You know you have awesome readers when you ask them for help and they respond in droves! Reader Cameron, who has been commenting since the early days of this blog, offered a post too. But this one might cause a bit of a stir. Because he will be looking at hacking the 4% rule!
In case you missed it, we already featured some other interesting guest posts too, including:
- The pension shuffle
- Where are the weird FIRE folks
- Why you company is not a great place for financial growth
Looking forward to your feedback on this one!
Hacking the 4% rule!
Unpopular opinion warning
- The 4% rule is too low.
- And timing the market beats time in the market.
There, I said it!
What is the 4% rule?
If you’ve been around the FIRE community for any length of time you’ll have heard of the 4% rule.
It’s the spending assumption when you consume income from your capital. You can safely spend up to 4% of your capital each year (adjusted for inflation) and expect with a very high degree of certainty not to run out of capital for at least 30 years.
The rule is the outcome of studies based on almost 100 years of historical price data for the S&P500 index and US government bonds using something called Monte Carlo analysis to model various mixes of equity and bond allocations and test them with different withdrawal rates.
Why is it so low?
The historical average annual return of the S&P500 index is around 7% when adjusted for inflation.
So why can’t we just invest in the index and safely spend 7% of our capital each year?
Then we’d only need to save 15 instead of 25 times our financial independence income target. Or we could reach a 75% higher income target within the same amount of time.
That’s what 7% instead of 4% means!
One reason the safe-withdrawal-rate is so low is that the main model portfolio in the studies is only 60% equities (and 40% bonds) meaning not enough capital is allocated to equities to expect the full rate of equity returns.
Another more consequential factor is something called sequence-of-return-risk, or sequence risk.
What is sequence risk?
Sequence risk is the likelihood that returns in the future will be so poor that our investment capital will be depleted and never recover, causing us to run out of money before we stop needing it.
Though we can’t know what annual returns will occur in the future, nor in which order they’ll arrive, we can achieve reasonable predictive value by modelling historical annual returns with Monte Carlo analysis.
Simply put, we randomly jumble up all the historical annual returns and replay them to simulate the journey of a portfolio through thousands of alternate histories. To the extent that we expect our future not be excessively different from our past, the predictive value of this analysis is expected to be high.
From this process it’s possible to infer that the highest withdrawal rate which ensures 100% likelihood of portfolio survival, when living off income from capital for a period of at least 30 years, is…… 4% .
So, what’s wrong with this, and why would we want to hack it?
The studies assume we stay invested in equities with a fixed asset allocation during times when the equity portion of a portfolio can return -30%, -40%, -50% or -60%, like the period from 1929 to 1931.
But I believe if we are able to hack this issue, we might instead be able to safely withdraw something closer to the historical average annual share market return of 7%.
The case for at least trying to figure out a solution is very compelling, and I believe it could be found in something called momentum investing.
Momentum investing to the rescue
Instead of the traditional strategy of sticking to the index through thick-and-thin and mitigating sequence risk with bonds and a conservative 4% (or lower!) safe-withdrawal-rate, I believe it makes more sense to have a strategy which manages risk while being more fully invested in equities.
I implement such a strategy by attempting to buy and hold positions in equities that are trending higher, and selling them when their momentum weakens.
The basic idea is to make as much as possible when market conditions are favourable, and protect gains and capital during other times.
This is the key to hacking the 4% rule.
By systematically reducing equity exposure and increasing cash holdings during unfavourable markets it becomes possible to achieve a dynamic defensive asset allocation. And as individual shares trend higher again and hope of a new bull market emerges the portfolio shifts back to a higher concentration of equities.
How do I do it?
Entire books have been written on the subject and still contain only a part of what there is to know about momentum investing.
I can’t hope to explain it all in a single blog post, but I can give a brief outline of my philosophy and approach.
My hypothesis is that an incremental approach to risk taking makes it possible to engineer an investment journey which avoids extreme price falls, like what happened during the bursting of the dot-com bubble in 2001 to 2003 or the global financial crisis of 2008 to 2009.
The diagram below shows the basic shape of the investments I’m trying to identify.
- Get into a trend and stick with it until it ends.
- Markets are just price, bid, offer and liquidity.
- An entry signal is only a possible profitable investment and has a significant chance of failing.
- Therefore, risk and investment management are more important than investment identification.
- A clear entry identifying when an investment is worth the risk.
- A specific way to identify when the investment is not worth the risk anymore.
- A systematic way of taking profit.
- I only buy when the market index has upward momentum.
- I only buy current constituents of the All Ordinaries index (a universe of 500 companies)
- Limit positions. I buy equal amounts of up to 20 companies at the same time. This balances between enough concentration, which is essential for profit potential, and diversification without excessive dilution.
- I buy based on a combination of technical criteria derived entirely from price action.
- The maximum I am willing to lose on any single position is 10%.
- To take profit I use a so-called trailing stop loss which follows rising price action higher and enables me to stay in a trend until it ends.
What’s it look like?
Below you can see the investment journey simulated over the long term.
The upper chart is the All Ordinaries Accumulation index. This is Australia’s equivalent of the S&P500. Accumulation means it includes re-investment of dividends.
The ribbon along the bottom shows when the system stops opening new positions (red) because the index is lacking sufficient upward momentum.
The lower chart represents invested capital (light blue) and cash holdings (green).
There isn’t any compounding of profits in this simulation, so after some years cash begins to accumulate.
Note in 2008 when the index fell more than 50%, investment capital losses were avoided.
Yet when the market trended higher recently, from late 2016 until mid 2017, capital levels remained flat until well into 2017. Periods like this are also inherent in the journey.
What’s the catch?
Losing is part of investing, but this strategy loses often. Much more often than it wins.
My long term per-investment win-rate averages barely 40%. In bad markets, that can fall to a meager 5%. That’s only one in every 20 investments!
The system tends to exhibit a pattern of many losses and infrequent big wins.
Capital slowly grinds down until the next big winner is caught, then profits flow in for a while, and the process repeats again. This means it’s not uncommon to experience extended periods of negative performance.
Another major drawback is solitude.
Developing your own rules and applying them, risking your hard-earned capital, is largely a solo endeavour. The process is repetitive. Grinding even. Plenty of online communities exist but you can’t outsource management of your investing to them.
Persistence, will and discipline need to be built, developed and maintained at an individual level.
Some last words
I commit a substantial amount of my net worth to this strategy.
My own journey is still well and truly in the accumulation phase so it’s yet to be seen if this gets me to where I want to go, in the way I am expecting, or whether it serves its intended purpose when I arrive.
It’ll take many years to discover whether future me thanks present day me for setting us on this course.
If I’m wrong, I won’t be getting those years back.
In not following more common wisdom I’m satisfying a strong do-it-yourself investing ethos and some need to feel unique, possibly at the expense of simpler investment strategies with superior outcomes.
I accept this and acknowledge that it may even be my Achilles heel.
For now though, my regret is not starting earlier and being more consistent.
Thoughts on this post, let Cameron know in the comment section!