Although our asset mix, portfolio value and CAPE ratio evolved over time, Big ERN’s Safe Withdrawal Rate formula helped us navigate through the past turbulent 3 years, and strategize our distribution strategy. Portfolio valuation needs to be examined with the CAPE ratio to be meaningful.
We need to start somewhere
Like most of us, we started investing because we were told to. We did it long before we discovered the FIRE concept. So, we bought individual stocks, individual REITs and a few ETFs. As our understanding of financial products evolved, we then decided to diversify into other asset classes (and more specifically into individual corporate bonds).
Indeed, when people refer to a 60% stocks / 40% bonds portfolio, they are referring to a 60% total stock index (S&P500 for example) and 40% government bonds (7-10 years government Treasuries). In this theoretical portfolio, there are no corporate bonds. Nevertheless, we preferred corporate bonds because of higher return compared to the meagre returns of government bonds since the 2007-2008 financial crisis. What we did not expect at that time, was the strong correlation between equities and corporate bonds in the bull and bear market that followed.
In the graph above, you can compare the performance of different bond ETFs at the beginning of 2020 with Covid started to disrupt the financial markets in February 2020. We can see here the positive correlations between equity and all sorts of bond ETFs, save for IEF which is a bond ETF dedicated to US Treasuries. The more equity dropped, the more the various bond ETFs lost value. The positive correlation really killed any incentive for us to hold bond ETFs as a diversification technique. Since then, we preferred to invest in distinctive assets which have negative correlations with equity, such as governments bonds ETFs instead of corporate bond ETFs or total market bond ETFs.
Asset Mix of our Portfolio
As you can see, the asset class mix of our portfolio evolved over the last three years. We didn’t actively rebalance of portfolio. It is because most of our individual corporate bonds which had a 4%+ yield-to-worst rate were progressively called. We used the cash we received to finance our quarterly expenses. And in case of larger sum redemption, we reinvested in stocks to set up a glidepath portfolio.
We also gradually reduced our REIT portion as we perceived it as a hybrid asset inheriting features of both stocks and corporate bonds. It resembles stocks because it is supposed to keep up with inflation. Whilst it is also close to bonds as it is created to distribute majority of its cashflows as dividends. Depending on the tax code of the country you live in, receiving dividends can be a sub-optimal financial outcome resulting in additional tax liabilities.
Towards the beginning of 2022, we started to introduce some cryptocurrencies which culminated to 7% of our total portfolio. As the saying goes, you should not invest more than the money you are prepared to lose. We have also invested into few stablecoins to profit from the good yield (3%~6%) compared to 0% cash yield at that time. Our stablecoins remained resilient with their convertibility to U.S. dollars. Since then, crypto markets have taking a hit with the backdrop of financial turmoil affecting much of the financial world. As crypto exchanges crippled with ever alarming bankruptcy risks, we withdrew our stablecoins and converted those into U.S. dollars. We now earn a decent and safe(r) deposit rate with Interactive Brokers, which is offering 3.3% interest on our cash position above $10k at the time of writing. Our other cryptocurrencies are safely kept in our Ledger cold wallet.
Portfolio evolution during FIRE
While the market evolved, our portfolio evolved too. We usually benchmark our portfolio value as at October 2019 to be 100% since it was the time when both Mama FC and Papa FC left their jobs and started their Early Retirement journey. You can see that our portfolio increased to $1.47million as at December 2021. We were very pleased and congratulating ourselves on the great investment decisions we made so far. We all know that we did not do anything particular, we were simply riding the bull market, no talent there.
Reality caught up quickly and soon market plummeted, finding its bottom slightly below $1.1 Million as at June 2022. It took 26 months to gain 47%, and 10 months to lose most of the gains! I have to admit that we felt a bit unease to see our portfolio value melting like ice cream on the beach – and there is not much you can do about it. Imagine seeing a sum equivalent to your annual expense vapored every month! And voila, 10 years of living expenses disappeared in less than a year.
Big ERN SWR formula
You might have heard about the Trinity study which suggests that a 4% static withdrawal rate should get you through retirement. Although the study was innovative and well conducted, most people ignore the assumptions and limitations. The Trinity study assumes a 30-year retirement period and capital depletion, whereas most early retirees are looking for a 50- to 60-year retirement period. Besides that, we all like simple thing, why bother with difficult calculation when there is one figure fits all magic? Yet, blindly applying a 4% withdrawal rate can have dear and dramatic consequences.
