In one of the previous post, we started to stress test the 4% rule with a Monte Carlo simulation offered by the portfoliovisualizer website. If you have not read that blog post, I recommend reading that one first, as we will build on those results here.
The simulation we ran at the time gave us a success rate of 81% on a 45 year time horizon. I want to show you the sensibility to the Sequence of Return risk, which we discussed here. In the tool, we will include exactly the same inputs as last time but we will assume that the we are going to have the worst 2 years in terms of returns at first (Year one starts with a bang at -42%!).
What do you think the impact will be? Let´s have a look together.
The impact is massive. Our success rate goes from 81% to 38%. Remember, the only thing that changed was that we assumed two very bad years at the beginning of our early retirement!
What is important to understand is that the average yearly (real) return is still comparable to the previous simulation (the 81% one) - so this drop is NOT related to a lower real return but just to the sequence of the returns themselves!
If you are shocked about the huge difference, well, join the club! If that should happen to anyone, I believe the key is to reduce cash flows to the bare minimum until the market recovers. Unfortunately, the tool does not offer the flexibility to simulate this - or at least I did not find the way to do it. Another option is to start the retirement with a less risky asset allocation than 100% equity. We will simulate this option as well in the future to see if it improve the overall success rate.
Now that we have discussed how devastating the Sequence of Return risk can be, let´s go back to another scenario. In this post, we mentioned how 4% SWR might be too optimistic and that 3.25% would be a safer bet. The question is, how much safer?
To find out, we just change the initial capital to 978,462 Euro - if the math is unclear, please go back to that post and you will immediately understand. The result is below.
Our success rate improves from 81% to 89% over the 45 years time period. Not bad as increase - but I was honestly hoping for more.
If you want a 95% probability of success and are not willing to compromise on the desired cash flow (assuming you keep the current asset allocation), you will need to go all the way up to approximately 1,250,000 mln Euro of initial capital. Assuming the 15 years of the original simulation, we need to save more than 5,200 Euro a month to get there!
If you want to go the other route to maintain your 95% success rate - keep your starting capital at 766,265 Euro and adjust your desired cash flows, you need to significantly tighten the belt: your monthly cash flow should drop to around 1,600 Euro / month. This implies a SWR of around 2.5%.
Bottomline here is that the Sequence of returns risk is much more impactful than what one would believe and that gaining even a few percentage points of success rate by increasing the starting capital will require you to start saving a lot more!
If you want to learn more about different topics, click on the links below:
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