In my previous investment article, we talked about how to guard against Black Swan events. To recap, Black Swan events are things that cause the stock market to crash. They’re unpredictable, and that’s why they’re bad. Examples of this include the Brexit, the oil crash, and the Great Financial Crisis of 2008.
Black Swan events and stock market crashes are a fact of life: They can and will happen during your investing lifetime. And while you’re working and accumulating wealth, stock market crashes are easy (well, easier) to see as a buying opportunity rather than a reason to panic-sell and run away because you don’t actually need that money to fund your everyday life. In fact, that’s what the principle of Rebalancing forces you to do: treat stock market crashes as buying opportunities by telling you to sell what’s gone up (bonds) and buy what’s gone down (equities).
The problem gets even harder to deal with if you’re already retired. The idea behind retirement is that every year you sell off a piece of your (hopefully sizeable) investment portfolio and use it to fund your living expenses for the coming year. You can see where this can go badly fast.
Let’s say you have a $1M portfolio and your living expenses are 4%, or $40k. On a great year, if your portfolio goes up 15% turning your $1M into $1.15M, it’s super fun to sell! You withdraw $40k leaving $1.11M in your account and pat yourself on the back for being a genius.
But if a stock market crash happens and your portfolio goes down 15%, turning your $1M into $850k, selling is decidedly NOT super fun. Taking a withdrawal leaves you with $810k, and you are now down 19%. In fact, because you’ve sold and locked in your losses, it will be even harder to climb back up to your original $1M. Markets will need to deliver a 23.5% gain just to get you back to your break-even point.
Now, I’ve claimed before that these boom/bust cycles don’t matter over the long term. In fact, over 15-year time periods, the S&P500 has never lost money. So none of this should matter, right?
Right, but only when you’re in the accumulation phase. When you’re retired and living off your portfolio, the busts absolutely matter, and the timing is especially important.
Let’s take a simple boom/bust cycle. Say the stock market has this repeatable pattern: gain for 15% for 4 years, then crashes by -15% for 2. Why did I pick this pattern? Well for one, this works out to be about a 4% yearly return, which should theoretically support a 4% withdrawal rule (but just barely). And second, stock market crashes, while painful, tend not to last more than 2 years of continuous declines.
OK, so let’s say you’re a early retiree like us that quits work and starts withdrawing 4% of their $1M portfolio, and you happen to start your retirement just on an up cycle. What does your first 6 years looks like?
Note that all gains/losses are real, after-inflation figures, so inflation is automatically accounted for.
Not bad, not bad at all. In Scenario A where we retire in a rising market, we happily withdraw our 4% rule and watch our portfolio rampage higher, and when the crash happens our portfolio gets hammered but not quite enough to drop it below its starting point. The next expansion will therefore keep pushing our portfolio up over time and we end up with what in finance terms is known as “a fuckload of money.”
But what if we retire right at the start of the downturn rather than the start of the rally? Well them, our picture looks…not so rosy.
Uh-oh. In Scenario B, our retiree had to withdraw during 2 down markets, and as a result, he was down to a shitty $648k after 2 years! Even the subsequent multi-year bull market wasn’t enough to get him back to his starting point, so when the next crash happens he’ll get hurt even more. This causes his portfolio to grind down and down, until we’re left with this.
And remember, this is the exact same stock market! The only difference between Scenario A and Scenario B is when they decided to pull the trigger. And since nobody can tell whether they’ll be in a rising market or a falling market over the next two years, it’s basically luck of the draw as to who makes it out of retirement with their portfolio intact.
Remember the Trinity study I wrote about where I said that a 4% withdrawal rate yielded a 95% success rate for retirement? The 5% that didn’t make it failed because of this. If someone retired right as a sharp decline happened in the stock market, that investor sold at the worst possible time and their portfolio never recovered. And the worst part is that nobody knows if a bust is right around the corner.
