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Back-testing the 4% rule

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Back-testing the 4% rule

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Retiring is easy, they say, all you have to do is save 300 times your monthly expenses. This is until you do the math and see that this isn’t walking around money. The 300-times-your-monthly-salary rule and the 4% rule is one and the same thing. Whip out those calculators if you must.

What is the 4% rule?

The 4% rule assumes that if you live on 4% of your capital, the growth on your investments will be enough for your capital to grow faster than inflation. This rule is widely accepted, and it feels like we’re at the point where no-one is questioning it all. So, don’t worry, I will question it for you! Consider the following…

Our model investor retired with R7.3 million back in 2000. The average inflation rate in South Africa since 2000 was 5.7%. The 6% we always quote as inflation isn’t too far off. If you increased the R7.3 million in 2000 with inflation, you would require R20 million capital in today’s money to have the same buying power (Yes the round number was planned).

Tested on the JSE

The average performance of the Johannesburg Stock Exchange (JSE) was 10.1% in the past 18 years, yielding a sweet dividend of 2.8%. If linear growth is assumed at 12.9% and the drawdown is 4%, your capital should grow to R38.81 million (Projected line on the graph). This is well above inflation. Even if you incorporated the erratic growth of the actual JSE, you still come out on top with a capital amount of R38.85 million (Actual line on the graph):

It almost looks planned how well the actual and projected lines join up in the end.

Tested on the NYSE

Instead of investing in the JSE, you could decide to invest in another market like the New York Stock Exchange (NYSE). Your average performance would then have been 7.55% with a dividend of about 2.5%. The 7.55% accounts for 3.67% growth and an average of 3.88% that the rand has weakened against the dollar.

Again, if linear growth is assumed at 10.05% and the drawdown is 4%, your capital should still grow to R22.64 million (Projected line on the graph), which is above inflation. It is marginally below the growth of the JSE though. Even if you incorporated the erratic growth of the actual NYSE, you still come out on top with a capital amount of R31.8 million (Actual line on the graph):

The reality is that at the age of 65, your investment horizon is still on average about 20 years. Be careful of going into cash products when you retire since this can deteriorate your capital faster than Zuma can achieve junk status. Cash products are typically earning 8% on your retirement capital. Inflation of 5.7% will catch you sooner than later if you draw down 4%.

So, why should you care about everything that I said above? Well, you shouldn’t, the 4% rule holds true when backtested on JSE and NYSE data. Granted, historical performance is no measure of future performance.  Just make sure you are invested in enough markets to get the average performance. Historically you should be fine if you draw down 4% of your capital. You will leave your grandchildren enough to blow it on gambling and Ferraris. Or gambling in Ferraris, if that tickles their fancy.

Article reposted with permission from the Tigers on a Golden Leash blog.

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We see people every day doing stupid things with their money. We do stupid things with our money. Be it in ignorance or habit. I want to become stupid rich. I want to be free from it all and I want to do something worthwhile. I write about achieving my financial goals, sharing what I have learned and being content with where I am in life. I’m doing the research anyway, so I might as well post it on a blog for you to benefit.

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