The 4% rule of thumb; this is what got me convinced about the concept of Financial Independence. I am taking some time to reflect on this rule after a few years to better understand how it shapes an investor’s journey.
The 4% Rule
According to the 4% rule, one can withdraw a maximum of this amount from their portfolio (consisting of stocks and bonds) each year and never run out of money. Therefore having a portfolio of which 4% can cover your annual expenses means that you are Financially Independant (FI).
This amount or Safe Withdrawal Rate (SWR) was determined by examining historical stock market returns. A lot of investors have no idea how much to safely withdraw from their portfolio, fearing that they will deplete it, so the 4% SWR is definitely a good starting point.
What does this mean in practice? As an example; if the investor has monthly expenses of £1,000 or £12,000 annually, we need to work out 25 times the yearly amount to determine the value of their required portfolio size – £300,000. A portfolio of £1 million would provide an income of £40,000. By saving and investing at least 50% of their income such a portfolio is attainable in a relatively short period.
Historical Withdrawal Rates – Impact on Portfolio Value
The table above from the Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable Journal, outlines success rates of portfolios with different stock/bond allocations over payout periods of up to 30 years. The data is for the period from 1926 to 1995. I do not expect results to be very different today and data from more recent periods shows even better results.
A quick glance shows that a Withdrawal Rate of 4% largely covers most individual scenarios with high levels of safety. 3% appears to be bombproof! 5% and 6% seem doable for the highly risk averse investors, and consequently means that they would need a relatively small portfolio.
It is interesting to know how much your portfolio could be worth after a range of withdrawal time frames. An illustration is shown here. Generally, the portfolio will be worth a lot more on average, and the longer the period the larger the value. A striking example for the 75% Stocks/25% Bonds portfolio over 25 Years. A sixfold increase while withdrawing 4%!
In my own personal situation, as of today i have achieved 62.37% FI in about 8 years with an average savings rate of 53.38%, while targeting a proportion of larger than 80% in stocks within my portfolio. It has been a bumpy ride, with markets ups and downs, but with stocks near all time highs things are looking positive.
My current Withdrawal Rate is 6.46% which is well short of the 4% I would be comfortable with. However, looking at the 6%/7% columns above makes me feel in a very good spot right now. Of course, lifestyle inflation can drastically alter these figures for the worse overnight, while Geographic Arbitrage can improve things.
A reflection of the progress and historical data shows that it is imperative to invest aggressively early on and stay the course until a safe level is reached. The aim is to buy stocks as often as possible, particularly when prices are low, while avoiding market timing.