Risk is in the eye of the beholder …

Our Philip Brewer Confest is almost over, and it’s time to thank him for his articles and inspiration for a series of posts exploring the concepts of safe withdrawal rates [AJC: which has¬†more to do with financial planning than family planning ūüėČ ], however I did want to wind up by exploring one of his comments:

I think your step 1 is the most important: Decide what you want to do with your life.

I wanted to write fiction. That doesn’t take much money, but it does require time (and high-quality time at that). So, for me, getting free of a regular job as soon as possible was a much higher priority than accumulating a vast amount of wealth.

For me, too, the turning point for my financial life – indeed my whole life – came in Step 1: finding my Life’s Purpose then using that to calculate my Number. For me, though, it happened to turn up a Large Number / Soon Date … that may not be the case for everybody.

Just remember that Time = Money and if you are desperate to achieve that financial freedom (e.g. in Phil’s case, so that¬†he can write that book) you may need a lot of both …

… IF so, then I have a hypothesis [AJC: tested on a subject of one i.e. me] that goes like this:

When you find your Life’s Purpose, you¬†will most likely find that you will¬†come up with a¬†Large Number / Soon Date¬†[AJC: remember, this is just my hypothesis albeit, now, supported by a little research]¬†and you will not¬†stop until you get it

… your priorities (including your financial priorities) will drastically change.

¬†But, what about Philip’s thoughts about risk?

I would like to suggest, though, that your ideas on which assets are secure and which aren’t could use some fine tuning.

It‚Äôs true that you may not be able to work during your retirement, but most people will be able to earn at least some money if they need to. It‚Äôs also true that government pensions can be taken away‚ÄĒbut so can anything else.

And don‚Äôt forget all the other ways that things can be lost or taken away‚ÄĒdeclining market can sap your portfolio, a lawsuit can seize your assets, a natural disaster can destroy your house.

My point is not that it’s hopeless, but rather that while racking up assets may increase your standard of living, at a certain point it no longer increases your security. (A flood can destroy a house worth $1 million as completely as it can destroy a house worth $100,000.).

At some point‚ÄĒand to my mind the point is well before you have $7 million‚ÄĒyou don‚Äôt get as much security from adding another million to your portfolio.

I beg to differ: until I made my $7 million Number, my thoughts were EXACTLY about ” adding another million to my portfolio” … but, that’s only because I calculated that I¬†needed it – not want, not desire, but need – to live my Life’s Purpose.

But, that may not be you; like Phil, you might just need a little extra time to write your book or to support¬†huminitarian projects like¬†backpacking to hotspots like¬†Haiti, so your Number may be $100k, $1 mill., or … ?

And, unlike me, your assessment of your Number may include allowances for earning extra income through part time work, income producing projects, pensions, inheritences, or even handouts.

In that case, I challenge you to substiute your Number where, in my blog, I use the $7m7y illustration … the principles won’t change much.

[AJC: unless, you have a “<$1 million in >20 years”-type Number, in which case this blog is NOT for you ūüôā ]

So, substituting your Number for mine, here is the second part of my hypothesis:

– While you are trying to reach [insert your Number] so that you can¬†achieve your¬†Life’s Purpose, ‘hold back’ concepts such as risk take a backfoot to ‘push forward’ concepts¬†such as¬†REWARD, suddenly opening your eyes to the ‘benefits’ of burning the candle at both ends, starting a business or three, trying to become a stock market and/or real-estate mogul, etc.


– Once you reach¬†[insert your Number], somehow your brain resets such that RISK (i.e. protecting your nest-egg) seems to become much more important than reward (i.e. growing the nest-egg) and all of a sudden CD’s, bond laddering, (dare I say it!?), index funds, 100%-paid-for-by-cash real-estate, etc. becomes much more attractive.

