Sequence of Return Risk

He he yes, saw that.

ERN really fired up when his links were deleted.

 

Retirement Income Analysis by Bill Sharpe - FREE

Retirement Income Analysis by Bill Sharpe - FREE - Bogleheads.org

 

The Life Cycle of Wealth

 

Hi all,

I've just switched a portion of my super into a Hostplus account - it's about $41K which is, I'm ashamed to admit, about 21% of my total super funds. I've switched it into there so that I can select some etfs and lics in a fairly low cost environment.

But for a week I've had analysis paralysis about SORR. So I've just let the funds sit in the Hostplus own indexed balanced fund, and not selected any others like VAS etc. (I can do that if I pay about $180 per year to be a ChoicePlus member)

But then I realised that since the old super account where the funds were, was allocated to International Shares, SORR shouldn't really be an issue, should it? The funds have come out of the share market and are going back into the share market, aren't they?

I hope this question makes sense - I only found out about etfs and lics and sorr over the last few weeks reading propertychat! (So if I'm confused it must be your fault!)

Kate

 

Hi Kate,

Yes sometimes the more you read the more confused you get and start to second guess every decision before you make it. I love reading and learning as much as possible. But I have slowly learning not to overthink everything and just stick with a simple plan.

If your moving your funds from one fund to another then yes your risk has not changed other than the risk of the particular manager. You said your super was invested in international. Now you are thinking of moving into lic’s and index funds like VAS. So if you go into an lic’s that also invests in international shares then only change of manager risk. VAS is a little different. With this one you are going Australian shares and 100% invested all the time. Managed funds and lic’s which is a managed fund as well can hold cash and not be 100% invested at times.

So that does change the risk profile when comparing actively managed funds compared to an index fund like VAS.
I have done a lot of home work on the topic of managed vs index and discussed this in a fair few posts on here. With the feedback of many wise members on here I came to the conclusion that I will go down the path of part managed and part index funds.

Generally we have established that index funds outperform a majority of active funds that benchmark against the index. I do see the benefit of active management in a down market, in hope that the super smart managers hold some cash when the market is tanking and re deploy it when the market takes some off again. But I don’t think many can pull that of very often.

I would like to deploy more $$$ into the market, but I think the market is a little frothy right now. I’m sitting back and building some ammunition right now for when a good buying opportunity comes around. If in the next 6 - 12 months that opportunity does not come around and the market continues to trot along then I will go back to my plan of doing small monthly buy ins.

Hope I haven’t added to your confusion.

 

Hi @Big Al - thank you so much - you answered questions I hadn't even expressed yet! I perfectly understand now.

By the way, it would probably be VAS all the way for me if it were not that ChoicePlus allows you to put a maximum of 20% into any one fund. So I get the fun of picking five funds! Thanks again for your kind and considered response.

 

Between January 2000 to November 30, 2010 the American S&P 500 index apparently went 10 years and 11 months without making a penny

Imagine the U.S and international stock market not making money for more than 10 years and global stocks crashing 51% halfway through your retirement.

 

Let's look at previous 10 years from January 1990 to January 2000.

S&P500 return per year including dividend re-investment was 17.38%. Check out the S&P 500 return calculator here

When you have returns almost twice long term average for nearly 10 years it should be of no surprise returns in future years would disappoint.

Here is another bit of interesting statistic you might not be aware of

Between 1997 to 2000 S&P 500 doubled
From 2000 to 2002 it halved
From 2002 to 2007 it doubled
From 2007 to 2009 it halved
From 2009 to present it doubled twice

Cheers,
Oracle.

 

@oracle does this mean some underperformance for S&P500 on the horizon?

 

Bill Bernstein has estimated only a 3% annual real return for US large caps going forward due to the high valuation.

 

CAPE suggests even less I think but that is skewed by some GFC data that will wash out in the near term.

 

No talking about single return figures in the SOR thread.

The return will be roughly somewhere between -50% and plus +50% in any particular year and that variability and when it occurs is what matters more than the long turn compound return rate.


Current valuation impact on sequence of return outcomes is however acceptable even encourages topic to dribble on about.

 

The 4% rule is a “rule of thumb” to try and simplify the complexity of sequence of return risk and make SORR understanding usable in real life. The rule of thumb says you can withdraw an initial 4% of your capital and index it for inflation annually and you won't run out of capital. Conversely it tells you that you need 1 / 4% = 25 X capital to be financially independent.


The 4% rule has some assumptions;
60 / 40% asset allocation.
30-year retirement horizon
Valuation unaware.

