Today I invited a professional to join me for a FIREy discussion around financial independence and living off the portfolio after early retirement. Allen Muller is a flat-fee advisor and CFA Charterholder who founded 7 Saturdays Financial after pursuing financial independence in a corporate career. Allen is one of the individuals I go to personally for specific questions and he was gracious enough with his time to contribute to this discussion.
One topic I’ve seen you talk about is the Get Rich vs. Stay Rich portfolio. What do you mean by this?
A: Once you’ve won the game, take some chips off the table and de-risk your portfolio a bit. You can get rich from concentration, but you can also get poor from concentration. The ugly cousin of high returns is high risk and the potential for ruin. Remember Enron? Kodak? Blackberry?
After you’ve built life-changing wealth, your focus should be on keeping it rather than swinging for the fences. Reposition your portfolio to a sensible allocation that will still grow, but with much less idiosyncratic risk. You don’t want to be that guy/gal who “had money.” This is especially important if you’re depending on your portfolio to fund your living expenses.
My favorite analogy for de-risking your portfolio is that you’re deliberately giving up the chance to hit a grand slam in exchange for avoiding a strikeout.
Some examples of transitioning to a “stay rich” portfolio include: diversifying the equity allocation across thousands of global companies and adding a meaningful allocation to bonds/alternatives to stabilize the portfolio.
R: I’ve found the biggest challenge of the Stay Rich portfolio vs. Get Rich portfolio as an early retiree is avoiding the fear of missing out (FOMO). This is true for me with growth vs. value stocks. I will generally tilt my portfolio towards value because it has a similar long term profile as growth stocks with lower volatility. The challenge with this is not getting too frustrated when the growth / NASDAQ sectors want to lead in a quarter or in a year and knowing the strategy works out fine over time. Since I’m withdrawing money from the portfolio monthly, volatility presents more risk to me than total returns.
I’ll take the beach over the office
What would you say to the people who criticize early retirees about a meaningful bond / cash allocation?
A: I would say they don’t understand risk. Yes, stocks generate fantastic returns on average – roughly 10% per year. However, year-to-year returns can vary widely. If you retire with a 100% stock portfolio, you’ll probably be fine. But there’s an uncomfortably high chance you won’t be. If the first few years of retirement are plagued with negative returns, your withdrawals can cripple the portfolio before the good returns show up. This is called “sequence of returns risk.”
Building a “war chest” of cash and bonds is critical. Yes, a more conservative allocation will result in slightly lower performance. But when stocks are down 30%+, less volatile assets come to the rescue. Ideally, you’ve designed your portfolio so you can fund your living expenses for several years with them. This buys you time to get through the worst of the equity drawdown, if not the whole thing.
Are there indexes you like in addition to or complementary to the financial independence portfolio of “100% VTSAX”
A: The FI portfolio of 100% total US market is simple to understand and implement. However, there are issues – it’s heavily tilted toward large growth companies, and there’s zero international exposure.
My preference is to use slightly less simple but more intelligently designed portfolios. Nobel prize-winning research suggests that tilting toward rewarded factors like small, value, and profitability can increase returns over the long-term. Diversifying internationally is just prudent risk management. During “the lost decade”, US stocks lost money from 1999 to 2009 but internationally had a positive return. Owning companies outside the US can provide rebalancing opportunities and lower overall portfolio volatility.
R: I’ve always believed there’s two components in return: The total return and the risk and volatility associated with the return. Value Stock Geek recently posted this (Extreme) example, taking a three asset portfolio split evenly between two volatile assets and the 10 Year US Treasury.
A: That’s a great point. There’s return, and there’s risk-adjusted return. Volatility isn’t a big deal until you get 8 to 10 years from retirement. But after that point, you really need to pay attention to stability and reduce volatility/drawdowns. It can mean the difference between cat food and caviar for dinner in retirement.
I’ve seen several people in the FI / fatFIRE forums getting incredibly wealthy on a single stock concentration, most prominently Tesla. These folks seem to struggle to sell and double down on their bet, complaining about tax implications if they do sell. What advice do you have for this situation?
A: There’s a ton of overconfidence bias among these investors, especially if they work for that company or are a fanboy of their products. This familiarity makes them think they “know” the stock is “going to go to the moon”. Of course they have no information advantage over the other seven billion people on the planet, and they haven’t even run the numbers to see what kind of earnings growth assumptions are embedded into current market value. Are they realistic? Who cares! To the moon!
When the stock is high, they don’t want to sell because it’s going to go higher. When the stock is low, they don’t want to sell because it just has to rebound.
It’s no different than someone at the casino who had a lucky streak and now has a fat stack of chips in front of them. Unless they turn around and walk out of the casino, they’re probably going to lose it.
Investment decisions should remove emotion as much as possible. One way to do that is to use “the overnight test.” Imagine you wake up tomorrow morning and your entire portfolio has been liquidated. Instead of the stocks you owned, you’re left with a big pile of cash. Now – would you buy the exact same assets you had before? Or would you invest in a thoughtfully designed, diversified portfolio that aligns with your goals?
If you’ve got a majority of your net worth in a single company, you absolutely need to unwind that position. Do it in a tax-efficient way and consider using options to hedge your downside risk while you exit.
R: I wanted to reiterate the difficulty for people to make a correct decision twice in a company. They can make the correct decision to buy, but often can’t make the decision to sell, or even worse, buy more based on their strong conviction and proceed to offset all the gains.
