The Importance of Managing Drawdowns in Retirement

[00:00:00] Welcome to Two Quants and a Financial Planner, where we bridge the worlds of investing in financial planning to help investors achieve their long-term goals.

[00:00:05] Join Matt Zeigler, Jack Forehand and me, Justin Carbonneau, as we cover a wide range of investing and planning topics that impact all of us and discuss how we can apply them in the real world to achieve the best outcomes in our financial lives.

[00:00:15] Justin Carbonneau and Jack Forehand are principals at the Lydia Capital Management.

[00:00:18] Matt Zeigler is managing director at Sunpoint Investments.

[00:00:21] The opinions expressed in this podcast do not necessarily reflect the opinions of Lydia Capital or Sunpoint Investments.

[00:00:25] No information on this podcast should be construed as investment advice.

[00:00:28] Securities discussed in the podcast may be holdings of clients of Lydia Capital or Sunpoint Investments.

[00:00:34] So Matt, today we are going to talk about the exciting topic of withdrawal rates and retirement planning.

[00:00:39] Which does it get any more exciting with this? I'm literally sharing with anticipation at how joyous this occasion is.

[00:00:47] Well, it just shows how much of a nerd I am that I actually am quite excited to talk about this topic because it sort of bridges my world of like quantitative analysis with your world of financial planning.

[00:00:56] And anytime I can run numbers and scenarios and all that stuff, it gets me very excited.

[00:00:59] It's like a war blanket for you. It is.

[00:01:02] It is. Six, six percent.

[00:01:04] It has many negative implications in other aspects of life, but in this particular aspect of life, it's actually a pretty good thing.

[00:01:11] This is a very good thing and it's an essential part of the thing.

[00:01:17] Often I'll say to clients, it's like, okay, we got this part out on the table.

[00:01:20] Now we have to go do math about it.

[00:01:22] And this conversation is literally just saying why we go do math about it, which is a big part of the process.

[00:01:30] And I assume most of the clients are not like me. They're not like, I'm excited. Let's go do the math.

[00:01:34] I'm terrified. I'm terrified.

[00:01:38] No, I'm just kidding.

[00:01:39] I love the ones who ask the questions because then you actually get into the philosophy of the math.

[00:01:43] And usually it's the ones who are most interested in the math behind these outputs

[00:01:49] that can get into the nuance of these things where we start to like we're going to talk about

[00:01:53] why Monte Carlo analysis is useful, but it's no holy grail. It doesn't predict the future.

[00:01:59] It's just a way to think about these scenarios.

[00:02:02] And if you have no understanding of math, you might just say like, okay, cool, the plan checks out.

[00:02:06] If you have a deep understanding of math, you start to actually appreciate some of the poetic nuance of what all these numbers represent.

[00:02:13] So there's a happy medium in here.

[00:02:16] And before we dig into that exciting topic, I also want to just mention you have a new podcast.

[00:02:22] And it's it is very, very cool. Like I really like it. Like it's hard. There's so many podcasts out there

[00:02:27] these days like coming up with a unique idea is very, very difficult. I mean, I've run out of them.

[00:02:32] But you actually have come up with a unique idea. I mean, you're bringing first of all,

[00:02:36] it's called Just Press Record. It's on the Cultish Creative YouTube channel, youtube.com.

[00:02:41] Cultish Creative. And your ideas, you can explain it better where you're bringing

[00:02:44] two people together who don't seem to have much in common and you're finding common ground with a common topic.

[00:02:49] And I love listening to the first two episodes and they're really good. So I would strongly encourage anybody to go there,

[00:02:54] check this out. It'll be very different than the type of content we have here, but it's really, really good.

[00:02:58] And I learned a lot from it.

[00:03:00] Well, you're very kind. Thank you for the quick commercial at the top. It wouldn't happen without you obviously too, which big ups Jack Forehands podcast skills and youtube skills.

[00:03:09] But yeah, hey, come come check it out. The fun thing here is

[00:03:15] I didn't want to do an interview show. I didn't want to do

[00:03:18] monologuing on something that I think is boring, but because both of us are active online in other places,

[00:03:24] constantly I'll see somebody ask a question and go, that's a great question.

[00:03:28] I would love to hear this person talk about this idea and bring somebody else I know who knows something about that too into the equation.

[00:03:36] And so the second episode we had Brian Portnoy and Matt Cashman on and Brian Portnoy brought all of

[00:03:43] his expertise and experience in behavioral finance and behavioral psychology to the table.

[00:03:48] Matt Cashman brought all of his options educator and former pit trading logic into the thing.

[00:03:53] And lest you believe it's just a conversation about finance,

[00:03:57] like we were talking about parenting philosophy and how to think optionality in life.

[00:04:01] And that to me that's so cool. I'd be a fly on the wall for this conversation.

[00:04:06] So the opportunity to create it for other people to hear is really, really cool.

[00:04:10] And that's what's great about it is you have the ability to take these people who seem to have

[00:04:14] nothing in common and find common ground. I feel like at some point you're going to be like,

[00:04:17] today I'm joined by Vladimir Putin and the Dalai Lama. And I found something in the center

[00:04:21] that they both make sense of both of them or something like that.

[00:04:24] Yeah, we're going to read Dostoevsky together which is probably the only thing I could think of.

[00:04:30] It's really cool.

[00:04:31] Something on the top of your head is very impressive.

[00:04:33] Well, and the fun part is too, then I have like, I get a message from, you know,

[00:04:39] Porto and Cashman apparently having dinner without me in Chicago and I'm going like,

[00:04:42] okay, this is awesome. I made two otherwise strangers friends and now they're getting

[00:04:46] together in the real world after, you know, I trolled them into joining a conversation

[00:04:51] where they had nothing, no idea what to expect except to log into a link.

[00:04:56] So I guess we'll go off our tangent now and we will return to financial planning.

[00:05:00] And you had mentioned in your initial thing, you mentioned Monte Carlo simulation and before

[00:05:05] we talk about this idea of drawdowns and retirement planning, I think the first thing

[00:05:08] you should do is for people who aren't familiar with Monte Carlo simulation,

[00:05:11] we should introduce what it is and how you use it as a financial planner.

[00:05:15] This is one of those words. It should trigger the thought of

[00:05:20] Monte Carlo, the casino in your brain first because what we're doing is this is basically

[00:05:25] a way to set odds on stuff happening. So as a planner, we're looking at Monte Carlo as a way to say,

[00:05:31] more things can happen than will happen. So how do we run a bunch of these scenarios forward

[00:05:37] with a whole wide range of outcomes and see on average what works out in a client's favor

[00:05:42] or against the client's favor? So full stop, Monte Carlo, think casino,

[00:05:48] think just running the odds to have an understanding of what might happen.

[00:05:52] Textbook definition. Monte Carlo is a model to predict the probability of a variety of outcomes

[00:05:58] when the potential for random variables is present. I don't understand what that means.

[00:06:03] So to break it down roughly, Monte Carlo again, think casino, we're looking for good,

[00:06:08] bad and mediocre realities. It's a model. So asking, is this the real life? Is this just

[00:06:14] fantasy? Yes, fantasy, the map is not the terrain. But we still want to map this thing out

[00:06:20] to predict the probability of a variety of outcomes that's risk. These are the definitely

[00:06:26] maybe's odds like market returns, things like this get folded in and when the potential for

[00:06:32] a random variable is present, that's uncertainty. It's the stuff that we can't know like how long

[00:06:38] we're going to live, what happens if we get another great depression or whatever else. So

[00:06:45] in a nutshell, and we have a great Monte Carlo episode two people can look up but

[00:06:49] life is random, death is not and some stuff will probably happen along the way. But we don't

[00:06:54] exactly know when so let's do math about it. How's that for a definition of money?

