Check out Episode 87 of The Best Interest Podcast below.
Show Notes – Episode 87
In today’s opening monologue, Jesse explores the concept of Sequence of Returns Risk, a crucial and often misunderstood threat to retirees, by illustrating how poor returns early in a retirement can severely impact long-term stability. He emphasizes the importance of diversification. Jesse then introduces the idea of path dependence, drawing parallels to the life of author Philip K. Dick, whose posthumous fame underscores the significance of a journey’s path, not just the journey’s outcome. Jesse connects this to investing, explaining how the sequence of returns can greatly affect an investor’s experience, despite the long-term average returns. Using “Sally the Investor” as an example, Jesse highlights the emotional and psychological challenges of navigating market volatility, reinforcing the need for resilience, understanding short-term unpredictability, and the benefits of diversification in long-term investing.
Tyler, the creator of Portfolio Charts, joins Jesse for the second half of the show. His site is known for its innovative financial tools and insights. Tyler, a fellow engineer with a passion for finance, blends technical expertise with creativity to clarify complex investing concepts. In their discussion, Tyler and Jesse explore critical retirement topics, including the safe withdrawal rate and sequence of returns risk.. Tyler introduces the concept of engineering tolerances for managing financial variability and discusses strategies like variable withdrawal rates. He explains the “flowing nature of withdrawal rate math,” illustrating how safe withdrawal rates change with longer retirement periods. If you’re looking for some evidence based, long term thinking in your DIY financial life, then this is the episode for you!
Key Takeaways:
- How poor returns early on can negatively affect my retirement.
- What is “sequence of returns risk”? And how can I create a financially resilient situation for myself?
- Diversification into a variety of financial vehicles is key to the long term success of your portfolio.
- Path dependence, illustrated by Philip K. Dick’s posthumous fame, emphasizes that the sequence of returns can greatly affect investment outcomes.
- What are “safe withdrawal rates”? And how can traditional average return calculations be misleading?
Key Timestamps:
- (01:07) Jesse’s Monologue: Understanding Sequence of Returns Risk
- (07:50) Mitigating Sequence of Returns Risk
- (08:35) Path Dependence: Lessons from Philip K. Dick
- (13:16) Sally’s Ride: A Real Example of Path Dependence
- (22:57) Investment in Knowledge: Path Dependence
- (25:28) Understanding Safe Withdrawal Rates and Sequence of Returns Risk
- (35:05) The Importance of Consistent Portfolios
- (47:29) Tyler’s Personal Finance Journey and Portfolio Charts
- (51:01) Conclusion and Listener Engagement
Key Topics Discussed:
The Best Interest, Jesse Cramer, Rochester New York, financial planner, financial advisor, wealth management, retirement planning, tax planning, personal finance, Tyler from Portfolio Charts, path dependence, sequence of returns risk, safe withdrawal rates
Mentions:
Website: https://portfoliocharts.com/
Mentions:
More of The Best Interest:
Check out the Best Interest Blog at bestinterest.blog
Contact me at [email protected]
The Best Interest Podcast is a personal podcast meant for educational and entertainment. It should not be taken as financial advice, and is not prescriptive of your financial situation.
Transcript – Episode 87
[00:00:00] INTRO: Welcome to the best interest podcast, where we believe Benjamin Franklin’s advice that an investment in knowledge pays the best interest, both in finances and in your life. Every episode teaches you personal finance and investing in simple terms. Now. Here’s your host, Jesse Cramer.
[00:00:21] Jesse: Hello, and welcome to episode 87 of the Best Interest Podcast.
[00:00:25] My name is Jesse Cramer. Later in today’s episode, a gentleman named Tyler is going to be joining me. Tyler is pseudonymous. We could say we think his first name is Tyler, but. As he has the right to do here on the internet, he prefers to keep his identity somewhat anonymous. But what Tyler does out on the internet is run a website called Portfolio Charts.
[00:00:45] And if you’re not familiar with it, Portfolio Charts combines amazing technical knowledge of the investment and financial planning world. with some beautifully created charts, graphs, plots, things that help us visualize personal finance topics and financial planning topics and a lot of retirement portfolio related topics, as the name portfolio charts would make you think.
[00:01:07] But before we get to Tyler today, I want to introduce a couple of his ideas, starting with this idea called the sequence of returns risk. which is an idea that many of us are going to face in our retirement. First off, this idea, sequence of returns risk, it’s a relatively math heavy idea. It’s not something on the softer side, we’ll say, of personal finance that has to do with our goals and our dreams and what we’re earning this money for.
[00:01:31] It’s a very technical idea. It’s not always an idea that people understand up front because it might fly in the face of some of what we understand about math. In short, sequence of return risks says, If you have a bad series of returns early on in your retirement, even if over the long run the the average returns end up pretty good, but if you have bad returns up front, It could derail your retirement plan in a way that you really can’t recover from.
[00:01:59] And we’re going to walk through pretty simple math idea today, at least I hope it’s simple enough for us to understand, for you to understand over this audio only platform. But we’re going to walk through an example that lays out a bit of the math and shows you exactly what the sequence of returns risk is.
[00:02:15] So for starters, I want you to imagine someone who’s just entering retirement. They have a million dollars, very much a round number, a million dollars. And they want to withdraw 50, 000 per year, 5 percent of their portfolio, 000 years is coming out. And we’re going to look at, say, a set of twins who both have this identical scenario of 1, 000, 000 and a 50, 000 annual withdrawal.
[00:02:39] The first twin is going to get 10 percent per year returns for the first decade of their retirement and then 0 percent per year returns or no returns at all for the second decade of their retirement 10 percent per year for decade one, 0 percent for decade two, and then the second twin flip flop those.
[00:02:58] They’re going to get no returns during the first decade of their retirement, but then they’re going to get 10 percent per year returns for the second decade of their retirement. So if we just zoom out on this scenario, as I’ve laid it out, we say, well, they have the same exact starting point and their average returns are identical.
[00:03:14] Each of them are getting 10 years at 10 percent per year. 10 years at 0 percent per year, identical returns. The only difference is the sequence in which those returns come. Are they going to get the 10 percent upfront during the early years of their retirement? Or are they going to get the 10 percent on the back end during the later years of their retirement?
[00:03:33] So if we start with the first twin who gets the 10 percent per year upfront, we say, well, they have a million dollars. They’re withdrawing 50, 000 per year, but then their portfolio is growing at 10 percent at the end of every year. And we can just say, well, 10 percent of a million. is 100, 000. So really they’re getting more growth than what their withdrawal is.
