Not touching the principal is one of those rules everyone hears about, it seems reasonable. Leave your money invested and let it make money for you! Great idea, but is it more complicated than that? Well, as it turns out, yes.
There are many sorts of investing, and the one most people think about when they hear the word is long-term investing. This is the simplest case: you want to put money in a deep, dark hole and forget about it, other than to occasionally look in the hole and see more money than you put in. Someday you'll want to take that money out, but that day is at least 20 years away. The classic example is a retirement account for someone that's under 40 years old.
The consensus of the industry is that until you have about $2m in liquid assets to invest, there's no point in doing anything other than broad market equity indexes for this class of investing. There are some caveats, but basically you never want to be in the business of trying to out-guess the market. You'll lose.
But what do you do if you need that money back out or if you need to draw an income from that money every year? What if you're trying to use that money to run a business or as your primary income?
This is a harder problem. There are many approaches, but they depend heavily on what you mean by "back out" or "draw".
This is called "income investing". The simplest case, here, is simply wanting to "draw down" the investment. That is, you have a pot of money, and you want to draw some amount of income from it every year until it's gone.
Some of the most challenging problems, however, come about when you want to gain some returns, but at the same time draw on they money you have over time. This is more complicated because you have two problems at once, or in the language of mathematics, you have two variables which you are trying to optimize.
There are many factors that influence income investing, from taxes to how much income you want to draw to how long you want to draw from it to how much you want to be left (if any) at the end.
Many people know one piece of traditional wisdom around such income: never touch the principal.
It turns out, this is wrong. It's actually extremely dangerous that people keep saying this without understanding what it means. Many forms of income investing involve specifically drawing down the principal over time (a retirement account, for example, unless you're trying to leave an inheritance). But the other issue is that "principal" is a vague term. There's your starting principal (the $100,000 in the example at the lead of the article) and there's the value of your investments at any point in time.
Let's return to the question that lead into the article: can you run out of money only drawing from the interest? Yep. In fact, it's quite easy to do.
So, here's the case that most people think of in this situation:
Our "strategy" is to draw 4% of the balance each year. This works well, and we get an income that rises slowly with inflation, while never "touching the principal". Nice, eh? Not so much.
Here's what happens in one real-world scenario where the market doesn't politely give you 5% every year:
Over the same 7-year period, you lose nearly 20% of your principal and so your returns are dropping at the same time. This is obviously because there was a very bad year, in there, but bad years happen, and -30% isn't even the worst year so far this century, much less the worst on record!
But we broke our rule. We drew from principal. In the second, third and second-to-last years, we drew more than the interest. So what if we cap our withdrawals at the interest earned. This will require that we wait until the year is over to draw, but that's fine.
Wait! We never drew from the principal, so how is it that we have less money at the end than we started with?!
This is the danger of thinking of your interest as separate from the principal. What you're actually doing is drawing from the rebounds of the market, so when your principal should be coming back to where it was, you're sucking away those gains. It's exactly as bad to draw when the market is moving up as it is to draw when it's moving down, so by limiting only one side of that equation, you've only constrained the problem, not eliminated it.
There are many ways to address this problem. You can only draw in years when the principal is larger than it's ever been before, and in those years only draw some fraction (say, 50%) of the interest, but this can lead to very long periods with no returns at all. In fact, just about every model that doesn't involve taking a tiny fraction of returns every year will result in periods of no returns. But you can optimize that a bit by averaging.
Here's the long-term result of drawing 4% of the principal every year, up to the average returns over the past 5 years in the face of a fairly catastrophic pair of years (-30% and -50% in the mix). This is called a "5-year rolling average":
Here, the returns do have gaps, but notice that the net result is very similar to only withdrawing in years that have new all-time-high balances, but you get a few extra years as well.
If you want to learn more about how this sort of income investing works, here are a couple sources to start with:
- Ang, Andrew. Asset Management: A Systematic Approach to Factor Investing, (Oxford University Press, 2014)
- Tacchino, Kenn. "How to drawdown retirement assets: the strategies", MarketWatch.com (MarketWatch, Inc. 2015)
- Kirkpatrick, Darrow. “These Are the Best Retirement Withdrawal Strategies”, Money (Time.com, Jan 04, 2016)
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