[00:06:58] It's good. You know, I mean, the idea is I've got a portfolio. I want to retire. I need to draw money

[00:07:03] out of that portfolio. A lot of stuff might happen in the future. And one way to look at

[00:07:07] the stuff that might happen in the future is to look at the returns of the market, all the

[00:07:11] different returns that have occurred in the past of the market and take those returns and

[00:07:14] order them in all kinds of different directions and say, All right, I've got my portfolio.

[00:07:18] I've got these returns. I've got my money coming out. Like what are the of all those scenarios,

[00:07:22] let's make thousands and thousands of possible things that could happen. How often do I run out

[00:07:27] of money or how what is my portfolio value that ends in all these things? And obviously this is

[00:07:32] the real world doesn't play out that way. In the real world, the hip has to get replaced.

[00:07:36] And other things happen that you didn't put into the Monte Carlo simulation.

[00:07:39] But the reality is it just gives you a good rough idea of where am I at?

[00:07:43] Like what are the odds I can achieve what I want to achieve? And if you look at all those outcomes

[00:07:48] and you look at kind of, how many of them are really, really bad? How many of them are really,

[00:07:52] really good? What's in the middle? I mean, you could just get an idea, I think, of what

[00:07:56] the potential things in the future could be. A cool thing about that too is because

[00:08:03] like what's stopping you from just saying stocks give me 8% or 10% or whatever Dave Ramsey

[00:08:08] thinks they give you this week. Like whatever the number is. Like 17 or something probably.

[00:08:11] Yeah, 20% of year. I don't think he said that. I think he's that. Well,

[00:08:15] I'm not going to say it's not that bad. You can take out as bad as he is and average out

[00:08:18] of yourself. So it doesn't just take the average return. It takes the average of the averages.

[00:08:24] That's an oversimplified way to put it. But this is a nice thing about Monte Carlo

[00:08:28] is it helps us think I'm not just going to get 8% a year for my stock allocations.

[00:08:32] It helps me average that out over different time periods and over different scenarios.

[00:08:36] And that's what makes it useful because it at least make sure we're putting some of the

[00:08:41] mess back into the assumptions and looking at the average messes that occur there.

[00:08:45] Good and bad and mediocre again, like there's lots of mediocrity in this. And that's part of the point.

[00:08:51] But it makes sure we're at least calculating for the mess to see the range of potential mess

[00:08:56] in front of us as opposed to just doing a straight line on a spreadsheet which is

[00:09:00] I don't know theoretically maybe you know that's what the pension company told you

[00:09:04] they could do in 1976. That's now belly upright.

[00:09:06] And it's interesting to me because there's this trade off. There's a trade off between

[00:09:11] if I've got a retirement portfolio, I'm earning a return, I'm taking money out.

[00:09:15] I obviously want to maximize the growth of that portfolio as much as I can like

[00:09:19] the ending value of that portfolio if I want to give it to my kids whatever it is.

[00:09:23] That could be an important thing. But the other important thing is I don't want to run out

[00:09:26] of money. I don't want there to be a very high probability that I end up with zero

[00:09:32] because then I've got a major, major problem on my hands. And those two goals can sometimes be

[00:09:36] opposed to each other and we'll talk about this. But when you construct a portfolio,

[00:09:40] what you want to do to optimize one of those goals, the maximum growth over time

[00:09:44] may not optimize the goal of the percentage chance that I don't run out of money.

[00:09:47] And a lot of what we're going to talk about here I think is kind of balancing those two

[00:09:50] different things. Yeah, because like let's be clear back to the that old sentiment of I

[00:09:56] want to die with a dollar left like the last check should be to the funeral home.

[00:10:00] That's great if you know exactly when you're going to die and all the other assumptions

[00:10:04] that go into this thing. But that's not reality. So balancing I want to have as much money as

[00:10:09] possible or leave the biggest gift to my kids that I can do or the university or the charity

[00:10:13] or whatever it is, we can't know those things. And therefore optimizing for a single variable

[00:10:20] is definitely, definitely impossible here, especially if it's like a savings goal

[00:10:24] or something else. And as soon as you start to balance, I want to grow my assets as much

[00:10:29] as I can. But I also want to take withdrawals off of them. That's where it's inevitably messy.

[00:10:36] So if we know it's going to be inevitably messy, that we need tools like this to help us understand

[00:10:43] how we might navigate those messes as they present themselves to us in our future.

[00:10:47] Yeah, like the book that was zero, which by the way is an excellent book

[00:10:52] executing and that's not what he's getting at in the book. But like the executing

[00:10:55] that in the real world is quite difficult. Like it would be great if I want to die like on a cruise

[00:10:59] in the Caribbean Sea when my last dollar has just come out of the bank account. And that's

[00:11:03] how I want to go. But realistically getting to that is basically impossible in the real world.

[00:11:07] Like it's not going to work out that way. Are we how many episodes deep and I haven't made a

[00:11:11] single Jack Kvorkin joke to you? You're halfway there. This is amazing. Okay, I'm going to

[00:11:18] put that back in my pocket and remind myself later. Well, so let's, I guess let's talk about

[00:11:24] this next because so the first big thing that happens on our ways on our approach towards these

[00:11:29] goals. So we run the Monte Carlo analysis, but one of the things that that forces us to grapple with

[00:11:34] is this thing called sequence of returns risk. And in a nutshell, that's basically

[00:11:40] the good years and the bad years because in markets. Hey, Jack, how often do we get the

[00:11:44] average annual return for the SMP and the actual real world experience SMP?

[00:11:49] Almost never. I mean, like if you put eight to 12%, like how many years is the market

[00:11:53] return between eight and 12%? I don't know the exact percentage, but it's very, very love.

[00:11:56] It's almost always above or below that. So then how do we think about sequence of returns risk or

[00:12:01] knowing that we're almost never going to get average? We're going to get a percentage above

[00:12:05] average or percentage below average every single time. How do we think about this? Why does

[00:12:09] sequence risk matter? Yeah, if the market returned 10% every year, we could just end

[00:12:14] this podcast and go a beer or something because there'd be no point in all this stuff. But

[00:12:18] the reality is that variation is what creates the problem. And so the easiest way I think to

[00:12:22] think about sequence of returns risk is if I give you, let's just say 20 years, if I give you

[00:12:25] 20 years of market returns and you're not putting money into your portfolio and you're not taking

[00:12:29] them out, you can spend the rest of your day ordering those returns, which I wouldn't recommend

[00:12:33] doing it would be that exciting. But you could do that. You're going to come up with the same

[00:12:36] ending value in your portfolio no matter what they could be at any order. It doesn't matter

[00:12:40] if the the worst fair market is the first year or the best bull market is the first year,

[00:12:44] you end up in the same place where we have a problem is when we start with drawing or

[00:12:48] adding money to that portfolio, it changes things. So when I'm withdrawing money from my

[00:12:53] portfolio to think about it like in an extreme way, if 2008 is the first year I'm retired,

[00:12:59] I retire right at the middle of 2008 and I'm withdrawing 4% of my portfolio and I have 2008

[00:13:05] right away. Now I've got two problems. One, I lost money in my portfolio, but the second is

[00:13:09] I'm now withdrawing money from the portfolio so that money cannot compound in the future.

[00:13:14] When inevitably the market comes back like it did after 2008, I've pulled a bunch of money when

[00:13:19] the market was down and that money's not going to compound. So I've caused a huge problem with

[00:13:24] my retirement and that's the idea of sequencer returns risk is when you're withdrawing money

[00:13:28] from a portfolio, this the order of the returns matters. It's not just like the original

[00:13:33] thing I said they can be in any order. And an interesting aside with this too is if you're

[00:13:37] a new investor who's just starting to save, you want 2008 right away. You want to just

[00:13:42] probably feel terrible. It's probably horrible behaviorally, but if I start saving at the beginning

[00:13:47] of 2008 and my portfolio just gets decimated, it's the best thing that could possibly happen to me

[00:13:52] because now I'm investing at those reduced rates. Now I'm buying the dip instead of selling the dip,

[00:13:57] I'm buying the dip and that's going to actually help me in the long term. So it's interesting

[00:14:00] to think about it from both ways, but that's what it is. It's the risk that you,

[00:14:04] it's the risk that because of withdrawals, the sequence of returns of markets matters.

