Reminder: Equity Valuations And SWR Are Inversely Correlated – Or Why Not to Worry About The Next Bear Market!

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by user4847378942

With the current market dip a lot of people might have gotten a little scared, especially with high equity exposure as probably most of us have.

So I just wanted to remind everyone, that even when the market corrects (when that will actually happen, is not really focus of this discussion here), it is not as bad as it might seem in absolute $$$ terms. The key point is what income stream (monthly or yearly) you can generate or withdraw from your nest egg.

With a classic high equity portfolio (80%+ stocks) which you will need for a long FIRE life 1, the important thing is the Safe Withdrawal Rate (SWR).

Research by Kitces and others has shown that there’s a strong relationship between SWR and Shiller CAPE 2. Hence when market valuations drop the CAPE goes down and the SWR goes up!

Now, there are multiple ways to calculate a CAPE based SWR rate 3, but the easiest is: SWR=1/CAPE 4

Compare the two income streams, before and after the ‘08 crash with a CAPE-based SWR:

  • Oct, 1 2007; Portfolio Value (100% VTSAX, 30.24 (Adj. Close) 5 ): $1,000,000; CAPE: 27.32 6; SWR: 3.66% –> Income Stream: $36,600/year ($3,050/Month)
  • Mar, 1 2009; Portfolio Value (100% VTSAX, 13.71 (Adj. Close) 5 ): $453,373; CAPE: 13.32 6; SWR: 7.50% –> Income Stream: $34,002/year ($2,833/Month)

For the above example I’ve simply assumed one has a portfolio value of 1MM, with no contributions/withdrawals. It shows that although the absolute value of the portfolio drops by roughly 55%, the drop in income stream is only 7.5%. In reality, when in accumulation phase, this might look even better, since buying is cheaper during the bear market, which would result in higher gains as the market corrects. I just wanted to post this, to say that a 7.5% drop in income stream is not too bad as the absolute worst case scenario 😉

Sources: 1: earlyretirementnow.com/2016/12/14/the-ultimate-guide-to-safe-withdrawal-rates-part-2-capital-preservation-vs-capital-depletion/ 2: www.kitces.com/blog/shiller-cape-market-valuation-terrible-for-market-timing-but-valuable-for-long-term-retirement-planning/ 3: earlyretirementnow.com/2017/08/30/the-ultimate-guide-to-safe-withdrawal-rates-part-18-flexibility-CAPE-Based-Rules/ 4: finpage.blog/2018/02/28/cape-and-safe-withdrawal-rates/ 5: finance.yahoo.com/quote/VTSAX/history?period1=1190239200&period2=1236639600&interval=1wk&filter=history&frequency=1wk 6: www.multpl.com/shiller-pe/table?f=m

EDIT: Here’s an example, how the two Portfolio’s would have performed since 2009 (first and second tab “Case Study”): docs.google.com/spreadsheets/d/1-wYzkzXr0MEC_ew7xWk7qiQvdBDAmjyyksDHlzK0D28/edit?usp=sharing

EDIT2: This is mostly a good approach to for all folks that are still in their accumulation phase. For all Early Retirees, you probably have this figured out anyway, if not consider looking at a bond-tent in the current high equity valuation regime 😉

 

Disclaimer: Consult your financial professional before making any investment decision.

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