The 4% safe withdrawal rule is not really a rule, but a general guideline that will result in a retiree’s portfolio outlasting their lifespan, most of the time. This should be true even for an early retiree that has achieved financial independence at a young age, because 4% is usually small enough to mitigate sequence risk, which is the danger that the market will decline soon after you retire. In most scenarios based on historical data, a balanced or aggressive portfolio will grow in perpetuity by withdrawing 4% of the initial balance per year.

The 4% rule does not mean you withdraw 4% of the present balance each year, but rather the initial balance. Typically, an inflation adjustment is included. If you retire with a $1,000,000 portfolio (for example, 80% stocks and 20% bonds), you would withdraw $40,000 in the first year, and if inflation is 2%, $40,800 in the second year, $41,616 in the third year, and so on. If you retired at the start of 2017, in 2017 your portfolio would probably have increased to about $1,175,000, but you would still withdraw $40,000 in the second year (or $40,800 with 2% inflation), not $47,000. You would withdraw the same amount even if it was a bad year for equities and generally, your portfolio would still eventually recover (rather than going to zero).

Historically, there are years where the 4% rule would not have performed well. Most recently, in 2000, but infamously in 1929 as well. The Great Depression was somewhere around an 80–90% decline, so if you retired right before the crash and then withdrew 4% of the initial balance the next year, that would be 20–40% of the decimated balance, leading quite quickly to running out of money. If you were lucky enough to retire in 2009, you saw immense capital gains in the following decade which has resulted in a much higher portfolio value even with annual 4% withdrawals. To account for potential market crashes, some have suggested changing the 4% rule to 3%. Of course, this is even more likely to leave huge amounts of money on the table when you die, which could be left to heirs or charity. Alternately, you could purchase a single premium immediate annuity from an insurance company, using a lump sum from your portfolio. Then, the insurance company will pay a fixed or inflation-adjusted monthly payment for the remainder of your life (“guaranteed income”). Of course, all insurance products have negative expected return, and their purpose is to protect against unlikely but disastrous outcomes. But, one can retire safely with a smaller nest egg when purchasing an annuity as compared with continuing to invest in securities.

If you are receiving other income, such as a pension or Social Security benefits, you can add these to the 4% rule when considering whether you have enough to retire. If your pension and Social Security give you $30,000 per year, but you need $40,000 to live on, then 4% of your portfolio only needs to amount to $10,000, which indicates an initial portfolio value of $250,000.

Vanguard has a piece from August 2012 on the 4% rule, which misses the point in a spectacular fashion. Vanguard complains about declining dividend yields from stocks and interest yields from bonds. Indeed, the average cap-weighted dividend in the U.S. stock market is presently only 1.87%, which is much less than 4%. But, issuing dividends is a boneheaded way for corporations to use excess capital, and in fact, income from interest and dividends is inferior to capital gains from appreciation in share price. A dividend compels you to take income on the corporation’s schedule, but you could simply sell a portion of your equity stake to receive income on your terms. Warren Buffett knows this well, which is why Berkshire Hathaway famously does not issue a dividend. This has fueled a meteoric rise in its Class A share price ($305,505 per share as of this writing) which otherwise would have been attenuated by the issuance of dividends.

Like most market forecasts, the Vanguard report takes part in a practice no better than fortune telling or astrology: predicting future market performance. Vanguard predicted quite pessimistic returns in August 2012… since then, the S&P 500 has doubled. Of course, it could drop by half in the near or distance future, but good luck figuring out when that will happen. Investing for the long haul is far better than trying to predict market returns.

As for timing withdrawals from your portfolio, because the duration you are invested in the market generally correlates positively with returns, anything that increases the duration you are invested is worthwhile. So, rather than taking your annual 4% withdrawal as a lump sum at the start of the year, monthly distributions are preferable, or even weekly if you can do it without fees or penalties. This is the same concept, in reverse, as to why paying a mortgage biweekly results in slightly less interest paid over the life of the mortgage than paying monthly.

Timing of withdrawals should also consider your tax situation. Because income taxes are assessed based on annual income, if you have less income in a certain year you might withdraw more to enjoy a lower tax rate on the realized income. If you need additional money during a year in which your income is already high, you could withdraw from your Roth accounts, but if your income is low, withdrawing from pre-tax retirement accounts or taxable brokerage accounts is more sensible.

