The 4% rule for early retirement is so often quoted but I never see a full explanation of it. People like to say you multiply your burn rate by 25 and say that is the size of the portfolio that you need. But WHY? This video will dig deep into the details and you shall see that the 4% rule is hardly a rule you should rely on at all.
How’s it going everybody this is beat the bush today i’m gonna explain in laymen terms what the 4% rule is basically it states that you can withdraw 4% away from your portfolio every single year and you should be ok with this technically for life now it’s important to figure out where this idea comes from who says you can actually withdraw 4% what if you run out so
It’s very important to know exactly where this data comes from all of this started with a paper published in 1998 by three professors from trinity university that’s in texas what they asked is a pretty logical question which is what is the rate at which you can withdraw from your portfolio and still be ok at the end of your retirement say 30 years or 40 years let’s
Say you start with some amount of money in your portfolio and you keep on withdrawing money out of it because you’re retired the question here is will you run out of money let’s say after 30 years and if you do run out that means that tests failed giving a certain withdrawal rate you can do to 2% 3% 4% 5 6 7 8 9 % the whole idea probably comes from people not really
Wanting to run out of money in their old age so what they did is attempted to determine and safe withdrawal rate a rate at which you can withdraw from your portfolio and not run out of money now success here is not being able to withdraw from your portfolio indefinitely in other words you will not be able to keep your portfolio intact perfectly at 100 percent of
Its original value so therefore as you retire you’re definitely going to draw it down over the years success in this study means that at the end of 30 years you will not be negative it means if you have more than zero dollars in your portfolio on your last day on your deathbed you still have let’s say a thousand dollars or something then this study considers that
A success now let me just explain one single data point because it makes things a lot clearer for example let’s say you have a 50% mixture of stocks 50% of bonds your withdrawal rate is at 4% you’ll have a 96% a chance of success at the end of 30 years that means 96% of the time you’re gonna have more than dollars at the end of 30 years you’ll have 4% chance that
You might dip below zero dollars in other words you run out of money so when you look at the trinity study and you see 100% 96% these are chances of success now what does this mean how do they get chances of success so how they got these success rates is based on historical data from 1926 to 1995 they do one simulation from 1926 to 30 years later 1956 and then
They go okay some guy had a 1 million dollar portfolio and they keep on withdrawing a certain percentage let’s say 4 percent from their portfolio for 30 consecutive years and then they see if this guy that started retiring at 1926 will have enough money by the end of 1956 if this guy did not run out of money then we call this a success and then after this they
Do another simulation maybe a month later maybe one year later so it starts from 1927 all the way up to 1957 and they do another simulation of another guy having $1,000,000 at the start of 1927 and then see if he run out money in that case and then they do a whole bunch of simulations and then they count how many of these people that start retiring at certain age
And then they do a certain withdrawal rate how many are these people in other words how many percent of these people will have success now the original study just took 4% from the original principal you do not go okay i’m gonna take 4% out from $1,000,000 that’s $40,000 and then the principal reduced to nine hundred sixty thousand dollars you do not take 4% from
That you take another $40,000 out so every single year you take $40,000 out you’re not doing four percent of whatever you have left in there so this is a fine point to consider later on they go well you know you don’t really want your quality of life to kind of slowly decrease so you want to keep up with inflation so therefore later on they go okay you withdraw 4%
Plus the consumer price index adjustment with this kind of adjustment you’re gonna see another set of chart that has another set of success rate which is slightly lower than before as it’s obvious you’re going to withdraw more money because you’re adjusting to inflation therefore you’re gonna have a lower chance of success now there’s also the 50% stocks and 50%
Bonds you might wonder what kind of stocks are they talking about what kind of bonds are they talking about well in fact they did their study for stocks on the smp 500 and for bonds they generally did it for long-term high-grade us domestic bonds so if you were to believe and use this data then you would go okay i’m gonna follow what they say by 50% sox 50% bonds
Now technically you probably can do this emulation with other kind of indexes as well but you know you’re gonna have to do your own study in that case now going back to the 96 percent chance of success thing you’re telling me that 96% of the time i’m not going to run out of money in fact i’m gonna actually watch my portfolio go from $1,000,000 all the way down
To zero in you know realistic case and you call that success and in 4% of those chances i’m actually gonna run out of money and i’m actually gonna be like laying on the ground on the streets seventy years old have no money in my pocket and that was gonna happen 4% of the time if you ask me i feel quite uncomfortable with this because i don’t want 4% chance even
