The 4% rule and its findings are critical to the success of the FIRE principle and understanding it is the key to being able to retire much earlier than you thought. I will try to give you a clear explanation of what the 4% rule is and how it can be applied to your life.
4% in a nutshell
The 4% rule is basically the rule that tells you how much you can withdraw from a investment portfolio and expect it to keep its current value. It is derived from two other numbers found out there in the economy that have shown to be the averages for the expected rate of return on investments and the average inflation rate of the economy.
Rate of Return- how much money you make from the growth of your stocks/bonds and the money they payout in dividends.
Inflation- the growing cost of stuff ie. how a candy bar used to be 50 cents in 1995 and now costs a $1.25
On average it has been found that the return on investment for the general economy is 7%. This does not mean individual picked stocks but is instead the growth rate overall for the whole economy.
During this same period of time the average inflation rate is 3%. So by doing a little bit of simple subtraction of you arrive at a sustainable withdrawal rate of 4%.
This idea has been back up by something called the Trinity Study which showed that over a 30 year retirement if you only withdrew 4% of your portfolio every year that your money has a 96% chance of lasting the whole time.
But now you might be saying to yourself only 30 years what if retire when I'm 40 is my money going to run out when I’m 70.
The simple answer is no because of a couple extenuating factors.
While the 4% rule is powerful the key to really making money lasting a lifetime is flexibility. If the economy tanks for a year or two and your return on investments is low you might have to cut expenses or get a part time job. When the economy is booming at 8,9 or 10% that would be a good time to go on a nice long vacation or buy some rental property that can provide you with another source of income.
Moral of the Story
The 4% percent rule and it should really be called a 4% guideline is something to give you a target to shoot at with your saving and investing. It is not something that you need to live or die by but instead use it as a benchmark to refer to when making your financial decisions.
Hello my name is Josh Larson and I am the creator of the Green Living Library. Here on the blog you will find updates to content found in the Green Living Library as well as stories from those living the sustainable life already.