Imagine retiring early and living comfortably for decades without running out of money. Sounds like a dream, right? Well, today we're gonna demystify the secrets of smart retirement planning that go far beyond the commonly touted 4% rule. Whether you're aiming for early retirement or just wanna secure a worry-free future, these strategies will help you navigate the complexities of safe withdrawal rates and market risks.

I'm Chris Hutchins, and today I'm joined by Karsten from Early Retirement Now. And big favor before we jump in is to give us a quick thumbs up to help others find this channel. And if you're new here and you wanna keep upgrading your life, money, and travel, consider subscribing.

You say that people can't afford not to retire early. Is that message really for everyone? Hopefully not for everybody, right? You want some really productive people to keep working forever, right? You want the Warren Buffetts and I mean, Charlie Munger, I think he was over 90 and still working when he passed away.

So we need those people too. So, but for, yeah, for most folks, I think early retirement is a great concept and it is attainable and achievable. And so that's why that's by my little byline there on my blog that you should recognize that you have this opportunity cost like going to the office every day, you miss so much in terms of family time.

And at some point you accumulate enough assets, then the opportunity cost goes the other way around from what we normally learn it in economics, right? Opportunity cost means you want to do fun stuff. You have the missed opportunity cost of your salary. If you have a lot of money, I think it's the other way around.

Keep going to work and getting more promotions and bigger gadgets, bigger houses, bigger cars. At some point, the opportunity cost goes the other way around, right? You miss out on life. But that's where this idea comes from. You can't afford not to retire early. At some point, you should consider this opportunity cost and spend more time with loved ones, travel more, have more relaxed time.

- A lot of the criticisms of the financial independence movement have kind of said, you know, that's great, but only if you have a high salary and only if you can do all these things. So do you think it's really attainable for the average employee in a company? - Obviously, if you look at what would be the ideal setting for somebody to achieve FIRE, right, it would be a married couple, no kids, very high salaries, professional salaries, say doctors, lawyers, engineers, finance professionals, accountants, live in a low-cost area and have no student loan debt.

So that would be the ideal setting. I think those people should probably make it very easily. And somebody who would have a very challenging time would be single, income family, lots of kids, high cost of living area. So they would find it more challenging. But nobody's always at the extremes, right?

So for example, my personal example is, yeah, I was in a very high-paying industry and a very high-paying job in finance. I had little to no student loan debt, so that was good. But we had a single family, so we had a single-income family, so my wife didn't work once we had our daughter, and we lived in a high-cost of living area.

So we checked off some of the boxes and we didn't check off some of the other boxes. I think even if you are somewhere in between, between the ideal and the not-so-ideal extreme, you can still make it. I mean, I did it, and there are lots of people who achieved FIRE and FIRE without ever earning six figures.

And I mean, if they can make it, it's a lot more attainable. And I think, yeah, I understand there are some challenges, but I think also a lot of the criticism of FIRE and FIRE is it's a little bit of coping, right? It's easier to make excuses than to get your act together and do it, right?

Because that's going to be a long path, right? It's going to be a 10 to 15-year path to get your finances in order and accumulate enough. And it's very easy to just fall back and say, "Well, only the very rich people can do it," and I throw up my hands and I'm not going to do it, so.

- I'm not going to walk through the process for that. I've done an episode on financial independence. We'll put it in the show notes. But when you talk to most people about how to think about this, the most common rule or rule of thumb is the 4% rule, which is like, how do you know if you can do this?

And it's that, oh, well, if you have enough assets that you can live off 4%, you're all set. What do you think people get wrong if they rely on something so simple? - So I think a 4% rule is a good guideline. If you are starting out and say you have zero assets and you're starting on this path and you think maybe 10, 15, 20 years down the road, you are going to need, say, $80,000 a year to live comfortably, yeah, and then you can say it's times 25, which is the equivalent of the 4% rule, right?

One divided by 25 is 0.04, is 4%. That's where that comes from. So this rule of 25X, so if you have $2 million, you should be able to roughly retire at that time. It's obviously just the rule of thumb, right? So this should not be generalized, right? We should not all wear the same shoe size and it's gonna be too tight for some and too big for others.

And the reason why this 4% rule has gotten such fame is obviously it's a round number, right? And the actual results, if you look at some of the extreme cases that you could have, say somebody who is really young, who has a much longer horizon, yeah, you probably have to go down to something like 3%, right?

And somebody who is really close to social security, right, who maybe only has to bridge a little bit of time until they have some other cash flows coming in, you could maybe go to 5%, right? So then people say, well, you know, this big range of 3% to 5%, 4% is right in the middle.

It's a nice round number. And then the 3% and the 5%, hey, it's just a percent difference, right? What is it really? So 4% seems to be this nice, precise, and round number. Of course, the problem with that is the range from 3% to 5% is not a 2% difference, right?

To go from, say, a $60,000 a year budget to $100,000 a year budget, say on a $2 million nest egg, that's not a 2% difference, right? To go from 60% to 100%, that's a 66% difference. So this is a really wide range, right? So if somebody says, yeah, it's 4%, but it could be anywhere between 3% and 5%, that's like saying the weather forecast, it could be anywhere between freezing and heatwave tomorrow, and that's obviously true, but it's really a useless forecast in terms of doing actually something concrete.

So my point is that the 4% rule, my problem is not so much with the 4% number, but it's about the word rule, right? It shouldn't be a rule, it's a rule of thumb. Your actual number should be more custom-fitted, and it should be custom-fitted, taking into account your personal parameters, your age, whether you would like to leave a bequest, whether you would like to make major contributions.

Say, if you have kids, do you want to help them with down payment in college later in life? Do you want them to also start from scratch, or do you want to help them a little bit, right? Whether you have supplemental cash flows later in retirement, whether you, when and how much social security you expect, do you have any kind of government pension, military pension, corporate pension that kicks in later?

So all of that could make really huge differences in your calculations, right? And so this is why you get this wide window. I have done safe withdrawal case studies for people, and they can range anywhere from somewhere in the 3% range to all the way to 6-plus percent, and that is such a wide range, tells you that you should take your personal parameters in account.

And the other thing you have to take into account is also where are asset markets today, right? If you're retiring at the bottom of a recession and a bear market, you can probably be a little bit more aggressive because, well, if the market is already down 30%, 40%, the probability that we tag on another Great Depression or global financial crisis on top of what we already dropped is very unlikely.

So you can probably factor in that you don't need to go by the historical worst-case scenarios, which would normally traditionally get you to that 4%. Well, then, yes, absolutely, you can also do a 6% rule or even more than 6%. So depending on where you are in the market cycle, you should also adjust that.

And so just taking one number and running with that, that seems really inappropriate, and that's really my little niche on my blog where I look into what can we learn and what can we put into our safe withdrawal analysis that factors in some of these idiosyncratic personal parameters, and then also looking at what the market tells us, how much we can withdraw at any point.

- So we'll link to the whole series because I don't actually know if you know how many words it is, but 60-plus posts, you know, it's basically a book at this point, if not multiple. - Right, right, right. - We won't cover it all, but I wanna double-click a little bit.

It sounds like what I heard you say might be one, 3%, if anything, is probably a really safe number, but very conservative for lots of people. When you start to try to dial in what this is, how much does longevity matter? Was the 4% rule designed to last for 100 years, or is it much more timeframe-sensitive?

- So the 4% rule, the original papers, they had a 30-year retirement horizon, and then what people did was, well, so the initial 4% rule, a success would have been if you run out of money after exactly 30 years, or you're running on fumes towards the end, and you have basically one cent left after 30 years, that would have been called a success, right?

So we can already see what kind of problems that creates if we extrapolate and make this a longer horizon. So if we take longer horizons, we probably have to withdraw a little bit less. Now, some people who are not very good at math, they would say, well, if you have a 60-year horizon, does that mean you cannot do only 2%?

And fortunately, that's not the case, right? You can do much, much more than 2%. So it's probably somewhere in the range. You go from 4% to maybe 3.25%, right? So basically, the just very basic safe withdrawal analysis is something that I could take a 60/40 portfolio, a 75/25 portfolio, and look at how you would have fared during the Great Depression.

Yeah, the good news is it would have lasted for 60 years if you go down into the maybe the low 3%. It's much better than 4% divided by two, but it is definitely much less. And I thought, and this was actually one of the reasons that enticed me to write my series.

I saw that there was a lot of misinformation out there in the FIRE community where people said, oh yeah, I mean, most of the time you last for 30 years, and most of the historical cohorts actually ended up with more money than they started with. And well, if you still have the same amount of money after 30 years, you just tag on another 30 years, and boom, 4% rule can be extrapolated indefinitely.

