This article was first posted on April 1, 2000.
Limiting your retirement withdrawals to anywhere near the "100% safe" withdrawal rate leaves you with a very good chance of realizing portfolio growth well beyond your needs. For example, let's take a retiree with a 40 year pay out period and a 3.54% inflation adjusted withdrawal rate. Let us further assume an investment return of 13.67% (about the average for the S&P500 over the past 30 years) and inflation that averages 3.5% annually. The yearly portfolio values and the dollar amount of the annual withdrawals are shown in the table below.
Portfolio Growth vs. Effective Diversification "D"
As the table above shows, while the portfolio value has increased five-fold (i.e., from $1 million to $5.039 million), the annual inflation adjusted withdrawal has less than doubled (from $35,400 to $59,310.) These results are depicted in the graph below.
As the portfolio value increases, a retiree has several options:
Effective diversification "D" is calculated using the relative value and non-market risk for each security in the portfolio. It's explained in detail in the article "Safe Withdrawal Rates for Concentrated Portfolios".
An S&P500 index fund would have an effective diversification of 50 or more. A portfolio consisting of 25% money market funds and 75% invested in the "Foolish Four" has an effcitive diversification of about 13. Replacing the 75% Foolish Four with a more volatile mix like the Motley Fool Rule Breaker portfolio reduces the effective diversification to a value of about 2 -- even though there are 14 securities in the portfolio! See the article on "Safe Withdrawal Rates for Concentrated Portfolios" for more on the details of these calculations.
There is ample evidence that holding a concentrated portfolio increases your chances of market beating investment returns. Unfortunately, it also increases your chances of under performing, or losing a large portion of your portfolio in a market downturn. Thus, this strategy should only be pursued by investors able to shoulder the risk, as evidenced by a low (i.e. 1% to 2%) withdrawal rate in retirement.
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