Conventional Wisdom Leaves Much to Luck

Imagine two similar investors, Leslie and Bob.

  • They each retire with a $500,000 portfolio.
  • They each withdraw 4% of their portfolio in the first year of retirement, then adjust that amount upward each year to account for inflation (as measured by the Consumer Price Index).
  • Their portfolios are identical: 60% in Vanguard Total Stock Market Index Fund and 40% in Vanguard Total Bond Market Index Fund, rebalanced at the end of each year.
  • The only difference is that Leslie retired at the end of 1994, and Bob retired at the end of 1999.

The Result?

  • 10 years into her retirement, Leslie’s portfolio had more than doubled, with an ending value of $1,062,606. (And 5 years after that, it had grown further to $1,105,982.)
  • 10 years into his retirement, Bob’s portfolio was worth only $400,354.

They each followed the rules (more or less) with fairly conservative, low-cost portfolios, rebalanced annually. Yet because of when they retired, their retirements look very different.

Leslie will be (mostly) free from money worries, and she’ll be able to give generously to her children, grandchildren, and charities of choice. In contrast, Bob will have to be careful so as to avoid running out of money.

Why such a difference?

For the first few years of Leslie’s retirement, the stock market was shooting upward. In contrast, Bob’s retirement began with a 3-year bear market. When Leslie liquidated investments to pay for living expenses, she was selling high. Bob was selling low.

By the time the market began to rebound in 2003, Bob had already liquidated a good portion of his portfolio, so he didn’t benefit as much from the bull market as he would have if it had occurred at the beginning of his retirement.

In short, if you follow conventional investing wisdom:

  • A bull market in the first few years of your retirement puts you on easy street, yet
  • A bear market in the first few years of your retirement can mean money worries for the rest of your life.

Ways to Protect Yourself

What can you do to avoid finding yourself in Bob’s position during retirement?

1) Most importantly, lower your withdrawal rate. Many experts argue that a 4% withdrawal rate involves taking on very real risk of outliving your money.

2) If you don’t have enough saved to use a withdrawal rate lower than 4%, annuitizing a portion of your portfolio can be help reduce the chance of outliving your money. (On the other hand, it also reduces the amount you’ll end up leaving to your heirs.)

3) Take valuation levels into account when determining your asset allocation. In other words, it was a mistake for Bob to have 60% of his portfolio in stocks at 1999 price levels.

What do you think?

How do you plan to prepare yourself for the possibility of a poorly-timed bear market as you near retirement?

My questions to Mike and to others: Even though Bob retired in 1999 at close to the top of the market, he’s selling at levels much higher than Leslie.  Hence, how can Bob have so much less after 10 years?   Doesn’t Leslie also start to hemorrhage a lot of money in the bear market as well since she hasn’t withdrawn everything out of the market?

Is it rational to expect that someone who retires would not sell a much greater amount and put the proceeds into stable investments with guaranteed returns?

About the Author: Mike Piper is the author of Investing Made Simple. He also blogs at The Oblivious Investor, where he writes about such thrilling topics as Roth IRA withdrawal rules.

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. says

    Why do I have such a hard time understanding all this? One says ‘investments, bear markets, portfolios” and my brain just stalls. I do get the jist of it. I think in Bob’s situation would be to consider retiring in one of the glorios expat retirement locations like Belize, Panama, Mexico (maybe), etc… Then his money would work better.
    .-= Money Funk´s last blog ..Week’s Round Up: The Ripple Effect =-.

  2. says

    I agree with the idea of using a portion of your portfolio to buy an annuity at retirement, or at the least some long-range and/or inflation linked government bonds. Ultimately there’ll always be some risk, whatever you do.

    @MoneyFunk – You just need to keep exposing yourself, it’s just new words like cooking or learning to drive. It does come eventually, honest! (Bear market means stocks are down for a while, portfolio is the investments and other assets (e.g. Gov bonds) you hold.
    .-= Monevator´s last blog ..Playing chicken with house prices =-.

