Yesterday, I mentioned that one ought to accumulate enough savings to as to only withdraw 3% of one’s portfolio annually. This requires savings of 33.33… times annual expenses. Why 3%? Because historically, 3% has lasted forever, while 4%, historically, “only” has lasted 30 years; and I am expecting to live beyond 63.

Naturally, the question begets: What if I am able to return numbers that are better than the market.

There are angles to this question. It is not only a question of having superior returns, when withdrawing money, volatility also becomes very important. Allow me to demonstrate with an extreme example. (I’ll ignore inflation so please pay attention to the principle of my point rather than the details.)

Suppose a super investor is able to achieve very high returns but do so in a very volatile fashion sometimes losing half the principle and sometimes doubling or tripling his money. The problem then appears because money need to be withdrawn every year. It is “well-known” that if you lose 50%, you need a return of 100%(!) just to get back to normal. If, then, you liquidate a “small” amount, say 10% after losing 50%, you no longer need 100% to get back to normal. No, you need 150%. The larger your volatility and the larger your volatility, the higher the chance of a completely wipeout.
You could also think of a situation in which your withdrawal rate is 10%, the market drops 50% and stays there for 5 years. Again, you are wiped out, or at least forced to take a significant reduction in your portfolio income.

Now, suppose instead you are able to generate superior alpha. I fully believe this is possible if you work in stocks that are not touched by Wall Street (very much). After all, alpha is superior return to the market at the same risk level, but if you’re not in the same makret, it’s like comparing apples to oranges. Here it depends on your overall risk tolerance. First of all, do you think you can keep that streak going until you die, that is, for the next 60 years? What if, when you’re 75, you are no longer so, eh, sharp mentally? Here my approach is to use superior skill to build more safety rather than to go “faster”. I can see that with a 3% withdrawal rate, there’s a substantial chance that I will be a millionaire anyway (in inflation adjusted real dollars, not even nominally) a few decades down the road. Trust me on this, if I hit 2%, I will not take this as an opportunity to increase my withdrawal rate, rather, I will move my money into something even safer.

Originally posted 2009-08-17 00:02:41.