There is this Financial Independence Retire Early (FIRE) message that is spreading and it is very attractive. Save a bit here and there, and I am on my way to a fully paid holiday for the rest of my life. The “FIRE” saying is that if you only withdraw 4% of your investment value as an annual income, you will be able to live off that perpetually. So, to have $2000 monthly income for the rest of my life, I will need $600,000.
Given that the minimum income to live in Singapore (assuming that your house is fully paid off) is S$1,379 a month (see this article), I assume $2k a month should be livable.
However, this 4% rule needs you to be invested in the stock market, and the stock market is very volatile. What this means is that your investment returns will not be the same as mine and there is a lot of uncertainty. Just take a look at the S&P 500 over the last 20 years (in the table below), it swings from -37% to +32% and everything in between. Using this data, we have a mean of 8.2% and standard deviation of 17.7%. This then begs some questions: With a $600k initial investment value, will withdrawing $24,000 (4%) per annum be wise given such large changes in the market? If I were to retire at 45 and live to 85, which means 40 years of retirement, will I be able to draw $2000 monthly or $24k annually with this $600,000 initial investment? Will this be able to weather a financial crisis? To answer this, I ran a Monte Carlo simulation with 100 runs. It is based on a 40 years retirement period, $600k initial investment value, $24k fixed annual draw down, and uses annual market returns with a mean of 8.2% and 17.7% standard deviation (as per the S&P 500 historical data from 1998 to 2018).
| year | returns |
| Dec. 31, 2018 | -4.38% |
| Dec. 31, 2017 | 21.83% |
| Dec. 31, 2016 | 11.96% |
| Dec. 31, 2015 | 1.38% |
| Dec. 31, 2014 | 13.69% |
| Dec. 31, 2013 | 32.39% |
| Dec. 31, 2012 | 16.00% |
| Dec. 31, 2011 | 2.11% |
| Dec. 31, 2010 | 15.06% |
| Dec. 31, 2009 | 26.46% |
| Dec. 31, 2008 | -37.00% |
| Dec. 31, 2007 | 5.49% |
| Dec. 31, 2006 | 15.79% |
| Dec. 31, 2005 | 4.91% |
| Dec. 31, 2004 | 10.88% |
| Dec. 31, 2003 | 28.68% |
| Dec. 31, 2002 | -22.10% |
| Dec. 31, 2001 | -11.89% |
| Dec. 31, 2000 | -9.10% |
| Dec. 31, 1999 | 21.04% |
| Dec. 31, 1998 | 28.58% |
So, I crunched the numbers and the results are in… I found that in 15% runs, I would run out of money before 40 years are up. However, because the volatility is so high, in the very best case scenario (99th percentile), I got about $74,000,000 at the end of 40 years!!! Woahhhh……. At the 50th percentile (which will likely be the scenario), I would end up with with $3.5M in investment value at the end of 40 years, much more than the $600k initial investment. This is not surprising since my average investment returns are 8.2% which is double that of 4%. Nevertheless, this just goes to show how volatile the stock market can be and how it can affect your investments.
Another thing that I discovered was that the investments were not able to recover if i were to hit a bad patch and my investment values drops below $300k. It almost never recovers if I continue to withdraw $24k annually, even if i get some good years thereafter.
Perhaps I am getting it wrong, why would people recommend this 4% rule if it is so very risky. Maybe it will be better to withdraw 4% of the current investment value instead of a fixed value based on the initial investment? Time to re-run the Monte Carlo simulation with this change. 100 runs, again.
And, here are the results. With a draw down that is limited to 4% of the investment value, I will never run out of money since I will always have 96% of the value left. But in this case, I found that I will end up with less than the initial value of $600k, 18% of the time. The 50th percentile case ended up with an end value of $1.8M, and the best case scenario ended up with $19M remaining. Do note that for this simulation runs, as your investment value increases, so will your draw down value and at $1.8M, you will be able to withdraw $6k a month. As you can see, this is much more stable (with limited upside and downside), but it would mean that the draw down is market dependent. In all likelihood, your investment portfolio will likely continue to grow beyond your initial investments even as you draw 4% of it as income. But, when the economy dives, be prepared to go out there and do some free lance work to supplement your income. In the worst case simulation run I got, the lowest investment value was only $60k, one tenth of the initial value and it would mean a draw down of just $200 a month that year… So yes, there are pros and cons, but this is a much better and more sensible investment strategy than a fixed withdrawal amount. Anyway, shouldn’t you increase your withdrawal/income when your investment portfolio increases?
At the end of the day, when it comes to investing, we need to be flexible and allow for some volatility in the markets. This is an investment after all, not an insurance scheme. No pain, no gain.
I hope you like this little simulation analysis, it certainly was fun and insightful for me. Definitely good to do your own if you can, so that you can play around with the numbers to suit your investment goals better. By changing the numbers, you will also be able to quickly simulate various scenarios and see the risk/returns for yourself. I believe the insights gained and experience will be a good life lesson too.
Cheers!
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