But yeah, I mean, the problem is that, I mean, this is obviously something of an amortization exercise, right? And if you expand the horizon, then obviously something happens to the payment, right? The question is, is there really a big impact or a small impact? And it's obviously much more optimistic than just having to half your payout if you double the horizon, but it is a noticeable impact if you go from 30 years to 40 years to 50 years to 60 years.

And again, it may not quite show up in terms of the percentage of that going from 4% to 3.2%. And again, this is not a 0.8% decrease in your budget, it's a 20% decrease in your budget. So it's better than a 50% drop, but it is a noticeable drop, right?

And this drop, you can track it. If you go from 30 to 40 to 50 to 60, you go from four to go and fill in basically the steps in between. So there is an impact of longevity. And it's important enough that we really should take it into account.

You can't just say, well, it works over 30 years. I crossed my fingers, it also works over 60 years. That would be really financial malpractice doing that. - And you've done a lot of testing with this. Are you testing kind of more historical data or are you also testing kind of modeled out Monte Carlo future simulations?

- So I've done both. On my blog, it's mostly historical simulations and I've justified that in my blog. I also like Monte Carlo in some way because now you can say we can run more simulations. Obviously, the problem with Monte Carlo is there's always a bit of a garbage in, garbage out proposition.

Of course, as I said, there's this hybrid method where you basically do the, you draw returns from the actual history, but then not just month by month, but really blocks of data. So you can solve some of the problems there. But I personally prefer to just use historical data.

- How can the average person who doesn't have that expertise start to model out what a reasonable number is for them? - So first of all, you don't need to understand all the underlying details. That's why I did the hard work. So people don't have to, right? So it's like if I'm sitting in an airplane, I don't have to understand all the mechanics that keeps that airplane afloat.

There's some people that thought about that for me and I just enjoy the ride. And it's almost as simple as that for people who want to plan their retirement. And again, as I said before, you have to do this as a personalized exercise, right? Because everybody's parameters are different.

So on my blog, I have a Google sheet. So I have a blog post and in the blog post, I go through basically as a manual how I would use my retirement simulation tool. And basically what you can do is you can put in your own parameters, your portfolio allocation, and then you can calculate, well, how would your personal retirement have fared in all the possible historical retirement cohorts since the 1870s?

If you think that everything before, say the 1920s, that is so outdated and you can obviously ignore that and only look at what would have been the results, say post Great Depression. And so anyway, so you can then do your personalized retirement analysis with your personal parameters. What is your retirement horizon?

What kind of future cash flows do you expect? What kind of cash flows are they? Are they inflation adjusted, right? Is it something like social security where you get a certain amount at a certain time and then that also goes up with inflation? It could be something like supplemental cash flows like many corporate pensions are not inflation adjusted.

So that would be some amount, but then that would be eaten away over time by inflation. So there would be ways to model that. You can hack your retirement and your retirement planning tool, probably in a way that no financial planner or no other free tool that you can find on the web would be able to do.

And so you can do this and then you can do it multiple different ways. You can check what would be the one level payout over my entire retirement horizon that would have still survived the entire horizon. And then by the way, surviving means you can specify that too, right?

So you can specify, are you okay with depleting your money versus having X percent left of your nest egg at the end? So imagine you have a big quest motive and you want to leave certain percentage of your nest egg to your kids or to charity. A lot of my blog posts were taken straight out of this tool.

And I mean, so some very serious, very serious retirement planning research came out of just using that tool. But I mean, it is really usable for just regular retail investors. And it might seem a little bit intimidating when you first look at it. But yeah, I mean, I have my, I think it's part 28 of my series where I go through what all the different features are.

And then there's two buddies of mine, they run a podcast, Two Sides of Fi. I think they have done two or so videos on how they would use it. And I think it's something like 30 minutes each. And if you just watch these videos, so you're pretty much off and ready to go and you can probably use 99% of all the features of that free tool.

- It is free, so anyone can go get it. And it's been really interesting to see a lot of the nuance of, here's what a reasonable withdrawal rate would be and at different confidence intervals. But one of the things you said earlier was it really matters when in the market's current situation you are.

And you've talked a lot about the sequence of return risk, which maybe you could explain a little bit and talk about how to even figure out where you're at and how that should affect your plan. - So sequence of return risk means that if you are a retiree and you are taking money out of your portfolio, you face some different challenges from say a buy and hold investor, right?

So imagine you're a buy and hold investor, you put your money in the stock market today and then in 30 years, you finally open that letter from Fidelity or Vanguard and you see what's in there. And it doesn't really matter how the market performed along the way. The only thing that matters is your average return over those 30 years, right?

So that determines uniquely what the final outcome would be, right? So imagine you had something like a 10% average return between now and the end point. And it doesn't matter if you had poor returns first and then very good returns later on or vice versa. And that's true for buy and hold investors, but it's not so much true for people who are either taking money out of the portfolio or putting money into the portfolio.

That's actually the flip side of this. And I've written about this in parts 14 and 15 of the series where I drill into the intuition and the mechanics of what a sequence of return risk is. And so it turns out that for retirees, it's not so much important what the average return is over your 30-year retirement horizon.

In fact, I have one chart somewhere floating around on my blog where I showed what, well, what were the failures of the 4% rule? What explains the failure of the 4% rule? And I can get you some example where the 4% rule failed, even though the buy and hold return from beginning to the end of the retirement, something like, I think, from 1968 to 1998, I think a 75% stock, 25% bond portfolio would have had a return of somewhere around in the high 5% or even low 6% in real terms, inflation adjusted.

Yet the 4% rule still failed. And the reason for that is if you have very poor returns early on and you withdraw money along the way on the bottom of the market, or even close to the bottom of the market, you are taking so much money out of the portfolio in terms of number of shares that you sell, that even if the market then recovers subsequently, you have compromised your portfolio so badly that even with a subsequent recovery, your portfolio still runs out.

So it's essentially, it's the opposite of dollar cost averaging. Because we're all familiar with dollar cost averaging and we tell people, "Oh, yeah, you don't have to be afraid if the market goes down and you put money in." Because the nice thing is if the market goes down, you're buying more shares.

And then if the market subsequently recovers, then those additional shares are going to look even better in your portfolio, right? Because you don't buy by the number of shares, but by the money that you put in, right? And you're buying more shares if the market is low. And people are amazed.

So this is obviously a feature during your accumulation period. And everybody is, once they find out about this and they think, "Oh, this is the best ever." Problem is this exact same feature hurts you if you're in retirement. Because now if the market is down, you are selling more shares of your portfolio because prices are down.

And so this is the flip side of dollar cost averaging. And that could actually wipe you out, even though the returns over the entire 30-year return history wasn't even so bad or it might've been really good even. So in fact, none of the failures of the 4% rule are because the average return was so low.

Every single failure of the 4% rule, you had returns that on average would have been enough to sustain a 4% rule, but it's because of the sequence of return that you had very bad returns early on. And then the subsequent recovery was too late. You had already depleted your portfolio so badly that there was no hope at that point.

So that's what sequence of return means. It's exactly what the name says. It matters in which sequence the good and bad returns come in. - So for example, in the $2 million nest egg that 4% would say, "Oh, I can take $80,000 a year out." If the first year you retire, the market's down 35% and you start taking 80,000 out, you're actually taking out more than 6% of your portfolio.

And if you do that three, four years in a row while the market's down, even if the market recovers, it's gonna make it really tough to get back there. - Exactly, exactly, yeah. - And so what should we do about that? 'Cause obviously we can't predict the future. Are there ways to know where we're at now and whether that should affect, are we likely to be there in the future or ways to react?

- So short of becoming a market timer and either knowing or predicting when the market drops, there's relatively little we can do about it. So the reason why I've written so much about safe withdrawal rates is that there is no easy solution, right? And some of the blog posts I wrote would be, "Well, somebody pointed out to me, "well, can't we just do such and such?

"And would that solve sequence of return risk?" And a lot of the proposed solutions are actually not really valid. So people have said, "Well, couldn't we just do something like, "well, we set up a portfolio "that has a dividend yield of 4%, right? "Boom, we're done. "We never dig into the principle "'cause the dividends are now so high "that they pay out the 4% "and we never even have to sell shares when they're down.

"So boom, there we solve our sequence of return risk." Well, the problem with that is, well, first of all, dividends can be cut, right? So, and they have been. Dividends, even if they are not cut, they could be depleted away by inflation. So if you look at, say, even S&P 500, you look at the dividend income of one representative share in the S&P 500.

Yeah, it had some, it grew a lot, the dividend income, but it also had some very nasty drawdowns. And then during those drawdowns, either you consume less or then you do have to dig into your principle to make up the difference. And then by the way, the S&P 500 hasn't yielded 4% for a long time.