In summary, remember that the 4% rule is in relation to the starting balance of the portfolio. This is related to the idea of declining risk with many decades of being invested in the S&P 500, whole U.S. stock market, or whole global stock market. The risk of loss approaches 0% with a longer duration of investment in relation to the initial balance, not the current balance. Consider two people: one invested $1 million in the S&P 500 on September 20, 2018, and another had $1 million in the S&P 500 as of September 20, 2018 that had been invested for 30 years. Both still wound up with a balance of about $800,000 on December 24, 2018, but the latter person still had much more money compared with their initial investment in 1988, even adjusting for inflation.

The 4% rule is an attempt to mitigate both sequence-of-returns risk and longevity risk. Sequence risk is the risk that you retire right before the market crashes, which could put you in the poorhouse. Usually, withdrawing 4% of the initial balance each year is sufficiently low to leave enough money in the portfolio for it to recover, despite the poor performance early in your retirement (although it is always better to withdraw less in such a scenario, if you can manage to do so). Longevity risk is the risk that you outlive your money, and the 4% rule mitigates this by leading you to dying with much more money than you started with when you retired, in most scenarios. Predicting one’s death is risky business… you can’t just look at life expectancy because that’s a median, which means 50% of people live longer than life expectancy. If you time your spending to run out of money right at 79, you might end up living to 99 but you will be destitute for those last 20 years. No one wants that.

Continued from Part 1, here are several more terms and my definitions for them.

Financial Freedom: For Americans, at a bare minimum this should mean one can “come up with $2,000 in 30 days,” a question that Peter Tufano found only half of Americans can answer yes to. A baseline of six months’ living expenses (an “emergency fund”) is more appropriate. This gives you the freedom of not living paycheck to paycheck or being compelled to work at a bad job.

Financial Independence: I look at financial independence as a term of art meaning you have enough savings/investments to live off of in perpetuity with no earned income and no sustained drawdown of real principal. Typically, financial planners and writers say you should have about 25 times your annual expenses to do this, which is $1 million if you spend $40,000 per year. This is pretty much the same as a financial endowment at the institutional/organizational level, but instead at the personal level.

There are 329 million people in the United States (November 2018) and U.S. households and nonprofit organizations hold an aggregate net worth of $107 trillion (2018 Q2), which is about $325,000 per person if evenly distributed, or about $425,000 if only distributed among adults—enough for $17,000 per year if income at a 4% withdrawal rate.

FIRE: FIRE stands for financial independence, retire early, a grammatically convoluted acronym that indicates achieving financial independence and then exercising the option to cease having earned income (“retirement”). Of course, one can be financially independent while continuing to work, and many who “FIRE” themselves end up continuing to work on a part-time basis.

Earned Income and Unearned Income: I would just use the Internal Revenue Service (IRS) definition for these. Earned income comes from work or pre-retirement long-term disability benefits, while unearned income includes bank account interest, dividends, and capital gains (e.g., from stocks).

Securities, Stocks, and Bonds: A security is an umbrella term that encompasses equities and debts, also known as stocks and bonds. Buying “stocks” actually means buying shares of a corporation’s stock, which confers ownership and possibly shareholder voting rights. If investing in an index-tracking mutual fund or exchange-traded fund (ETF), voting rights are conferred to your custodian rather than to you (e.g., Vanguard, Fidelity, BlackRock, etc.). Corporate bonds, another type of security, represent an obligation by a corporation to repay with interest, but confer no ownership rights. Stocks are generally more profitable than bonds, but if a corporation files for bankruptcy protection, bondholders get paid first. Many argue that U.S. Treasury bonds are the best type of debt to buy, because they are backed by the full faith and credit of the U.S. government, and that the reduction in risk compared to corporate and municipal bonds outweighs the lower yield. Municipal bonds may be useful to those with higher income who are subjected to state and/or local income taxes, due to their tax-advantaged status.

Emergency Fund: An emergency fund is money that is liquid, accessible, and protected from loss of principal. This is money that you have set aside for emergencies. Because the emergency fund could be needed at any time, it usually should not be invested in stocks because stocks can experience substantial short-term declines. See “The How and Why of Emergency Funds” for more information. If you have credit cards available, most emergencies can be paid for by credit card and then repaid by the statement payment due date, without interest, as long as you have been paying the full statement balance in full each and every month (otherwise, interest begins accruing from the date of the charge). Therefore, you can use an online bank for your emergency fund with limited or no ATM/cash access and pay back the credit card using the bank account.