I have whacked together a “rule of thumb” model to explore some of the fixed variables in the 4% rule.

The short cut assumptions in the model produce similar outcomes to much more extensive historical back testing, but by its simplified nature can’t be as accurate as a full historical back test. However, if you consider the future may not actually resemble the past which nullifies even the most accurate historical back test then I think this simplified model is useful enough to explore the variables that are important to work out how much capital you need under different variables.



The file where you can change the variables is attached.

Please have a play and give feedback, especially any feedback where you think it is giving unrealistic outputs.

Remember it is only attempting to be a rule of thumb model – just enabling exploration of the variables that are fixed in the 4% rule.

 

...
I have whacked together a “rule of thumb” model to explore some of the fixed variables in the 4% rule.
...
I am not quite sure how your rule of thumb works, Dunno - but I like it! A lot!
Table of SWRs below is calculated using your spreadsheet, and these numbers resonate with much more complicated attempts to model SWRs (either from historical backtesting or monte carlo projection). Great stuff


I can see from your s/sheet that the secret sauce is in your Equity Adjustment Ratio. Can you offer any explanation (hand-wavy one will do) as to your thinking on the formula you have in there (where you have the equity adjustment ratio defined as being equal to 150% of the ratio of the current market level to the all time high level)?

Nice work.

 

Very interesting. I'm keen to know the thinking on the adjustment ratio too.

 

I’m experiencing senior moments here trying to find a way to save the Xcel file on my IPad so I can open it in the Xcel app.

 

Hi @PeterT and @ChrisP73

No secret sauces, it’s just a very simple calculator to mimic the output of much more complicated historical data calculations. As such it must have inherent inaccuracies – which is why you must think about the results as rule of thumb. The strength is you can easily play with the variables that effect safe withdrawal to get an idea of impact. I threw it together in relation to a question @blob2004 asked about how to know when you are at/beyond sequence of return risk. Put in your personal data and if the income produced by your capital at the SWR rate is above your desired income – you are reasonably safe unless we get something worse than historical data.

You mention monte carlo simulations – I would caution going anywhere near those calculators for SWR. Monte Carlo is no good at simulating data that is serially correlated (data with trends) Market data has trends – that is why terms like Bull and Bear market exist. Historical simulations are as good as we can get, never forgetting we may not have seen the full aray of possibilities yet in the historical data.

The calculations (and logic) that the spreadsheet uses to mimic complex historical simulations.

It is assumed that cash after tax and inflation has a zero real return – It is consumed as a 0% annuity over the life expectancy entered.

Underperformance risk of equity comes from over valuation. A “reasonable approximation” of much more complicated fair valuation series and “using just one input” for simplicity is to give the all-time high(ATH) market price a haircut. The calculator haircuts the ATH by 1/3. We then compare todays level against fair value to get an adjustment factor for equity and divide equity amount by adjustment factor.

6733.2 * 2/3 = 4582.1
6491.8/4582.1 = 1.42
Say 1,000,000 equity @ current value / 1.42 = $705,834 at fair value.

It is assumed that equity has a 4% real return @ the fair value level. (This assumption not only has the calculator mimic the complicated historical calculations best, but the rate is also supported by long term historical observation of the Equity Risk Premium) The fair value equity is consumed at 4% annuity over the life expectancy entered.

If the above hasn’t clarified the shortcuts the calculator takes let me know, I’m happy to keep trying to explain. No calculations should be relied upon unless they are understood.

Again, I stress this is for rule of thumb knowledge only. Better than making wild stabs but nothing about the future can be a certainty and this model with the shortcuts taken for simplicity is not even an accurate representation of the past. But I see people taking wild stabs at number that bear no resemblance to reality. This calculator should be better than wild stabs, perhaps its most valuable attribute is not the absolute SWR it produces but that you can play with the variables to see the quantum of changes.

I knocked it up in literally 30 Minutes without a lot of thought and am more than happy to tweak it if anybody has some suggestions.

@Nodrog has indicated to me that Ordinary Dollar – Financial Independence for Australiansis working on a SWR calculator for Australia, I have been meaning to contact him, but alas am such a lazy bugger I haven’t done it , so no idea how his project is going but am hopefully that he will come up with something that is far superior, something too watch out for – In the mean time this little model can help those interested investigate the variables that drive SWR.

 

So far I’ve arrived at one conclusion. Most times I read any posts by @dunno it confirms what I’ve always suspected. That is, that I’m dumb.

 

I want to be dumb and retire early like you. Any tips ?

Cheers,
Oracle.

 

Yeah, LUCK.