Most of the younger folk reading this will go WTF? Bear markets are the investor’s best friend. You get more for your money. The trouble is, that a human life is not infinite. It is short, and a working human life is shorter still, unless you have a trust fund working for you until your 20s.
The human financial life cycle – buyer at the start
There is a human financial life cycle2, and that life cycle has two big events in it where you make a big financial decision at a time which is more a function of when you were born than any financial considerations. In the first case, you are a forced buyer. In the second, you are a forced seller.
The first one I got very, very wrong, and that is the time you buy your first house, should you be earning enough to do so. Buy at a bull market high with a mortgage, and it will take you decades to recover from that error. Although it’s true that you don’t have to buy a house at any specific age, the human lifecycle is such that that becomes more of a consideration in your thirties, and it tends to be more of a consideration when breeding. The latter you need to make happen in a space of about 10 to 20 years, and you’re probably too skint or haven’t met the Right One in your early twenties, so this window is more like 10 years in practice. Unlike the financial markets, cycles in the housing market are long and slow, and you take this decision with little experience of market cycles. And you do it with leverage.
The upside is that you take this decision early in your working life, so there is enough time to recover from errors, though if you get it very wrong it will cramp your style for a long time. Leverage is lovely when the asset you purchase rises in value over time, and it is frightful when it goes down over time. Most of the time housing goes up over time, which is why 90% of Britons regard residential property bought with a mortgage as a money tree3. But if you take a negative equity suckout early in your career you’ll be paying off a long time.
The second decision you take when you are out of ammo, and you become a forced seller, every year. It’s called retirement, and while on average a 4% ‘safe withdrawal rate’ SWR is considered acceptable (it used to be 5% a few years ago) you’re still a forced seller.
And a seller in retirement – an early bear market hurts your SWR
The early retiree, and particularly the extreme early retiree, has a tough balance to strike. What most people want to run their life is a steady income, preferably matching inflation or earnings growth, whichever is the greater4. Sure, in an ideal world you’d want to have as much as possible, but when wrangling the art of the possible, something that looked like their income when working would be nice.
Living off a capital sum and unreliable investment income is really, really hard. It leads to suboptimal outcomes, too. I will be glad when I have a base income that is defined. There’s then a clear answer to ‘how much can I spend in a year’. In the years of living off savings and investment income, the answer to ‘how much can I spend in a year’ was always ‘as little as possible’ and now in hindsight there’s a case to be made that I spent too little over the last eight years. Now that’s easy to say looking at an ISA bloated by ten years of a bull market. It could have been different, and I could have needed the money I didn’t spend had things gone differently. Most of the win I had was in the fact of not working for The Man, the stress of weaving a way through the financial jungle is far less than the stress of working was at the end.
But I never considered taking the CETV of my DB pension. Younger readers probably tap their heads and think that crazy. But I have had enough of living from an unstable income. It’s just not how I want to live. The Irrelevant Investor’s article shows the problem. If you set your income at 4% of marked-to-market investment income at the start, then a bear market at the start of your retirement will kill off your capital in 20 years.
You can fix that easily. Stick with the 4% rule and spend 4% of your capital as marked to market at the beginning of the year. Simples
Our retiree didn’t get anything like 40k that his SWR promised him most of the time, and suffered 2:1 swings in income. “Can we go on holiday next year? God knows…”. Had the bear market happened at the end, then of course he’s been living high on the hog, ending up with a lot of money.
You can theorise all you like, but you have to live a particular sequence of returns trajectory rather than the Monte Carlo average. Sure, you can pool resources with other people to reduce the swings a bit. That’s called buying an annuity. It’s what you had to do until as recently as 2014, but when most people look at how much they have to pay for an annuity they run away in the opposite direction. Heck, even where people already have an annuity in the form of a defined benefit pension (which is annuity in all but name) and someone dangles a CETV in front of them to buy them out of getting that annuity many of them take the money and run.
There aren’t any good answers to this problem. There’s an argument that I have made the other mistake – fearful of the hazard of ever having to go back to work, I ended up with an ISA that is worth five times my gross salary at the high-water mark of my career, about to draw a pension that meets my needs and most of my wants. There is a case to be made that I underspent in the last seven years.
And yet it could have turned out differently. Because I started in the teeth of the financial crash, more than half of that capital came from investment rather than from savings. That investment gain might not have come. The market could have gone lower. That is the conundrum of trying to live off investment returns. There are a number of paths through the maze, as things like firecalc can show you. But you don’t know which track the hand of Fate has allotted you until you look at the path you lived, and there is much variation in the particular sequence of returns you can live through. In the early years I believed I would run out of money within five years, reaching 2017 with no fuel in the tank.
I was lucky. That early bear market never happened, and so I reached the finish line with more than I started with. It now makes sense to draw my main pension a little early, and to shift the profile of the ISA towards income, so that I smooth my income until I get my state pension.
I will give up some total return doing that, but in return I get peace of mind. I learned many things across the interregnum between taking my last pay packet and getting my first pension pay. One of those is that I am not a good judge of sell calls. Although the largest holding I have is VWRL which probably is my largest dividend paid per year, I have shifted recent purchases towards higher yielding investment trusts and of course the original HYP is still working. I should be able to make my income aim out of the ISA with the top up from my PCLS over a couple of years, while still nto having to sell.
Sure, if I wanted to optimise income, I wouldn’t start from here, particularly with all the VWRL which is a lousy dividend payer at 2%. I was led off the HYP path by the siren song of the passive investing shibboleth. But I can get what I want by a shift back towards income with future purchases. Without having to sell anything. I don’t want to shoot for the moon now. I want an easy life, and get an income uplift without making investment decisions.
- a long time because the real return of the market is piss poor on average, 3-5% in real terms I would guess. That means you need 100k of capital to get 4-5k of annual income ↩
- This should be prefixed “in the developed Western world” – and perhaps even more qualified “In pre-Brexit Britain”. Other European countries are more rent-friendly or have multigenerational living, and in Britain itself there have been higher levels of homeownership and more stable employment patterns, both of which are changing as a result of globalisation. ↩
- It always puzzles me why people don’t ask themselves what ground that money tree grows in. It is the hopes and dreams of their children trying to buy their houses 20 years down the line, because the parents pay politicians to water their house price money tree with tax breaks and credit pumped into the residential housing market. After perhaps too many drinks I greatly offended some berk at a party once who was mithering on about how it was so unfair that his kids couldn’t buy a house nowadays, after talking about how he’d done so well with property that he was thinking of getting into BTL. You couldn’t make it up… ↩
- Matching inflation keeps your absolute standard of living stable, but humans generally compare themselves with other humans, and if the others are working and earnings increase above inflation then workers will be able to buy the latest iPhone when you can’t, because they will be able to pay more. ↩