[00:03:54] So we expect their portfolio to grow annually over these first 10 years. And sure enough, it does. And if we just plug that math into a simple Excel spreadsheet, we’d see at the end of 10 years, despite the 500, 000 in total withdrawals, 50, 000 times 10 years, their portfolio will be about 1. 7 million at the end of the 10 years.
[00:04:15] Started at a million, grew to 1. 7 million, even despite the 500, 000 in withdrawal. Great. So now we enter the second decade for this first twin, and the second decade has no growth at all. And that actually makes the math pretty easy. They’re withdrawing 50, 000 a year for 10 years, that’s 500, 000 total with absolutely no growth in the portfolio.
[00:04:36] So 1. 7 million minus the 500, 000 of withdrawals gives them an ending balance of 1. 2 million at the end of 20 years. Let’s keep that number in mind, 1. 2 million at the end of 20 years. Now let’s go look at the second twin. where the second twin has the same returns, just in the opposite order. So they start with a 0 percent return on their million dollar portfolio for the first 10 years.
[00:05:01] Again, the math is pretty straightforward here. They’re going to withdraw 500, 000 with no growth. So their million dollar portfolio is going to turn into a 500, 000 portfolio at the end of 10 years. But now, here comes the growth for the second twin. It’s going to grow at 10 percent per year for the following 10 years, for the second 10 years.
[00:05:20] And yes, I’ve set up this scenario intentionally because the math remains pretty easy. They’re withdrawing 50, 000 per year and then their 500, 000 account is growing at 10 percent per year. Well, what’s 10 percent of 500, 000? It’s 50, 000. So it’s growing at 50, 000 per year while they’re also withdrawing 50, 000 per year, meaning at the end of the second decade, their portfolio is exactly where it started.
[00:05:43] All of the growth of 50, 000 immediately comes out as a withdrawal that same year. And their portfolio ends 20 years at 500, 000. Twin number one ends 20 years with 1. 2 million. Twin number two ends 20 years with 500, 000. That is the sequence of returns risk. The risk is that twin number two ends up in a much, much worse situation, right?
[00:06:08] They’ve lost half their total portfolio value over a 20 year period because they had some pretty bad returns. They had no returns up front for their first 10 years. Twin number two actually has a net 20 percent growth in their portfolio, even after a million dollars worth of withdrawals because they had their good returns up front.
[00:06:28] And if we kind of zoom out on this situation and we say, okay, is that the pattern that plays out over time that we’d rather have better returns early on in our retirement? The answer is yes. The simple reason being when we have bad returns up front on top of the withdrawals we’re taking, our portfolio value drops.
[00:06:45] It becomes smaller than we’d like it to be. And then when those good returns eventually come, those returns are acting on a smaller amount of money. And therefore, the total growth as measured in dollars is relatively small. We’d much rather have the good years come, the positive returns come, when we have a big nest egg, and therefore that 10 percent or 20 percent or 30 percent per year growth acts on a bigger sum of money, resulting in more dollars or less.
[00:07:12] earned in the portfolio or a bigger as measured in dollars and cents, a bigger amount of growth in the portfolio. So that’s the sequence of returns risk. It’s the risk that bad markets will strike early in your portfolio or early in your retirement. I should say early in whatever the period is that you’re looking to withdraw.
[00:07:29] And it’s a risk that we all face. It’s a risk that we don’t have too much control over, right? If we’re Invested the smart way that we talk about here on the podcast. If we’re invested in a diversified low cost index funder or something similar to that, well, the returns are going to be what the returns are, right?
[00:07:46] The market’s going to give you what the market gives you. There’s not a lot you can do to control it. Some of the things that you certainly should be thinking about are something like diversification. That’s a great strategy. And what I mean there is diversification between asset classes. The idea that, well, maybe you have five years worth of spending in bonds so that if the market does behave in a way that’s not ideal for you, if you get that bad sequence of, of stock market returns early on, that sequence of return risk strikes you, well, you might have some stable, safe bonds that you can draw on during those early years.
[00:08:16] to ideally give the market a chance to recover. That’s one of the main rationales for holding bonds in the first place. As far as I’m concerned, it’s the idea that you want to give yourself some runway. You want to give yourself a certain number of years of relatively safe, fixed income in case the more risk heavy, more growth heavy side of your portfolio doesn’t perform the way you want it to.
[00:08:35] And now for a second way of introducing this idea, I wanted to read from an article I wrote in June of 2022, and it’s called Path Dependence, A Lesson for New Investors. And we’ll throw this link in the show notes. I want to start with a little anecdote, and I started this article with a little anecdote about Philip K.
[00:08:51] Dick, an author, Philip K. Dick. In 2007, PKD, as his fans call him, he became the first science fiction writer included in the illustrious Library of America book series. Have you heard of Philip K. Dick? Most people haven’t. I certainly didn’t think he was a household name or anything like that. But you probably had heard of Total Recall, Minority Report, Blade Runner, A Scanner Darkly, The Adjustment Bureau, or The Man in the High Castle.
[00:09:19] Each of those movies or TV shows is an adaptation of Philip K. Dick’s work. And one of his novels, called Ubik, was listed by Time Magazine as one of the 100 Greatest English Language Novels. So, suffice to say, Philip K. Dick is one of the preeminent 20th century writers. He is a cultural influence. He’s downright famous.
[00:09:38] His work is downright famous. But, P. K. D. died in 1982, before the movies, before the shows, before the national recognition. He earned a few small science fiction accolades and awards while he lived. But nothing more than that. His eventual fame, the way he’s famous right now, it was completely unknown to him while he was alive.
[00:09:59] He spent most of his life as an impoverished writer who, unfortunately, abused drugs to kind of pass the time recreationally. Dick’s fame, It had a different timeline than his life. That’s an eye opening example, in my opinion, of path dependence. We can zoom out and convince ourselves that everything was good about Philip K.
[00:10:17] Dick’s realm. He was an excellent writer. He found his fame. All’s well that ends well. The cream rose to the top. And it did, but only eventually. Because when we zoom in, we realize that the specific path to Philip K. Dick’s fame, it really did him no favors while he was living. It all came too late. And to me, that’s a good lesson.