At least, that’s how it happened for me …

This doesn’t mean that risk isn’t important (after all, we spend a lot of time on this blog covering strategies to manage risk), it’s just that in some respects, it’s in the eye of the beholder ūüôā

The Ideal Perpetual Money Machine …

So,¬† it seems that creating a mix of bonds and stocks and then picking some magic withdrawal rate (e.g. 4%) is not the ideal way to plan our retirement (a.k.a. life after work) after all …

… instead, it seems that we need to create our own Perpetual Money Machine: a renewable resource of cash ūüėČ

The¬†ideal Perpetual Money Machine¬†– at least, according to my liking –¬†is Real-Estate (more wealthy people build their own Perpetual Money Machines using real-estate that any other investment, even more so than cash, CD’s, bonds, mutual funds, or stocks):

1. Real-Estate (particularly commercial real-estate, when purchased well) protects your capital and keeps pace with inflation; it will last as long as you do, and then some!

2. Real-Estate (when managed well -and, this is something that you CAN confidently outsource) protects your income (i.e. net rents; they will grow with inflation).

3. The bumps in your real-estate road can be managed with insurance and provisions: you can insure against most catastrophic losses (and, you can spead your RE investments to minimize even those risks), and you can keep a % of your rents (and, starting capital) aside to help smooth your income stream (against vacancies, repairs and maintenance, etc.).

For example, with $7 million (aiming for a $350k per year gross income Рindexed for inflation Рwhich should net $200k Р$250k after tax), you could:

1. Keep $500,000 as a two years of living expenses cash buffer (one year to allow for the rents to start coming in, another year “just in case”),

2. Invest $6.5 million CASH into 5 x $1.0 million to $1.25 million dollar properties (allowing for closing costs, etc.),

3. Which should provide 5 x 7.5% x $1.0 million to $1.25 million = $400,000 gross rental income

4. Of which you would pay tax of 30% (say) and divert another 25% of the remainder¬†to your ’emergency /¬†provision fund’ leaving $215k (PLUS, tax benefits such as depreciation, tax deductions of cars, certain travel and other business expenses etc.).

After every few ‘good years’, you can trim your provision fund back to two years of living expenses, allowing you to buy some more real-estate (therefore, providing the basis for another future pay rise!).

If you don’t like real-estate, then you can always lower your spending expectations and dust off your bond-laddering books ūüôā

The broke actuary …

All this talk of ‘safe withdrawal rates’ begs the question: can you build a perpetual money machine from stocks and bonds?

I’m going to go out on a limb, here, and say NO.

To help us find out why, let’s try and answer Rick’s question:

I agree if you can live on what your investments produce over inflation you’ll never run out of money.

Does it still make sense to plan using the rule of 20 when you don’t think you will be able to reliably pull out 5%?

It seems to me use a more conservative rule say 25 or 30.

Also, you could still use stocks- you would need some other income sources too- bonds or cash to draw upon in down years.

Rick raises a three part question:

1. Why base the Rule of 20 on a 5% withdrawal rate, when that doesn’t appear to be safe?

Well, given that I don’t think ANY withdrawal rate is safe, for me at least, the Rule of 20 should only be used as a PLANNING figure i.e. to help you convert¬†¬†your required annual income into your Number.

As a planning figure, I think the Rule of 20 underestimates your Number; the chances are that you will overachieve it rather than underachieve it.

Given that it’s extremely unlikely that you will exactly achieve your Number, you will either undershoot or overshoot it … if you wait until your Number is a virtual gimme before selling your [Insert Number Reaching System Of Choice: business, real-estate, stocks, horses, etc., etc.] you will probably find that it takes time to decide what/how/when to sell and in that time, your assets have appreciated even more.

If you don’t think that’s the case for you, use a higher multiplier … I just don’t think it’s necessary to stress¬†over it¬†ūüôā

2. Why can’t you use stocks to create your ‘perpetual money machine’?

It is a rare stock that provides the kind of income that we need without compromising the underlying business, but they certainly do exist: you would need to find a business (that you can buy stock in) that generates at least a 4% dividend, yet still grows the stock price at least according to inflation … consistently, over 30 to 50 years after you stop work!