[00:14:10] And I think this matters and it's important to say this too. There's the cash flow reality of money

[00:14:16] that you're putting in and money that you're taking out. And there's also the other realities of

[00:14:21] like reinvested dividends or interest reinvested coupons, tax drag on these things. These are all

[00:14:28] pieces that go beyond kind of like the headline what did the S&P do this year? It's like well

[00:14:32] the S&P did this and then if we include dividends, then we have to know if it's an

[00:14:35] a taxable account or a tax deferred account. Then we have to know if you paid the taxes out of those

[00:14:39] things or did you pay them out of somewhere else? All this stuff is just stacking layer upon layer

[00:14:45] upon layer upon layer of the mess that goes into these things. And so your sequence risk becomes

[00:14:50] tremendously important and hey, it also becomes super important when we get outside of one asset

[00:14:57] class. The more the asset classes are correlated with each other, the more you

[00:15:01] have this type of problem. Because what I'm worried about with sequence of returns risk is I'm

[00:15:06] worried about negative years early. And so as I think about additional asset classes,

[00:15:13] like the correlation of those asset classes with whatever I already have becomes really important.

[00:15:18] So and this is something you think about a lot when you see a year like 2022

[00:15:22] where bonds and stocks are down together. So what a lot of people probably modeled out in terms

[00:15:28] of the sequence of returns risk of stocks and bonds may have played out a little differently than

[00:15:32] they thought because that was one of the worst years ever, I think for a 60-40 portfolio because

[00:15:37] stocks and bonds were down together. And that's a lot of what we'll talk about in this episode

[00:15:41] is this idea of what I'm trying to do is if my goal is I'm trying to limit the chance that I

[00:15:47] run out of money, then I'm not just trying to create the best return, but I'm also trying

[00:15:52] to manage the risk in the drawdown part of the component at the same time because that

[00:15:56] allows me to have a better sustainable withdrawal rate. And that's where these other asset classes

[00:16:01] come in. That's where things that go up when stocks and bonds are going down can be helpful

[00:16:06] when you test these things historically and you say like, what is my withdrawal rate

[00:16:10] that I can sustain? But before I get into that, I want to just ask you this idea of failure

[00:16:15] rates because the idea of a sustainable withdrawal rate comes from this Monte Carlo

[00:16:19] simulation which is like I can have a certain withdrawal rate on my portfolio

[00:16:23] where I have X percent confidence that I'm not going to run out of money. And obviously,

[00:16:28] to your point at the beginning, the past is not a complete predictor of the future. So this is not

[00:16:32] like we're saying cast in stone, this is your percentage chance of running out of money. We

[00:16:36] don't know that. But you have to when you do these, you have to decide what is the rate

[00:16:42] I'm willing to live with in terms of the percentage chance I run out of money? Because

[00:16:46] I don't think if you try to run these things to 100% chance I don't run out of money,

[00:16:51] I think you're looking at a situation where you're basically not taking any money out of your

[00:16:53] portfolio. So like, how do you think about that as a planner? Like what is an acceptable risk

[00:16:59] that I run out of money? So two pieces. First off, some people hit the 100% number from the

[00:17:04] scenario. That's usually because they're either really severely limiting withdrawals for

[00:17:10] plenty of good reasons. You might just have a boatload of money and you don't need any

[00:17:13] money out. Congratulations, you can get to 100. It might be that you're just not spending any

[00:17:18] money. So somebody might be on maybe their social security totally is the total expense of their

[00:17:23] lifestyle and they don't do anything except take local books out of the local library and call it

[00:17:27] a day. These people are out there and that's a good life. There's nothing wrong with that if

[00:17:31] that's what makes you happy. And they can hit 100% too. Now for the rest of us who like to

[00:17:36] spend our money on expensive boats and clothes and whatever else I assume you spend your

[00:17:40] money on, Mr. Forehand. This is a squishy area. So 90% is a lot of financial planners will say

[00:17:49] we try to run the analysis, we try to get people to 90%. And that's fine. That's well and good.

[00:17:54] That basically is saying you're within approximately two standard deviations around the

[00:18:01] median or medium withdrawal rate for this thing and that most of the scenarios you're covered.

[00:18:06] So 90% is still basically an A plus rating on the plan and the Monte Carlo output. Now here's

[00:18:15] here's the messy idea this successful plan can actually have a 50% success rate.

[00:18:22] And that's a little bit counterintuitive first because last time I went to school,

[00:18:27] if I got a 50 on a test, my mom was not very happy. So how could that be possible? Do you

[00:18:33] know this logic or do you remember this logic, Jack? Well, I assume I would accept 50% if I

[00:18:39] have the ability to change my life first of all. Like if I think this is what I'm withdrawing,

[00:18:43] but in a scenario like that, I could actually not spend money on this and I could not spend

[00:18:48] money on this and I'm willing to live with that as a client. I would think that's one thing

[00:18:51] that would do it. Absolutely. I try to explain this or remind people of this in terms of

[00:18:57] weather. So when there is a 10% chance of rain, there's also a 90% chance of not rain.

[00:19:04] And this gets almost as much in a risk attitude as it does anything else. So if I have a 90%

[00:19:09] chance of not rain, then I'm probably concerned within that 10%. Is it like it might get overcast?

[00:19:15] It might get drizzly? Am I in Florida where I might have one of those like

[00:19:19] world ending thunderstorms out of nowhere or something? Am I going to be near a car

[00:19:24] or shelter? Or am I standing in a field? And this stuff starts to come into play.

[00:19:28] Now, when I'm at 90% success, I might not have to do much to avoid that what if I get wet weather

[00:19:35] scenario? But if I'm 5050, then I have to look at to your point, what can I do to change along

[00:19:41] the way? The reason 5050 and a Monte Carlo often still worked is because there's a substantial

[00:19:47] amount of time where I can change my lifestyle, change my consumption, change something so that

[00:19:53] I can actually boost those numbers back up in that scenario. This can be stuff and we talk about

[00:19:59] this a lot in the planning process. What happens if I get sick? What happens if a spouse or both of

[00:20:04] us die too young? What happens if we get sued? What happens if we live too long? These become

[00:20:09] those scenarios in the rainy day, the rainy side of the equation that we go, if any of these

[00:20:14] things start to happen, what else do we have to do to boost our odds of success from there

[00:20:20] forward? 90% chance? Great. I mean, 100% chance. Wonderful. 90% chance you're well, well on track

[00:20:28] with whatever your assumptions are 50% chance plan can still work. You just need to do a little more

[00:20:34] work around if one of these bad things starts to happen. How are we going to respond in real time?

[00:20:40] That is a tremendously useful financial planning conversation.

[00:20:44] Yeah, it's like it's almost like balancing the rainy day against the normal life. Like,

[00:20:48] if I'm retiring, I want to go on the cruise. I want to go do enjoyable things. But how much

[00:20:53] am I willing to give up on the situation where things go really wrong in order to do that? That's

[00:20:58] probably a different answer. Obviously, in the academic stuff for like 10% failure rate or whatever,

[00:21:02] but it's a different thing for every single person. First of all, it's like, how bad is

[00:21:07] the rainy day? Is the rainy day I have to get rid of the boat? Or is the rainy day I like

[00:21:11] can't eat food? Those are two different rainy days. How bad is the rainy day and then how

[00:21:16] much do I want to balance that with living my life the way I want to, especially because

[00:21:20] when people are younger, they have more opportunity to live the life they want to.

[00:21:24] For me personally, I'd probably much rather do more stuff in my 60s,

[00:21:27] understanding the risk is I might be like living on social security when I'm 92 or something.

[00:21:33] I'm not going to be able to do as much when I'm 92. I don't know if other people think

[00:21:35] through it that way, but there's so many balances in this thing.