[00:10:36] That the path to a result is just as important as the result itself. In investing, we also have this thing called path dependence. And I think it’s a vitally important topic for investors, especially for new investors to understand, but it’s not usually covered in introductory personal finance or investing education.
[00:10:54] For example, the typical social media finance influencer, even the typical financial advisor might tell their clients that, you They should use a 7 percent annually inflation adjusted return to describe stock market expectations, right? 7 percent per year after adjusting for inflation. Most of us have heard that before and I’m fully willing to admit that I’ve used that in my spreadsheets before.
[00:11:16] Uh, yeah, because if you look out over the long run, if you zoom out, that’s the number that falls out of your, of your math, right? 7 percent per year. It’s pretty easy. We’ve all seen that 100 plus years of us stock market history and inflation data. It’s clear as day if you put it into a spreadsheet, but many people gloss over the fact that these are path dependent results, and you need to zoom in to see those path dependent results.
[00:11:39] And I know some of you might be thinking right now, Jesse, you always tell us to zoom out, but now you want me to zoom in? I don’t get it. Yes, we do. We observe the past in years and decades, and that’s the way we should look at the past. And sometimes that’s the way we should think about the present. But I also think we have to be honest with ourselves.
[00:11:56] We experience the present in hours and days and weeks. Life, as we know it, the present, is pretty zoomed in. And I think to be a good investor, you need to understand both sides of that coin. You need to know how investing works on both a short and a long term basis. Because yes, the long term stock market performance does seem relatively smooth at 7 percent per year, but we have to be aware that when we zoom in, the short term can be choppy and bad.
[00:12:21] I’m recording this, I’m speaking to you right now on August 8th. 2024. And I believe this episode is going to publish next Wednesday, which would be August 14th, 2024. Who knows what will happen over the next eight days, but I can tell you over the past two and a half weeks, what the S& P is down something like 10 percent kind of out of nowhere, right?
[00:12:39] We had a pretty smooth sailing 2024 so far, and then boom, choppy, bad results. That’s the nature of the stock market. That is the nature of the beast. And when that short term is choppy and bad, It can be challenging to be optimistic about some supposedly positive long term future or some supposed positive long term investment returns.
[00:12:59] The intelligent investor, I believe, accepts that challenge and says, I know what happens over the long run, but I’m going to inform myself and educate myself over what is possible over the short run. To describe that even further, I want to go through an amazing example, a real example of path dependence for the long term investor.
[00:13:16] I’m getting a little bit punny here, so we’re going to look at Sally. Sally the investor. And we’re going to look at Sally’s Ride. Yes, Sally Ride pun for all of you astronauts out there. Sally started investing in the S& P 500 in 1991. And if we look at Sally’s results and we’re saying that she’s dollar cost averaging into her account as time goes along, she’s making monthly deposits into her investing account.
[00:13:38] So let’s look at Sally’s performance by 1995. It’s been four years and she’s returned an annual adjusted rate of 12 percent per year by 1995. Pretty good, right? Four years of 12 percent returns per year. She’s pretty happy about that. And then let’s zoom ahead to 1999. And if you know what’s going on in the market in the, in the nineties, you’ll know this is the dot com boom.
[00:13:59] So by 1999, Sally’s been invested for eight years and she’s had an annualized rate of return of 17 percent per year. Can you blame Sally at that point for thinking that her investing ride was particularly blessed? She was on a rocket ship, right? She was having a great time with her investments. Okay. But then the dot com bubble burst.
[00:14:18] So if we zoom ahead now to 2003, Sally’s been investing for 12 years and her portfolio really has fallen back to earth. Over the 12 years at that point that she’d been invested, she has now seen an average return of 8 percent per year, right? That’s what negative returns will do. What do we say in 1999?
[00:14:34] Eight years at 17 percent per year, which is great. But after she goes through that dot com bear market, she’s been invested for 12 years now at only an average return of 8 percent per year. But we know that inflation adjusted an 8 percent per year. Rate of return, that’s pretty normal. Good for Sally. But then, even more bad news strikes.
[00:14:53] As we know, the great financial crisis occurred in 2007 and 2008, and if we look at 2009, if we zoom in on Sally’s portfolio in 2009, she has now achieved 18 years of 3. 5 percent annual returns. It’s been almost two decades, 18 years, and Sally and her portfolio are performing at half of the annualized rate that was supposedly promised to her, right?
[00:15:18] If I’d been sitting here saying, Oh, it’s 7 percent per year, it’s 7 percent per year. That’s what the stock market does over long periods of time. Well, here Sally’s sitting there in 2009 saying, it’s been 18 years, isn’t that a long period of time? And I’ve only gotten 3. 5 percent per year. And if you compound that, if you look at the difference between a 7 percent per year rate over 18 years compounded against 3.
[00:15:41] 5%, it’s not just half, it’s much less than half. So the path dependency here must have felt pretty terrible for Sally. And for all we know, because we really don’t know, something like this might happen again in the future. And if you’re unlucky enough for this to be your particular investing journey in the stock market, it’s going to feel pretty bad.
[00:16:00] I just think we need to be aware of that fact. But now, let’s keep on going, right? 2009, we know, I think it’s March of 2009 actually, was the very bottom of the great financial crisis. And after that, things turned around in our favor. So if Sally had stayed invested, which is a very important if, and I hope she did stay invested, the 2010s bull market made her whole and then some.
[00:16:24] So by 2021, which is about the time I wrote this article in 2022, by 2021, Sally would have seen a full 30 years of investing and achieved over that time an 8 percent annualized return, inflation adjusted. There’s a plot in this article that shows her annualized rate over time. And you can see. The peaks of ecstasy that she must have felt in the late 90s when her average return was 17 percent per year, the big drop off from the dot com boom, the further drop from the great financial crisis.
[00:16:54] And then the slow, steady growth during the 2010s that got her to an 8 percent annualized return. The question is not, did Sally achieve her expected returns? She did. She got, in fact, more than her expected returns. She got 8 percent per year and maybe she only thought she was going to get 7 percent per year.
[00:17:10] So good for Sally. But instead, the question that we really need to focus in on is, how did path dependency make Sally feel along the way? And to that end, was Sally able to stay the course during those worst of times? Now, in the depths of 2008 and 2009, Was Sally consoled by the promise that was originally made to her of a 7 percent average?