So you have to supplement your S&P 500 portfolio with a lot of other stuff that is very high yielding and potentially very risky, something like high yield bonds or preferred shares. So I checked that one out. And so that doesn't really work. At least it doesn't work reliably. So the one thing that I propose that maybe doesn't solve sequence of return risk, but at least it takes a little bit the edge off is that when you retire, you're a little bit more cautious with your stock bond allocation.

So instead of being 75% or 80% stocks, maybe you start out at 60% stocks, 40% bonds. You know, the good old 60/40, right? This might not be a bad starting point, especially today, right? Because we are recording this in early July. So 10-year bonds are again in the mid 4% in their yields.

I haven't checked it this morning, but it was something like 4.48. - I just pulled it up. - Yeah, so right in the mid fours. And it's not a bad yield for a relatively safe investment. And so you start a little bit more on the cautious side, but remember, we also have a very long retirement horizon, right?

And even at that 4.5%, after you take out inflation, maybe 2% to 2.5%, a bond itself has a little bit of a lean real return of maybe 2% to 2.25% right now. So you need equities obviously in the long run. And the way you do that is while you start very cautiously, but then you shift into higher equities later in retirement.

So that's called a reverse glide path, right? Because we know the glide path is the glide path into retirement where you go from high equities, low bonds, into more bonds and less equity. And quite amazingly, this reverse glide path where in retirement you shift out of bonds and back into equities, it actually helps you at least very partially with the sequence of return.

So for example, I've had some case studies where maybe over a long horizon, you had something like a 3.4% safe withdrawal rate with a 75/25 portfolio. You can maybe raise it from 3.4% to 3.6%. Again, you don't go all the way from 3.4% to 4%, but at least you cover maybe a third of the distance to go back to 4% with this reverse glide path.

And so I'm not the inventor of this, but I've definitely done a lot of research on that. So it's a guy called Michael Kitsis has proposed this weight file, who is a very big name in the retirement planning community. So they have written about this extensively. I have written about this.

So that is actually one route that you can do to maybe not solve sequence of returns, but you can alleviate a little bit because, well, you take off what... Because your retirement success so much depends on the first five to 10 years of returns early in your retirement. Maybe you take a little bit less risk early on, but then you shift into higher risk assets again later in retirement.

So that seems to work. Not much else really works. There are some other proposals where you follow something like a market timing strategy. You do some kind of a momentum trend following strategy. I haven't published anything on that, but I think that's gonna be my next blog post where I look into that.

That's probably gonna be part 62. It solves some of the problems, but it also creates some other issues. So it's like squeezing a balloon almost, right? So you fix this problem, but then the balloon blows up on the other edge. And there were a few cases where a sequence of return risk wasn't that big of a problem, but then using that momentum strategy, suddenly it became a problem in that episode.

But I mean, this is something that people have proposed. I am a little bit skeptical that this momentum and trend following is gonna work reliably. Again, I want to point it out. Yeah, but I mean, apart from that, I mean, the only thing you can really do is be more cautious with your withdrawal rate, right?

Take a withdrawal rate that in the beginning might be a little bit leaner. And then obviously chances are you did not retire at the worst possible time, and then you would eventually walk up your retirement withdrawals. And by the way, this is what we do in many other aspects of life too, right?

I mean, when I fly somewhere and I go to the airport, I plan my departure time at home when I go to the airport to set the probability of missing the plane to 0%, right? I mean, there's nothing I can do about missed connections. If you fly through Chicago in the winter or Atlanta in the summer, you might miss a connection because of thunderstorms or snowstorms.

But at least the part that is in my control, right, I have this asymmetric risk profile wasting some time at the airport. Yeah, okay, I can deal with that. Missing a plane and missing a vacation, missing a cruise, missing a birthday, missing a wedding, missing a funeral, that would be a very one-sided risk.

And I view it the same in retirement, right? I probably over-accumulated assets and I could have in hindsight retired a little bit earlier, but I think the risk is asymmetric and I would rather accumulate a little bit more and retire a little bit later, but then retire in comfort and without worry that I run out of money.

And so, yeah, I mean, the best way to deal with sequence of return risk is to simply be a little bit more cautious on your withdrawal rate in the beginning. - Now, you mentioned that in the first five to 10 years are kind of the most important when it comes to sequence of returns.

If you had a strategy where you said, "Hey, I wanna retire when I'm," let's pick an age, 45, 50, it doesn't matter. And you said, "But if when I decide I'm gonna retire, "I'm willing to say this is a bad time, "the market's not great, "I could work a little extra in those first five years." Could that level of flexibility give you the ability to actually retire a little earlier knowing that if something happened in those first few five, 10 years, you could change?

- Basically, we're talking about flexibility, right? Can't I just be flexible and either consume less or work a little bit more? And I say, yes, absolutely you can and you should be, but make sure that maybe you model that too, right? And the way you can model that in my tool is, well, yeah, maybe for the first five years, you still model something like a side gig, and then you can see how much of a difference does that make in my safe withdrawal analysis.

I mean, there's some people who say, "Yeah, if you are just more flexible, "you could raise your safe withdrawal rate "to 5.5% from 4%." And I say, "Well, are you sure you wanna do that?" Because if you look at what your rule, what your "flexibility rule" would have created is, yeah, in the beginning, you withdraw 5.5%, and then something bad happens in the market, and then you go down to something like 2.75.

You have to cut your spending by half and say, "Well, you only do the necessary stuff and everything else. "Either you don't spend "or you have to supplement with a job." And then the problem is people misunderstand that this spending cut or the side gig has to last for only as long as the bear market lasts, but it doesn't, right?

Because your portfolio might be taken down so badly, even now we are back in a bull market, but your portfolio is still in a bear market, unfortunately, and it's still underwater. So this flexibility might last longer than you are comfortable with, right? So what I always call this is, again, you take one failure and you replace it with another failure, right?

The failure of the 4% rule is, well, you run out of money after 27 years, and you almost create a worse failure by now all the pain starts very early on, and you have to go back to work, you have to cut your expenses, right? You are young and you have all of this drive, and now I want to travel, and I want to do this and that, and I want to volunteer more.

And now you have to put this on ice again, and I have to put this on hold again. And so I think that would be a failure of sorts too. It wouldn't be quite as dramatic as running out of money at age 81, but it would still be impactful for a lot of people, it would be impactful for me.

So, and again, I would say that if you have this flexibility, sure, model that flexibility and maybe stretch the flexibility for as long as you're comfortable. And if you say, you know, I could work on the side, I could do some consulting, maybe two or three years, but after two or three years, it really gets old, and then I want to go back into retirement.

So what difference would this two to three years really make in my safe withdrawal analysis? And what I found is it's, yeah, it makes a difference, but it's not a huge difference, right? So be careful about it, because if some people say, oh, you have to be flexible, and then you can raise your safe withdrawal rate from 4% to 5.5.

First of all, it wasn't 4% to begin with, right? So even over a 30 year, I think it's something like 3.8, because they were at the 4% rate, there were a few failures. So if you want to make it a 0%, it's maybe 3.8. So you can't just take it from 3.8 to 5.5 and expect that the flexibility is going to be completely painless.

It's actually the flexibility potentially would be quite impactful. And I wouldn't say it would ruin your retirement, but it would come close to ruining your retirement, because the flexibility, the length of the spending cuts and/or side gigs that you have to do in retirement, and the depth might be so painful that it might not be very palatable.

The other problem is, obviously, right? I mean, if you look at, well, when were these times when you needed to go back to work in the past? It would have been, say, you have a labor market like in 1932, when you had 25% unemployment rate, or I think even in the '80s, we had double-digit unemployment.

So it's usually not the best time to go look for a site. Maybe it's easier for some people than others. But yeah, so it's this whole flexibility solution to a sequence of returners. It raises more problems than it really answers, in my view. - I never thought about the fact that looking for extra work when the market is down 40% is probably not an ideal time, but is there any way, without predicting the future, that we could adjust our withdrawal rate based on current market conditions, whether we feel like it's over- or under-priced?

- This is also something I found somewhere on the web, where people look at the Shiller-Kape ratio. So Kape ratio stands for a cyclically-adjusted price-earnings ratio. So if we are stock investors, we probably heard about a price-earnings ratio, right? Our problem is, if you look at the, just the price-earnings ratio, and you can do this with backward-looking earnings or forward-looking earnings forecasts, the price-earnings ratio is not really the best indicator for future returns.

And that's just because sometimes the market gets a little bit ahead of itself and then keeps going up. And then, so some of the best returns happened when the price-earnings ratio was actually quite unattractive and vice versa. And so what Shiller proposed is that, so we take a longer-term view of, we look at the last 10 years of earnings of the S&P 500, and then we also do inflation adjustment, right?