[00:21:38] We try to really take people through this like live, die, sick,

[00:21:42] sued scenarios on the rainy day side. And for exactly that purpose, if I'm going to retire and

[00:21:48] sell my house and go be one of those people who like lives on cruise ships or whatever.

[00:21:52] Okay, great. So you want to do that. But then what happens if the pandemic happens

[00:21:56] and all the cruise ships shut down? Back to the rainy day scenario, 90% chance of sun,

[00:22:03] 10% chance of rain. If I'm going to watch, you know, the kids in a soccer game or something

[00:22:08] like that. I'm not too concerned, maybe my car is in the parking lot or whatever. But if I'm like

[00:22:13] outside at a soccer tournament all weekend, like am I maybe throwing an umbrella in the car just in

[00:22:18] case I'm stuck standing in a field with a bunch of kids? Yeah. So depending on your level of

[00:22:24] success and the lifestyle you think you're going to lead at the various phases or chapters

[00:22:29] or whatever in your retirement plan or scenario, or whatever we're running this Monte Carlo for

[00:22:33] that gave me more than just retirement that we're looking at, we start to go,

[00:22:37] what are then the variables in this lower expectation of success that we might have to

[00:22:44] adjust and that we're comfortable adjusting on real time? Because this gets back into that thing of

[00:22:49] what are the tradeoffs that are present? Because there's a big difference between

[00:22:53] going, okay, if the money doesn't work out, you know, the kids not going to go to Harvard

[00:22:58] and instead is going to go to a trade school versus like, I don't know, enter indentured

[00:23:02] servitude or something like there's, there's a wide range of outcomes Monte Carlo and the output

[00:23:09] of these results can help us drill into what are those tradeoffs? What are those priorities?

[00:23:14] How do we actually think through them in real time because your point, the academics,

[00:23:19] we throw numbers and percentages on this stuff like it's reality. That's not the reality

[00:23:24] of life. You'll have real decisions standing staring you down in your face.

[00:23:30] And that can be really messy. That's mom and dad got sick and I had to move home.

[00:23:34] That's mom and dad got sick and my spouse got sick all at the same time and I'm across three states.

[00:23:40] Life's messed up. Monte Carlo is never going to capture that. It's just a way for us to

[00:23:44] preemptively think about how we prioritize things inside of the plan.

[00:23:49] Yeah, and as we think about this in terms of how it leads into investment management and how

[00:23:52] a portfolio is run, like that's where this really becomes interesting because the whole thing

[00:23:57] is you want to manage, drawdowns become preeminent. Like they become very important when you think about

[00:24:03] it this way. So when I'm trying to manage the risk that I run out of money, what's going to kill me

[00:24:08] going back to sequence risk is massive drawdowns. And so a lot of people say all the time, you'll

[00:24:12] get the question like, all right, I want to withdraw 4%. Even though the 4% is not really

[00:24:16] what happens in the real world. We'll just use this as our example. Like I want to

[00:24:19] want to withdraw 4% of my portfolio, give me 100% equities. I've got a 30 year timeframe

[00:24:24] in retirement. Let's do this. And the reality is that does not work. It does work a lot of the time

[00:24:31] and a lot of the scenarios that exist, a pretty decent percentage of them, you'll be okay.

[00:24:36] You won't run out of money. You won't get 2008 at the front end. You'll actually have pretty

[00:24:40] good growth in your portfolio. You'll be able to sustain that withdrawal rate over time.

[00:24:45] But a stock only portfolio has 50%, 60% drawdowns or can. And if those happen at the wrong

[00:24:52] time, now you've blown up your portfolio. Now you have no money. And this is where introducing

[00:24:57] the other asset classes gets into this because as we introduce anything other than stocks,

[00:25:02] unless we're like putting venture capital or something in there or crypto or something

[00:25:05] like that. If we're putting like these uncorrelated asset classes or even lower risk asset

[00:25:10] classes, even if they are correlated, we are now reducing that drawdown number.

[00:25:14] And we're now we may we're probably paying a price in terms of our long-term return,

[00:25:19] but we are getting a benefit in terms of that percentage of time I run out of money is going

[00:25:24] down. And this becomes a huge balancing act in terms of how do I get this right? Like how do I

[00:25:29] think about constructing a portfolio that gives me a good long-term return, but also has

[00:25:34] a the lowest percentage possible chance that I'm going to run out of money

[00:25:37] to help manage the sequence risk. So I think another we're going to talk about buckets in

[00:25:44] a second. Very important to distinguish and very important in the planning conversation to

[00:25:50] distinguish between the drawdowns which are so you've rolled this snowball, and the snowball's

[00:25:57] gotten bigger. And a drawdown is basically like when half the snowball just falls off because

[00:26:02] you know, you slip and you fall and you put your arm through it or something like a drawdown

[00:26:06] is just the reality. The ball is still intact, but I've knocked something off by accident.

[00:26:11] The withdrawal is I'm choosing to take something away from them. It's not an accident that it's

[00:26:16] taken away, and I might not be able to pick that up and roll it back over. So when we think about

[00:26:21] drawdowns, we're literally thinking about the things totally out of our control. We didn't

[00:26:25] necessarily expense something. The markets did something to the stated value of our asset,

[00:26:31] they messed up our snowball in some way. A withdrawal is a choice for better or for worse

[00:26:36] to go ahead and take something out. And no, you might not be able to roll that back up again

[00:26:40] or make it back up to there. The quick reminder of the math of withdrawals is savage in that if I

[00:26:48] have a 50% loss, I need 100% return to get back to even that scales you should play with the

[00:26:55] math if you never have. But this is why this matters so much. And this is probably the

[00:27:00] great place where and you comment first on this, let's talk about asset allocation.

[00:27:04] I'll explain the bucket strategy that we use for thinking about this. But

[00:27:09] how do you want to set this part up, Jack? Yeah, before we do this, like what the point you just

[00:27:12] made is really important, which is you do some people at least have control over that withdrawal

[00:27:17] component. I mean, obviously if I need every dollar of it, I don't. But when you look at

[00:27:21] all these strategies you can run, I think we did an episode on like variable withdrawal

[00:27:24] strategies and stuff. And so one of the ways you can maximize or minimize the chance I

[00:27:29] run out of money is to be when you get that bad outcome to be willing to do something

[00:27:33] with the withdrawals. There's all these different fancy formulas or we don't need to go into all

[00:27:38] that. But the reality is if you were able to reduce the amount of money you're taking out,

[00:27:43] if you get the bad outcome, then you're going to have a much larger sustainable withdrawal

[00:27:48] rate over time. So we'll talk about on the portfolio side, but just if not just on the

[00:27:52] portfolio side, like for people who have the ability to do it and say, you know what, I'm

[00:27:56] going to take this higher withdrawal rate. But I know if things go bad, I'm going to cut it

[00:28:00] a lot and I have the ability to do it and still have my necessities met. That's a really

[00:28:04] important component of this as well. Yeah, just like we talk about on breaking news all the time.

[00:28:09] It's all about the flows. So understanding how you're going to mitigate negative outflows or

[00:28:14] negative events and the money you need to pull in and out at various times. The more you

[00:28:19] understand the different sides of the snowball here, the different variability of the variables

[00:28:26] to way, way overuse that word more than it ever should have been.

[00:28:29] That's really important understanding the nuance of why,

[00:28:32] again, we run the Monte Carlo analysis to help us think through all this type of stuff.

[00:28:37] Yeah, so I did this a long time ago, but to get to your question about asset classes,

[00:28:41] what we're trying to do here as we introduce other asset classes in the portfolio is we're

[00:28:45] trying to introduce asset classes that would either reduce risk or are uncorrelated. So they'll

[00:28:51] reduce risk by being uncorrelated with the other asset classes. So bonds is an example

[00:28:55] of something that is definitely less risk than stocks and can be uncorrelated to stocks,

[00:28:59] but also can be very correlated to stocks. Some of these other things you could put in,

[00:29:03] you know, whether it be gold or commodities tend to have much lower correlation to stocks.