[00:17:31] I doubt it. It’s just like Philip K. Dick. His eventual fame was unknown to him, and Sally’s eventual 30 year performance data was unknown to her. She couldn’t really zoom out to see a bright future. The future was just a dense fog. All she knew, all she was aware of, was that the one and only investing path that she was given was severely underperforming her expectations, and that her retirement was probably in jeopardy.
[00:17:56] It looks like maybe she had to spend a few more years working at NASA. Now that is the curse of path dependent investing. It’s directly correlated to the risks that you take. The more risk you take on, the more volatility you have in your potential returns. the more path dependency you are putting yourself at risk against.
[00:18:13] Now, of course, it’s a double edged sword. The risk that we take on in our portfolio is directly correlated to the long term rewards that we will seek. So, of course, we need to take on some risk. We just need to be aware that the downside of stock investing, especially of having a really heavy stock allocation in our portfolio, is that we’re exposing ourselves to that kind of volatility.
[00:18:34] And we’re exposing ourselves to the potential type of path that Sally took. Now, one really cool thing, not to pat myself on the back, but something I, I’m glad that I did, was I re ran Sally’s experiment for other 30 year periods. I looked at a whole bunch of different, I, I just went to round numbers, so I looked at, you know, 1920 through 1950, 1930 through 1960, etc.,
[00:18:55] etc., a whole bunch of different decades. And I wanted to look, how do those paths look compared to Sally’s? And if there’s anything that you take from this episode other than the brilliant stuff that Tyler is going to bring us later on, I would say go to the show notes, go to this article and look at this particular chart, which is about halfway through the article.
[00:19:13] You’ll see that some periods start hot and end cold. Other periods start cold and end hot. In the long run, after 20 or 30 years, all of these periods converge to 6, 7, 8 percent per year. Even a couple of the periods look kind of close. You might be able to get away with using the word steady, that you get a relatively steady performance of something like 8 or 7 or 6 percent per year over the entire 30 years.
[00:19:37] But a lot of these periods, almost all these periods, are really path dependent and bumpy. And so I’d encourage you to look at, say, how these different time periods, but the performance was like five or 10 years in. You could be as bad as something like negative 2 percent per year over 10 years to something as good as 20 percent per year over 10 years.
[00:19:57] But eventually John Bogle’s iron rule of investing, it’s reversion to the mean. That’s what John Bogle said. Eventually the period that starts really poorly in the equity market, it recovers and it ends strong. The period that starts really strong in the equity market, eventually it reverts to the mean.
[00:20:11] It hits a bear market and it ends kind of weakly. But only if you give yourself enough time, and only if you’re willing to write out the path dependency in the meantime. It’s really hard to look at this chart and say, zoom in on the, in this particular case, it’s the red line. It’s an investor who started in 1970.
[00:20:26] It’s hard to look at that particular investor and say, it just. Just wait, you 1970 investor. Yes, you started with 12 years of negative performance in the stock market. 12 years of negative performance. How terrible was that? But stay the course for 12 years because eventually that red line hits the bull market that ran from 1982 to 1999, and it ends up actually being one of the most profitable periods on this chart.
[00:20:50] But are you sure you’re going to be able to convince someone to wait the first 12 years of negative returns? That’s pretty hard to do. Long term investors are almost always affected by this thing called path dependence as their portfolios grow. And then path dependence strikes, of course, after we’re done investing, too.
[00:21:04] During portfolio withdrawals during retirement, we have the sequence of returns risk that we’ve already talked about. That’s another type of path dependence. So that’s why I’d argue that there might not be such a thing as 7 percent per year average in the stock market. Path dependency makes that a false promise.
[00:21:18] We’re much better off saying After 30 years or so, you’ll probably see somewhere between a 500 percent to 800 percent total inflation adjusted return. Any shorter period, though, all bets are off. And by the way, past returns don’t promise future outcomes. The problem is that doesn’t really roll off the tongue, right?
[00:21:35] It’s much easier just to say, hey, 7 percent per year average. And I don’t want to put people down who use a 7 percent per year average. I’ve used it here on the best interest. It’s a very convenient shorthand that makes our job easier. But it leads unsuspecting new investors to expect some sort of guaranteed return over short time spans.
[00:21:52] And those faulty expectations lead to disappointing outcomes. Disappointing outcomes, it hurts feelings, it hurts friendships, and ultimately it probably hurts someone’s finances. If you want a guaranteed return, well, go buy a high grade bond. But that guarantee, of course, means low risk. And lower risks aren’t as fruitfully rewarded.
[00:22:09] For anyone who wants higher returns, I think you should stop thinking about annual averages. Just erase it from your mind. It’s misleading to think about it on a one year basis. Perhaps you can consider something like a decadal average, but not an annual one. Now, this idea would be incomplete without mentioning the one and only true free lunch in investing, which is diversification.
[00:22:29] A diversified portfolio suffers path dependency to But on a smoother basis now in investing parlance, that’s because the risk adjusted reward is maximized by diversification and a smoother ride is just easier to stay on. So path dependency is real. It’s not just science fiction. I mean, you can ask Philip K.
[00:22:47] Dick. But it’s often ignored, and that ends up hurting the most vulnerable members of the investing community. Small, young, inexperienced retail investors. And that’s just not a good outcome. So hopefully this idea, path dependence, reminds some of you that an investment in knowledge pays the best interest.
[00:23:02] So stay the course, and enjoy the ride. Especially if it is, at times, a little bit bumpy. Here’s a quick ad, and then we’ll get back to the show. Every week I send a quick free email to thousands of readers that shares three simple things. One, my new articles and podcasts. Two, the best financial content of the week from all over the internet.
[00:23:22] And three, a financial chart that explains some important concept in the news that week. It’s a great primer to boost your financial know how.
[00:23:31] INTRO: Ah, but Jesse, I don’t want another email.
[00:23:34] Jesse: Well, this might not be for you. But I do hear you, which is why I make it very short, sweet, and full of only the essentials.
[00:23:41] A whopping 66 percent of subscribers read my email at least once a month. They’re enjoying it and maybe you will too. You can subscribe for free on the homepage at bestinterest. blog. Again that’s a free no strings attached subscription at bestinterest. blog. So now I want to welcome on Tyler from Portfolio Charts.
[00:24:02] Portfolio charts is a wonderful website. Links are in the show notes and is created and maintained by Tyler, just him and him alone. Tyler is a mechanical engineer by training with a small math education, a deep personal interest in finance and investing and some pretty nifty Excel skills that he’s picked up along the way.
