One of the most important numbers in the world of FIRE (financial independence/early retirement) is known as the 4% rule.
This comes from the well known Trinity Study that found the optimal portfolio drawdown rate was 4% of the initial balance.
If you assume that inflation will be around it's historical average of 3%, then a 4% withdrawal rate means your money must grow by 7% in order to keep up with inflation and your withdrawals.
But where does that 7% come from? And is it even right?
Historical returns of the S&P 500
Before you fall asleep from reading that headline, I'll just give you the spoiler alerts up front.
The average return of the S&P 500 between 1928 and 2017 was 11.4%.
But you can't just take the average return and run with it, here's why.
Why the average stock market return is misleading
Imagine you start with $100 and invest it in the market. At the end of the year the market is up a whopping 50% so you now have $150.
The next year the market drops 50% so your $150 is now only worth $75.
In those 2 years, the average return of the market was 0% but your portfolio is actually down 25%!
Even though the year to year fluctuations can be enormous, over a long enough time horizon the returns of the market end up right around this 10-11% range.
Burt Malkiel who wrote the amazing book A Random Walk Down Wall Street has a nice chart showing the minimum, maximum, and average returns over different time horizons.
This chart is really important to understand, especially with the increase in day trading and people using Robinhood (which I love btw) where people can hold stocks for less than a day and consider themselves "investors".
If you are holding an investment for less than a year then your returns are essentially random. But if you hold for the long term, you can expect to be somewhere in that 8%-17% return range based on historical data.
Since most of us in the FIRE scene are focused on an early retirement and a very long holding period for our retirement, the 25 year return is a pretty safe estimate of what to expect for the stock market's return.
So how does 11% turn into 7%?
If the S&P 500 has a historical average of returning 11%, then why don't we just dump everything in $SPY and call it a day? Why do we bank on 7% returns instead of 11% returns?
In a word: diversification.
One of the ways to reduce risk and variance in your portfolio is to hold a variety of assets.
Someone who was 100% invested in real estate was probably living large right up until 2008 when the housing market collapsed during the recession.
And somebody who was invested 100% in gold would have made $0 between 1985 through 2002 before seeing a 8x return on their investment in the following decade.
Since different types of assets perform better in different environments, it's recommended that you diversify into a variety of different asset classes.
The typical recommendation for people in the accumulation phase of their FIRE journey is somewhere around a 90/10 to 80/20 split between stocks and bonds. Depending on how much you enjoy investing and spending your time tweaking your portfolio, you can add in additional asset classes like real estate or REITs, precious metals, and a variety of other more exotic asset classes (like affiliate websites which are like digital real estate for me).
But to keep it simple, when you're young and in your earning phase you'll be looking at a portfolio that is mostly tilted towards stocks with a minimal amount of bonds. As you get older you'll generally shift more towards bonds and hold less in the stock market.
This is because a 25 year old can afford to take a 50% draw down in 1 year because they have a lot of time to make it up. If you're 1 year away from retirement, you don't want to see your portfolio drop by 50% because it takes that much longer to make up those losses and you could go from retiring in 1 year to retiring in 20 years if you lose too much of your portfolio.
For someone who is in retirement with a higher percentage in bonds, you can't expect to achieve the 11% historical return of the S&P 500 because you might only be holding 50% of your portfolio in stocks.
If half of your portfolio is gaining 11% on average in the stock market and the other half only gaining 3% with bonds, you get an average return of 7% for your entire portfolio.
Obviously as you change the asset allocation in your portfolio and see year to year fluctuations in the total market return, you'll never hit exactly 7% but for now it's the best approximation we have and makes it easy to estimate how much you need to save for retirement.
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