[00:29:08] And so the idea is like I wrote this article a while ago, but what I did is I was looking at

[00:29:12] like this idea I use portfolio visualizer, which by the way is an excellent tool.

[00:29:16] And I was looking at this idea of like your 90% confidence withdrawal rate. So going back

[00:29:20] to what we talked about before, like on a certain portfolio, how much can I take out and

[00:29:24] have 90% confidence? I'm not going to lose money. And when I did that at this time, and it may have

[00:29:29] changed this then, but when I did that with 100% stock portfolio, that number was like in the

[00:29:33] threes somewhere in terms of what the 90% confident withdrawal rate was. And that portfolio had,

[00:29:39] as you run the simulations, that portfolio had a 58% maximum drawdown. And its maximum

[00:29:44] drawdown with cash flows was 100%. So why was this maximum drawdowns with cash flows 100%

[00:29:49] because I ran out of money in some of the scenarios. So if I run out of money in

[00:29:53] some of the scenarios, then I have a maximum withdrawal rate with cash flows of 100%.

[00:29:57] So that's what it looked like with stocks. Now when I put bonds in there, that withdrawal rate

[00:30:02] went up some because and my maximum drawdown on the portfolio went down to 26%. And my maximum

[00:30:07] drawdown with cash flows was now 34%. So meaning I did not run out of money. So what we're

[00:30:12] doing is as we add these, these other asset classes in, we are reducing our return. I mean,

[00:30:17] you can't argue that if I go to a 60 40 portfolio instead of 100% stocks portfolio,

[00:30:21] my historical return is lower. Over time, I'm not going to get the return. But what I am getting is

[00:30:26] I'm limiting that drawdown part of it. The percentage chance I run out of money is going

[00:30:31] down. And for most people in retirement, that's a trade off they're willing to make.

[00:30:36] They don't want to take the huge risk I run out of money to try to invest in stocks or

[00:30:41] something that's high risk and produce the absolute long term return because I have

[00:30:45] to worry about how devastating that percentage of time I run out of money is going to be to

[00:30:49] me. And for some people, that's obviously, you know, if you don't have the ability to adjust

[00:30:52] your spending, that could be very devastating. Like it becomes like I live on social security,

[00:30:57] I have to sell the house, you know, there could be some really bad things

[00:31:00] that exist in that percentage time, you know, that things go wrong. And so I have to manage that

[00:31:05] as I go. And so my idea was what I was looking at in this article was just as I add things

[00:31:09] to this, how does it impact those things? You know, overall what I'm doing. So adding bonds,

[00:31:14] I get a lower return. But I also get a better sustainable withdrawal rate because there's less

[00:31:19] outcomes where things go bad. What's interesting, and you know, this is a lot of the guys we've had

[00:31:22] on excess returns have talked about this, when you start to introduce some of these other asset

[00:31:26] classes, and you start to run something along the lines of a risk parity portfolio,

[00:31:30] things get things can get substantially better on that confident 90% confident withdrawal rate

[00:31:36] thing. Because effectively now I'm introducing asset classes that are going to be going up

[00:31:40] when stocks and bonds are going down. So like things like gold, you know, if you use a simple

[00:31:44] example of it, like the permanent portfolio, stock short term bonds, long term bonds and gold,

[00:31:50] that type of portfolio is going to have a much higher sustainable withdrawal rate

[00:31:54] than something like 100% equity portfolio or a 60 40 portfolio. Now we could argue what its return

[00:31:59] is going to be against those I mean against 100% stocks, it's going to be lower against 6040

[00:32:04] it has been lower for a very, very long time whether it will be in the future, who knows.

[00:32:08] But the one thing you can't argue is that portfolio stocks bonds and gold has a sub 20%

[00:32:14] maximum drawdown. Whereas stocks and bonds had 26 stocks had 58. So I'm bringing this maximum

[00:32:21] amount I can lose down. And what that does is that creates when I do that simulation with those

[00:32:26] thousands and thousands of things, that has there's less and less negative things in there

[00:32:31] that can destroy my plan. And that's the idea is as we're adding these uncorrelated asset

[00:32:35] classes, we're having less and less things that can be that really, really bad outcome.

[00:32:40] Because if I'm withdrawing 4% of my portfolio, a 10% decline in my portfolio at the beginning

[00:32:46] is far, far different than a 40% decline in my portfolio at the beginning.

[00:32:50] And so the more I can limit those major major drawdowns, the more money in theory I can

[00:32:54] take out over time. So when we get into it on the portfolio construction level relative to

[00:33:01] the financial plan. And I think what you just explained is the perfect version of inside a

[00:33:06] portfolio construction, here's how to think about it. And here's all the various ways to

[00:33:10] understand reduced drawdowns in asset allocation or construction decisions that can help you.

[00:33:17] People can go out and read academic papers about that they can look at real world results

[00:33:21] they can to the degree you want to hire somebody to figure this out for you figure it out for

[00:33:25] yourself. The internet's amazing in the financial planning world. What we tend to look at is we tend

[00:33:32] to first walk people through our big areas CCBS, the calendar, the cash flows, that's all the money

[00:33:39] that goes in and out, and then the balance sheet. That's the net result of surpluses or deficits

[00:33:44] from cash flows over time. So if over the years, you're accumulating money, meaning

[00:33:50] you're saving money, you're building an asset, where is it is it tax deferred accounts,

[00:33:54] is it taxable accounts, whatever. And then in both directions, maybe you retire now you're living

[00:34:00] off your assets great. So now I have a deficit in my cash flow, I'm spending down stuff on

[00:34:04] the balance sheet to make ends meet whatever. Once we understand what kind of that arc is

[00:34:09] on your calendar and that arc is in your cash flows for what's expected to come in and out.

[00:34:14] Now we start to break the balance sheet down into what we call buckets.

[00:34:18] And we like to say you have at least three buckets, everybody has three buckets,

[00:34:22] some people have four, I'll explain in a second. But the three basic buckets are you have a short

[00:34:27] term bucket where you want almost no volatility at all. This should be cash, it could be money

[00:34:32] markets, it might be T bills. But it's basically I get paid, it goes into bucket one. And in

[00:34:39] bucket one, I can pay my bills and usually at least a year if not a couple of years forward

[00:34:43] worth of time. So that if something happens, I've got plenty of time to make a new decision

[00:34:50] and change. Bucket two is where we start to go this isn't money that I need tomorrow,

[00:34:56] I might not need this for a bill, but it might be this is money earmarked that maybe the kids are

[00:35:02] going to college in three years. I know I'm going to start to spend this so I should probably take

[00:35:06] less risk with this money, because this is coming up down the pike. And bucket two is really

[00:35:12] based on money that you might need anywhere from two or three years out to as long as seven to

[00:35:18] 10 years out depending on how conservative you are about those things. So bucket one immediate

[00:35:23] expenses, bucket two planned expenses or things that I know are coming down the pike and are going

[00:35:29] to hit my hit my budget. Bucket three is where we start to go this is long term money. It's

[00:35:35] at least five years away if not seven or 10 years away or more might be unknown. You might be

[00:35:41] 35 and saving for retirement and going I don't have a frigging clue I just know I don't want

[00:35:45] to work forever. So the 401k is bucket three money. Bucket three money is where we can take more risks

[00:35:52] and take more drawdowns. Bucket four just spoil it for a second. Not everybody has this. But if you

[00:35:58] have illiquid investments, if you have private investments, if you so bucket four might be where

[00:36:04] the value of the home goes bucket four might be where the valuation on your business goes that

[00:36:10] you don't know if you're going to sell or whatever else it might be where your hedge

[00:36:13] funds or your private equity or something else goes to the degree that it's maybe evergreen and

[00:36:18] you may never see a liquidity event. So outside of those illiquid or hard to define privates

[00:36:25] in those three buckets, if Jack if you have enough money in the savings account to pay for

[00:36:30] the next two years of expenses, if you have enough money in bucket two to pay for I don't

[00:36:35] know college and something else, and the market your bucket three takes a big drawdown.