However, using “bonds or cash to draw upon in down years” is a losing proposition (it’s not income … you are spending your capital!); I think that a two year emergency fund is a great idea … but, is there a reasonable chance of a stock downswing that will deplete that fund?

If so, I would not¬†like this stock+bonds+cash retirement strategy one little bit … which brings me to the final – and, key – question:

3. Can’t we use¬†a more conservative rule say 25 or 30?

Here’s the crux; the Trinity Study (for example)¬†says that we have a small chance of running out of money, even if we choose a “safe” 4% withdrawal rate …

… the longer we expect to live – hence have our money last – the larger the failure rate (which can be as low as 2%).

Here’s my question to you: if you are facing even a 2% failure rate, what are the chances that your money will last as long as you do?


Well, you would think so, but I once asked a doctor friend a similar question when – in a moment of rare weakness (thankfully now passed) – I actually thought about getting a vasectomy.

I told him that I heard that the operation was quite reversible. I asked him what the reversal success rate was. 

¬†“In your case” he said ” exactly 50/50 …

… either it will work, or it won’t!”¬†

So, Rick, find an actuary to help you choose any multiplier that you like and the chance is still¬†50/50 for you: either your Number will be enough to last as long as you do,¬†or it won’t ūüėČ

The fundamental rule of money?

Here’s the difference between conventional personal financial advice and 7m7y thinking in one slide; according to Brian Taylor the fundamental rule of money is to:

Either earn more than you spend or spend less than you earn.

Simple … and, much better than the alternative (spending more than you earn) …

… but, wrong!

There is only one fundamental rule of money:

Earn more than you spend

Can you see why? Your financial future depends upon it ūüôā

Fitting a square peg into a round hole …

The real problem with any of the so-called ‘safe withrawal rates’ that we explored¬†yesterday – with 4% currently¬†being perhaps the most popular amount advocated –¬†is that they all assume a fixed annual spending amount, but are actually generated by a totally volatile (some would say random) portfolio.

We’re trying to fit a square peg (fixed annual spending) into a round hole ( a ‘random walk down Wall Street’) ūüėČ

But¬†7m7y readers have an even more fundamental problem with planning our ‘retirement’ based on this type of common industry wisdom: we are planning on¬†retiring early, hopefully, with a very large Number and a soon Date!

Most retirement models assume a 30 to 35 year retirement lifespan …

…¬†I don’t know about you, but I retired at 49 and intend to live AT LEAST another 40 years ūüôā

Many of my readers will be aiming to reach their Numbers even sooner .. and, may expect to live even longer!

The bottom-line: traditional retirement planning models don’t work, because we need money that will last as long as we do … we need a Perpetual Money Machine, because we don’t know how long we will live once we stop working.

A Perpetual Money Machine is anything that:

a) Protects your capital over the long-run, even allowing for the ravages of market changes and inflation, and

b) Produces a reasonably reliable stream of income, that also (at least) keeps pace with inflation.

Neither stocks nor bonds – the traditional tools of retirement investing – fit the bill for us:

1. Stocks are too volatile, and the income tends to be artificial (e.g. so-called dividend stocks attempt to fix the level of dividend provided even as the company’s profits fluctuate).

[AJC: Raiding marketing, R&D, and other seemingly non-essential budgets in lean years in order to protect the dividend stream is Рto my mind Рthe mark of a poorly run company]

2. Bonds provide a very safe return, but the % returned each year is too low, meaning Рat least, to me Рan unnecessarily reduced lifestyle, especially after allowing for reinvestment to try and keep up with inflation.

That’s why my Rule of 20 is exactly that: a planning rule, NOT a 5% spending rule!

[AJC: Otherwise, I would have called it the 5% Rule, d’oh!].

In other words, my advice for PLANNING your Number, is to decide what initial income you want and multiply that by 20 in order to find your Number

… but, my advice for LIVING your Number is to turn on your Perpetual Money Machine and live off whatever it happens to produce, after allowing for¬†taxes and¬†provisions against inflation and contingencies.