[00:24:19] And I can attest to that. Tyler also has a unique background in design and consulting that helps him think creatively and communicate complex ideas more effectively than your average engineer. And I can attest to that too with my own former mechanical engineering background. If you mix it all together, it’s a pretty good recipe for some great new financial tools and a fresh take on investing.
[00:24:39] So I’m really excited to bring a smart, Engineer who presents these ideas in brilliant ways here onto the podcast. I know some of you are thinking really two engineers at once talking about personal finance, but I promise you Tyler really brings it. So without further ado, here is Tyler from PortfolioCharts.
[00:25:01] Well, Tyler, thank you for joining us on the Best Interest Podcast. And it’s kind of funny, a lot of the expert interviews on past episodes, sure, they’ve had a little nuance to them. There’ve been some complicated topics. A lot of the foundation for those complicated topics are kind of the general principles of personal finance.
[00:25:17] Whereas I think what we’re about to talk about today is more complex than a lot of those topics have been, and therefore maybe we need to pause and set up a little of the foundation ourselves. And we’re going to talk about two concepts today and some offshoots of those concepts. One of them is called the safe withdrawal rate.
[00:25:34] Another one is called the sequence of returns risk. And now if I’m a pre retiree planning my retirement, I’m going to I’m affected by safe withdrawal rates and sequence of return risks, even if I don’t know it, but we should give some definition to those terms. So what exactly is a safe withdrawal rate and what factors should be considered when deciding on someone’s safe withdrawal rate?
[00:25:55] Tyler: Safe withdrawal rates are really, they’re a conservative spending amount that survived the worst retirement scenario on record. It’s a complicated thing that goes into like variability and when it comes to historical returns. And honestly, I think the thing that you just mentioned that. helps just lay the foundation for that really is the sequence of return risk.
[00:26:13] So I might even recommend starting with that topic.
[00:26:16] Jesse: Yeah. Let’s, let’s dive into that then.
[00:26:17] Tyler: Yeah. So the sequence of return risk, it’s a term for the reality that your own investing experience actually could be much worse than the average. And so you have to be able to understand secrets of return risk in order to be able to plan conservatively.
[00:26:30] So the thing about investing that a lot of people kind of get tripped up on, especially early on in their investing careers, or even sometimes by the even advanced people who get a little bit lost, it’s depending too much on the average. So the average return is naturally the thing that most people want to look at when they look at historical returns, or even the investments they’re trying to find for the current expected return looking forward.
[00:26:51] But the trick with averages is that no one in the real world actually receives the average. So on a year to year basis, your return is never going to be the historical, like, 7 percent real that the U. S. stock market earns. You’re going to either get much higher than that one year or much lower than that another year.
[00:27:08] And the other thing where a sequence of return risks comes in is it’s not just that year to year may be different. It’s just the actual order of those years has a big effect on your compound return. So, for example, if your portfolio has a 50 percent loss, like a really big loss, In one year, it’s going to take you, you know, a hundred percent return to get back to even where you started.
[00:27:30] So the order of returns has a major effect on your actual investing experience that’s much more complicated than just the average. And it gets to the topic of withdrawal rates. That order is compounded by the regular withdrawals that you have to take out every year. So let’s say that, again, with a kind of extreme example of your portfolio dropping by 50 percent.
[00:27:51] That doesn’t mean that your mortgage drops by 50 percent that year. It stays the same. So your actual withdrawal rate doubles. And so when you’re thinking about withdrawal rates, you really have to start with thinking about sequence of return and the risk that comes along with your real world experience that’s much different than the average.
[00:28:07] Jesse: You’re a man after my own heart, because I think of an article that I wrote once, and I think the title of the article literally is Actual returns are not average returns. It’s so understandable why the average DIY investor would use the shorthand of, Oh yeah, I’ll get 7 percent real returns per year for my stock portfolio.
[00:28:26] And you know what? If I’m doing compound math over the next 20 years of accumulation, of growing my portfolio, maybe that’s a reasonable assumption. One thing that you really just highlighted, I believe, and correct me if I’m wrong, is that when we’re in the decumulation phase, Average is no longer the appropriate thing to use.
[00:28:46] Tyler: That’s right. I’ll get to a little bit of why that is in just a second when we talk about William Bengen and the safe withdrawal rate. But I guess one other metaphor I like for terms, talking about sequence of returns, I think you’ll appreciate because you’re an engineer. Is it’s a little bit like engineering tolerances for people who aren’t familiar with what engineering tolerance is.
[00:29:06] It’s very similar to what I just talked about, how the average return is just like a baseline and no one receives the average, but when you’re on a manufacturing line and you’re making, you know, thousands or sometimes millions of parts, you may have your drawing that the engineer has made that this is what the dimension should be for this part.
[00:29:24] But every part that comes off the line is going to be just a little bit different because just sub natural variability. And so the tolerance is the amount of variability that’s allowed, that’s safe, and that you know that as long as it’s within a certain band of measurements, it doesn’t have to be exactly the average, but it’s still going to function all right.
[00:29:45] So tolerances allow us to specify the allowable uncertainty, that they guarantee that your assembly is always going to fit together no matter what, even if the part’s a little different. And in a similar way, the sequence of return risk, when you’re able to quantify that, It allows us to make sure that our plan works even in the toughest times.
[00:30:03] The thing about safe withdrawal rates is interesting is that they were first, I don’t know if he was literally his first person to come up with the idea, but his first person really write about heavily was by William Bengen back in, I think 1994, he wrote a famous paper about safe withdrawal rates and his preamble to why it was important is like something I think everyone should read.
[00:30:22] And what he talked about was, he’s an investment advisor, and he was, uh, talking about how he was trying, he gets questions all the time about, from retirees, about how much is safe to withdraw from my portfolio. And up to that time, the standard advice in the industry, Was to recommend that you should be able to take out the average return that your investments have made over time.
[00:30:45] Why that sounds like a reasonable theoretical thing. He was thinking about like, uh, the many people he had seen advise that, that were still like surprised to run out of money for earlier than they expected. And so kind of going back to the tolerances, he kind of realized that the average return that people were falling back on was actually failing people, because that may sound like a reasonable thing to do, but let’s say if one third of the time.
[00:31:08] Your returns are far enough below the average that you actually run out of money in 10 years in, that’s a serious failing of planning. What safe withdrawal rates do is instead of just depending on an average that really hides those worst case scenarios and leads to those surprise failures, and also instead of, by the way, just relying on anecdotes of like this worked for me, the thing, the important thing for most people to remember is your own personal retirement timeframe.