[00:36:41] Do you understand where that feeling of insulation would come from where you don't

[00:36:44] have to mess with bucket one or two if you've set this money aside?

[00:36:48] Yeah, and I think the way people think about this mentally is so important. Like if you think

[00:36:52] about it in buckets, then you treat that money as like it's the short term money is like my risk

[00:36:57] my low risk money. I've got that. And I think about the other money differently. And

[00:37:01] when you I think if people like analyze their whole portfolio as a total portfolio,

[00:37:06] or if they think about it in these buckets, you know, it probably leads to very different outcomes

[00:37:10] with clients. Like if I just look at my over of my cash return is just integrated them

[00:37:13] and the rest of my stuff and the money's kind of coming out haphazardly from everything.

[00:37:17] It's probably a very different thing than if I think about it with buckets.

[00:37:20] So this is this is rooted in behavioral finance. We explain it this way and

[00:37:24] I'll say it this way too. We want to think about these things kind of on a continuum.

[00:37:28] We want one side of the continuum to be the bucket approach, which is going to help you

[00:37:33] anchor risk to these various terms and these various time horizons on your calendar on purpose.

[00:37:40] Conversely, we want to look at the global asset allocation to we want to think about not just

[00:37:44] asset location taxable tax deferred, but asset allocation in your gross risk exposure all the

[00:37:50] way on the other extreme, because that that's your balance sheet evolving over time. If you're

[00:37:56] taking a bunch of risk in the 401k, because you're young and you're saving a lot of

[00:38:00] money and it's going up a lot, what some point down the road we have a problem, a good problem.

[00:38:05] But we have a problem that that asset's going to keep ballooning theoretically.

[00:38:09] And now we might have a situation where we go great, a huge part of our net worth is represented

[00:38:15] in these tax deferred assets. And now we have a looming tax liability as we convert that back

[00:38:20] into income through our cash flow and now have to pay ordinary income on these taxes.

[00:38:25] What the buckets do on one end, compared to what the total portfolio allocation view looks like

[00:38:30] on the other end, helps us navigate how to think about this stuff. And importantly,

[00:38:35] in periods of volatility, if I know I need money out to pay for something non negotiable,

[00:38:42] like say it's the kids school tuition or something like that, I know the process by

[00:38:47] which in a downturn I say, I'm not touching bucket three. I'm taking bucket two money,

[00:38:54] and I'm moving it to bucket one to cover this expense. Conversely, if I built up a healthy bucket

[00:39:00] two, I might have a scenario where there's a giant drawdown in bucket three. And maybe I don't

[00:39:06] need as much in bucket two, I was being overly conservative because I didn't know when I was

[00:39:10] going to retire or something else. Now I can be opportunistic back to the scenario you

[00:39:14] laid out at the beginning. If you're a new investor, you want a huge drawdown at the beginning of your

[00:39:20] period, this sequence of returns. So what this allows us to do in thinking in both at both sides

[00:39:26] of this continuum is actually think how can I be opportunistic? And how like how can I be

[00:39:31] defensive at the same time? And that is a huge advantage that individual investors have.

[00:39:38] I loathe when this gets painted as like your only advantage is time horizon, I mostly agree

[00:39:43] with that. I don't think that should be just turned into the Vanguardians of the Galaxy argument

[00:39:47] that like just go buy a passive index fund and everything will take care of itself.

[00:39:51] I do believe though, time horizon is your friend, it is the greatest gift and advantage you have

[00:39:56] as an individual investor. If you think about it across these buckets, if you think about it

[00:40:01] across now, I've budgeted enough that in bad times, I might be able to be opportunistic

[00:40:07] and take advantage of this. And in good times, I might also say, holy crap, bucket three just went

[00:40:13] up this much. I need to pay for my kids college in five years or 10 years or whatever it is.

[00:40:18] Let's take some out of bucket three and move it to bucket two, because now I know that that

[00:40:22] got paid for earlier because I had three years of exceptional above average returns in a row.

[00:40:28] That totally changes the stakes to how you're managing your portfolio.

[00:40:32] Yeah, I was thinking about when you're saying that there's if I want to limit the risk that

[00:40:36] I run out of money, there's really three levers I can pull and we talked about two of them before.

[00:40:40] One is I can reduce my withdrawals during periods the markets down. The second is I could do it on

[00:40:45] the portfolio level. I can create a portfolio that has lower drawdowns. And so I have a better

[00:40:50] chance of achieving my goals. The third one though, which you're talking about is interesting

[00:40:54] and it's probably a double edged sword to some degree as if I have these buckets,

[00:40:57] when I do have the drawdown, I can change where I'm taking my money from

[00:41:01] or I can think about where I'm taking my money from. So for instance,

[00:41:04] if I'm pulling all my money from my T bills during the drawdown, I'm limiting the sequence risk long

[00:41:10] term because I'm not pulling out of the market. I'm keeping my market allocation. I'm pulling

[00:41:14] the thing that's going to eventually go up. I'm not pulling from, but that's a double edged

[00:41:18] sword to some degree that if I sit there and I exhaust, I don't know when the market

[00:41:22] decline is going to end, when do I start doing this? If I start doing this at 10% down,

[00:41:27] it's like eventually the market thing could get out of hand and now my portfolio

[00:41:31] allocation is completely different than it was. It's interesting to think about that because that

[00:41:36] is one way you can handle it is if you're pulling money from your low risk stuff,

[00:41:40] when the market's down, you're limiting sequence risk because the money that can compound in

[00:41:43] the future is not getting impacted by this. So I don't know how you think about that,

[00:41:46] but it's an interesting thought process. So it's interesting because I've seen

[00:41:51] some advisors, I've met advisors who actually use a version of this bucket strategy.

[00:41:56] They will have different accounts for each. I've met advisors who will tag

[00:41:59] different account types or different allocations with each. There's no one right way to do this.

[00:42:04] There's a number of ways to do this, but I'll give you like the problem example

[00:42:09] of what you just said. And it's a pro rata rule. It's not the same pro rata rule that applies

[00:42:15] when you're doing Roth conversions and stuff like that. So financial planning people

[00:42:20] take this word surface level, everybody else just understand what this means.

[00:42:24] Let's say, and this is a common thing, run into used to run into this a lot still run into it a

[00:42:29] fair amount. Somebody works their primary savings vehicle is their work 401k. So the biggest asset

[00:42:36] outside of their house ends up being the 401k, it's all tax deferred money. And now they want

[00:42:40] to come in and have a retirement planning conversation. So we go, Okay, great. Here's your you've

[00:42:45] been risky inside of this account. Maybe it's mostly stock. And they're going I know I have

[00:42:49] to take risk down because I'm a retire in one or three or five or whatever years,

[00:42:54] and they're thinking about it. And the conversation comes up, well, I think I'm

[00:42:57] just going to leave the money in the 401k when I retire, and I'll take money out.

[00:43:01] In many large scale retirement plans, they have a pro rata function once you're retired,

[00:43:07] separated from service, where you can't choose to say what you just did. You can't

[00:43:13] choose to say I just want the money out of the stable value fund or outside of my bond fund,

[00:43:18] or markets just went up three years in a row at 20%. I want to take it out of my stocks,

[00:43:23] they force you to take it out pro rata. Meaning like an even slice. So if I want $10,000 and I have a

[00:43:29] million dollar account, then it's going to actually break it up equally across my stock,

[00:43:33] my bond, my cash, whatever exposures I have in there. This to the sequence of returns risk

[00:43:39] to the asset allocation risk to these bucketing strategies can be problematic. It takes away

[00:43:45] your ability to really be as surgically opportunistic as you like, and it takes away your ability to be

[00:43:50] as surgically deliberate and where you take out withdrawals as you like. Because in a year when,

[00:43:56] back to that example, what year was it when stocks and bonds were both down double digits?

