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Subject:  Re: Allocating for retirement? Date:  4/27/2004  11:08 AM
Author:  rkmacdonald Number:  40712 of 81979

Author: freakydeac wrote:
I meant, if you need $50k per annum, you need approx $1.25 mil [50000/ .04], if you intend to use all the gain. But if you intend to use only about 4/7, as in your example, you need either to increase risk to gain 7%, or defer retirement till you have about $2.18 mil, living on 4/7 of the gain, or the same $50k.

Maybe you don't understand that you simply cannot spend the full average total return. Here is an example:

Assume a stock has an average total return of 7% per year for 4 years.

Assume $1,000,000 in initial stock value.

Assume you need 7% ($70,000) per year to live on.

Consider this scenario of 7% arithmetic average total returns (I'm using arithmetic averages here for simplicity, while CAGR would normally be used):

Year 1, -60%, $330000
Year 2, -60%, $62000
Year 3, +58%, $27960
Year 4, +90%, -$16,876

Average total return: 7%

Even though the average return over these four years was 7%, you would run out of money if you counted on that fact and spent the full 7% of the original value each year.

Granted, this is an EXTREME and unrealistic example just to make a point. It shows that you cannot depend on spending a yearly amount that is equal to the average total return of a portfolio. Note that if the +58% and +90% years had occured before the two -60% years, the portfolio would have survived just fine. So, the point is that the amount you can take from a portfolio, with a reasonable chance of long term survival, is highly dependent on how volatile the portfolio is and the order of the yearly returns.

This is why economists equate volatility with risk!!

The purpose of adding bonds or REITs to a portfolio is to reduce volatility and smooth out the returns, while retaining as much growth as possible, in order to increase the safe withdrawal rate.

As I said, the maximum that you can expect to withdraw from a properly balanced portfolio is about 4% (initial amount, indexed upward each year for inflation) and possibly 4.5% if REITs are added. In other words, even though the portfolio returns 7%, you can only take 4% (initial amount, indexed upward yearly with inflation) or the portfolio will become exhausted.

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