Hacking the 4% rule!

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:

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!

Hacking the 4% rule!
Hacking the 4% rule!

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.

Hacking the 4% rule!
Hacking the 4% rule! – Trends

Aim:

  1. Get into a trend and stick with it until it ends.

Principles:

  1. Markets are just price, bid, offer and liquidity.
  2. An entry signal is only a possible profitable investment and has a significant chance of failing.
  3. Therefore, risk and investment management are more important than investment identification.

Basic elements:

  1. A clear entry identifying when an investment is worth the risk.
  2. A specific way to identify when the investment is not worth the risk anymore.
  3. A systematic way of taking profit.

System rules:

  1. I only buy when the market index has upward momentum.
  2. I only buy current constituents of the All Ordinaries index (a universe of 500 companies)
  3. 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.
  4. I buy based on a combination of technical criteria derived entirely from price action.
  5. The maximum I am willing to lose on any single position is 10%.
  6. 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.

Hacking the 4% rule! - Investment Journey
Hacking the 4% rule! – Investment Journey

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!

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12 Comments

  1. Good points. I do feel you might’ve missed an important one. I;ve blogged about it before, see https://www.thinkingbig.nl/geld/vroeger-met-pensioen-in-nederland/ for an example. I’ll write a better post sooner.

    The summary is: you live in the Netherlands, which has high taxes… but also an INCREDIBLE social system (and infrastructure, etc.). The Netherlands are safe. You cannot fall as deep. You pay high taxes, but you get what you paid for.

    The 4% rule aims at an portfolio which will last you forever while withdrawing the same every year. It’s basically fear-driven. As a lot in the USA is 😉 You, as a Dutchy, are able to say: the returns this year are disappointing… I’ll withdraw less and use less. How? Because you’ll be eligible for AOW and at least a small pension after a certain age.

    Also there should be no stellar healthcare costs, no huge legal costs, no other weird American riches-to-rags events. So the 4% rule is too conservative, because it’s American.

    1. Points well noted! We actually do see the AOW and pensions we already have as our financial buffers, but still aiming to be fully FI on our wealth. That being said, we don’t worry to much about the 4% rule, as we primarily have real estate and dividend shares, got to love cash-flow 😉

    2. Thanks for the comment.

      I agree that reliable pensions are a valid argument for higher safe withdrawal rates. Knowing you have that safety net of income coming online at a future date, would mean you could afford to somewhat deplete your own capital.

      Question: could you, for example, retire at 50 with 450,000e of invested own capital, run a 6.5% SWR, for a 30,000e p.a. income, and run the risk that you grind down your portfolio by 2.5% a year, knowing you’ve only got to have 250,000e intact at 68 y.o. because that’s when 20,000e of lifetime pension income is due to come on line?

      I believe these are valid scenarios for Dutch FIRE folk to consider.

  2. Do you also use shorts on the market or do you only take long positions? With trend following, traders typically look at both sides of the coin, not just buying on the local high, but also shorting on the low as well. I read a post close to 10 years back with a trader who used the same trend following routine. Your stop losses might also be too tight, cashing you out of the position before you can capitalize on the pullback.

    1. I only trade long. One reason is that equities have an upward tendency. It’s the same reason why indexing works. Another big reason is the shape of up moves versus down. The adage is that the bull climbs up the stairs and the bear falls out the window. My system, which you rightly identify as trend following, requires quiet trending market conditions. Major corrections (like what we’re seeing how) and full-fledged bear markets tend to correlate with an increase in volatility. In those environments the system doesn’t work and I try to shut it off (Rule #1 – I only buy when the market index has upward momentum) and wait until more favourable conditions return.

      I know people who try to implement market correction/plunge protection with options, but it’s as much to protect against major losses (trying not to lose as much) rather than short-side trading as such.

      My maximum stop loss is 10%, so quite wide. My average per-trade loss amount is also pretty close to 10%, so there are plenty of failed take-off attempts! :S

  3. This is a very interesting approach and I like contrarian ideas. It tells a story about the person who doesn’t simply accept what the crowd preaches but goes the extra mile, learn, plan and something from scratch. This is how great success starts in my opinion. The only important thing IMO is to don’t go all in and have an escape plan. That way you either win the prize or learn something. Thanks for sharing 😉

    1. Thanks for the encouraging words 🙂 Admittedly, I was probably too heavily allocated in this strategy, so I put a cap on it by saying that until reaches a certain level of performance, I won’t add more. In the meantime other allocations have increased so it’s total proportion of my net worth is calibrating lower with time.

      One key feature of the idea is that it’s possible to know when the system might be broken by understanding current performance relative to historical performance benchmarks. Negative performance outside the historical performance boundaries can indicate that it’s time to *escape*.

    1. Thanks for the comment.

      There are smart people who believe we all end up at the index and DCA. It may yet be my destiny too!

  4. My favorite hack is to establish cash flowing businesses or assets, like real estate rentals. Then you can safely go with 4% or LESS.

    Alternatively, hack number 2 is to work a little longer. SUFFER!!! LOL. First world problems abound, no?

    Nice post my friend. Definitely good food for thought for the equity heavy crowd!

    1. We both share a passion for cash-flow Big C! That being said, I like to read about different ways to look at the “established” FIRE systems. This post was interesting enough to publish, hope it generates some discussions!

    2. Thanks. Yes, completely agree regarding the income generation potential of businesses and managed rentals. I have more of my portfolio in rentals because I saw it as more of a sure thing in the short-to-medium term. The investing system I describe in the post is quite a bit more speculative. That said, if I can get it to work the time-to-manage is very low. Literally 10-15 minutes each weekend. In that way it’s a different beast than a business, managed rentals, Airbnb etc.

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