Because these are usually nominal numbers. And then we look at today's index over this average earnings over the last 10 years. And the reason for that is, sometimes the market fluctuates, but at least on the earnings side, we take longer-term averages, because, well, sometimes during recessions, earnings temporarily could actually become negative, right?

Because then what is a price-earnings ratio if earnings were negative, right? That's not that meaningful. But if we take 10-year averages, at least we know that this is a little bit more stable. And what Shiller basically said, yeah, I mean, you can deviate from long-term averages, but eventually markets are gonna catch up again with earnings.

And so looking at the Shiller CAPE, that, too, is not really a good predictor of next month or even next year S&P 500 returns, but it is a relatively reliable predictor of, say, the next 10-year returns, okay? So there is a pretty noticeable correlation between the CAPE ratio and 10-year returns.

And, well, guess what? 10-year returns is roughly the horizon that matters for retirees. So it's a natural extension that we, as retirement researchers, should look at the CAPE ratio and let that educate us in determining what should be the right safe withdrawal rate. And then if stocks are very expensive, so that means the CAPE ratio is high, or the earnings yield, which is one over the CAPE ratio, is very low, then we should also take back a little bit our safe withdrawal rate.

So now, basically, what you created is a method for doing retirement withdrawal planning that gets rid of some of this headache that you pointed out earlier, right? You start with a 4% withdrawal rate. The market drops by X percent, and now, suddenly, you are withdrawing 6%, right? And you ask yourself, "Well, the market is down.

Okay, yeah, maybe I could withdraw a little bit more, but is it really a good idea to withdraw 6% instead of 4%?" So the nice thing about these CAPE-based safe withdrawal rate rules would be that you have a way to fine-tune and make dynamic your safe withdrawal rates because you would respond to market conditions.

The nice thing, though, if you look at this more valuation-based approach from the CAPE ratio, so imagine the market goes down by a certain number of percent. Your portfolio is down. But because the market is down, now the earnings yield also looks a little bit better. So your percentage withdrawal rate goes up, and your portfolio is down.

So the net effect is that, yeah, you're still going to withdraw less, but not really one-for-one. Maybe you withdraw 10% less. So, and this would be a way to at least systematically and dynamically adjust your withdrawals. So there is a way to basically rethink, well, yeah, I mean, the market is down already so much.

I can now, I don't have to withdraw 4% of that decimated portfolio. I can withdraw a little bit more than 4% now. And you can do that in a systematic way, and it's, especially for somebody with a finance background, that's something that actually makes a lot of sense. And also gets rid of this problem, right?

So for the math geeks, if you wonder about the Bellman principle of optimality, right, so that actually would satisfy this Bellman principle of optimality in the sense that if your portfolio is down by X%, and now you basically re-optimize, and your behavior would be no different from somebody who just retired with that portfolio level at that time.

So you would both withdraw the same. Whereas if you do the 4% rule, right, you withdraw now 6% of your decimated portfolio. If somebody else retired with that same portfolio level and used the 4% rule, they would withdraw only 4%. So mathematically, that doesn't really make a lot of sense that you both have the same portfolio level, the same age, the same retirement horizon.

You just retired at different times. And the one guy withdraw 6%, and one guy withdraw 4%, it can't both be optimal. Whereas this method that creates a withdrawal rate that's purely based on market condition and nothing else, I think that's a mathematically sound, and also I think financially sound method.

So, and by the way, this is something that you can also model with my spreadsheet. So there's this, you can use the CAPE-based safe withdrawals. But so as a caveat, it again generates this headache, right? It creates failures. You never fail in terms of running out of money, but you would potentially fail in the sense that, yeah, if you retire at the wrong time, you might have to cut your withdrawals very substantially for long periods of time.

So it's not a panacea, but it's something that if you have a little bit of flexibility with your spending, you should definitely consider. - Is an option to just take a look at the kind of CAPE-Shiller ratio now and say, oh, it's high or low. Maybe I should just be a little bit more aggressive or conservative before retirement, maybe work another year or not.

- Right. And so right now the Shiller-CAPE ratio, if you look at Shiller's webpage, it's in the 30s, I think it's something like 33, and it's extremely high by historical comparison. It's not as high as right before the dot-com crash, but I mean, we are talking about as high as before the 1929 crash.

So if, I'm not saying that the 1929 crash has to repeat, but I mean, we are definitely now in an environment that looks exactly like some of the past market peaks. And so I, again, I would say this is now the time to be a little bit more cautious.

And by the way, I also freely admit you should also do the opposite, right? So for example, when we were close to the market bottom in October, 2022, I wrote a blog post where I said, well, now is actually the market is down so much and the CAPE ratio looks very attractive again, now is the time to raise your withdrawal rate.

And actually 4% rule works again, that was back then. Now I would probably be a little bit more cautious because we definitely market looks a little bit overvalued. And again, I do this on my, in this Google sheet, you can look at, well, what were the safe withdrawal rates and what were the probabilities of running out of money, say for a fixed withdrawal rate, like the 4% rule.

Well, the 4% rule normally works if the CAPE is below 20. And if the CAPE is above 20, then the probability of running out of money is a lot higher than what you would deduce from the Trinity study, for example. So these are all things that I report in this Google spreadsheet exactly for that reason, right?

You want to look at market valuations and then conditional on market valuations, you potentially get very different safe withdrawal rates, right? The safe withdrawal rate could be 3.8% if the CAPE is high, and it could be as high as 5% or 5.5% if the CAPE is really low. But as you said, definitely take into account where the market is.

And we are recording this in July, but if somebody looks at this maybe three years down the road and we have very different CAPE ratios, you definitely want to make adjustments for that. - This might be what you were referring to with Post 62, but if you adopt a strategy of starting your retirement at a kind of more reverse glide path approach, and one, two years in, you see a big market correction, can you increase or I guess decrease the failure rate and increase the success rate by at that moment shifting from fixed income to equities and increasing the stock allocation?

- Right, and you could do that. And if you are smart enough or lucky enough and you grab exactly the market bottom, you would look really good at that time. Now, nobody knows exactly how deep we're going to fall, and so in that sense, this is why I like the glide path because it takes a little bit the emotion out of it.

You do it slowly over time. And what that would do is if you really have a bad bear market early on, it would almost work like, well, by shifting the weight, you're probably going to effectively when you look at the portfolio every month and you take money out, it's you would potentially take mostly money out of bonds and you would potentially already shift money from bonds into equities on top of that.

So you wouldn't be, so not only would you not take money out of stocks that are being hammered and potentially beaten down and this overreaction on the downside, like we saw in March of 2009 when everybody thought the world is going to end. And so you would already do that, but you wouldn't pick one particular point when to do that.

You would do this over time. - And that's just because you're rebalancing the portfolio. - I've done some simulations on that too. How often do you rebalance the portfolio? Should you do it every month? In my toolkit, I assume that it's every month. It's actually easier to calculate it that way.

A little technical side note, but of course in practice, you might not do it every month. If you do it every second month, every third month, every year, results are still going to be very similar to my toolkit results. If you never rebalance, then now you might kind of sort of wander off in some weird direction.

But as long as you at least occasionally rebalance, that's fine. But so here's, so you're rebalancing. Now the question is, what do you rebalance to, right? In the toolkit, most of the work I do there is a fixed allocation, and you specify that fixed allocation. I have one little feature where you can do a case study of one particular retirement cohort and then check how a glide path would have performed better or worse.

Most of the, not most of, all of the time when you do a glide path from less equities, more bonds, into more equities, less bonds, you would do better in all of the worst case scenarios. Of course you do worse if nothing bad happens, right? If the bull market continues and continues for another five years, and you had too little in equities, you would give up a little bit on the upside, but you're fine to do that, right?

It's almost like an insurance contract, right? You pay out if you do well, but you make a little bit of extra return when the market is going against you. So anyways, yeah, so this glide path has a little bit of this feature. If the market goes down, you would actually shift somehow resources from fixed income to stocks.

And the glide path takes out the emotion and the market timing in that, because, well, what if you take your entire bond portfolio and to plow it all into stocks, and the stock market is already down by 30%, and then it goes down another 20%, right? How would you feel about that?

You, maybe in the long run and in the big picture, it was still the right move, but you would probably feel a little bit emotional that you got that market timing wrong. So it's better to do it over time in small steps. You're not gonna get it completely right, but at least you're not gonna get it completely wrong either.

So that's the advantage of that glide path. - To backtrack a little bit, you talked about and made a lot of references to inflation. How, when people think about their withdrawal rate, their early retirement, how does inflation play a role in all of this? - Right, so obviously what you want to do is you want to adjust everything by inflation, right?

Because nothing makes sense if you look at just nominal numbers. And so the gold standard that you want to follow in every single safe withdrawal analysis is that first of all, the withdrawals should be adjusted for inflation. And then also when you look at, well, what is my final value at time X, that should also be adjusted for inflation, right?