[00:31:35] It’s going to look much different from your parents and grandparents. So just because something worked for them, it doesn’t mean it’ll work for you either. So he took a more systematic approach that I, at least to me as an engineer, I appreciate that he did a pretty sophisticated study where he looked, he measured the actual retirement performance of let’s, of every retiree looking 1927, like starting on subsequent years and tested different combinations of U S stocks and bonds.
[00:32:03] And different withdrawal rates to see maybe it’s 2%, 3%, up to 8%. And to kind of get a feel for what really was a safe withdrawal rate that would be able to spend money safely, he assumed up to 30 years, like, depending on a typical retirement age of 65, living to 95, to be able to spend it down to zero and survive even in the worst case.
[00:32:24] So based on that, he called that number the safe max, which is where safe withdrawal rate came from. It’s kind of his shorthand. And that’s where the famous 4 percent rule that people come to become kind of a rule of thumb, where that number comes from.
[00:32:38] Jesse: It’s a perfect explanation and matches up with, you know, I didn’t know all those details and for sharing that, Tyler.
[00:32:44] But you pointed out something pretty interesting there, which is that the safe max rate or the 4 percent rule Really is a conservative rule that survives even the worst case scenarios. So maybe now we can start to transition to some of the ways in which we say, well, if the 4 percent rule survives all the worst case scenarios, And that means in many cases, the 4 percent rule ends up being too conservative.
[00:33:08] How does a potential retiree bookend these risks of, of getting their withdrawal rate wrong so that they’re not too aggressive or they’re not too conservative? What are your thoughts on that?
[00:33:17] Tyler: There
[00:33:17] Jesse: are a couple
[00:33:18] Tyler: of ways to approach that,
[00:33:19] Jesse: I
[00:33:19] Tyler: think. One is to think beyond the very standard definition of withdrawals that people like Bangan and some of the more traditional studies used.
[00:33:29] So for reference, their assumption when they’re doing these studies was that you would, you They have a safe plateau rate, let’s just say it’s 4%. And let’s just say you have a million dollars in your portfolio just to make it easy. The assumption of the study is you would take 4 percent of your 1 million out in your first year in order to fund your spending for the year.
[00:33:48] And then the next year you would not even adjust your withdrawal by your portfolio performance, but adjust it simply up by inflation. So it maintains constant purchasing power over time. So one way to answer your question of how you might address that, that’s the worst case and sometimes is the best case, is that other people have talked about variable withdrawal strategies.
[00:34:08] Where, uh, they could set up different rules where you can actually ratchet up how much you’re allowed to take beyond just inflation based on your portfolio performance. There’s others that kind of actuarial where you’re trying to plan it out, maybe a higher percentage of safer, depending on your age, there’s some with all kinds of different triggers that you could do, raise it only after it goes up a certain amount and ratchet it in different ways.
[00:34:30] So there’s actually been several studies by famous people like KitKiss and Bob Cliet and even some of my own work that looks into those types of things too. Um, So if you look at portfolio charts, I have two charts, three actually, but the two I’ll talk about most. One is withdrawal rates chart, which you can actually visualize the safe withdrawal rates for any portfolio that you want to enter from any different, one of 12 different countries, by the way.
[00:34:53] And the other is called the retirement spending chart. And that gives you a bit more flexibility where you can add in, uh, withdrawal rules that you can ratchet up and ratchet down your spending and kind of see how that affects the numbers as well. The topic that I think is least, is most underserved and the retirement space is talking about the effect of allocation on safe withdrawal rates.
[00:35:13] So the reason that, like you said, withdrawal rates, they do represent the worst case, and sometimes it could be drastically better than that. Is most of the time they focus on a very limited number of investment options of the U. S. S& P 500 and U. S. Intermediate bonds, but not all stocks and bonds are created equal.
[00:35:31] And so not just in the U S where you have small cap value stocks, you can invest in international stocks and international bonds and, uh, commodities and gold and all kinds of things. And when you mix these things together, they can drastically affect your withdrawal rates. But not only do they affect the numbers, but they affect the consistency of your portfolio.
[00:35:49] And when you’re looking at safe withdrawal rates, the number one thing you can do, in my opinion, to help yourself out is to look for a portfolio that improves the consistency and that accomplishes two things. Is one is it tends to raise the withdrawal rate. You can actually find portfolios with higher withdrawal rates than 4 percent because they’re far more consistent.
[00:36:07] They don’t have the same drawdowns as other like very hot stock, heavy portfolios do. If you look at the spread of outcomes of all these different start dates for consistent portfolios, it’s a much tighter spread than for very volatile, inconsistent portfolios. So when you pick a consistent portfolio, not only is your safe withdrawal a little bit higher, but you’re also less likely to miss out on a much higher thing that like get FOMO from spending more because every single outcome tends to be follow in a much tighter band.
[00:36:36] And for people, you know, concerned about looking for. Both safety and consistency. That’s the type of performance I think is really important for people to seek out.
[00:36:45] Jesse: Two followups on that stanza, Tyler. The first one is you mentioned a couple of charts earlier, I believe, on the portfolio charts website, which we will throw those links in the show notes so that our listeners can, can go look at those themselves.
[00:36:57] And then the second thing is you mentioned some portfolios that. provide a little bit more stability or consistency, I think is the word you used. And I know on portfolio charts, you dive into some pretty cool detail of some various portfolios, whether they were of some other famous investors making or of your own design.
[00:37:15] And when you think of that kind of consistent portfolio, that’s not necessarily just stocks and bonds. Can you describe one example of that to us right now?
[00:37:23] Tyler: Probably the classic example of a non standard portfolio that is known for its consistency is something called a permanent portfolio. And it was one that was invented by a man named Harry Brown, who’s actually the Libertarian candidate for president back in the day.
[00:37:37] But he also was an investor. He wrote several books that are like terrific on the topic of investing. And the Permanent Portfolio was his solution looking after a lot of the chaos in the 1970s that happened in the markets where you had crushing inflation, it feels probably a lot like today, with stagflation, and it was during the oil crisis during Jimmy Carter, and there were some very serious market conditions that were pretty terrible.
