In the previous chapter, we learned how increasing your rate of investment return would help you create more passive income.
We looked at building a nest egg with assets that gave us a few different rates of return:
- A) A bank CD at 2% interest per year
- B) Bonds that earn approximately 5% per year
- C) Stocks that earn approximately 10% per year
In other words, if you had $1,000,000, these assets could theoretically passively generate the following levels of income for you each year:
- A) Bank CD: $1,000,000 x 0.02 = $20,000
- B) Bonds: $1,000,000 x 0.05 = $50,000
- C) Stocks: $1,000,000 x 0.10 = $100,000
While that might seem pretty obvious, one thing that people often forget is that a higher rate of return could also mean that we might not need as big of a nest egg.
Think back to our Retirement Equation from Chapter 1. If I wanted to create $50,000 per year of passive income, for example, that I could use to cover my living expenses, then using each of the rates above, all I would need to do is save up the following:
- A) Bank CD: $50,000 / 0.02 = $2,500,000
- B) Bonds: $50,000 / 0.05 = $1,000,000
- C) Stocks: $50,000 / 0.10 = $500,000
Now, let me ask you: Which one would you rather save up?
If you’re like me, I’d much rather go the easy route and only save up $500,000 as opposed to $2.5 million!
As you can see, the withdrawal rate you choose can inversely amplify the size of the nest egg you need to save up. The larger the rate, the less money you’re going to need to save.
For this simple example, our earnings rate = withdrawal rate.
But is it always? …
Danger: Average Returns are Not the Same as Guaranteed Returns!
There’s a very good reason I used the example above to make a point and lead you astray …
… nearly everyone makes that mistake when they first get into retirement planning!
(Even yours truly made this rookie mistake.)
What’s more scary is that up until the 1990’s, financial professionals, the people from that $49 billion dollar industry you paid to help you with your retirement planning, believed this to be true and were unknowingly ill-advising their clients.
They would look at:
- The investments you had.
- Approximate your average rate of return.
- Determine how many years you’d need your portfolio to last (basically, estimate how long you were going to live).
… and then use these figures to make your plan.
Think of it like the opposite of a mortgage. For example, you might have:
- A nest egg of $1,000,000
- Be earning an average of 6% per year
- Expect to be retired for 30 years
In this circumstance, your pre-1990’s advisor would have incorrectly recommended that you could withdraw 6% of your portfolio. In fact, they might have gone so far as to recommend that you could take out as much as $72,649 per year (a withdrawal rate as high as 7.3%).
But as you’ll soon find out, that would have likely been a HUGE mistake. And here’s why.
The Difference Between Average Returns and Guaranteed Returns
A “guaranteed return” is exactly what it sounds like: No matter what, you’ll get paid exactly the amount you were quoted for your investment.
The classic example is a bank CD (certificate of deposit). When you invest in a bank CD, the bank pays you a pre-determined interest rate in exchange for you not using that money. It’s as simple as that.
(Believe it or not, in the 1980’s and even the 1990’s, it wasn’t that uncommon to find banks offering CD’s with rates as high as 10%. Could you imagine locking into one of those rates today?)
An “average return”, on the other hand, means that the rate reported was merely an average of the rates that were experienced. (To get technical, it’s the geometric average.)
Stocks are a very good example where it’s appropriate to report their “average return”. Each day, stock prices fluctuate up and down. But at the end of the day (like you hear on the evening news), they often state something to the effect of “stocks were up by 1% today”. For the common person, it’s not exactly newsworthy to report each and every value that they fluctuated between.
The same is true on an annual basis. It’s more useful to say that “stocks went up by an average of 10% this year” then to report which values they fluctuated between.
But therein lies the problem: Those market fluctuations are by no means trivial! The exact order and magnitude that your investments went up and down can have a dramatic effect on your nest egg as you withdraw money for your retirement nest egg.
This is a very real phenomenon known as “sequence of returns” risk.