The Myth of the Safe Withdrawal Rate …

I have noticed an¬†unusual phenonemom: I write a post on one theme and¬†your (i.e. our readers’)¬†comments explore another one entirely!

This is a GOOD thing … it means – I hope – that we are building an online community dedicated to the idea of linking our finances to our life, rather than simply attempting to¬†fit within¬†society financial ‘norms’.

Case in point: I wrote a post exploring various windfalls, and the comments lead us down the path of exploring so-called ‘safe withrawal rates’, which is the idea that there is a Magic Percentage of your Number that is ‘safe’ to withdraw to¬†live off each year.

The problem is, what % do you choose?

For example, I have proposed the ‘Rule of 20’ for calculating your Number, which seems the same as proposing a 5% ‘safe withdrawal rate’, but Jake disagrees:

A 5% drawn-down rate on the pot of gold is a little on the risky side if you want the money to last.

After looking at a bunch of data, I feel that a draw-down rate of 2-3% is too conservative, but 5-6% to aggressive. 4% or so seems right. I know, only 1% off from your value but over time it makes a huge difference.

So, Jake has highlighted one problem with selecting a ‘safe’ withdrawal rate … if you are out by even 1% your spending can be over (or under) the ideal by 20%. I don’t know¬†about you, but a 20% payrise (or paycut) is a pretty big deal … people quit their jobs over less!

So, what do the experts recommend?

Believe it or not, there is support out there for just about any annual % of your nest egg that you may choose to spend, for example:

7% – Not so long ago, the financial services industry proposed spending as much as 7% of your portfolio each year in retirement.

6% – More recently, Paul Graangard wrote two books proposing a bond-laddering and stocks strategy that supported a spending rate as high as 6.6% of your portfolio each year.

5% – Investment funds routinely allow spending of 5% of the portion of their investment portfolios dedicated to simply keeping up with inflation. Indeed, my Rule of 20 appears to support this withdrawal rate, too.

4% РA large number of studies Рprobably, the most famous of which is the so-called Trinity Study Рadvocate spending up to 4% of your initial portfolio (ideally, 50% stocks and 50% bonds, rebalanced each year), which provides somewhere between a 90% and 100% certainty that your money will last at least 35 years.

3% – ¬†A whole slew of¬†new retirement planning tools (generally using a Monte Carlo approach to modelling tens, hundreds, or even thousands of potential economic scenarios)¬†have been released over the last 4 or 5 years by the financial services industry, purporting to¬†analyse¬†hundreds of alternative economic scenarios to try and model what would happen to your retirement portfolio (i.e. simulating changes in interest rates, market booms and busts, etc.) to¬†find the ideal¬†‘safe’ withdrawal rate.¬†The trouble is that a lot of these advocate very low withdrawal rates, typically¬†in the 2.5% – 3.5% range.¬†

2% – Some even advocate a totally ‘risk-free’ approach to retirement savings by investing close to 100% of your retirement¬†portfolio in inflation-protected bonds (i.e. TIPS);¬†historically, these have provided a 2% return, after inflation and with total protection of your starting capital.

So, which is right?

None, as TraineeInvestor explains in his comment to my post:

I‚Äôm not fan of draw down models either. If you have to spend your capital to avoid eating cat food (or the cat) or are working with a very limited time period fair enough. But with a sufficiently long time horizon, my view is that any draw down rate is dangerous ‚Äď in fact I would be uncomofortable if my nest egg was not growing at at least the rate of inflation (after taxes and spending).

Another way of looking at it is that if you are relying on draw down of capital for living expenses you are very vulnerable to adverse events. No thanks ‚Äď I‚Äôd rather sleep soundly at night.

Me too! ūüôā

The One Minute Business Checkup!

