Managing Investment Risk in Retirement

A few weeks ago I talked about the retirement savings rules: the 30x Rule, 25x Rule, and 20x Rule. These rules are based on a >90% probability of success in retirement with a higher than standard life expectancy using financial market data that goes back to the 1870s.

Although most low-fee, balanced or growth-oriented index portfolios will provide an inflation-adjusted return of about 6% annually over the long haul, we know stock markets go up and down somewhat erratically and investing is not a smooth ride.

Benjamin Graham, a stock market legend, created the allegorical character of "Mr. Market"—a bipolar depressive individual—to describe the changes in stock market price behaviour. Mr. Market is rarely even-keeled. He is often optimistic and demands higher and higher prices for his stocks, but suddenly he becomes pessimistic and offers stocks at lower prices. Thankfully we know Mr. Market is more often happy than fearful which is why stock markets tend to go up over the long haul.

Dangers of Mr. Market

Depending on your age and length of retirement, you could withdraw between 3.5% to 5% of your initial portfolio value at retirement each year and adjust that withdrawal amount up each year to account for inflation. While we believe the stock market will return an average of 6% per year adjusting for inflation, we can't withdraw 6% per year.

The 20x to 30x Rules make up for Sequencing Risk—knowledge that withdrawing money from your investment portfolio during large market drawdowns can cause severe, long-term damage to your portfolio. In fact, all failed retirement scenarios in history are caused by starting retirement just before a large market crash or just before a rapid inflationary period.

For example, let's say you are retiring in your 60s with a $1,000,000 portfolio and follow the 20x Rule. You withdraw $50,000 to fund your first year of retirement bringing your portfolio down to $950,000. The next year we get a market crash and your portfolio drops 40% to $570,000. Inflation went up 3%, so you withdraw $51,500 to fund year 2 of retirement. That's 9% of your investments and the value of your portfolio now sits at $518,500. Your portfolio climbs 6% to reach $549,610 and inflation went up 3% again. The year 3 withdrawal is $53,045 ( 9.7% of your investments) which drops your remaining portfolio down to $496,565. We could continue this example on and on but you can see that you are quickly in a precarious situation.

Although it's unlikely for the market to return only 6% in the years shortly following a massive 40% crash, this type of return sequence is exactly what happened in the 1930s. I think any retiree who is living off the proceeds of their portfolio would be sweating if they found themselves in this situation.

Increasing Retirement Success

There are a few ways to significantly increase your odds of success when retiring on your investment portfolio for a very long period (30+ years). The first way is to simply follow the 30x Rule. We know the 30x Rule worked 100% of the time since 1870; barring complete catastrophe worse than the Great Depression, two World Wars, the inflationary 70s, and the Financial Crisis, we will be good when we withdraw 3.33% of our portfolio in the first year and increase with inflation from there.

If we want to increase to the 25x Rule in long retirements, we need to maintain a high allocation to stocks and guard with some shorter term government bonds and gold. In a standard passive portfolio, withdrawing primarily from stocks during good market years and primarily from bonds and gold during bad market years we can mitigate Sequencing Risk.

Stock market downturns typically last less than two years. In the year following the market bottom, it's common for stocks to increase 30% or more. If you can make your bonds and gold stretch up to 2 years, you will be able to increase your odds of success into the 95% range.

Another way to improve success is to create a bottom target and top target for spending in retirement. An appropriate top target might be 4% of your initial portfolio adjusted for inflation (25x Rule) and bottom target at 3.33% of your initial portfolio adjusted for inflation (30x Rule). During good market years you spend at your top target and during bad market years you spend at your bottom target. Reducing withdrawals 15% or so by cancelling vacations, cutting back on entertainment, halting monetary charitable gifts, and the tax savings of withdrawing less for a year or two are often tolerable changes to make. Using this strategy we can increase our odds of success to about 100% in a long-term retirement.

Take Away

There are many strategies you can use to ensure financial success in retirement. Success depends on spending flexibility, knowing that withdrawals over 5% of your initial portfolio is reckless at any age, and understanding withdrawal rates over 4% are dangerous in early retirement. After that, disciplined portfolio strategy can carry you through even the worst downturns.

