Beating the market to maximize retirement income

Warning, this is a somewhat geeky technical post!

Besides accumulating more wealth by working longer there is one very direct way to increase your income in retirement. Beat the market’s return. Higher returns will lead to higher SWRs (safe withdrawal rates) for the most part. (The other way to increase retirement income is to reduce volatility). Of course, most would say that this is not possible over the long term. The market is efficient etc… Thus, most of the standard retirement asset allocation models that give us the 4% rule are based on a a market index of stocks, usually the SP500 or a total US stock market index. But this advice is based on a mis-understanding of efficient market theory. Even efficient market theory says you can beat the market and increase your safe withdrawal rate above the standard 4% by investing in certain classes of stocks. Lets take a look.

I won’t go into the details of efficient market theory lest I bore everyone to tears (see here and here if you’re interested) but modern versions of the theory all agree that there are certain attributes of stocks (called factors) that beat the market over the long term. The attributes that are well known to beat the market are value, size, and momentum. Value stocks beat growth stocks usually measured by price to book value. Small stocks beat large stocks measured by market cap, and momentum stocks beat the market measured by last 12 months performance. The market data that shows this goes back to 1927. And the great thing is that you can access all this data for free. Professor Kenneth French of Dartmouth, of the famous Fama-French 3 factor model, makes all kinds of historical market data available for free at his website. Using the historical data at the site here are the returns for the market and these factors going back to 1927.

As the table makes clear value beats growth, small cap beats big cap and momentum beats as well. Also, combining these factors works, i.e. small value beats big value. So, you can beat the market. And as you probably expected at lost of those higher returns come with higher volatility (Stdev in the table). But a lot of that extra risk is worth it, as measure by the higher Sharpe ratios which measures return per unit of risk. Now, the question we’re trying to answer is what impact does this have on SWRs in retirement.

Running retirement simulations going back to 1929 using the classes of stocks that beat the market, with various mixes of bonds allocations, yields the following SWRs.

The table shows the three types of stocks that beat the market, what mix of stocks/bonds gave the maximum SWR, and what that SWR is. For example, small value stocks yield the maximum SWR at an allocation of 50% small cap stocks – 50% bonds, and that SWR is 5.52% which trounces the market SWR of 4.38%. The max SWR comes at a lower stock allocation due to the increased volatility of small value stocks. There you go. More income in retirement by investing in known proven factors that beat the market over the long term.

In summary, even efficient market theory shows you can beat the market and the 4% SWR rate by investing in certain types of stocks. Small cap stocks, value stocks, and momemtum stocks provide higher SWRs than the market index. Every retiree should allocate some of their retirement funds to these market beating asset classes. I’ll touch on some specific investing options in future posts.

P.S. I’ve touched on this topic in a previous post(here) indirectly. Both the IVY portfolios (buy and hold or timing) also increase SWRs in retirement, mainly through achieving market like returns at much lower volatility.