Over the last few years, the FIRE (Financial Independence, Retire Early) community has gained a tremendous amount of popularity. The FIRE movement began with the idea that anyone with a decent income could live below their means to save and invest 50-70% of their income in order to be free from the corporate grind. They could then retire early and live off a combination of income generated by the portfolio along with small amounts of distributions of principal each year.
Among many other factors, this acclaim has been fueled by an almost 11-year-old bull market between 2009 and early 2020. Over this time, stock market returns have added up to more than 300%. Naturally, this might lead some to conclude that historical returns on the market can be looked at as a proxy for future returns. This is, however, confirmation bias at play and can expose an investor to more risk than appropriate.
Don’t get us wrong: the idea of being financially independent and not having to rely on an unstable job market is great. The part of the strategy which depends upon your portfolio appreciating in value after you retire early makes it particularly risky.
One risk factor is the sequence of returns risk. It wasn’t as obvious when the market was on an upward trend, but the current crisis has exposed the underlying systematic market risk.
To give an over-simplified example, let’s assume we have two portfolios with a starting balance of $1 Million with the same exact returns, just in reverse order. This is our base scenario:
This scenario assumes that there is no withdrawal of principal - in other words, you were not forced to sell your equities when the market was down in order to sustain day-to-day spending. If you’re still working or have multiple streams of income, the variability in year-end returns may not have a big impact on your finances.
Now assume that you FIREd and will use your stock portfolio to support your living expenses. Let’s complete the example above with the assumption that in both scenarios that your annual spending is $40,000 a year (not adjusted for inflation, which diminishes your buying power year after year) and this is the amount you’ll withdraw from your portfolio.
Here’s a quick visual representation of how we end the 10 years in both scenarios:
So if you get hit with a few bad years early on in your retirement, and you have no choice but to keep making the withdrawals you depend on to pay your bills, you could lose a big portion of your portfolio value that you didn’t plan for. In the two scenarios above, the difference in portfolio value due to hits early on was 30 percent!
Sequence of return risk is almost the flip side of dollar-cost averaging: when investing, you do better in periods of market downturn because you buy when prices are low. When withdrawing money out of the market, a few bad years early on could lead to drastically different results in your portfolio.
Retiring at any age carries an element of time risk. The standard 30 year retirement period can be impacted by variables such as future tax rates, inflation, government policies, healthcare expenses, and more. By retiring early, you extend that time of uncertainty to 50 or 60 years. In a rapidly changing society and economy, choosing to retire early can have uncertain and unplanned consequences.
While striving to be financially independent is a worthy endeavor, you should be aware of all the risks you are taking on if most of your portfolio is in equities. Sadly, the risks involved with FIRE are played down while the benefits are expounded on in virtually every internet forum.