[00:44:01] 2022.

[00:44:02] 22, right? So like in 2022, they're both down about the same, maybe it doesn't matter,

[00:44:07] but still, what's the upside potential in your stock allocation versus in your bond allocation?

[00:44:12] If the stocks are expected to bounce back further and I'm taking this money out over a 10 year

[00:44:17] on a bucket three horizon, then I really want control over this stuff, even though it's inside

[00:44:22] of the same account to say, oh no, no, take the money I need for my income this year out of

[00:44:27] that fixed income portion. This flexibility and understanding this logic, I think is

[00:44:33] one of the great advantages that individual investors have. And it's kind of the

[00:44:37] marriage of all these concepts all into one.

[00:44:40] Yeah, and even if you can do it, it's tricky to figure out the right way to do it. So like,

[00:44:43] I'm just thinking through like 2008, like in a decline. Well, the first thing that's happened

[00:44:47] is my stocks are down a ton. So my asset allocation is actually off target now. So if I take all my

[00:44:52] money out of my low risk, I'm actually bringing myself back to where I want it to be. First of

[00:44:56] all, I'm taking money out of what I want to take it out because ultimately I think my

[00:45:00] stocks are going to do better over the long run, but I'm also returning myself

[00:45:03] sort of to my target allocation. Now the problem is if I keep doing that,

[00:45:07] in an extreme example, like now I have no low risk money, bucket one is gone. Now I'm 100% equity,

[00:45:14] now I'm way off my target allocation. If this decline gets a lot worse than I thought it was

[00:45:18] going to be, now I've screwed the whole thing up. So there's a lot to this probably in terms

[00:45:22] of thinking about how to actually do this in practice. It does make some sense in theory.

[00:45:27] And this is where the financial planning side of the equation becomes so important

[00:45:30] because you can't do an investment allocation without a financial plan and vice

[00:45:35] versa, firm believer in that. So in those scenarios, this is where having the calendar

[00:45:39] in front of you having the cash flow that maps back over the calendar in front of you is so

[00:45:43] important because if it's 2008 and you're still gainfully employed and this is pure savings,

[00:45:50] then you do want to be over-optim opportunistic in this. You want to over-rebalance into risk

[00:45:56] assets and you want to say I don't actually need bucket one and bucket two because I work for

[00:46:01] I don't know, whatever industry didn't lay off anybody in that period of time.

[00:46:05] I work for the central bank, I'll be fine, whatever it is. The flip scenario is if you

[00:46:12] retired before something like that and now you're going I have to preserve bucket one

[00:46:16] and bucket two, your asset allocation might look really messed up for a period of time.

[00:46:22] I think I've told this story before, went through a situation where had some clients

[00:46:27] that were of an age and of the expectation that there was going to be some shake up in their

[00:46:33] in their specific industries. And they thought if mergers or other things happened, they would

[00:46:39] get pushed out of their current roles and jobs. And as we came into the financial crisis,

[00:46:45] one of the biggest concerns was if this happens and we don't get cobras and some of the other

[00:46:50] things with it, our health care expenses could be really, really high with an unfortunate

[00:46:55] slightly early retirement than we had planned for. So we spent several years leading up to this period

[00:47:02] partitioning off bucket two money just for health care expenses. So don't know if this bad

[00:47:08] thing is going to happen. But in their mindset, despite what the Monte Carlo says, they're

[00:47:13] deliberately being overly conservative to deal with an extra bigger expected expense that

[00:47:18] might happen and if it did would really blow a hole into the side of their plan. Good solid

[00:47:22] work, everything else. The variable we never saw coming was that not long after the financial crisis

[00:47:28] is when we ended up with the Affordable Care Act, we ended up with Obamacare. And effectively what

[00:47:33] happens is they lost their jobs mergers happen the other things that they expected happen. But

[00:47:38] now all of a sudden health care if you didn't have income was effectively free. Well,

[00:47:43] when your bucket two money has ballooned because you set all this money aside for health

[00:47:48] care expenses, and you don't need it, and now you don't have to touch your retirement accounts,

[00:47:52] and you're still pre social security and all these other ages, they were able to basically

[00:47:57] live off the bucket two money, all the way into the Social Security Bay's and beyond at this point,

[00:48:03] because they just it was there. So opportunistic can mean I can be okay with my stocks going

[00:48:10] down. Opportunistic can mean I can buy more stocks. Opportunistic can mean I can successfully

[00:48:16] fund my lifestyle and let bucket three recover. Understanding all these and parsed out variables

[00:48:22] and having a plan for how we're going to march through it on the calendar, back to the rainy

[00:48:26] day scenario. If I know I'm standing in a field all day, and it's a 50% chance of rain.

[00:48:33] Okay, the rain boots, the raincoat, maybe the umbrella are all coming with me.

[00:48:38] Know how you might react to the change in the environment that is such a powerful

[00:48:43] message that we can convey as planners and as investors.

[00:48:48] And also, you've brought up this idea a few times of this thing you didn't see coming, and

[00:48:51] that's so important to talk about because Jack can sit here and run his Monte Carlo simulations

[00:48:55] all day and I can imagine a 4.3% withdrawal rate will work in this scenario. Well, there's a million

[00:49:01] things that are going to come and you don't know what they are, but you know they're coming

[00:49:04] that are going to be there and completely throw this plan off. And so

[00:49:06] this is all this math and all this exciting stuff, but we do this in the real world.

[00:49:11] And when you do this in the real world, it's going to change over time.

[00:49:14] Things are going to come you didn't expect that withdrawal rate you thought was going to work is

[00:49:17] not going to work. Your withdrawal rate is not even if I throw all that out. It's not like when

[00:49:22] you have someone who comes to you for a financial plan, you're like, well, you can sustain a 4.3%

[00:49:26] withdrawal rate. Let's go ahead and set that up. I'll adjust it for inflation.

[00:49:30] Call me back in 20 years. We'll go ahead and run that. These things are theoretical,

[00:49:33] these withdrawal rates. No one has a consistent withdrawal rate and just carries it out

[00:49:39] with inflation. You call them up on January 1st every year, like here's your inflation index.

[00:49:44] We're going to raise the withdrawal rate. The real world is messy and these things can

[00:49:48] teach us about the real world, but they're not the way things actually work in the real world.

[00:49:53] This whole again, more things can happen than will happen

[00:49:56] night. I can't remember who said this originally. Super useful quote for this.

[00:50:00] I was going Mark Twain. Mark Twain.

[00:50:02] Yeah, never actually is Mark Twain, but I was going Mark Twain.

[00:50:04] But you know everybody knows it's wrong or mostly wrong. It's a safe fact.

[00:50:08] I said this in our Monte Carlo episode, I think it bears worth repeating.

[00:50:12] The three Montes. Do you remember the three Montes Jack?

[00:50:15] I remember you saying about where they were.

[00:50:17] I found my notes in the, the three monies when we're talking about this stuff because it lays

[00:50:22] into this more things can happen than will happen. They will be both good and bad and you

[00:50:28] definitely can't predict them. So the three monies to remember whenever we're talking about

[00:50:33] money, Carlos scenarios and everything else. So Monte Carlo is the casino.

[00:50:37] It's there's fabulously good. There's disasterously bad. There's mostly mediocre,

[00:50:42] but Monte Carlo, the casino is looking at the odds of the unknowns in front of us.

[00:50:47] And that's useful in and of itself. The second money is money Python.

[00:50:51] And that's we can't forget to think about like the weird stuff.

[00:50:55] There are dead parents. There are men in drag for uncomfortably long periods of time.

[00:51:00] There are silly walks. All of these things are part of the scenario too.

[00:51:04] And you might not even be able to dream them up. But this is why it's okay in the process

[00:51:09] to come up with outlandish scenarios. It's okay to say what if me and my spouse both get into

[00:51:16] long term care facilities with dementia or with Alzheimer's or whatever else.

