This piece first appeared on The Rich Investor.
You know the rule: Stocks “always” return 8% to 10% per year over the long term, right?
This is the assumption most financial planners make, and it’s practically considered holy writ in 401(k) promotional literature.
I’m not going to tell you that this received wisdom is wrong, per se.
Over the long term, stocks generate returns in that range, or at least they have up until now.
But this certainly doesn’t tell you the whole story.
That 8% to 10% number is an average, but the numbers are wildly different in any given year.
You might have a year of 10% gains followed by a year of 20% losses followed by a 40% gain. That averages to 10% per year, but it’s a wild ride to get there.
Furthermore, the “long term” generally means 20 to 30 years or more, and there are long stretches where returns are flat or negative.
As a recent example, the S&P 500 went nowhere between its peak in 2000 and 2013, getting chopped down by two nasty bear markets. Thirteen years is a long time to go without a return on your investment.
And if you were regularly selling stock and taking withdrawals to meet your living expenses, you could have seriously depleted your portfolio.
This is exactly why I focus on income investments in Peak Income.
I don’t know what stock returns will be over the next 13 years, but given today’s starting valuations I’m betting the number is lower than the historical 8% to 10%.
And, if they are, that’s perfectly fine. If you’re living off the dividends and interest produced by your portfolio, you don’t have to worry about dipping too heavily into your portfolio to meet your living expenses.
Let’s run the numbers…
Just for grins, let’s play with a Monte Carlo simulation.
A Monte Carlo simulation is a modeling tool that runs thousands of scenarios to come up with a probability of success or failure.
In each iteration, the simulator follows a random path of returns.
Though not perfect (all models are only as good as the assumptions used), a Monte Carlo is a better way to assess your risk than using historical averages alone.
In my model, I assumed the investor is freshly retired at 70 years old, is starting with a $500,000 portfolio invested 60% in stocks and 40% in bonds, and is planning to withdraw $30,000 per year, or 6%, adjusted by inflation.
The simulator showed that, by age 90, 12% of the scenarios had failed (i.e. the investor ran out of money). By age 100, 34% had failed.
Now for the fun part.
I changed the model to assume a 30% bear market two years into retirement (age 72). This raises the failure rate to 25% by age 90 and 53% by age 100.
Raising that number to a 50% bear market – which is in line with the last two crashes — raises the failure rate to 40% by age 90 and 69% by age 100.
And all of this assumes that stock and bond returns and inflation are all roughly in line with historical averages.
Playing with the numbers again, I reduced the expected annual return on stocks by 3% and the expected annual return on bonds by 1% to be more in line with today’s valuations.
Assuming no crash, the failure still jumps up to 32% by age 90 and 67% by age 100.
I don’t know about you, but the thought of running out of money in my 90s and living out my last days in a government-funded nursing home for the poor is simultaneously depressing and terrifying.
So again, it comes down to income generation.
Peak Income’s current recommendations have an average dividend yield of over 7%.
Based on the current allocation, you could take out 6% per year in dividends for your living expenses, leaving 1% to 2% of “excess” dividends in the account to be reinvested, and never touch your principal.
The specific stocks and funds I recommend change over time, of course, and a year from now these numbers might look a little different.
But you get my point: Investing specifically for income is a lot safer than simply buying a 60/40 portfolio and hoping for the best.