I personally experienced this with a well known restaurant chain I purchased. An activist investor got involved in a company that was expanding too fast and not focusing on existing operations. Within a couple of years, the company improved, delivering me a triple on my investment plus a dividend paying nearly a 10% yield on my original cost within three years.
The easy gains were gone, but I didn’t sell. It was some combination of using capital gain taxes as an excuse and “believing in the company”. Management proceeded to spend 1/5th of their equity in an acquisition with minimal disclosure in 2019 and the company still hasn’t recovered. I got out of most of my position, but waited far too long. The company still hasn’t come close to it’s 2019 due to this acquisition and running out of easy levers to pull in the business.
I’m seeing a bunch of people out there doubling down on a certain electric car company with nearly a billion dollar market cap and declining margins believing the next ten years will be similar to the last ten years.
Why do you think some investors can’t stop taking concentrated / leveraged risk?
R: My most frustrating clients in my old career were entrepreneurs whose current cash flow and net worth were tied to their small business. It was an amazing way to build wealth because the owners could make an income while building while simultaneously selling their company at exit (and enjoying capital gain rates at the sale). Unfortunately very few of these business owners would diversify or barbell their risk and offset the small business risk with a portfolio of cash / treasuries. Often I’d see some real estate holdings for diversity, which was great for net worth but terrible when these owners needed to generate cash during distress.
This is probably less of an issue for FIREy folks, but an early education I learned about risk when I saw these successful entrepreneurs have something happen to their business and they lost both the current income and the long term value they were relying on to sell.
I see a similarity with real estate people that can’t diversify into public / liquid market investments. Real estate people will say “I don’t want to invest is something I can’t control”. There’s three ways to make money in real estate: value add, interest rates, and demographic / market growth. Value add is the only part of that equation that is mostly in control of the entrepreneur. I think many real estate investors have a false sense of control and are taking more risk than they realize.
A: Great points about real estate. They’re often concentrated in a single geography which can be great (Austin) or horrible (Detroit). And it’s definitely an “apples to oranges” comparison when you think about how active real estate investing is vs. laying on the couch and buying index funds.
We talk a lot about early retirement and the 4% rule, which sometimes can be debated up or down. Where do you fall in this debate and why? Specifically, what do you think about the sustainable withdrawal rate changing as someone ages?
A: This is one of the most hotly debated topics in the FIRE community. There are a lot of misunderstandings about the 4% rule and the study it was based on. The Trinity study did NOT conclude that 4% was a safe withdrawal rate for a 100% stock portfolio – it suggested that 4% worked for a portfolio ranging between 50% to 75% stocks. Also, the 4% withdrawal rate was found to be viable for 30 year time periods. If you’re retiring in your 40’s, you should plan on a 50 year retirement which means a slightly lower safe withdrawal rate (somewhere around 3%).
Another thing to mention is that most of these studies examine FIXED withdrawals based on the starting portfolio balance. They only adjust for inflation, not actual portfolio performance which is unrealistic. It’s like a pilot setting course from NY to LA and then tying their hands behind their back so they can’t course-correct if there’s a problem (or a good jet stream to ride).
Nobody is going to just spend, spend, spend while their portfolio crashes and burns 3 years into retirement. And they’re probably going to increase their lifestyle a little if their portfolio reaches 3x what they retired with. This is why I’m a huge fan of dynamic withdrawal strategies, aka “guardrails.” Guyton and Klinger wrote a paper on it. The idea is that you can start with a higher withdrawal rate early in retirement as long as you’re willing to make minor adjustments to spending when (not if) the portfolio declines in value below a certain point. On the flipside, you get to increase spending if the portfolio grows to a level where you’re above the upper guardrail. This strategy helps prevent BOTH types of plan failure:
- Outliving your money
- Dying with millions in the bank (unintentionally)
The asset allocation matters a lot when deciding on a withdrawal rate. Going beyond a traditional stock/bond mix and adding small amounts of alternatives (like gold) can have a stabilizing effect. It’s counterintuitive, but a lower return portfolio can often sustain a higher safe withdrawal rate than a higher return portfolio. The reason is lower volatility – you don’t need as much of a buffer between the withdrawal rate and the average annual return.
Related: Four Years of FIRE – Our Drawdown Strategy
Wrapping Up
It’s difficult for people to change habits, especially when the habits are something that achieved substantial success. I see this discussion over and over when it comes to both investing style and spending as someone transitions from scarcity to abundance in financial resources. Reducing the overall risk in the portfolio and utilizing money to improve life experiences becomes the goal vs. achieving the highest savings rate possible and maximizing returns.
I appreciate Allen’s generosity and contributions. He can be reached at 7 Saturdays Financial.
Thanks again for this post!
I agree that a dynamic withdrawal has many advantages. I personally appreciate the one that is based on equity valuation suggested by Big ERN.
I also find the “overnight test” very useful. We should aim for the portfolio that we want, instead of thinking about the structure of our current portfolio. Naturally, we have to take into consideration tax implications before adjusting the portfolio.
Finally, as bonds are now positively correlated with stocks, bonds are losing their hedging property and offer less diversification. Although we currently have bond funds, we will likely transition to cash instead.
I’d add a minor correction to your last paragraph… bonds were positively correlated with stocks in 2022. I’d stop short of saying that they “are” positively correlated with stocks going forward.
I just checked. Bonds are still positively correlated in 2023. No one can predict the future, certainly not me. However, it seems that the shift from negative to positive correlation since 2022 is not limited to 2022.