[00:51:20] It's okay to put that on the table. Get weird, get money Python about it.

[00:51:24] And then the third one was called at the full Monty, which is if stuff goes wrong,

[00:51:30] we all lose our jobs and everything else. How else can we still be okay?

[00:51:33] It's not saying you need to go full Monty and raise money that way as the wonderful movie and

[00:51:38] Broadway play can tell you. But it's this idea if everything goes wrong or we end up in that

[00:51:43] disastrously bad scenario, what can we do about it? And of course, the fourth honorable Monty

[00:51:49] was Montell Jordan, which is if stuff goes right, how can we really have some fun,

[00:51:54] AKA I'm kind of buzzed. And it's all because this is how we do it.

[00:51:59] But this is what happens. Monte Carlo was about looking forward to casino of returns,

[00:52:06] the weird stuff that we can throw into the mix, the full Monty, what do we do if it goes bad,

[00:52:10] but never forgetting to the Montell Jordan, what do we do if it goes right so we can enjoy this?

[00:52:16] Thank you for the listeners. I think when we did this, when you did this in the other

[00:52:19] episode, Justin actually sang, This Is How We Do It by Montell Jordan and

[00:52:22] we're not going to get that now. So we can't cut that clip in.

[00:52:28] Chop it in.

[00:52:29] In the whole podcast, it'll just appear and do that. We won't explain it in any way. It'll just

[00:52:33] pop in there. I love it. I've always wanted to do, and by the way, this is a total aside,

[00:52:38] when we do these songs, I think you can't do it for copyright reasons. But when we were doing

[00:52:42] Michael Bolton in the last episode, I've always wanted to put the song in there.

[00:52:45] But I don't think I could actually do that. But I would love to do that.

[00:52:48] Would add some value to us to just listening to us talking.

[00:52:50] YouTube is notoriously unfriendly to copy, copyright written music and these things.

[00:52:56] But yeah, who knows? We'll eventually we'll make the access returns playlist.

[00:53:02] We'll put that somewhere. They'll have Montell Jordan, Michael Bolton,

[00:53:05] and all sorts, and Sammy Hagar probably to be a great mix.

[00:53:10] So one thing I just want to talk about before we wrap up here is this idea of factor investing

[00:53:13] because you actually did this interview on access returns with us where we interviewed Matthew

[00:53:16] Pellerine of Dimensional. They've done a bunch of work around this idea of factor

[00:53:20] investing for retirement. And the idea here is in general going back to what we

[00:53:24] talked about the whole time, like I have my return I'm generating. I have my drawdowns.

[00:53:29] I'm trying there's a balance between those two things. So if I can add something that boosts

[00:53:34] my return and the impact of my drawdowns is not that much, then that's going to give me

[00:53:38] better outcomes in retirement. And that's what they were doing here. They were talking about

[00:53:41] how do I use factors? I believe they use size, value and profitability as the three

[00:53:46] factors they use. And they said, how can I use that to enhance retirement outcomes?

[00:53:50] And if that can boost your return and it doesn't impact those drawdowns too much,

[00:53:55] it'll do that. Now that the challenge of factor investing, as you know is if I start doing focused

[00:53:59] factor investing, I'm not going to do that. I mean, I potentially will boost my return if you

[00:54:04] believe factors will work in the future like they did in the past, but focus factor investing

[00:54:08] has crazy drawdowns. It deviates a ton. And so it introduces too much risk in something

[00:54:14] like retirement where you really have to focus on these drawdowns because it's not

[00:54:17] just a matter of me staying in the course, I'm pulling money so I can get screwed up even

[00:54:21] if I do stay the course. So those types of strategies don't work really well, but what

[00:54:25] DFA did, which is really cool is they took, they used a much more watered down version

[00:54:30] of factor investing. They said, let's have slight tilts in my portfolio towards these factors.

[00:54:34] So I'm not really doing much on the drawdown side, but I am getting a small increase in my

[00:54:39] return, but a small increase in my return compounded out over 30 years can actually

[00:54:43] lead to a better withdrawal rate. And so that was the idea in their research is

[00:54:46] they actually got a little bit of an improvement. They got better withdrawal rates for investors

[00:54:51] by using this portfolio that tilted towards factors. So I love this approach. I love factor

[00:54:56] investing as a part of this. And if nothing else, if you understand factors, especially

[00:55:01] across asset classes, this can also help you with the tilts is part of your rebalancing or

[00:55:06] your withdrawal or your ad strategies. So as an example, if I know in my bucket three money

[00:55:12] that I'm not spending this money for a long, long time, and I know that small cap value has

[00:55:18] been dreadfully underperforming, I might decide to have a size and a value tilt into that category

[00:55:24] in any point in the last, well, how many years Jack, but certainly coming into this year,

[00:55:30] certainly coming into this year, I might go, wow, large cap growth is way above average for

[00:55:36] the last period of time. And small cap value is way below average for an extended period of time.

[00:55:41] And that can just say, here's an informed way to take the tilt on new dollars added to to a plan

[00:55:48] to a strategy. That can be super powerful, especially in bucket three, where we have time for those

[00:55:54] things to work out. It can also be useful in buckets to not so much bucket one, because

[00:55:59] we're not really investing there. But even in buckets to if we're doing maybe it's predominantly

[00:56:04] fixed income, maybe it's merger or maybe it's stuff that has just less variability or

[00:56:09] volatility, because of the time to goal that we're doing here, time to objective time to whatever.

[00:56:14] And the idea being it might be look at a year ago when we had the giant uptick in rates. So we

[00:56:21] have this giant uptick in rates, we have a push down and bonds but then we have a higher return on

[00:56:25] cash. That kind of stuff can inform us and go Oh, great, let me get the cash return.

[00:56:30] When rates go from one and 2% up to like 5% if I had a goal that was three years out,

[00:56:37] and now all of a sudden I can get 5% on it and my money market is all of a sudden yielding way more,

[00:56:41] I might now be able to turn around and lock it in. That's a version of understanding factors

[00:56:47] and understanding how to tilt your portfolio and your additions and withdrawals that can help

[00:56:54] actually increase and improve performance and lived experience over time. Matthew Pellerine's

[00:57:00] work on this is exceptional. And definitely go back and listen to that interview if you want

[00:57:04] to deep dive into just this way of thinking because it's so cool. And I think the conclusion

[00:57:09] here is like everything in investing is about tradeoffs. And you know, in this case we have the

[00:57:13] tradeoff between I'm trying to produce a good return over time, but I'm trying to manage drawdowns

[00:57:18] and there's a lot of thoughtful ways you can do that. And we talked about some of them in this

[00:57:22] episode, I mean using multiple asset classes, you know, at the end we talked about factor

[00:57:25] investing. There's a lot of different ways you can accomplish that goal. But that's the

[00:57:29] overreaching goal. And you know, unless Mac can get me in the medallion fund,

[00:57:32] I'm going to have to have some tradeoffs. And I don't think you can do that for me.

[00:57:36] I'm getting you in the Kevorkian fund. Have you heard of that?

[00:57:39] Which guarantees the loss of all your capital. Plus, I guess yourself as well.

[00:57:44] It's the ultimate gifting strategy really if you want to think of it that way.

[00:57:50] Well on that note, I guess we can wrap up. Thank you for everybody for joining us and

[00:57:53] we'll see you next week. Hi guys, this is Justin again. Thanks so much for tuning into

[00:57:57] this episode. You can follow Jack on Twitter at at practicalquant. You can follow me on Twitter

[00:58:03] at at JJ carbonam and follow Matt on Twitter at at cultishcreative. If you found this discussion

[00:58:09] interesting and valuable, please subscribe in either iTunes or on YouTube or leave a review

[00:58:14] or a comment. Also if you have any ideas for topics you'd like us to cover in the future,

[00:58:19] please email us at accessreturnspod at gmail.com. We would like this to be

[00:58:23] a listener driven podcast and would appreciate any suggestions. Thank you.