So obviously it doesn't make a huge difference if your goal is to deplete your capital. Well, $0 30 years from now, it doesn't matter if it's a nominal or real dollars, right? But if you have a goal of giving a bequest of a million dollars in 30 years, it makes a huge difference whether that is after inflation or before inflation, right?

So everything I do is always inflation adjusted. So when I say you withdraw a fixed value over time, that is all inflation adjusted. And then when you specify, I would like to keep say 30% of my nest egg after 50 years, I want to keep that either as a reserve or as a bequest, then it's also 30% of today's portfolio value adjusted for inflation.

So inflation adjustments have to be always in there, otherwise you're comparing apples and oranges. And I've seen people out there mixing up the two where they say, oh yeah, there's a 90% chance that after 30 years, you still have your original portfolio value. Problem with that is, that usually means it's a nominal terms.

And in nominal terms, the same portfolio value as 30 years ago could mean anything or nothing, right? That could mean it's 80% depleted if those 30 years include the 1970s and '80s when we had these big inflation shocks. So as I said, gold standard, everything has to be inflation adjusted.

- One thing that I've heard a lot of people say, and I think inflation is actually the answer, is like, oh wow, if you look, everything from one month to 30 year treasuries, you're in the five and a half to four and a half range, doesn't that solve for the 4% rule?

And is the answer, or the 3.25% or whatever it is, and is inflation the reason why you can't just rely on rates right now that happen to be very high for a long period of time? - First of all, and again, everything depends on, so first of all, your horizon and whether you are willing to deplete your capital, right?

So first of all, treasuries are not inflation adjusted. So it's actually, you have maybe 5%. I've seen some CDs in the 5.4, 5.5% range over one year. I think 10-year bonds are now down. We just established that to about four and a half percent. 30 years are probably also in that range, maybe a little bit higher.

And again, you have to, but to take out an inflation estimate, right, maybe two, two and a half percent, the real yields of treasuries would still be a little bit above 2%. The solution, if you want to completely hedge against inflation, would be TIPS, right? Treasury Inflation Protected Securities.

And last time I checked, they were yielding a little bit over 2%. Let me check. It's 2.31 for the 30-year, 2.31 for 20 years. So in that sense, if you can get 2.31 over 30 years, so you do the back of the envelope calculation, if you want to keep your capital, you could model a 2.31% withdrawal rate.

It's not quite true because the more near-term TIPS, they have slightly lower yields, but it's also close enough, 2.12 to 2.3. Let's make it two and a quarter percent. So you could create something like a TIPS ladder, right, where you buy TIPS with all of the expiration dates staggered over your retirement horizon.

And then you get real inflation-adjusted returns of somewhere around 2%. So it means you could generate a 2% or two and a quarter percent safe withdrawal rate with zero risk. - That also leaves you with your entire principle. - That leaves you with your entire inflation-adjusted initial net worth.

So you could do that. The other thing you could do is, and I always did that calculation. So imagine, and this is now boiling down basically to an amortization calculation, right? So imagine you have a 2.3% real yield. Well, how much money can you take out? So you imagine you think of that as a mortgage, right?

Instead of paying off the mortgage, you hand over the money and they pay you. And then after 30 years, the mortgage then is forgiven. So your money is exhausted and all you get is a flat payment stream. It's actually, even with a 1.3% real yield, you could generate a 4% safe withdrawal rate and completely wipe out your money after 30 years.

So that's actually quite astonishing, right? Because the 1.3% return is what pays only maybe a third of your payment. And the other part of it is basically just exhausting your capital, right? And so the nice thing is that you need actually relatively low real returns and fixed safe real returns to generate already a 4% safe withdrawal rate.

And so I actually wrote about that in part 61 of the series, which is called Safety First, right? This is what people understand. Safety First is, you know what? Instead of worrying about a 4% withdrawal rate, why don't I just, instead of investing in stocks, why don't I just completely hedge my retirement and put money in safe investment and just either put it in an annuity.

Problem with an annuity is it's not inflation adjusted usually, but say a tips ladder would be the inflation adjusted method. And so, yeah, you could say that, yeah, even with a 1.3% real rate, you could get a 40% retirement and a 4% safe withdrawal rate. Problem is it doesn't work for early retirees, right?

- Yeah, because the maximum duration. - After 30 years, your money is wiped out, right? Or you do the 2.3% withdrawal rate, which seems a little bit lean. And so, yeah, I mean, this Safety First, I think it's a viable solution for traditional retirees who are willing to completely wipe out their portfolio.

And maybe they have, or it doesn't mean that they don't care about their kids, but maybe they have already given enough of a headstart to their kids. It may be paid for college, paid for home down payments. And they say, okay, kids, this is all you're gonna get. Don't expect any retirement.

So you don't expect any bequest and any estate. We're gonna leave exactly $0 because we're gonna take our money and transform it into a fixed cashflow. And that's gonna last us a lifetime. Yeah, I mean, it would be okay for traditional retirees. If you retire at age, say, 40, and the longest you can structure with a TIPS letter would be up to age 70.

So now at age 70, what do you do? Maybe you have to set aside some money that you put in a stock market and let that grow over 30 years. And cross your fingers that over the next 30 years, it actually grows to a big enough portfolio that then you quote-unquote re-retire.

But then again, so yeah, now your safe withdrawal rate is no longer 2 point something or 4% if you use that exhaustion of cap. It's a little bit less because you can't take your entire portfolio. You have to set a little bit aside. And now you again have some uncertainty built in.

And that uncertainty will reveal itself at age 70 because that's when you re-retire, right? That's when your TIPS letter is used up. And you now have to look at, well, what did my stock portfolio grow to over the last 30 years? So you can, as for early retirees, it's a real headache.

You can't completely take out the risk with fixed income security. And again, it's exactly because of that inflation issue. You can't just go with the 4.5% yield in the 10 year or the 4 point something percent in the 30 year. You have to factor in inflation. And once you factor in inflation, some of these fixed income routes look quite unappealing, I have to admit.

- And you mentioned annuities briefly. And one of the challenges is a lot of the annuity yields are nominal yields. So it sounds great. Oh, I can get this payment every year for the rest of my life. Another problem, even if you could find one that was real is fees are high.

Have you, if you look at annuities, have you found any product or package that's even worth someone looking at or considering? - Probably the lowest fee, one would be an SPIA, single premium immediate annuity. And funny thing is I realized I can even get it at my age already.

So I'm 50, I turned 50 this year. I think they can go all the way down to age 40. You can probably get an annuity already. And the nice thing about that is that is such a standard product. It really only differs by the credit rating of the insurance company, right?

So if you shop around with all the AAA providers, you should probably get similar quotes and you just pick the best one because there's nothing else. So there's no other bells and whistles. It just pays as long as you live. There might be some other issues with some survivor benefits.

It could be a joint survivor. It could be only single survivor, but it's such a standard product. By the way, you can even plan for it, right? You can plan that on average, inflation is gonna be 2% over the next 30, 40, 50 years. And when you get X amount dollars today, it will slowly dwindle away from perspective of after inflation.

And maybe you don't transfer everything into the annuity, right? You keep a little bit of a reserve. And then over time, when you realize that my purchasing power has been depleted, you buy another annuity. And so it's possible in general, but again, because yields are, they are higher than they were three, four, five years ago, but they are still not quite as high that I'm super urgently knocking on annuity providers doors that I would be interested in buying them.

I would still take my chances with my stock and bond portfolio, but if interest rates were a little bit higher, I would probably start to look into that. And again, it's never an all or nothing proposition, right? You could do a partial conversion of your net worth into annuities and keep the rest in your 75, 25 portfolio and run with that.

So again, this is something I wrote about recently in that part 61. It's probably something that works well for traditional retirees that don't have huge bequest motives. If you are a young retiree and you want to keep money as a reserve for say health emergencies or helping out your kid or kids, I would probably still hold on to my portfolio and not do the annuity round.

- One thing that we didn't touch on, which is pretty relevant to a safe withdrawal rate is the tax situation of your portfolio. So if someone has a $2 million net worth, that could be a $2 million net worth that has a cost basis of $100,000 and will be subject to lots of taxes, or it could be a $2 million net worth where half of it's in a Roth IRA with no future taxes at retirement.

How do you think about taxes as it relates to the current value of that portfolio? - Taxes are obviously the whole additional layer. So, and I have to admit in that Google spreadsheet, I don't model those. So that means what you take out of that portfolio is still subject to taxation.

Now, a good news is that in the US, I think we are pretty blessed in that. I think if you stay below a certain income threshold, you can structure your retirement to be almost tax-free. Maybe not in California because, but even in California, I mean, I did the math, right?

