No. of Recommendations: 92
This post is intended as an amplification to Post 68232, put up by mhtyler yesterday morning in the "I Cashed Out Thread." In my humble opinion, the mhtyler post is the second most important post ever placed on this board (my #1 favorite is the one that started the "For Art's Sake" thread). The reason is that it expresses a subtle concept that it would be easy for many to miss, but which I believe to be of tremendous significance in putting togther a workable Retire Early plan.

I have tried in my fumbling way several times to make the point that Mark made in his post yesterday, but I don't believe I have been able to communicate the thought clearly as of yet. I'd like to take note of what he said here, and then toss out for consideration a little mental exercise that I hope may be of use to some in seeing the implications of Mark's argument.

The purpose of Mark's post was to defend another poster's strategy of lowering his stock allocation because of the effect that falling prices have had on the viability of his Retire Early plan. Intercst faulted the other poster's decision to take money out of stocks, arguing that there would be a financial price to be paid for this "emotional" decision. Mark faulted this response as excessively "abstract."

I should let Mark speak for himself, as he makes the point more clearly than I ever have:

The cash vs equity issue is so often discussed as though it was a fly in amber that cannot or should not be changed to fit the market. For someone with a 3M nest egg living on 1%, a 33% loss means you've got 2 million left and your next years withdrawal is what...2%? What about the guy with 1M who was withdrawal is 4% and who's nest egg is now 600 thou???

RE philosophy starts looking ridiculously abstract at that point. (my idea to put this in bold)

I don't doubt the over all efficiency of the 70/30 rule, but its one you
have to be well heeled to sustain in hard times. For the person in the first example it is NOT hard times, its a bump in the road. For the person in the second example it's a bloody heart wrenching disaster. Them thats got, gets.


I know that there have been some who have been perplexed when I have argued that there is not one safe withdrawal rate, but many, that the safe withdrawal rate varies according to the personal circumstances of the particular investor at issue. What I like about Mark's post is that he takes the concept that I have been trying to get across and conveys it in down-to-earth terms. He is not directly saying that there are different safe withdrawal rates for different investors. But he is speaking from the same premise that caused me to make that claim.

What he is saying, in my view, is that it is an artificial exercise to look at historical data regarding what sort of withdrawal rate applies for stocks without factoring in the practical reality that stocks are always owned by people, and people respond differently to different circumstances depending on their particular life goals and financial circumstances. Ignore this factor, and you are looking at only half of what goes into the calculation of a safe withdrawal rate. You can come up with a number without considering this factor. intecst has done that. But that number will have little similarity to the safe withdrawal rate that will apply in the real world.

The safe withdrawal rate study, as currently presented, is, in Mark's words, an "abstract" exercise. It is of some theoretical interest. I have noted on the boards many times how I have used the numbers in the study to guide my own investment strategies. It has value. Where it falls apart is when you try to use the conclusions of the study to guide investment decisions in the real world. As a purely theoretical document not considering factors that are important to the determination of safe withdrawal rates in the real world, it cannot be put to that purpose with the expectation that it will produce good results. The Safe Withdrawal Rate study has value as an intellectual exercise, but not as a practical investment-planning tool.

A Mental Exercise I've Come Up With to Illustrate Mark's Point

A man comes to you with an "investing" proposition. He says that he will ask you to guess whether a coin will come up heads or tails. If your guess is correct, he will pay you $200,000. To play, you must agree that, if your guess is incorrect, you will pay him $100,000.

The odds of the bet are clearly favorable. He is offering you two-to-one odds for a bet with a 50-50 chance of going either way. Still, I believe that there are circumstances in which you would be making a big investment strategy mistake to take the bet.

Let's say that you have been saving for early retirement for 12 years, and that you are two months from reaching your goal. Reaching your goal will mean that you will be able to spend more time with your wife and kids, who have had little of your time for the past 12 years. If you "win" the bet, you will be able to retire two months sooner than if you did not play. That's a small gain. But if you lose the bet, you will have to delay your retirement for several years. That's a big loss. You are being offered a very bad investment proposition.

Now, let's change the scenario a bit. Let's say that you are offered the same proposition, but that you have $10 million in accumulated assets and have already been early retired for years. Your only reason for wanting to invest for a bigger return on your assets is to be able to give more money to your favorite charity.

In this circumstance, I see the bet as an appealing proposition. If you lose the bet, you remain early retired and you still have lots of assets to give to your charity. If you win the bet, you get to increase your contribution to the charity this year by $200,000. In this scenario, the downside is far less than in the earlier one. Thus, the upside--which is considerble--is more worth pursuing.