Inflation and Nominal and Real Value of U.S. Dollars: “Nominal” just means numbers, so when we talk about nominal returns, this means we are not adjusting for inflation. Although the Austrian school of economic thought defines inflation as an expansion of money available (e.g., the monetary supply and quantitative easing programs of the Federal Reserve), this definition is unusual and not in common use. The predominant definition/measure of inflation is based on market prices of consumer goods, represented by the U.S. Bureau of Labor Statistics’s Consumer Price Index (CPI). Nowadays, the Federal Reserve aims to achieve 2.0% inflation per year, which means prices of consumer goods should increase by 2% each year. As of November 2018, many online savings accounts are paying an annual percentage yield (APY) of 2.0%. If inflation is 2%, this means that although the nominal account balance will increase 2% in a year, the real value will remain flat. When talking about past money, it is common to use CPI data to talk about the equivalent in today’s dollars. When talking about future money, discounting returns by about 2% per year to come up with a real, present day value of future money is common. If the stock market returns 10% in nominal returns in a particular year, this is probably about 8% in real returns, due to inflation.

Here are some items I intend to define in future posts:
Market Timing, Retirement, Sequence Risk, Single-Stock Risk, Index Fund, Tax-Gain Harvesting, Mutual Fund, Exchange-Traded Fund, Diversification, Tax Brackets, Payroll Taxes, Income Taxes, Tax Avoidance, Investment Management Fees, Load Fees, Dividends, Capital Gains

Here, I will seek to define several common personal finance terms that are often conflated and misunderstood.

Financial Literacy: There is no consensus definition of financial literacy, but I would say it is mainly concerned with having financial knowledge. However, personal finance is an eclectic field; having a high level of financial literacy requires knowledge in other areas, such as behavioral economics, psychology, information literacy, law, and even nutrition. Although financial literacy is usually correlated with good financial practices, this is not a given; one can easily have expertise but fail to apply it, or succumb to believing they are exceptional and can earn more in the stock market than others, or miraculously avoid a probable, deleterious outcome.

Financial Capability: I would define this as financial literacy combined with demonstrated financial competence, which hinges on consistently making good financial decisions, given one’s available choices and opportunities. What constitutes a “good” financial decision is not always clear, but we can often put items in rank order. For example, taking a payday loan is objectively worse than taking a credit card cash advance, because payday loans have far higher interest rates. One can have financial capability but not be able to do much with it—for instance, marginalized peoples and those in adverse situations. Conversely, privileged people may squander a portion of their privilege due to low financial capability. To be financial capable, one must not only make good financial decisions but also know why their decisions are good, and why they selected them over alternative courses of action. Such expertise should result in repeated beneficent decision-making, whereas someone of low financial capability might make a good choice by chance, but is unlikely to reliably do so.

Gambling: Many people conflate gambling and investing, but they are not the same thing. I define gambling as an act or series of acts where you are more likely to lose money than not, meaning that your expected returns are negative. However, there is an exception for insurance that insures against unmanageable losses, including losses that may potentially be unlimited (e.g., health insurance). Obviously, insurance companies have to come out ahead overall, but insurance is worthwhile to insure against unlikely but highly deleterious financial events. Returning to the element of likelihood, any student of statistics knows that if you gamble $1 with a 49% probability of coming away with $2 but a 51% probability of coming away with zero, your odds of making money are close to 50:50. But, if you keep making this bet again and again, your probability of losing money overall gets closer and closer to 100%. This is how lotteries and casinos produce guaranteed profits. When you invest in a broad swath of the stock market (e.g., an S&P 500 index fund), your probability of making money on any one trading day is about 54%. However, in a given year, it is about 83%, and in a given 10-year span, it is about 91%. Assuming you don’t need the money for a long time, this is investing, not gambling. However, if you try to pick stocks or put all your money in your company’s stock, your expected return might be negative, and there is a large risk of catastrophic loss. This is gambling. A kinder word is speculating, but it is certainly not investing.

Speculating: If you pick individual stocks or even entire market sectors, you are basically speculating. Buying gold, silver, oil, or corn futures is speculation. Buying BitCoin is speculation. These assets don’t have a solid track record of producing real returns (after adjusting for inflation). Modern portfolio theory tells us that holding uncorrelated (diversified) assets can be advantageous, so it makes sense to have gold—but not more than a small percentage of your assets. Speculation is often better than gambling, but certainly worse (as a decision) than investing. Although you might have fantastic results from speculating, this just means you had the unlikely fortune of making a bad decision that resulted in a good outcome. However, if this inflates your ego, it can easily lead to future misfortunes!