So I think in California, I think if you stay somewhere below 60 or $80,000, it's the really high marginal tax rates don't yet kick in. And I live in Washington, so I don't have state taxes, state income taxes, but yes, on the federal level. So taxation, so adds to the complexity.

First of all is from a cashflow point of view, right? Lots of people have everything tied up in a 401(k). Well, how do you access that now? So hopefully you could do some Roth conversions and then do that Roth conversion later over a five-year period. And then you can take the money out of the Roth.

And yeah, but so the other issue is if you are lucky enough and you have a lot of money in taxable brokerage accounts and you have long-term gains that you need to tax, at least on the federal level, there are very high exceptions. So first of all, you have the standard deduction.

And then on top of that, I think you have something like 79 or $80,000 that a married couple can have in long-term capital gains. - Looks like for 2024, it's up to $94,059. - Oh, wow, 94. I think, yeah, even in 2023, it was already over 80. Yeah, yeah.

So you have these, if you structure everything as long-term gains. And so there are obviously some tax hacks and I haven't written about those very much because other people have already done that. So I think that if other people have already done the job to do that credibly and to my standards, and I don't have to redo the math, right?

I think GoQuery Cracker wrote about it. For example, at some point, you could do tax gain harvesting, right? So imagine you have a taxable income where you are below that threshold, right? Where you are not even maxing out all your 0% capital gains. Well, you could sell some of your tax slots and then re-buy them again the next day or even the same day.

You just realize the gains, fill up the 0% tax bracket. So you could do that. You obviously want to probably make sure that you at least utilize the, I think now it's $27,700 in standard deduction for married couples, at least fill that one in with ordinary income. So if you don't have any other ordinary income, maybe you use some Roth conversions to fill that one in because that will create ordinary income.

You might even fill up the 10% or maybe even the 12% bracket with some Roth conversions. Yeah, so I personally haven't really modeled really too much of this tax optimization. The way I think about it is I have something like an average tax rate of, and it's in the single digits, probably in the low single digits.

And so this is just the drag that it's basically like an expense that it's like property taxes for me. It's probably even in the same ballpark per year. And I don't really model that any further as a lot of people in the FIRE community, I mean, especially if it's married couples, they will very likely stay below that.

And it's now probably, I think it's in the $120,000 range that you can have $120,000 in income. If you fill up your standard deduction with ordinary income and the rest with long-term capital gains, you can pay zero federal income tax. And then maybe you go even a little bit above if you have kids and you can get the $2,000 tax credit in the US.

So the US tax code is extremely, extremely friendly toward early retirees. Unless you really have such a big footprint where you're early retiree, but then you also have something like a $200,000 a year lifestyle, then probably the tax planning is becoming a little bit more urgent. But I've never felt a huge, huge urge to really stress out over any of the tax issues.

- It sounds like if you realistically think your kind of needs each year in terms of withdrawals from your portfolio, that would generate income, not just withdrawals, but the income on the capital gains are kind of above the $125,000 mark, taxes may play an impact more than you think, but still at the capital gains rates, not at the income rates, which can be lower.

Okay, so I mentioned I wanted to talk a little bit about portfolios. We talked about the reverse glide path, which probably explains why target date funds could be a pretty terrible choice if they're doing the inverse. But you could also make a case often as someone being aggressive, especially with bonds where they were prior to the last few years of being 100% stocks.

How do you think about that allocation during accumulation, since we kind of talked about what it could be in retirement? - Right, so accumulation, I have done 100% equities and it worked for me. It might be a little bit too volatile for some people, but pre-retirement glide paths, how crazy is it to hold 100% equities until retirement?

So that's part 43 of my series. And so I make the point that on your accumulation path, it's defensible to have 100% equities until retirement. And the nice thing is, well, of course the problem with that is, well, what if at your retirement date, you just are in the middle of a recession and your portfolio got so clobbered that, well, suddenly you can't retire anymore.

So that would be the risk. Remember, maybe at that bottom of the market, you don't have to apply the 4% rule. You could probably apply the 6% rule because the equity valuations are, again, much better. But even if you say, well, there's a little bit of risk that at that target date that I want to retire, well, maybe my portfolio is really down and I have a little bit of flexibility about, well, if I maybe work a year longer, would that be such a big concern?

Yeah, if you have a little bit of flexibility in your retirement date, maybe you could do that 100% equity portfolio. For example, I had it, right? So I said, well, if in 2018, when I want to retire, the market totally evaporates, well, then I'm just gonna stay another year at my old job.

So it's not the worst thing. I was actually a good job and liked everybody around me. So it wasn't terrible. But of course, there are some people who say that, yeah, I want to retire after, say, 20 years of government service, and I don't want to work a week longer.

And if the market is down at that time, then that would be a huge problem. So in that case, yes, absolutely. You want to do a glide path, and the glide path would be just like a target date retirement glide path. Now, I personally don't like these traditional target date funds because they start shifting from 90/10, 90% stocks, 10% bonds, into something like 50/50, probably 55% stocks might be still, some providers would offer that.

The problem with that is you would do that over 20 years. Well, most people don't even accumulate for 20 years if they plan fire, right? So you can't really use the traditional glide path for target date funds. So you have to, and I ran some simulations. Well, how would the optimal glide path look like for somebody who has a much shorter accumulation period?

And well, it turns out that the shape of the glide path still is the same. You start very high equity, and then you shift into bonds, and you kind of, at the halfway point, you start shifting into bonds. Well, if your accumulation period is only 10 years, well, you actually start shifting into bonds five years before retirement.

If your accumulation period is five years, you would start shifting into bonds maybe at the two or three year mark. So it's, qualitatively, it's the same glide path, but it's compressed. So it's not, you don't take the last five years of the target date fund, where you go, say, from 60% stocks to 50% stocks.

That would be way too conservative for most early retirees. So, and actually, I ran some simulations, and that's actually where I ran both historical simulations and also Monte Carlo. And yeah, so I agree. I think 100% equities is actually not bad. And so, by the way, in the target date funds that the big fund companies put out, it's 90% is the maximum stock.

It's actually, I think it's an ERISA regulation. You cannot go above 90% stocks. If you do it yourself, you can definitely do 100% because you don't have to follow those regulations. And I actually think 100% is better than 90%. And so that 10% fixed income, that's really just a fig leaf for, so nobody can claim that you didn't have enough diversification, and nobody can sue you if somebody's unhappy with having big losses in their 401(k).

If you're familiar with JL Collins and all the gang from the personal finance community, yeah, yeah, I mean, you can take a little bit of a bear market in between. You know, market goes up again. And so, yes, absolutely, 100% equities. It worked for me personally. If you have a stomach and an appetite for that, I recommend it to everybody who listens.

But I also say that if you have concerns about you don't want to work way past that planned retirement date, maybe do a little bit of a glide path into more bonds. And then I tell people, hey, it's not forever, right? Because then you can do the reverse glide path again in retirement.

So you do something that's called, they call it a bond tent, right? Because the bond allocation then looks like a tent, right? It goes up as you go to retirement, and then it goes down again as you're in retirement. And it looks like this triangle and a tent. And that is actually recommended by Kitsis and Pfau and me, that that seems to be something that takes a little bit the edge off of the sequence of return risk, right?

And again, sequence of return risk, right? It affects both savers and retirees, right? So the last few years of your accumulation phase, you also have sequence of return risk. You don't want to have the really bad returns towards the end of your accumulation period. Or if you do, you want to hedge against that a little bit.

You don't want to be 100% equities right around the end when you have that huge portfolio. And then on the way out again, that also helps you with the sequence of return risk in retirement. So this is not some voodoo science or anything. There's actually some economic and mathematical principles behind that, right?

Because basically what you do is the glide path into retirement, right? Why do you start high equities, low bonds? Because your contributions over your next 40 years, they are something of a long bond position, right? So they act, but they are not a long bond position, but they act like a long bond position, right?

And because you're so overweight with bonds, you don't want to pile on even more bonds, so you start with very high equity. But then as you get closer to your retirement date, your human capital becomes less and less and your future incomes and your future contributions into your nest egg become less and less.

And that's why now you put bonds into your portfolio because you run out of bonds, quote unquote, in your human capital. And the same with your retirement. Well, what is your retirement? You're taking money out of your portfolio. In some way, that's a short bond position, right? Because it's almost like a liability you take out of your portfolio every year.

There's some cash flow and it's relatively certain and predictable. So it acts like a bond. And because you take it out of your portfolio, it acts like a short position in bonds. And in order to overcome this risk of having a short bond position, you want to have more bonds at the beginning of your retirement.

But then over time, you can phase that out again. So this explains why you both go into bonds as you reach retirement and then out of bonds as you progress in retirement. So there's some math and some intuition behind it. It's not just a pure numerical result and nobody understands why that happens.