  3. says

    @ neal@wealthpilgrim

    Hi Neal. Indeed, it may help to adjust one’s allocation based on market valuation levels. I keep getting hung up on the actual implementation though–how under or overvalued does the market have to get before you adjust your allocation? How much do you adjust your allocation as a result? And, at what point do you bail out of it doesn’t appear to be working?
    .-= Mike Piper´s last blog ..Weekend Reading 2/19/2010 =-.

  4. says

    I’m a little confused; couldn’t Bob reallocate his holdings to improve the return on his investment? Jim Cramer is fond of saying “There’s always a bull market somewhere”, so his portfolio seems to be a lot weaker than it should. We call it a bear market but that doesn’t mean every company’s stock price is in the toilet, and the same with a bull market, there’s going to be plenty of dogs during a bull market.

    Plus I’m not a big fan of a fixed 60/40 split between stocks and bonds since yields on bonds also change periodically based on interest rates and the value of the dollar. It’s probably a good approximation but I would think it’s smart to adjust as necessary. But I agree with the idea behind your argument that it’s better to retire during a bull market than a bear market. I’ll keep my fingers crossed that I can pull that off :-)
    .-= David @ MBA briefs´s last blog ..Easy ways to improve your memory =-.

  5. says

    I’m confused too. I’d much rather be Bob and retire at the top of the market, than Leslie and retire right before the bull market.

    If I’m Bob, I’m moving all my investments to money markets or annuities to live off the cash flow/interest, and am NOT playing around with equities anymore since I have no more means of accumulating money.

  6. The Rat says

    Nice post. It really highlights the importance of Asset Allocation and not spreading yourself too thin! It’s pretty crazy how just a few years could make such a difference. Cheers, The Rat
    .-= The Rat´s last blog ..Is A Housing Bubble Imminent? =-.

  7. says

    No one can predict the future direction of the market. My take is that Leslie got lucky with her timing but that both retired with too few assets.

    Since we don’t know twenty to thirty years in advance of our retirement that there will or won’t be a bear market the only way to prepare is to arrive with excess reserves.
    .-= LeanLifeCoach´s last blog ..What Is Your Learning Style? =-.

  8. says

    I’m confused on whether Bob and Leslie retired at the same age, OR if Bob stuck it out an additional 5 years. Wouldn’t he have more invested in the market if this was the case? I need all the variables to figure this one out.

    I’m with you MoneyFunk, this whole stock market/investing/retirement thing is very confusing. I get the whole Bull is good, Bear is bad thing, but I need a more concrete …”This is what you do…” lesson on investing and how to save enough for retirement. Anybody game for this type of post?
    .-= Little House´s last blog ..Making the Most of a 3-Day Weekend =-.

  9. says

    This makes the very simple assumption both remain 60/40 invested in stocks and bonds once they retire. What about re-allocation every year to ensure they are still 60/40 mix?

    I didn’t run the numbers but Bob I know be much better off if they changed the asset allocation once they retired.
    .-= Investor Junkie´s last blog ..Are You Saving Too Much? =-.

  10. says

    Hmm, to retire with 60% in the stock market seems kind of risk. Following the standard retirement asset allocation models 100 – age (or 110 – age if you are more risk tolerant), shouldn’t both of their account only have 35 or 45% stocks? That might have helped a little, at least in Bob’s case. I’m not sure if international exposure would have helped or not. With the global economy, it seems like all countries rise and sink together anymore…

    If I was either retiree, I’d make sure my house was paid off too (a little asset class diversification)! That would enable them to live on less more easily.

    Life isn’t fair sometimes, too bad Bob didn’t have more money when they retired… If Bob did, the downturn might not be as painful for him. Really, 1/2 a million isn’t a lot to try and retire on. Perhaps Bob should have picked up a part time job after his primary retirement…

    Although not a major point, in terms of real money, Bob retired with a little bit less than Leslie because of the effects of inflation on money (but that’s just me being picky).

    Lately, I’m a believer of asset class diversification in addition to the classic financial asset diversification.