My blogging friend, Andee Sellman has unveiled a corker … but, I have a STRICT no advertising, no product placement or promotion policy …

[AJC: it’s the only way that I could think of to convince people that I’m genuine, after all, do I want to say to people “I made $7 million in 7 years, plus an extra $4 a week from my blog” ūüėČ ]

.. so, I’ll just gently lead in with a story instead:

Many years ago, in a very short-lived experiment, my parents bought my sister a flower shop [AJC: mistake # 1].

However, because they knew that she wouldn’t take any of their advice (just the shop sans advice) they asked me to take the other 50%, which I agreed to [AJC: mistake # 2].

Unfortunately, I had no business experience in those days, so it was like ‘the blind leading the blind’ … however, I did go looking for help.

One of the first things that I tried to do was get some help on the NUMBERS that the shop should run according to; things like:

– What % of our sales should the flowers and other materials that we bought account for?

– What staff and other administrative costs should we allow?

– What salary should my sister draw?

Unfortunately, my accountant wasn’t much help [AJC: he basically told me to come back when I had a tax problem … when the problem was, we weren’t making any money, so there was no tax!], and I did find a benchmarking report on florist shops, but it didn’t really tell me what the numbers meant or, much more importantly, what to do with them.

That’s why I was really interested when Andee sent me a link to his new tool – I’ve checked and it is totally free –¬†called the One Minute Business Checkup … I think it would have been of great benefit – even though it is fairly simple, and works on just three (that I could see) critical benchmarks:


This measure looks at how much of the customer value you are retaining in your business by looking at the value the customer pays you and deducting the cost you incur to make those sales.

From experience we know that if the customer value measure falls below 20% a business will struggle and may fail completely so that is why the benchmark is set at 20%. i.e. retaining 20% of the customer value as a return to the business owner.

Example of Measure

Sales   $500,000
Product $250,000  
Business Owner $50,000  
People $50,000  
Marketing Costs $20,000  
Distribution Costs $30,000  
Total Costs   $400,000
Customer Value Retained   $100,000
Percentage to Sales   20%


The transaction flow measure is about determining the volume of sales that is running through your business. A business may have very high customer value (margin) but only a trickle of sales to take advantage of that value.

Our quick way of measuring transaction flow is to look at administrative cost compared to the sales in a business.

We have found that to be sustainable a business needs to spend no more than 12% of sales on its administrative costs. Often small businesses need to INCREASE SALES rather than decrease administrative costs to achieve this percentage.

Example of Measure

Sales $500,000
Administrative Wages $30,000
Administrative Expenses $20,000
Total Costs $50,000
Percentage to Sales 10%


The money flow measure is designed to find where the money is hiding in your business. Does money flow easily or are there places in your business where it gets ‚Äėstuck‚Äô and takes time to flow through to you.

A very significant place that money hides in your business is called working capital. There are three significant items:

  1. Inventory ‚Äď this can be raw materials, work in progress or finished goods
  2. Accounts Receivable ‚Äď this is money owed to you from customers
  3. Accounts Payable ‚Äď this is money you owe your suppliers

Money can get stuck in inventory and accounts receivable. It can also be lost from the business by undisciplined payments to suppliers.

The activity in your business can be measured by sales and this needs to be compared to the working capital invested in your business. We have found that to be sustainable and to give your business the best chance to grow, working capital should be no more than 12% of sales. Beyond this, too much of your money gets tied up in the business and is not available to fund growth.

Unlike the other two measures the money flow measure can be negative.

Negative working capital is a very dangerous situation needing urgent attention.

Example of Measure ‚Äď Positive Working Capital

Inventory $30,000
Accounts Receivable $55,000
Accounts Payable -$35,000
Working Capital $50,000
Sales $500,000
Percentage to Sales 10%

Example of Measure ‚Äď Negative Working Capital


Inventory $30,000
Accounts Receivable $55,000
Accounts Payable -$95,000
Working Capital -$10,000
Sales $500,000
Percentage to Sales -2%

If you have a small business, I recommend that you give this a try [ http://oneminutebusinesscheckup.com/ ] and let me know what you think?