There's this very good understanding why that happens. And it's very intuitive, which makes me wonder why this has never reached the target date fund industry, because basically what that means in the target date funds post-retirement, they should go back into equities, but they actually shift further out of equities and go more into even shorter term bonds.

And again, I'm not a lawyer or anything. Maybe there's some regulation that mandates even that, but definitely the math, both the empirical results from past simulations and then also the mathematical and financial intuition points toward that bond tent. And it's not done. Only the one half of the bond tent is done, but not the other in target date funds, which is mind-blowing.

- I think we have a version of saying this thing that we've done for a long time is actually not right. So I would imagine there's something with, oh, yeah, the thing we sold you and we've been, it's all wrong. We've got a new way and it's better. I feel like people would rather keep doing the wrong thing than admit that there's a better thing that they didn't know about.

But I don't know, I'm not in charge. I don't know. - Yeah, yeah, maybe that's how that comes about, yeah. - Within the equity position, we've talked a lot about recessions in the United States. You've talked a lot about the S&P. What role does international diversification, whether it's developed or emerging markets, have in the way you have equities?

- Right, so I have some international. I probably have less international than would have been recommended just by pure market cap. I think right now US market cap is, of the US market cap of the overall world market cap is definitely over 50%. But I probably have probably closer to 90% equity allocation is in US domestic equity.

So, and it's just, I always had it that way and it's hard to move it, especially because then you realize, well, what if I move it just at the wrong time? And, but so far it's actually served me well. So the nice thing, obviously, that we have in the US is that we are big enough and important enough that you can probably get away with an all US equity portfolio in the sense there is probably not that much diversification from international stocks.

And then of course there is diversification, right? I mean, and you can basically draw an efficient frontier diagram of past return data and then you put in international stocks and then you see that the efficient frontier expands a little bit. So that's all really nice and good. So I agree with that, I don't doubt that.

What I'm saying is that we are very different from say an investor in New Zealand or Belgium, right? I mean, if you're in some of these small countries and you have only domestic stocks, you really run the risk that your country goes through some very idiosyncratic crisis and you could have gotten diversification from international equities.

But it's also true that every single US recession and bear market has spread across the world, right? So on the way down for sure, every correlation in the equity world pretty much goes to one, right? If we have a recession and bear market in the US, everybody will feel it.

I think the diversification for international stocks probably comes more from the non-recession times, right? There were times where the recovery, for example, out of the dot-com crisis was better abroad. So part of that had to do with just the stock markets doing better there. And part of it was also basically just an exchange rate effect, right?

So if the dollar depreciates, you will be better off with the foreign stocks. It has nothing to do with diversification. It has more to do with basically currency and economic diversification. But I mean, it's definitely true that when we have bad bear markets in the US, you have also bad bear markets abroad.

But it's also been true that post-global financial crisis, the US recovered much better from that. So Europe had very, very weak and very disappointing recovery. Also post-pandemic, lots of Europe has not done very well. So I've been very happy with my US-centric allocation. It's in the back of my mind, should I maybe now that I've done so well with being US-centric, should I now diversify?

Because at some point, Europe and rest of the world is going to come back. I also have to tell you that, so I'm from Europe, right? I'm from Germany. And so obviously I'm in the US because I like it better here. So I think the US economy is a better functioning economy.

And it's more dynamic. And I think it's better run overall than a lot of Europe. So I have a little bit of an aversion against Europe because overall, I think the US is the stronger economy and has more growth prospects. Now, of course, as an efficient market proponent, well, it should be already priced.

And this, by the way, explains why Europe valuations, price earnings ratios look much more attractive. It's much cheaper. It's also, well, it could also be cheaper for a reason, right, and the reason is that one single stock in the US, I think somebody did the calculation, Nvidia is worth more than the entire market capitalization of most European stock markets, right?

So, and that tells you something, there's all of the big innovation and all of the, especially the AI innovation, that will all come from the US. And I think this is why everybody is crowding into the US. This is why probably I'm also not that, it's not itching me to diversify.

I have a little bit, maybe 10% non-US stocks, it's all index funds, by the way. I, yeah, I have a strong belief that the US will do very well. And then again, I mean, nobody else but US investors should think that way, right? If you're Canadian, if you're Australian, if you're from New Zealand, it should be exactly the other way.

Or you probably have to have at least 50% of your portfolio should be US stocks. But we have a great luxury that we can be oblivious to what's going on abroad. - Four quick portfolio things we can run through. I'm curious to get your take. We talked about rebalancing already, so I'll skip that one.

What's your take on tax loss harvesting? - Yeah, I mean, tax loss harvesting, I have done it myself. I think it's a neat tool. The sad thing is that if you have no gains to use them as an offset and you are bound by these $3,000 a year, so you can write off $3,000 against your ordinary income from tax loss harvesting.

Some people will argue it's not really worth the hassle to do that. For me, personally, because I generate some capital gains, so I do some options trading, and that generates both short-term and long-term capital gains. So I have done tax loss harvesting, and it's offsetting some of that income.

And I've used that very heavily. So I think it's a useful tool. I've used it, and it brings up a whole other issue. So for example, a lot of people now want to do direct indexing, right? So instead of buying the index fund, they still do the index, they still do the S&P 500 index, but they implement the S&P 500 index with the underlying constituents.

And then you can do a lot more tax loss harvesting. And yeah, I mean, if you have enough gains to offset, it might be a really good idea. And I know your connection with Wealthfront and everything. So I can see how, so for some people with a lot of taxable gains that they want to offset, that is very useful.

If you don't have a lot of taxable gains and the $3,000 is all you can really offset every year, it might be a whole lot of hot air over nothing. But I mean, definitely for a lot of people, tax loss harvesting can be super helpful. - My other criticism of it, I'm not gonna let my past employer influence my opinions, is that especially for people who are early retirement, when you're not actively contributing to your investment portfolio, you end up in a place where there aren't a lot of losses.

So my portfolio right now is, during the pandemic, did a lot of tax loss harvesting. And so since the floor of the pandemic, the market's up quite significantly. I don't have any losses to harvest because my cost basis is now so, so low. And the unfortunate thing is I now have this large amount of carry forward capital losses that I would need to find a use for.

I actually do have some gains in individual equity positions that I would like to get out of. And so it turns out that it's a good opportunity. But if you're not actively contributing, if you have a big nest egg already, the value of tax loss harvesting diminishes quite significantly.

- Right, right. One way would be, so for, I don't know how you do any kind of, so cash management. So imagine you have $100,000 cash reserve or something. So there is a new ETF, it's called BOXX, B-O-X-X. And it does some options trading and it creates, basically recreates a three-month T-bill, but the income comes in terms of capital gains and they don't pay dividends.

So your return would come in terms of capital gains. So you could create something that looks like a cash or money market portfolio, but the way, and then on top of that, you only get taxed when you realize the gains. So you could create basically three-month T-bill interest rates, but it's only taxed when you sell and generate gains.

But then when you generate the gains, they would be capital gains and not ordinary income. So if you have a lot of stuff to offset, you could use that to offset something that would have otherwise been ordinary income taxes. - Yeah, I actually read the post you wrote about that strategy.

And in it, you advocated for some people, it's a better deal to execute yourself. But if you live in California and you're in a high state tax bracket, it's particularly, it's particularly good. - It's very painful, it's very painful. Yeah, yeah, I agree there. - So I haven't looked too much, but I will.

And what about asset location, right? We talked about allocation, but do you think very strategically about where you put all of your assets across retirement and non-retirement accounts? Or do you kind of just keep that same consistent portfolio everywhere? - I think it's pretty much consistent almost everywhere. And so I wrote about that, which one is that one?

Asset location, that's part 35. So do bonds really belong in retirement accounts? And so it's not a complete slam dunk, but it used to be, and it's probably now back to exactly that scenario. Again, if bonds pay relatively high interest rates, then probably bonds belong into tax deferred accounts.

And stocks belong into your taxable account, right? So, and the reason is that you have to, bonds would be tax efficient in a taxable account. - Especially, I guess, if you plan to sell those stocks at a point in time or those index funds where you can stay under that threshold at 0% capital gains, then you're really looking good.

- Yeah, I definitely follow that example. I don't really have a lot of real bonds. I have preferred shares and I actually do have them in a taxable account, but they pay ordinary dividends. So that's taxed at a lower rate than ordinary income. As we said earlier, during the accumulation phase, maybe you want to have only stocks anyways, but even then, well, maybe keep your REITs very tax inefficient in a tax deferred account and keep your S&P 500 index funds in your taxable account.