    Luck has an element in life, that’s for sure… At least they still have their full Social Security benefits to help out, most of us next batch of retirees won’t have that safety net the way things are going… at least not the full net. ;)

    Don@MoneyReasons’s last blog ..Saving By Paying Attention – Impulsers, Part 1 of 4

  11. Pineview Style says

    I feel like I am in the same boat as Money Funk and Little House. I do have the basic fundamentals of investing, but my brain starts freezing up when I start looking at graphs and charts. I’m hoping that maybe I understand it better than I think and it’s just a matter of excecuting a plan of action, but I would second Little House’s idea of a “This is what you do….” type of post. :)

  12. says

    To Financial Samurai: I’m not sure what exactly you’re asking. I can send you a spreadsheet with the numbers if you’d like so you can check the math.

    Basically the lesson is this: liquidating your portfolio at the same time you’re having negative returns leaves you with little money left so that you can participate in the next bull market when it arrives.

    Yes, Leslie also lost money in the bear markets, but because her retirement began with a bull market, at 15 years into retirement, her portfolio is worth more than twice what it was worth on the day she retired.

    Little House: The idea is that they each retire at the same age, but Bob is 5 years younger than Leslie. As such, he retires 5 years after she does. And even though he follows the exact same conventional wisdom investment strategy that she follows, he ends up far more likely to run out of money.
    .-= Mike Piper´s last blog ..Weekend Reading 2/19/2010 =-.

  13. says

    @Mike Piper
    I figured something out, and it comes to your assumption #1.

    Leslie is likely older, and she retires right before the bull market with $500,000.

    Bob, 5 years later and after the bull market retires with $500,000.

    Bob’s $500,000 was largely helped by the 5 year bull market after Leslie retired, whereas Leslie’s $500,000 accumulate occurred through previous time.

    Are we not comparing Apples to Oranges then? Of course Leslie will have more money, because she has more money to start with and has a 5 year head start no? She will lose money in the ensuing bear market, but she will ALWAYS have more money in relations to Bob if they have the same portfolio.

    So the lesson learned is to reallocate ALL funds come retirement to a stable yielding asset class upon retirement, b/c you don’t know whether you will make or lose money in equities. I really think this is the bottom line.

    Best,

    Sam
    .-= admin´s last blog ..How To Get Your Super Motivated Boyfriend to Marry You =-.

  14. says

    @ admin

    It has to do with timing, not age as such. There are plenty of scenarios in which the 5 year younger person would have had a better retirement.

    My thoughts are neither here nor there on moving to a 0% equity allocation upon retirement. I’m absolutely not going to be doing that myself. But I can completely understand that many investors might like the (greater though still imperfect) degree of certainty that, say, a 100% TIPS portfolio would allow.
    .-= Mike Piper´s last blog ..Weekend Reading 2/19/2010 =-.

  15. says

    I am probably going to get slammed by Mike and Neal…but what might have helped was a deferred or even immediate annuity which could have helped during those year which the market was down.

    This obviously doesn’t work in all cases, but its just a thought.

  16. Charlie says

    cool chart. Very good points I never thought about before. I still have a ways to go before I can retire but will definitely keep this post in mind for down the road!

  17. fredct says

    Timing is undoubtedly very important, which is why you’re probably better off waiting until you can be somewhat under 4%.

    But I also agree with the comment that 60% stock is probably too much… *especially*, in my mind, if you only have $500K. Or, really, if you’re withdrawing at 4% rate. That means that your fixed income investments are only 40%/4% = 10 years of non-equity money available, and thats kinda low.

    Second, I’m not sure a ‘total bond market fund’ is an appropriate fixed income fund for retirees… at least not as the only one. “Total market” means it has short term but also long term. It has AAA rated, but also A and lower rated. And… no cash! No stable value in that 60/40 at all.

    Same with the ‘Total Market Stock Fund’. There are ways in which its too aggressive. Shouldn’t retirees stock allocation have be dividend & blue-chip heavy? But there’s always ways its just missing things… shouldn’t they also have international for diversification? Shouldn’t they have some precious metals & commodities and other things that are counter-cyclical?