Now, let's consider another change. You are offered the same proposition as above, but with a condition attached. In order to take the gamble, you must be willing to take it ten times in a row. You can't just accept a $100,000 loss and walk away. You must continue to play with the chance in your mind that you will lose $1,000,000 before the game is through. Let's assume here that, were it not for this investment proposition, you would have the assets needed to early retire in two month's time, and that that amount is exactly $1 million. By taking the bet, you risk turning your financial circumstances from heavenly to hellish. You are taking the chance of going from complete financial independence to complete bankruptcy in the time it takes to toss a coin ten times.

Your first thought is that the bet is not worth taking. But then you see a study examining how similar coin tosses have gone in the past. You see that the odds of losing out on 10 picks in a row are slim. And you see that, getting a two-for-one return for each time you get a correct pick, your wealth can build more quickly in the coin-toss investment class than in any other you know of. So you accept the proposition, and the coin toss begins.

Your picks fail on the first four tosses, and your net worth is now down to $600,000. You have nowhere near what you previously calculated you will need to live on for the rest of your life. You are wondering how to tell you kids to forget about college, how to tell your wife that you need to move into a far smaller house, how many years or decades your early retirement is going to end up being delayed because of your misplaced confidence in the study. You are feeling sick about your mistake, kicking yourself for ever having done anything to jeopardize the financial independence you had worked for decades to win for yourself. While you are in this frantic, self-critical mood, the man who offered you the investment proposition comes forward with a new idea.

He says that, while you are obligated at this point to play the coin toss game six more times, and risk total bankruptcy, he is willing to let you out of your promise if you are willing to pay for the privilege. His price is $200,000. Give up another $200,000, and you will be permitted to keep $400,000 as the starting stakes in your effort to build financial independence for yourself a second time.

You look at the study again, It suggests that you are crazy to pay $200,000 to be released from the bet. The study says that the two-for-one odds are very good odds for this bet, and you should not be willing to pay anything to get out of the coin-toss investment class. But then you remember how your earlier decision to follow the study's recommendations turned out. It caused you to lose in two minutes wealth that it had taken you decades to accumulate. You decide that it's well worth the $200,000 payment to at least limit the damage you will suffer for your earlier mistake (you clearly see is as such now). You pay the $200,000, and begin walking off to return to your job, which you now do not expect to be able to retire from for many many years.

Before you are out of earshot, you see the man offering the unusual investment proposition walk up to another potential investor and ask him whether he would like to play. He says yes, and you remain a few moments to see how things turn out. Your jaw drops open as the new investor makes four straight correct picks, winning $800,000 for himself. Money that "should" have been yours. So the result predicted by the study, that in the long run people guessing the result of the coin toss will get it right 50 percent of the time, turns out to be accurate in a theoretical sense afterall. It just didn't do much good for your hopes of being able to enjoy an early retirement in this lifetime.

The stock market over time will pay the sort of returns shown in the data used to put together the Safe Withdrawal Rate study, I believe. There's no guarantee of that, but I believe it is a reasonable presumption. It is NOT a reasonable presumption, however, to say that any one investor or any group of investors can assume safety in a decision to make 4 percent annual withdrawals from a Retire Early stash with an 80 percent stock allocation to support a retirement beginning at a time of overvaluation comparable to the level applicable today.

To know what sort of safe withdrawal applies to real-life investors, you need to know what sort of investors they are. That's what determines how they will respond to the price drops that make the high growth associated with this asset class possible. Not all investors will respond the same. Those with $10 million in assets will respond differently than those with $1 million. Those with 40 percent stock allocations will respond differently than those with 80 percent stock allocations. The historical data suggests that what you do before the stock price drops is the biggest factor that determines how you will respond when they do.

What the historical data suggests is that the worst possible way to prepare is to go with a big stock allocation at a time of extreme overvaluation. The historical data suggests that most investors that do that WILL NOT remain fully invested in stocks as their portfolios diminish. I can't predict the future. I can't say that it is not different this time. All I can do is report what the historical data says. It says the opposite of what the Safe Withdrawal Rate study presumes.

Investors who follow the recommendations of the Safe Withdrawal Rate study are putting themselves at risk of experiencing the worst that the stock market can dish out. I am not saying that they will indeed experience the worst. I am saying that the risk that they will experience it is far greater than zero percent. And I am saying that the presumption of the study that any one particular investor will not diminish hs or her level of stock market participation in the event that he or she experiences the worst flies in the face of all historical evidence. This is not a study that tells you what sort of safe withdrawal rate you might get if the future is something like the past. It is one that tells you the sort of rate you might get if the future is nothing at all like the past.

Let's assume for a moment that middle-class investors did not jump out of stocks when prices headed downward. Let's assume that they remained in stocks through thick and thin, as the Safe Withdrawal Rate study presumes they will. In the world in which that assumption is true, the data used to determine the safe withdrawal rates would not be the same. If the middle-class investors who left the stock market in the late 1970s and early 1980s had never done so, but had remained fully invested in stocks, you would not have seen the high stock market returns that you saw in the late 1990s. The reason is that there would not have been new money avaiable to invest in stocks at that time.