This is what’s known as Sequence of Return risk, as is something even many early retirees don’t understand.
So what’s an early retiree to do? Well, we actually had to answer this question for ourselves when we retired at 31, and here’s how we guarded against this happening to us.
As a first line of defence, we joined every major religion and prayed really really hard that a stock market crash wasn’t around the corner. Because we didn’t know which diety would answer us, we diversified and asked them all. You can index religions too, apparently!
On the off chance that Strategy #1 didn’t work, we realized we needed to make our spending “bouncy.” Yeah, I know, it’s a term I just made up, but basically we needed to come up with a plan to reduce our spending if the stock market refused to co-operate, and that plan ironically is to travel more.
When we talk about our Nomadic lifestyle, it may seem we’re bragging about how great our life is. And don’t get us wrong, that is a big part of why we keep talking about it. But in actuality, our constant travelling is an essential part of our retirement strategy. You see, life in North America is hella expensive. To our surprise, living in Eastern Europe or Southeast Asia caused by day-to-day spending to drop by half! So by simply allocating more time to low-cost countries like Hungary, Thailand, or Vietnam, we can easily reduce our living expenses to $20,000.
We summarize this aspect of our retirement planning thusly: If shit hits the fan, we’re moving to Thailand.
Now what does this do to our unlucky retiree in Scenario B if we implement our Nomadic lifestyle?
Much better. Here, our retiree didn’t get hit as badly by the crash, getting out with $684k vs $648k, and as a result, he has more money in the market when the rebound happens. This causes him to pretty much wind up back at his initial starting position by the time the next crash happens. Here’s what his portfolio now looks like over time.
Again, much better. Over our 45 year retirement, our portfolio just kinda zig zags up and down between two points but doesn’t go much up or down over the long term. But hey, we don’t run out of money so whatever.
So that’s the effect Nomadic Living can have on your finances. Your fixed costs (i.e. a mortgage, car payments, etc.) naturally disappear, and when anything unexpected happens, you can just switch countries where the costs of living are appropriate for you. This is also why we hate houses. If something happens in our city like the cost of food goes nuts or our mortgage rates shoot higher, we have no choice but to just sit there and watch our portfolio slowly grind downwards into dust. But since we live out of a backpack, we can just shrug and hop a plane to Ecuador. The fact that living Nomadically is objectively awesome is just an added bonus.
But still, even in this scenario, our portfolio is still slightly negative, and we don’t like that. That’s why in addition to living Nomadically, we also…
Keep a Cash Cushion
Because a stock market crash tends not to last more than 2 years, the first 2-3 years of your retirement are the most critical since they determine whether you’re retiring in sunny Scenario A or doom-and-gloomy Scenario B. To hedge against this, we kept a cash cushion equal to 3 years of our living expenses outside our portfolio. This ensures that in the case that we end up in Scenario B, we can essentially wait out the storm and withdraw nothing. What does this first few years of retirement look like now?
Woo-hoo! At the end of our first 6-year cycle, using this cash cushion strategy, we are now higher than where we started! That means that going forward we can expect an upward trajectory like this.
So those are the main ways we use to guard against Sequence of Return Risk. Other things we’ve previously talked about such as Rebalancing of course help even more as they make the recoveries sharper, but that’s just showing off at this point.
So how has this actually worked out on the ground? Well, turns out it may not have been needed. We’re still glad we had it though, because in our first year of retirement the oil crash happened in late 2015, sending world markets in a dive and hammering the TSX specifically by a stunning -12%. Because we were globally diversified with lots of assets in fixed-income, we emerged break-even in 2015, but it sorta started looking like we may have hit Scenario B, retiring right as world markets were about to collapse. But then, everything just sorta worked out and as of August 2016 the S&P 500 is sitting at an all-time high. So now it’s starting to look like we’re actually in Scenario A.
Funny how things work out, but I guess that’s how our Engineering brains work. Hope for the best but plan for the worst.