    For instance, this is what Vanguard’s retiree fund has.. 65% bonds, 30% stocks, 5% stable value.
    (https://personal.vanguard.com/us/funds/snapshot?FundId=0308&FundIntExt=INT#hist=tab%3A2)

    I’d be interested in how much that would’ve helped.

  18. Kosmo @ The Casual Observer says

    @ admin

    “Are we not comparing Apples to Oranges then? Of course Leslie will have more money, because she has more money to start with and has a 5 year head start no?”

    Since Mike is comparing RELATIVE years (retirement + 5) that than absolute years (2010), this is apples to apples.

    At the top, you say
    “Even though Bob retired in 1999 at close to the top of the market, he’s selling at levels much higher than Leslie. Hence, how can Bob have so much less after 10 years? Doesn’t Leslie also start to hemorrhage a lot of money in the bear market as well since she hasn’t withdrawn everything out of the market?”

    One thing to note is that Bob is BUYING during the bull run, Leslie is not. Sure, he’s selling at a higher price, but his basis is higher. Just because I sell a stock for 100 and you sell for 70, it doesn’t necessarily mean that I’m making more money – I may have paid 65 per share and you may have paid 10.

  19. says

    Take valuation levels into account when determining your asset allocation.

    This is the answer.

    The conventional wisdom is that stocks are “risky.” But the conventional wisdom, as Rob Arnott, says, is rooted in “myth and urban legend.” 80 percent of the risk of stock investing goes away for investors willing to abandon Buy-and-Hold and follow valuation-informed strategies. There has never been a time when stocks performed poorly in the long term starting from a time of moderate or low prices. There has never been a time when stocks performed well in the long term starting from a time of insanely high prices (like what we saw from 1996 through 2008).

    The problem is that we cannot talk openly today about what works. The Stock Selling Industry made hundreds of millions promoting Buy-and-Hold and it is viewed as career suicide today to report openly what the academic research has been telling us for 30 years now. Many bloggers don’t want to give up the links they get by promoting Buy-and-Hold strategies, which remain popular for so long as the money keeps coming in for The Stock Selling Industry.

    I believe that people are going to get fed up after the next crash. The last 30 years of academic research has taught us wonderful things about how to invest effectively and, when we are able to share what we have learned, we will be seeing The Golden Age of Middle-Class Investing. The trick is going to be surviving that next crash, which threatens to bring on The Second Great Depression.

    Rob
    .-= Rob Bennett´s last blog ..“It [My Claim That Long-Term Timing Works] Is Consistent with Shiller’s Analysis & Could Be True” =-.

  20. says

    Humh, I’d always heard of 4% as the bottom, ‘safe’ withdrawal rate, with many experts maintaining that it gives you a reasonable (although not certain) chance of having enough money to make it through retirement. Ben Stein and Phil DeMuth recommend somewhere around 5% during the first few years of retirement, only pulling back to 4% in the event of a downturn in your first few years, and Peter Lynch (in)famously suggested that you could take out 7% each year without a problem. Heck, Bob’s account only declined by about 20%, in spite of having his first ten years of retirement coinciding with the ‘Lost Decade’ and taking a sizable and increasing amount out each year to fund his retirement. Not horrible, by any stretch.

    Good advice on how to deal with such a decline, though.
    .-= Roger´s last blog ..Taxing Financial Transactions: Good Idea or Not? =-.

  21. says

    As far as I understand, the best way is to be invested in assets that are as uncorrelated with market returns as possible. I prefer dividend payers which are no longer in a growth phase. I would also like to get some kind of real estate. Of course the most predictable means is simple in finding a way not to spend the money. That has 100% return.
    .-= Early Retirement Extreme´s last blog ..Your budget is like a leaking ship =-.

  22. tom dicks says

    I am building a dividend growth portfolio for future income i am retired and living on ss my portfolio cururrently yields 6.2% so when i start taking income from my portfolio 4% withdrawal means never having to sell i also believe my yoc will be more like12%.
    happiness is never having to sell
    thank you
    tom dicks
    the dividend geezer

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