The 4% rule and the Shiller PE ratio

People pursing FI (Financial Independence) use the 4% rule to determine when they can pull the trigger for retiring. The problem with that is that the  4% rule is applying for retiring in a random year. When you target a number to retire on the year you retire on isn't random. I'm going to repeat that it's important. When you target a number you are no longer choosing a random year. The 4% rule is predicated on the fact that you are retiring at a random point, when you use a number to retire on the years where the market is up is where your stock is worth the most and when you are closest to hitting that FI number.


Well we know we can't time the market, and if you can your too rich to be reading this blog, so what can we use to evaluate the current market cycle? Enter the Shiller PE ratio, and a couple of definitions.

PE ratio- Price to Earnings. What this does is get a sense of how the company is doing versus how much you would pay for it. Think about it like this, if you bought a bar or a rental property how long should it take for the money that you earn to pay off your initial investment? That's what the PE ratio is giving you a sense of, how much money are you making vs how much you paid for it. It does not give you a sense for how risky an investment is, stick to index funds.

The Shiller PE ratio was invented by a smart bloke at Yale. Basically if we know the PE ratio of a company why can't we figure out the PE ratio of all the companies? So he did that and then applied some other fiddle bits to it. He took the annual earning over the past ten years, adjusted them for inflation and then took the ratio of the price of the S&P 500 over the average earnings of the last 10 years.  The fiddle bits smooth out the graph so that expansions and recessions look like normal years. This range of PE ratios can help you visualize if the current prices are in the range of reasonableness.

The 4% rule or safe withdrawal rate is based on using low cost index funds and the Shiller PE ratio lets us know where stocks are at based on the historic averages. So before you decide to never work again see where stocks are at. If stocks are much higher then normal (very likely when targeting a number to retire on) then stress test your retirement budget with a more reasonable ratio.

For example the current ratio at time of writing this is 30.3 with a historic mean of 16.9 a drop of around 55% would not be out of the question here. So when evaluating the index funds that are being relied on could you make it with 55% less money? Also a 55% drop is not going to be offset by a 55% rise, this is called the sequence of returns.  If you had 600,000 dollars a 50% drop is 300,000 dollars. A 50% rise from there is 450,000. If we expect the annual rate of return to be 7% (adjusted for inflation and dividends) it is going to take about 10 years to recover that 50% drop. Maybe having more in bonds for a couple of years, or cash (yuck) would be enough to make it - but it's going to be a couple of stressful years early on in your retirement if your right on the edge of your number. If you can't tighten the belt or bring in some extra income for 10 years retiring right when you hit your number is a lot more risky then you might think given words like 'safe withdrawal rate'. If on the other hand your retiring when the Shiller PE ratio is under 16.9 than your probably more than ready to ride off into the sunset.