Luckily, some math-mind blogger such as Big ERN has deepened the study and ran more analyses. If you don’t know Big ERN, we invite you to discover his blog and his invaluable financial assessments and simulations. He proposes a Safe Withdrawal Rate formula and back tested it. If you allow me to shortcut his detailed and fantastic analysis, his formula can be expressed as:
SWR = 1.75% + 0.5 / CAPEAs of Nov 2022, the Shiller CAPE ratio stands at 28.01. Thus, the SWR = 1.75% + 0.5/28.01 = 3.53%. The concept of his SWR is that the valuation and the return of the market portfolio are linked, so it should serve as a guidance for the SWR.
Last 3 years FIRE Withdrawals
Despite the painful fall in portfolio value, are there any lessons to draw upon? Actually there are.
Assess your portfolio value AND the CAPE
Very often, we look at our portfolio value and think that is our wealth. But does it really matter that we have $1 million or $20 million in the bank? For those on their FIRE journeys, portfolio value is just a number on the screen that has a significant influence on our mood and mindset. It should not make us happy or sad. What matters more to our lives and wellbeing is the amount of money that we are able to withdraw and spend every month. Do you have enough money to pay for your home and to protect your family, put food on the table, engage your activities that enrich your life? It is comforting to know that your lifestyle is within your means.
As I look into the data, I observed that I can derive a similar $3,400 withdrawal value based on the portfolio value and CAPE at two very different points in the recent past – April 2021 when the world started to vaccinate its people and mood was buoyant and August 2022 when inflation haunted much of the world with war in the background. Despite a portfolio value difference of 12%, the withdrawal amounts ended up being very similar. What has just happened? While the portfolio has dropped in between the two time points, the CAPE ratio has also reduced significantly. Given SWR is inversely correlated to the CAPE ratio based on the formula, we end up with a similar safe withdrawal dollar amount.
The point of this exercise is to demonstrate that the portfolio value in itself is irrelevant to your wellbeing. You ought to take the CAPE ratio into consideration to understand how much you can spend.
| Time | CAPE | SWR (1.75%+0.5/CAPE) | Portfolio Value US$ | Safe Withdrawal amount in US$ |
|---|---|---|---|---|
| April 2021 | 36.55 | 3.12% | $1,312,757 | $3,411 |
| August 2022 | 28.42 | 3.51% | $1,163,302 | $3,402 |
Withdrawal amount speaks louder than SWR
The standardized formula is essential to show a communicable percentage, while our minds work better with actual dollar amount. Thus, once you have calculated the applicable SWR, you can multiply it with your portfolio value to obtain the safe withdrawal amount in dollars.
Each of the below charts shows the SWR and respective withdrawal amounts, both using $1 million portfolio in October 2019 as a start. On the left, the intercept was set at 1.75% while the right was 1.50%. Other parameters such as CAPE, portfolio value, and asset mix are kept the same.
Standard SWR
The left chart with 1.75% intercept corresponds to the formula Big ERN uses most of the time, and I will refer it to the “Standard SWR”. You can see that the SWR oscillated between 3% and 3.75%, which is way smaller that the golden 4%. The reason is the high CAPE ratio during that period with a mean of 32.5 dragged down the second component of the formula. The Safe Withdrawal bottomed at $2,700 at the beginning of Covid – luckily people cooped up at home during those days couldn’t find many ways to splash anyway. The maximum Safe Withdrawal topped above $3,800 at the end of 2021.
Conservative SWR
The right chart has a 0.25% reduction on the intercept. This small twist in the formula has a significant impact on the SWR. I named this version with 1.50% intercept a “Conservative SWR”. With the same vertical axis and scales for comparison, you can visualize the impact of a 0.25% reduction of your SWR. I do not have a strong rationale to explain why one should choose 1.50% over 1.75% intercept given the reduction in withdrawal allowance. By design the 1.75% intercept is already a safe figure given the backtest results. However, as us FireCrackers are rather conservative people, and there are always unexpected expenses. Thus, the 1.50% may help to rationalize the extra frugality in exchange for peace of mind.
As an example, don’t let me start on the ballooning effect of education expense when you have three young children. So, the Conservative SWR allows us to sleep better at night, and affords us to make minimal amendments to our lifestyle when market drops.
How do we track our expenses vs Safe Withdrawals?
We consider the SWR more as an upper limit of the amount that we can spend. Some months we spend less, and we do not feel the need to spend more than we need. Some months we spend more but we would make sure it does not become recurring. We look at our expenses over a year. We believe a yearly view makes more sense as some expenses are paid for the year. It is only with a yearly view can you capture the seasonality of expenses like education, insurance premiums and holidays bills.
Note: For simplification, I have excluded the impact of taxes as there are many variables to take into account such as tax residency and income brackets. Moreover, there are many ways to optimize your tax liabilities using non-taxable accounts and financial products. I aimed to keep my examples simple.
What is your distribution strategy during your retirement? What is your SWR and your retirement horizon? Please share your experience (good and bad) with our community. Happy Fire Cracking!!