Investing: Over time, investing results in a probability of real returns that approaches 100%. As Vanguard mentions, for an S&P 500 index fund, which consists of 500 of the largest U.S. public companies invested proportionate to the companies’ market valuations, your probability of positive returns on any given day is 54%, but in ten years it is 91% (based on 1988–2018 data, but others have shown similar results even going back 100+ years). Besides the stock market, one can be successful at investing in real estate, or even one’s education, as those with more education tend to be more happy and successful in life, including financial success. Of course, there is presently a student loan “crisis” going on, and it is important to avoid high-cost tuition and housing expenses while also finishing your degree. On another note, investments must have a high probability of succeeding within a reasonable timeframe, and what is investing for one person could be gambling for another based on how soon they need the money (e.g., older people should have “safer” investments meaning less risk of short- and medium-term losses and lower expected returns).

I will follow this up with a Part 2 in the near future.

This is a June 2018 video by Richard Thripp (39 minutes) explaining the choices, answers, and rationale to a financial literacy quiz written by Richard Thripp in May 2018.

When watching it, I recommend adjusting the YouTube quality setting to the highest resolution (720p).

The video covers computing compound interest, numeracy skills, stock investing, tax issues, healthcare, retirement, credit scores, and many other issues.

New: I made a narrated video explaining the questions and answers.

This is a financial literacy quiz written by Richard Thripp in April 2018 and published on Tippyfi in May 2018. It covers interest rates, compounding, numeracy skills, stock investing, tax issues, healthcare, and retirement. After submitting, you will see how many points you scored, the answers you chose (marked with a red X if incorrect) and the correct answers (marked with a green checkmark) for all questions, and explanations for all questions.

1. Suppose you deposit $1,000.00 in a savings account that earns interest, amounting to a 1.00% annual percentage yield (APY). This means that after each year passes, the account balance will be 101% of what it was a year before. After two years, what will your account balance be?


2. Suppose that when a person earns money, they pay 10% of their earnings as a tithe to their church. Pretend that other expenses and taxes (e.g., income, payroll, and sales taxes) are zero. For this person to be able to afford to purchase a $100.00 item, how much money must they earn?


3. If five (5) people all have the winning number in a lottery and the prize is $2,000,000.00 (two million dollars), how much will each of them get? Assume the prize is split evenly, taxes are zero, and that there is no penalty for a lump-sum payout. (Question adapted from the 2004 Health and Retirement Study)


4. Suppose that a credit card charges a 24% annual percentage rate (APR) on purchases, compounded daily from the date of purchase (365 days per year). This means that each day, the amount owed is 100.06575% of what was owed the previous day. One year after a purchase is made, how much of the original amount will be owed? Assume no payments are made toward this purchase and no penalties are assessed.


5. If inflation increases prices by 2.00% per year for a given item that costs $100.00 now, how much will this item cost in 10 years?


6. You are shopping at a clothing store in a clearance section where all items are 50% off the marked prices. Items marked with a yellow tag receive an additional 30% off. Which method of computing the discounted price would result in a lower price for the customer?


7. Over a 30-year timeframe starting now, which of these is most likely to be the most profitable investment?


8. Avoiding income taxes is a reason to contribute to an individual retirement arrangement (IRA).


9. Monies contributed to individual retirement arrangements (IRAs), 401(k) accounts, and 403(b) accounts can be invested in certificates of deposits (CDs), money market accounts, and fixed-income assets (bonds), but cannot be invested in equities (stocks).


10. In a 10-year period, which of the following earnings scenarios will result in an unmarried individual paying less money in U.S. federal income taxes?


11. Given the performance of U.S. equities (stocks) in the past, if one invests in an index mutual fund of the whole U.S. stock market, the probability of making money in any particular one-year period is approximately what?


12. Given the performance of U.S. equities (stocks) in the past, if one invests in an index mutual fund of the whole U.S. stock market, as the number of years one stays invested increases (e.g., 10, 20, 30, 40 years, etc.), the probability of making money gets closer and closer to 100%.


13. If one has plenty of money saved, it is generally a good idea to purchase insurance that protects against minor expenses.


14. In most U.S. states, giving a person durable power of attorney means they can make medical decisions for you if you are incapacitated, even if their decisions are contrary to your family’s wishes.


15. Generally, designating someone as a payable-on-death beneficiary of a bank or investment account supersedes or bypasses beneficiaries named in a will.


16. A downside of health insurance is that hospitals typically negotiate higher rates with insurance companies than what they would bill an individual who did not have health insurance.


17. A disadvantage of accumulating an emergency fund is that you may become ineligible for means-tested benefits such as Supplemental Security Income (SSI).


18. Overall, the distributions of income and wealth in the United States have both been becoming more equitable since the 1970s.


19. On a dollar-for-dollar basis and without considering taxes, funds acquired through hard work and funds acquired via a windfall (e.g., winning the lottery) are of equal value.


20. Which of the following has a positive impact on your credit scores?