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Housing: Rent or Buy (Part 4)

It's been several weeks of house talk here at By now you've probably found I believe house prices in Canada are stretched wwwaaaayyyyy beyond what they should be.

From the beginning of this series, I pointed out my belief that the average house has a long-term value that's based on the citizen's ability to afford residential property. This affordability is determined by median household incomes and average mortgage rates. Household incomes have not exceeded the inflation rate since the 1970s, so we know wages are not responsible for today's ridiculously priced real estate.

In Part 2 and Part 3, I talked about interest rates and their relation to mortgage rates. Although interest rates bounce up and down in the short-term, I believe the long-term, low-end interest rate on government bonds for prosperous, stable countries is around 3%. This translates to a mortgage rate of around 5%.

In Part 2 the number I threw out for an average house price on today's 2.6% mortgage rate was $368,000. However, in Part 3 I dropped a long-term expected house price of just $287,500 based on a still-low mortgage rate of 5%. This assumes the average Canadian family saves a 20% downpayment and will spend around 20% of their gross household income on their mortgage payments.

How Did We Get Here?

With a current average house price of more than $475,000 we are 30% above our target current house price of $368,000 with current low interest rates. We're a whopping 65% higher than our long-term expected house price of $287,500 at long-term average mortgage rates.

This huge variation in housing prices has been fueled by two powerful emotions: greed and fear. Millions of homeowners and thousands of investors have greedily borrowed to the absolute max so they can buy residential property at astounding prices. They believe they will see the paper value of their homes and their leveraged equity skyrocket with the help of an asset that "never goes down".

The constant circling of parents, the media, your local real estate teams, and every third TV show suggests if you don't own a house now you: are throwing away your money, are making your landlord rich, are missing out on massive equity gains, are getting priced out of the market, might never be able to own a house again, and you are simply stupid. People are scared to be perceived as stupid, so they follow the crowd out of fear.

In the short-to-medium term, asset prices are the product of human psychology. Higher prices beget still higher prices... until they don't anymore. This is called bubble formation and it happens all the time across different assets: housing is no different!

Ask your parents about gold in the 1970s or tech stocks in the late 90s. Ask your American or Irish friends about their housing in the mid-2000s. Every time these bubbles formed the same narratives appeared. Bubbles always start slow, look bulletproof, and you can come up with creative and seemingly sound reasons for massive price appreciation.

Due to this greed and fear surrounding real estate, Canadians have been stretching themselves to the absolute and unsustainable max to buy, keep, and upgrade their houses. Downpayments? Nope! Saving for the future? Huh?! Work-life balance? Gone! Paying off your credit cards and lines of credit each month? Impossible! Buying anything at all without monthly payments? No one can afford that!

Fortunately (or unfortunately) bubbles work both ways. They inflate grandly and deflate with surprising velocity. Once prices start falling people start panicking and lower prices beget lower prices. Those sound reasons justifying the high prices fly out the window and it becomes so obvious why the asset failed. All of a sudden everyone sees it!

If you're trying to buy a house with multiple bids, when there's no inventory available, and properties are sold with mere days on market you might be stupid. But it sounds like a great time to sell!

"Be fearful when others are greedy and greedy only when others are fearful." - Warren Buffett

What Happens Now?

To move to a long-term average house price of $287,500 in today's dollars, there would need to be a massive equity erasing, country-wide correction of about 40% from current house prices.

Houses are not stocks that can quickly be traded with erratic price jumps; I don't believe houses will drop 40% in months like the stock market can. Rather I believe it will look more like a halt in sales activity, followed by slow price trickles, followed by more aggressive price drops, followed by eventual price stability with increases below the inflation rate. The unwinding process is a painful one that can easily take a decade or more.

As ridiculous as it may sound today, I have little doubt that one day in the coming decades, the average house in Canada will be worth $287,500 in 2017 inflation-adjusted dollars.

Would you hang onto your highly leveraged house when mortgage rates are increasing, you're staring at inevitably higher monthly payments or a massive refinancing once your current mortgage term comes due, houses in your city are dropping by a couple thousand dollars each month, and your equity is shrinking faster than your income?

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