if such an event was to persist for any length of time it would be the worst case for a new retiree relying on withdrawals from a portfolio. So the true foolishness in retirement income planing is ignoring what you will do if the worst happens. Be pessimistic and have a plan for the bad times so you don’t panic. The feeling of loss of control when you see your finances literally decimated must be avoided so having a plan of action other than panic selling into a falling market s a great help.

[Deleted User]

I was counting my losses in Honda Civics.  Losing a bunch every day. Kinda accounts for inflation between bear markets.  Fun times… But my sleep wasn’t affected so that’s something. It was too short for a proper test. People who lived through 1970s and stayed 100% invested, they can really predict own behaviour in times of trouble. 

bostonerimus

Deleted_User said:

I was counting my losses in Honda Civics.  Losing a bunch every day. Kinda accounts for inflation between bear markets.  Fun times… But my sleep wasn’t affected so that’s something. It was too short for a proper test. People who lived through 1970s and stayed 100% invested, they can really predict own behaviour in times of trouble. 

Looking back over the last 30 years of my investment life there have been several down turns that have taken over a year to work themselves out. So I expect at least the same to happen over the possible next 30 years of my retirement. The retirees who will have the lowest blood pressure will be those that are prepared both financially and psychologically for those bad times. If we go back to the times of disco, flares, high inflation and stagnant markets you will need a plan other than just listening to Gloria Gaynor sing “I Will Survive” and hoping for the best.

Malthusian

bostonerimus said:

 If we go back to the times of disco, flares, high inflation and stagnant markets you will need a plan other than just listening to Gloria Gaynor sing “I Will Survive” and hoping for the best.

If disco and flares make a comeback then the obvious strategy is to go live in the woods, after using what's left of your pension fund to buy a tent and some survival gear.

(Couldn't resist the obvious joke, I like disco)

Terron

Deleted_User said:

There are 4 “buckets” that each retiree needs to think about:

1. Basic, routine needs.  Food. Shelter. Car if you need it. Books. Newspapers. Beer.  Those kinds of things.  This income is best secured by something actually safe. State pension. Other DB pension. Annuity. Government bond (sucks right now).   Stockmarket is highly variable and the future is unknown.  Stocks can’t do this job. Keep in mind that longevity  is a good thing but also a risk for someone who relies on highly volatile investments.  And if you are on a pension board then chances are you will live longer than an average Brit. 

2. Contingency.  Roof needs replacing.  Your son needs help. Not necessarily “emergency” but non-routine expenditure. This requires a liquid source of funds.  Your stocks are technically liquid but not if you use “4% rule”.  In that case your investments are needed to secure your future 4% withdrawals and can’t be touched.  For this pot you need a separate “slush fund” in cash. 

3. Discretionary income.  Things that are “nice to have”.  Annual holidays in Hawaii. New  Porsche every 5 years. Major upgrades to your property.  Stocks are perfect for this pot. They are volatile but do provide the best chance of long term growth. Given you already secured 1 and 2 with genuinely safe sources of funds, you can and should be invested aggressively. This pot should be 100% in stocks and depleted based on the size of the pot. 4% rule does not apply. If this pot goes up by a factor of 2 in 5 years or 4 in 20 years (as it often does), it would be dumb to withdraw based on its size 5 or 20 years ago. 

4. Legacy. This pot could be in stocks (and combined with 3).  Or it could be insurance. Or certain types of annuities. 

Yes, the four buckets are desirable, but the first is the most important. Yes, it is best if it can be secured completely safely, but that safety often costs. The state pension may not cover it all. Getting a good DB pension might require doing a different job. Annuities may cost more than drawdown. Sometimes a level of risk has to be taken.

Drawdown seems to be the way that gives the greatest income from a given pot. Thus it is the method that works best for people with only a small pot. Work out what you need as a minimum to live on, on top of the SP. Using the 4% rule you then need at least 25 times that as a target. It is better to go for more but that is a good target.

If you were using the 4% rule (or some refinement of it) for bucket 1, anything above that 25 times can be used for pot 2 and later. The 4% rule is not for pots 2,3, or 4. It is aimed at how to do the best you can for pot 1 using a DC pension.

As someone who remembers the inflation of the 1970s I do not consider cash to be completely safe.

I have various forms of income, but apart from the SP in a few years time nothing that is absolutely safe. My annuity has no indexing. One DB pension virtually none and the other is capped at 5%.  That does not bother me. My DC pot (even at 3.5%) would with the SP be enough to live comfortably on, without touching my emergency fund.