[00:38:02] So the Permanent Portfolio was his way of kind of, how do I address this? And so what it consists of is 25 percent stocks, 25 percent long term treasuries, the type of bond, 25 percent cash and 25 percent gold. And so things like, especially long term treasuries and gold and higher percentages of cash or something that, you know, most standard advice today don’t include in the portfolio at all.
[00:38:26] And it also, when you look at those things in isolation, a lot of them don’t seem very great. Like, why would you have that much cash? People think that’s like leaving money on the table or. Gold seems volatile and so right. Why would you add that? But the interesting thing is even though each of those four things are kind of complicated on their own, when you mix them in those proportions, the resulting portfolio is honestly one of the most consistent things you can design in terms of building something to protect your money.
[00:38:53] And the reason Harry Brown, uh, explained that it worked was the idea of it. Picking those, each of those four things deliberately to address economic conditions. So stocks would be for prosperity. Cash would be for times of recession where everything else is doing poorly. Gold would be for times of high inflation, or I would argue that’s overly simplistic.
[00:39:13] It’s really more times of negative real interest rates. Long term treasuries are for times of deflation. There’s are also there are very generally pretty uncorrelated from stocks. So by buying all of those things, four different things that react to different economic environments. There’s always going to be one doing well, even when others are doing poorly.
[00:39:31] And so it’s that kind of portfolio thing. And there’s lots of others examples beyond just out his ideas. But if you’re looking for one example of a consistent portfolio, I’d recommend reading about that. And then really studying the history compared to like a hundred percent stocks. And if you look at a few charts and look at every start date all at once, which is kind of my specialty with the way I design visuals, is you can really see it’s very stark how the permanent portfolio is like a, it’s like shooting a laser beam to hit a target.
[00:39:56] Versus a shotgun where maybe a few pellets hit. It’s just a very different investing experience.
[00:40:02] Jesse: Here’s a quick ad and then we’ll get back to the show. A few of you occasionally inquire about two different topics that are actually related. The first type of question seeks out details about my professional life and the wealth management firm that I work for here in Rochester, New York.
[00:40:17] The second type of question involves the best interest, which operates with no advertising, no pushy sales, no paywalls. And the question is, how can the best interest stay afloat? Well, to answer both of those questions, I want to point you to Episode 78 of the Best Interest Podcast. I intentionally recorded Episode 78 to shine light on those topics and inform you how you can actually help the best interest stay afloat.
[00:40:41] If you’re so inclined. So if you’ve ever been curious about the business of the best interest, please go listen or download episode 78 and let me know what you think. You talked about Tyler. It’s the flowing nature of withdrawal rate math. What do you mean by that? What is the flowing nature of withdrawal rate math?
[00:41:00] Tyler: So that goes back to an interesting characteristic of withdrawal rates that I call the flowing nature because it actually ties to the, some of the visuals I created. So if you were to open. The Withdrawal Rates chart that I mentioned on the website, picture a bunch of, I will try to explain it in a way that even works on a, audibly too, but I’ll do my best, but picture a bunch of blue lines flowing downhill, kind of like a river.
[00:41:24] The way Withdrawal Rates work is they, the interesting characteristic is they vary by the, your retirement length. Which sort of makes intuitive sense. Like, let’s say you only need to retire for one year. You wake up tomorrow, you have one year left to live. Well, your withdrawal rate could be 100%. You can spend every dollar you have that year, and that’s your withdrawal rate, and that works just fine.
[00:41:47] If you go toward the other extreme, like the Bingen study, is that he looked it out for 30 years, and at 30 years, his safe withdrawal rate is about 4 percent that he found for the portfolios he looked at. Well, the interesting thing is, if you draw a line in between that 100 percent at one year and 4 percent at 30 years, it’s not a straight line.
[00:42:08] It’s a curved line that looks kind of like a waterfall flowing into a river. So it starts very steep dropping. If you go from the one year, it’s like a hundred percent, two years, it’s around 50%, but at around 15 years, it kind of turns the corner and starts to flatten out, like it’s flowing into a river and ultimately to a lake.
[00:42:25] And so that’s what I mean by the flowing nature of the withdrawal mate math as the withdrawal rates, depending on the retirement length you’re looking at, they always flow downhill. And they do level out after a while into kind of a, uh, a level smooth. rate that kind of leans towards another concept like the perpetual withdrawal rate.
[00:42:42] Practically speaking, it’s how endowments work. So if a typical retiree maybe is planning for 30 years because they retire at 65 and want their money to last to 95, a college endowment has to plan their endowment portfolio to last forever. And so the money that they design to spend out of that portfolio isn’t what they make every year.
[00:43:01] It’s more like a perpetual withdrawal rate that’s planning out not to 30 years, but let’s say to 60 or 70 years, which practically speaking that number levels out. So once you reach that kind of steady state level. That’s the type of portfolio that an endowment might appreciate, or also on the other end, an early retiree who wants to retire much earlier than the normal age.
[00:43:23] If you look more towards the long term withdrawal rate or the perpetual withdrawal rate, that’s the type of spending level that could theoretically last forever.
[00:43:30] Jesse: So in that illustration, which again, we will throw links into the show notes, and you did a great job describing audibly. So we have this withdrawal rate that is kind of maybe flattening out.
[00:43:40] Or if we were being really math dirty, we’d say it’s reaching some sort of asymptote over time, right? It’s reaching a limit. Yep. I’m thinking about the difference between a safe withdrawal rate and that perpetual withdrawal rate, or maybe more specifically, I’m thinking to myself, you know, if someone’s retiring for 30 years and their safe withdrawal rate is 4 percent say, and we compare that to a safe withdrawal rate at 75 years or at a hundred years or at 200 years, which is maybe the timeline that an endowment is thinking of, At some point, what you’re saying, I think, Tyler, is that, you know what, the safe withdrawal rate at 60 years is pretty darn close to the safe withdrawal rate at 100 years, because you’ve reached this limit, and that limit is what you call the perpetual withdrawal rate.
[00:44:22] Is that reasonably accurate?
[00:44:23] Tyler: It’s reasonably accurate with one caveat. The perpetual withdrawal rate from a calculation perspective is a little, just a twist on the safe withdrawal rate. So if the safe withdrawal rate calculates the withdrawals to deplete a portfolio to zero after, let’s just say 30 years, perpetual withdrawal rate does the same exact same calculations, but finds the withdrawal rate that maintains the same initial inflation adjusted principle after the same 30 years.