There would still be a little bit of a tax drag from dividends. So you just have to live with that. And then on top of that, right, if we talk about, so somebody wants to implement a bond tent, right? Move from stocks into bonds. Well, you would do that also in your tax deferred accounts or in your tax advantaged accounts, because you don't want to have to realize a lot of capital gains.

And then basically, and then by the way, you have the bonds in the right place. So you have the bonds in your tax advantaged accounts when you want to do that bond tent. Yeah, I mean, absolutely. So there is some tweaks you can do both in the accumulation phase and then later in retirement that, yeah, there's some tax efficiency planning to do there, yeah.

- The last one comes back to my wealth front time where I remember looking at the, this was not in today's interest rate environment, but at the interest rates about three, four or five years ago, interest rates were super low. And all I could think about was like, well, we've got a risk score that goes from zero to 10.

Could you get to 11 by taking out a 10% margin loan and putting it into the portfolio? You've written a little bit about leverage and I'm curious if you think, the historical argument I've heard is, well, mortgages are fine. You can leverage real estate because you don't have any risk of default because you're locked in, but in a stock portfolio, there is that risk.

But at a 10, 15% level, there's not really that risk. Do you think there's a case for juicing the portfolio, if you will, by adding on a little leverage, even if it's just leveraging up VTI? - Right. Yeah, I agree with that. Now, the question is, so the problem with that is that retail investors might find it a little bit harder to do leverage.

And so you can always do leverage. If you go and you do leverage through a brokerage account at Fidelity or TD America or something, they will charge you margin rates that are so unattractive that it's not really worth it. You can go with interactive brokers, which is a little bit more for sophisticated investors.

So I have my option trading account with interactive brokers. That works maybe a little bit better, but I think margin interest rate is still a little bit high. I think they do something like maybe a fed funds rate plus a percent or something like that. And you can do leverage through this box spread trade that I mentioned once.

So that would even make the interest effectively tax-deductible. So that's a pretty neat way. So it brings new cash into your account, and then you take that cash and buy more stocks. You can definitely do that. And again, the idea here is that it goes back to this intuition I told you before, right?

So if you do a glide path optimization, and I've worked on this, I've written about it on my blog, but I did the maximum stock position would have been 100%. And the reason why 100% was optimal was not because 100% is optimal, it's because I set the upper limit to 100%.

So if you're really young and you have relatively little in investments, and you still have enough runway to retirement, yeah, you could definitely go above 100%. And as long as you don't do it too crazy, there seems to be some, in some bogleheads forum, there's somebody who wrote this horror story where as a grad student, he went into equities with some leverage, and then the global financial crisis hit.

And I think he lost almost everything. So bad things can happen if you do leverage. I think if you do it reasonably and you do something like 110% equities, you do a little bit of extra leverage. I think that mathematically, it's definitely the right thing to do from say a lifetime asset allocation point of view.

And I'm not sure everybody has a stomach to do that, but if you do, you should obviously do that. I guess the easier thing to do is say, if you already have a house and a mortgage, think of the mortgage as almost like leverage. So instead of paying down, instead of making accelerated payments on your mortgage, maybe put everything in the stock market and then keep 100% equity position, that's almost already like a equity with leverage, because you have the mortgage on the side, it is basically just the money is fungible.

So think of almost the mortgage as the leverage. But yes, I absolutely agree with that. And it goes back to this idea, you already have a lot of bond-like allocation, which is an implicit allocation, which are your future contributions into your 401(k) and, or 401(k) or NASDAQ in general.

And because you have this big bond allocation, you want to overcome that and have maybe not just 100% equities, then it could be 110 or 120% equities. And then minus 20%, you have some borrowing, ideally as something like a box spread trade where you can get, I mean, you can borrow money at maybe three months treasuries plus 0.3%.

And that stuff is also tax deductible, which is not really the case with a lot of other things. - Okay, I think I hit on all the portfolio stuff. The more you talk about options, the more it makes me wanna do an entire another conversation about option strategies, 'cause you've got a great series there.

We'll punt that for the future and we'll have you back. As we wrap up, you're kind of one of the people I know who've gone through this early retirement thing. What advice do you have for someone who's still in that accumulation phase beyond just some of the stuff we talked about now, maybe more about the life and the mindset that you've picked up along the way that you'd like to share?

- As I said earlier, if you're early on in your accumulation phase, go aggressive. So 100% equities is not a dirty word. Also keep up the pace. So you have to almost rewire your mind. If equities are at an all-time high, great. Momentum is working. I'm going to keep investing and this thing will keep rolling forever.

And then if equities are down, then, okay, forget about momentum. Now we think valuation, right? So now we say equities are cheap. So now is a great time to invest too. So there's always a great time to invest. And think about that as what we said before, right? For retirees, it's a real headache.

There could be a bear market around the corner and you have sequence of returners. The flip side of that is that actually a recession and bear market could work okay for savers because you have dollar cost averaging. You keep investing through the trough and you pick up more shares at cheaper prices.

And then when the market retires again, you look really golden. I mean, definitely it worked for me twice, right? Once during the dot-com crash and once during the global financial crisis. And so if you are still saving and preparing for retirement and saving for an accumulating for, whether it's traditional retirement or early retirement, don't really sweat the volatility, don't really sweat valuation so much.

Worry about that later and then you can check out my blog, but on the way there, just keep plowing money in. And, but then at the same time, I also wrote a blog post it's called Stealth Frugality. So you don't want to overdo this frugality business, right? I mean, you also want to live a little bit and don't want to shortchange your fun.

And I mean, it's really fun to live in early retirement, but you don't want to be too frugal during the accumulation phase. And then because you might fall off the wagon and you might hate it. So even if it takes you maybe two or three years longer to reach that early retirement date, I mean, if the path there is fun, it's much easier to save for two or three more years.

So keep that in mind. - And would you say stealth frugality is just, be frugal where necessary, but don't be so frugal that everyone knows it and you don't have fun. Or how do you think about it? - Well, people talk behind your back about it or something, right?

I mean, you want to send some signals. So I never sweated, for example, going out for coffee, the work lunches. So we would go out for lunch at some of our favorite places in San Francisco. And so, yeah, it's a little bit extra expense, but it's also, I value the social interaction and picking up the gossip around the office and connecting with people.

And yeah, also making friends and actually making lifelong friends too. So don't shortchange your accumulation phase, make that fun too. And then retirement will be fun. - And the last thing, do you think, one thing about retirement that because you're in it, maybe you can help me kind of grab with is, or maybe you can help me understand is, I feel like with all this free time in early retirement, you'd actually have more time to spend.

And so if I look and say, "Oh, right now I spend," let's use our old example, $80,000 pre-retirement. Do you think from all the case studies you've done, that number should be higher or lower? Because you've talked about die with zero. One of Bill Perkins' points was people in retirement spend less, but what about people in early retirement?

- So, I mean, obviously people in retirement spend less because you have this cliff when people retire at age 65 or 67, right? So maybe some people slow down already. Sometimes it's also, it's basically job-related expenses that you have less of. So for me, it's probably, yeah, we probably now might be spending more, say outside of some of the fixed expenses that you had in California, right?

A big mortgage. So that is now gone, but what you spend on top of the mortgage, yeah, I mean, you didn't even have time to travel as much. And so we definitely spend more on travel. We have to pay out of pocket more for health expenditures. Yeah, I mean, keep that in mind that some of that might change.

You might spend less on work clothes and commuting, but yeah, you have more time to spend money. You have more bandwidth. You sit in front of the computer. Maybe just out of boring, out of boredom, you check out Amazon and do some therapy shopping. And so it could be a problem.

I definitely noticed we spend more on certain categories, but spending less on work clothes and less on the mortgage, and we have no mortgage right now, but yeah, it could be a problem for some people. You should have this guy on the show as Justin from Root of Good, so he can tell you more about it.

So he definitely, he has this theory that he's spending somewhere between $30,000 and $36,000 on a lifestyle that would require a $100,000 salary for the average middle-class American. So he can probably tell you that, no, because you have more time, you can do more stuff yourself. You have to outsource less.

You can do more home repairs yourself. You can do yard maintenance yourself. So there are definitely going to be different views. My personal view is, yeah, probably outside of the sum of, so if we had stayed in San Francisco, we probably would still have that cost and maybe a little bit more.

So maybe just purely by numbers, we're spending less now, but that's because we don't have the mortgage in San Francisco anymore. This has been awesome. Everybody should go check out the series. If they want to go deeper, we'll link to that. We'll link to the site. We'll link to the toolbox and the spreadsheet you built.

Is there anywhere else you want to send anyone or any parting words you want to share? Check me out on my webpage. And we probably have already common audience, but if you haven't found me yet, that would be good to check me out. Early retirement now is where everything is.

Links are in the show notes. Karsten, thanks for being here. You bet.