Resetting expectations on the Safe Withdrawal Rate

In the previous blog post, we introduced the Safe Withdrawal Rate (SWR) and the 4% rule of thumb. This rule states that you should be able to withdraw 4% of your capital every year and still have money left after 35 years. 


I have to say that the rule made perfect sense to me - and you have seen that in our little exercise we got quite close to it. However, we have also seen how the Sequence of Returns Risk (SORR) can wipe out the capital in a much shorter timeframe. 


The gold standard I support now is shared in a blog post by earlyretirementnow that shows how a SWR of 3.25% is more likely to ensure the long term survivability of your portfolio and therefore of your cash flows. A big reason for the difference is related to the high Cyclically Adjusted Price Earning (CAPE) ratio.


Let´s break this down into pieces - the Price Earning (PE) ratio is a well known financial metric that divides the price of a share by its Earning per Share (EPS). This - in turn - is just the profit made by the company divided by the number of shares of the company itself. 


If a company delivers 1000 Euro profit and has 100 Shares, the EPS will be 10 Euro / Share. If the price of a share of the same company is 50 Euro, the PE ratio will be 5. 


The higher the number, the higher is the valuation (=price) given to the company itself. You can have companies with the same EPS but very different PE ratio - and this reflect the differences in market evaluation of different companies. 


The Cyclically Adjusted part means that instead of taking the earning of a single year, we take the avegage of the last 10 years adjusted by inflation. This "smoothens" out the ratio compared to the normal PE


Below we can see the CAPE until 2020.

From the graph it is easy to see that the peaks are correlated with some of the most important market crashes in history (1929, 1987 and 2000). In general, as demonstrated by earlyretirementnow, there is an inverse relationship between CAPE and stock returns in the following years. 


This can be intuitively understood as follows: a high CAPE means that every Euro of (adjusted) earning is priced very high by the market, leaving more room for the price to go down in the future than to go up. 


For these reasons (and more) it is safer to go for a lower withdrawal rate than 4%, especially at the beginning. If we then recalculate the required capital using our model and a SWR of 3.25% (e.g. lowering the expected return on investment from 6% to 5.1%), we get to 978,462 Euro (vs 766,265 Euro). To build this amount in 15 years and starting from zero, we need consequently to raise the monthly investment to 3,900 Euro (vs 2,850 Euro).


This is quite ambitious (also the previous one to be honest) - so either I should prolongue the time horizon or lower the desired cash flow.

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