[00:44:52] The kind of asymptote or the limit that the, if you’re looking at the withdrawal rate curves, it’s actually something kind of in between that. I call it the long term withdrawal rate. And it ends up being, practically speaking, I measure that as the halfway point between the perpetual and the safe withdrawal rates at 60 years.
[00:45:09] And it’s really this close to the same, but that’s the number where if you kind of pick at, that’s the one that both of those, the safe and the perpetual numbers approach over time.
[00:45:19] Jesse: Got it. When I’m working with someone on their financial plan, and we’re thinking through how they’re going to withdraw money in retirement, There is an interesting, I don’t want to call it a mental hiccup per se, but I would say that the average person has a bit of an aversion to withdrawing down on their investing principle.
[00:45:36] They don’t mind spending gains, but the idea of, you know, I’m retiring with 2 million and you are telling me you want me to spend 80, 000, even if it knocks me below the 2 I only want to spend my gains. So even whether right or wrong, I mean, I think you and I understand the math and understand. Yeah. You know, there are some cases in some retirement scenarios where you should draw down on your principle.
[00:45:58] It won’t kill you. The math says you’ll be fine, but, but some people are averse to that. But for those people, the perpetual withdrawal rate. Is a more conservative and safer withdrawal rate typically, or maybe always mathematically, it’s always more conservative, I would think, but also it, it, it gives that person a little bit of that safety feeling of, Hey, this particular more conservative withdrawal rate ensures that you’re never going to draw down on your principal.
[00:46:24] Tyler: Yes. It doesn’t ensure that your portfolio will never go down. That’s the number that historically given enough time proposals about the down all the time. But it will eventually recover back to that number. And, uh, by using the perpetual rate, the interesting thing about that is that it’s the perpetual, the safe volatile rates drop over time.
[00:46:42] The longer your retirement goes, perpetual volatile rates actually go up over time. So at very early on, you actually may need a negative perpetual rate because your stocks may drop. And so unless you put money back into your portfolio, obviously it’s going to have less. But over time that kind of rises up and that reaches its own steady state.
[00:46:59] But yes, the perpetual thing if, if you’re looking for something that’s more conservative and that’s safe and that’s much better to planning for the longterm, it just think of frame, reframe your mindset from spending down your money to nothing to sustaining your portfolio level over time. And just that one mental reframing and a strategy that helps support it, I think goes a long way to, at least for me, that gives me a lot more security in my own plan.
[00:47:24] Jesse: Yeah, that totally makes sense. And I’m curious, and I’m putting you on the spot a little bit here, Tyler. I’m fine with that. Go for it. When it comes to your own plan, not that you have to share the nitty gritty details, but here you are, a fellow engineer. Who, I mean, I told you via email that I am just so impressed and astounded by the technical detail in your charts, but then also the way in which you present the data in such a clear way.
[00:47:47] And I tell you have such an amazing grasp of this data. I mean, how has this project, Portfolio Charts, and the knowledge that you’ve learned along the way, Helps you in your own personal finance journey, potentially in your financial independence journey. I’m making a bit of an assumption there. What have you learned and how has it helped you to invest in this knowledge yourself?
[00:48:07] Tyler: My background is in mechanical engineering, just like you. And I spent a lot of time in product design and building lots of things over the years, not just, you know, satellite telescopes, but consumer electronics and medical devices and all kinds of things. One of the things about the, you know, that type of product development rapid process, especially in the consumer businesses, man, the treadmill is hard and it burns you out.
[00:48:30] A while back, I guess nearly 10 years ago, I decided to take a break from that and go on a bit of a sabbatical and just kind of relax and decompress a bit. Man, I needed that real bad. And after about six months of like decompressing and probably playing too many video games and finish up all my home projects is, I mean, I was trying to figure out how to still, I have this creative energy and this engineering mind, so how do I put that to good use at the same time?
[00:48:55] So PortfolioCharts was actually my personal project. That was like my early retirement. Thing I was going to put my energy to. So that was actually born of my early retirement experience. And I feel blessed to have the ability to take the time to be able to do that and clear the white space in my brain to put that together.
[00:49:12] So it’s actually had a profound impact on me because it wasn’t just me just trying to put stuff out there. Like I was a finance professional. Really. It’s like me sharing my learning process to everyone else at the same time I’m doing it. So many of these charts, like the withdrawal rates chart, that is one of the first ones I put together, even though it’s evolved over the years.
[00:49:28] Was to give me my own confidence in my own plan. That makes me more, even more than just your typical finance guy. You’ll hear giving a speech somewhere who comes from a finance background. I tend to think, talk more in theory because I’m an engineer. I’m all about evidence. And so being able to build tools.
[00:49:45] That act like stress tests to my investing concepts. Those types of things give me the confidence to be able to depend on things beyond just a theory that I understand. But for my engineering experience, theories are only as good as the first failure that you had to figure out what was wrong with your theory.
[00:50:02] You know, I put a lot of care and craft into the visuals because I’m a visual thinker. And so they, uh, being able to do that is what made me actually understand the concepts more than just the numbers. But also because I, I want to be able to present, allow data to speak for itself. So other people, not just me, who has the luxury of having a lot of time to look at data, But other people researching things themselves can also understand the concepts as well.
[00:50:23] Jesse: Awesome. And Tyler, I’m so excited to share your work. Not only share your words today, but as I’ve mentioned before to the listeners, share your links to these charts in the show notes. Because if you guys have not checked out Portfolio Charts before, I think it’s a terrific website worth spending some serious time to look at and understand just all the excellent data to support whether you’re a DIYer, whether you work with a CFP, whether you’re new to your retirement journey, or whether you’ve been doing it for a long time, I think there’s something you can learn from Tyler.
[00:50:53] Tyler of Portfolio Charts, thank you for joining us today on the Best Interest Podcast.
[00:50:57] Tyler: Thank you for having me. It’s really an honor.
[00:51:01] INTRO: Thanks for tuning into this episode of the Best Interest Podcast. If you have a question for Jesse to answer on a future episode, send him an email. at jesse at bestinterest.
[00:51:11] blog. Again, that’s jesse at bestinterest. blog. Did you enjoy the show? Subscribe, rate, and review the podcast wherever you listen. This helps others find the show and invest in knowledge themselves, and we really appreciate it. We’ll catch you on the next episode of the Best Interest Podcast.
[00:51:33] The Best Interest Podcast is a personal podcast meant for education and entertainment. It should not be taken as financial advice and is not prescriptive of your financial situation.