Of you know being at my old age and laying on the ground basically and having no place to live and no money to pay for my expenses especially in those years where i will have no ability to make more money now looking into all this you realize that all of this assumption is based on back testing which is basically taking historical data and testing things out and
Checking the probability of success based on history whenever you buy stock they always go past performance is not a basis of future behavior so how are you gonna reconcile all this because if you just look at history you’re gonna have to say okay you know history is set in stone already it’s already happened and you’re gonna say i’m gonna project what happened in
History into the future now there’s always this dark cloud hanging over that i think kind of hangs over you know my beliefs if i were to invest in something like this and go you know and believe and trust in my retirement and just sort of pour everything into the smp 500 and just hope everything is okay all the way 30 years in the future the thing to watch out
For for me is catastrophic events because once those things happen well you’re gonna be wiped out and things that has not happened in the past could happen in your future so this makes me a little edgy with you know this whole assumption that it’s a 96% safe withdrawal right even if it’s a hundred percent safe withdrawal rate i do not believe that it’s 100 percent
You’re not guaranteed a retirement because something can happen so just because it says 100 percent this is only 100 percent if you can warp back in time to 1926 or something and then repeat history that is 100 percent going forward is not 100 percent another thing to watch out for whenever you use this chart is that you can have a million dollars in portfolio and
Then you can retire just today and then you go okay i’m gonna withdraw $40,000 four percent withdrawal rate i’m gonna have a pretty good chance of success however if the market crashes within the next few years you’re gonna have to withdraw a lot less in your retirement years all of a sudden you can only withdraw 3% because if your portfolio dives nosedives in the
Earlier parts of your retirement it’s kind of like saying okay you retired now with six hundred thousand dollars rather than 1 million because your portfolio went down so much so early on so this is a common argument against this safe withdrawal rate now what does the author of this paper say is that a lot of people go and take this out of context sometimes people
Would take this 4% rule and not even know that it came from this trinity study they would go oh yeah 4% oh you’re guaranteed that as long as you invest in 50% mp5 hundred and fifty percent us domestic stocks the whole idea with this paper is it just gives you an indication of the ballpark numbers if the market tanks you kind of have to stay flexible you have to go
Okay yeah my portfolio went down a bit i need to withdraw a little bit less so i’m gonna adjust my lifestyle to change so that i do not withdraw as much from the portfolio so that it would last longer so this four percent rule even if you read one hundred percent success rate it’s not a guarantee you cannot go okay i’m gonna retire today $1,000,000 four percent
Rule could take out forty thousand dollars plus consumer price index increases so you’re gonna add inflation on top of this every single year and then you cannot go oh i’m always going to reach draw this amount because the trinity study says you know you absolutely can it already says one hundred percent success rate no the four percent rule is not a rigid thing
You cannot keep on withdrawing this amount you have to adjust based on the market conditions now with all this set i certainly feel very very uncomfortable even if i you know instead that do the three percent rule or even two percent rule if one day you go okay i’m retiring and you’re never gonna make a penny after this you’re only gonna make money you know just
Through your investments this is a very very risky thing in itself because you are essentially relying on you know this trinity paper thing you know that the market is just gonna keep on going up what i think is a safer bet is always have some sort of residual income outside from your investment just have multiple sources coming from everywhere when you retire
I’d advise to go pursue the things that you’re interested in i do not believe that everyone is going to be like super duper lazy they just want to lay on the beach you know for a year or something it gets really really boring what you want to do is go look at after the things that you’re interested in whatever it is it does not have to make any money at first but
You know have an eye for whatever that you do try to monetize it a little bit as you retire the first year second year maybe you make zero dollars but as you work on it you’re likely gonna get better so i feel like that is a much better guarantee so even if you have enough money to retire right now i feel like you still should pursue you know those little side
Projects that you do not consider work when you apply yourself in areas that you’re interested in it makes life that much more interesting and it sort of gives you an insurance plan against this 4% rule failing to me i feel like you can only vacation for so long before you come back home and you go you know what there’s there should be other things to do that
Is interesting that you can make a little bit of money on and you would not consider it at work i hope this was a great run down for you guys on what the 4% rule is i feel like it’s very very important to understand in excruciating detail what this is this video should be enough so that you don’t have to actually go read that paper thanks for watching this video
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Transcribed from video
Where the 4% Rule Comes From By BeatTheBush