Bear markets are a necessary precondition for bull markets. You can't have the latter without the former. If by some wild chance the presumptions of the safe withdrawal rate study were shown to be accurate, stock prices would zoom in the few years following as investors left all the inferior investment classes for the one that offers both the best growth potential and the highest safe withdrawal rate as well. At that point, prices would be so high that stocks from that point forward would provide extremely low long-term returns, lower than what stocks have ever offered in the real world in the past.

The presumptions you make in a study always influence the results you produce. The assumption that investors will this time behave in ways that they never have before in recorded history is not a safe presumption. It is a highly hazardous one. It's likelihood of coming true is small. The returns produced by making highly hazardous assumptions are not "safe" returns. They are highly hazardous returns. Some investors will obtain the 4 percent annual withdrawals promised by the study, but they will do so by taking on large risks. Few investors have enough slack in their portfolios to be able to obtain that sort of withdrawal rate safely in stocks at today's prices. That is not to say that it is not possible to obtain a 4 percent safe withdrawal rate in investments classes offering lower growth potential, or that it is not possible to obtain 4 percent safe withdrawals from stocks at other valuation levels.

The study works its magic trick by considering one effect of risk, that it produces high returns, and ignoring another, that it causes people to jump in and out of asset classes. But the historical data shows that the one effect generally goes with the other. If you want to assume that investors will remain in the asset class you are examining, you have to study an asset class that the historical data shows people do not jump in and out of much.

I do not consider risk a bad thing. Risk is often associated with high investment returns, and I like high returns, so, in the right circumstances, I am willing to purchase assets offering considerable levels of risk. However, I think that risk needs to be controlled. Knowing the accruate safe withdrawal rate for stocks for people in my particular circumstances would help me better control risk in developing my investment strategies. My dilemma is that, at this point, it's clear to me that my safe withdrawal rate for stocks is a number below 4 percent but it's not clear to me exactly how much below. If it is somewhere near 3 percent, it may be time for me to begin moving small amounts of money into stocks. If it is 2 percent or lower, I'm probably better off staying out of stocks for the time-being.

My hope is that at some point the board will lose interest in debates about whether stocks are better than other investment class or not. It's a debate that could continue until the end of time and never be resolved. It can never be resolved because it is a nonsense question. There is no answer to the question "which investment class is best?" They are all best at serving the paricular purposes which they were created to serve. You need to know what you goals are to know which investment class is best for you.

Each individual poster addressing the question of "Which investment class is really best?" uses the same data to support his or her arguments, but each approaches the question from an entirely different perspective, a perspective influenced greatly by his or her particular financial circumstances and life goals. They are doing the right thing to do so--it's absurd to try to analyze investment possibilities without allowing these factors some influence--but the fact that each person is working from different understandings of what constitutes investment "success" makes it unlikely that they will convince many others that they are "right."

For one person to take his or her definition of investment success and impose it as dogma on the rest of the board is a receipe for frustrated and unproductive dialogue. It may or may not be that the 4 percent number is the true Safe Withdrawal Rate for intercst. He has a lot more assets than me, and I believe that having more assets moves your Safe Withdrawal Rate up, so I am willing to accept that his Safe Withdrawal Rate on a stock allocation of 80 percent at today's prices may be somewhere in the neighborhood of 4 percent. I know that mine is nothing close to that figure.

I'd like to be able to have a dialogue on the subject of Retire Early investing with people like Mark and any others who have come to the realization that the Safe Withdrawal Rates often discussed on this board are not the Safe Withdrawal Rates that apply to them. If there are others who would like to have such a debate, please let me know (by e-mail if you prefer not to reveal yourself on the board) and I will try over the course of the next six months or so to make it possible.

Perhaps there are ways that the majority of this board could agree to allow a minority to have their discussions in peace, without regular assertions of the presumed greater wisdom of the majority position. Perhaps there is a need for a separate board to discuss only the question of Retire Early investing for those who do not accept the view of the majority of this board. If the group wanting a new sort of discussion s small enough, perhaps it would be better to put together a list of people who will trade e-mails on the subject, and not have the material posted on a public board. Perhaps there is not enough interest in such a discussion today to make it a worthwhile endeavor at this point, and we should hold off for six months or a year and reassess the level of interest then.

I'm open to various possibilities. Whatever works. I believe, though, that any community of people seeking to understand how to achievce financial independence early in life at some point needs to address itself to the queston of how to invest in ways that will make that possibility a realistic one in more than just an abstract "on paper" sense.
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