We all invest for a reason—to have a better future. For most, that means some combination of a longer/better retirement. However, this leaves us in a bit of a quandary—how much do we need? How much wealth do we need to build in our portfolio in order to successfully accomplish our retirement goals? It turns out, Joule’s law can provide us with some powerful investing insights—particularly regarding planning and preparing for our retirement.
Many moons ago, I began my “adult” life studying aeronautical engineering. While I ultimately progressed into other fields of study and professions—including acquiring my MBA and finding a love for operations finance, my unique and serendipitous path has exposed me to a diverse field of studies and experiences. As such, I have always strived to leverage that bank of knowledge by identifying and applying insights from other fields into both finance and investing. It turns out this approach—we’ll call it a quasi “unified field” approach—has added a significant amount of value to my long-term investing.
Joule’s law is a perfect example. As we’ll discover, we can inject some additional value into our investing (and retirement planning) by borrowing some fundamental insights from the world of electricity and physics.
We’ll start off by exploring some of the problems and shortcomings inherent in traditional approaches to retirement investing and spending. Next, we’ll explore Joule’s law and how it applies to investing. Finally, we’ll connect the dots and show how this approach can provide solutions to the problems created by the traditional approach.
The information presented in this article is significant—especially for those taking a FIRE (Financial Independence Retire Early) approach to life! Contrary to popular opinion, it is possible to accomplish your retirement goals without being miserable in the process—it just requires a change in thinking and approach!
The traditional approach to retirement has been to build a nest egg that is large enough to allow you to live off the assets acquired as you deplete them over the course of your retirement.
In 1994, William Bengen published his seminal study on safe withdrawal rates. He established what is now commonly referred to as the “4% Rule.” This rule argues that if you take the value of your account(s) at the start of your retirement, you can spend 4% of that total (adjusted for inflation) each year and be unlikely to run out of money.
For example, if you have amassed $100K in retirement savings, you should be able to safely spend $4K (4%) each year (again adjusted annually for inflation) for thirty years and not run out of money—based on a mix of returns and liquidations.
While this sounds great (and provides folks with a target to shoot for), it is not without some serious problems:
These two problems call into question the validity of the 4% rule—both in terms of your annual spending and the total target amount you will need in retirement.
Furthermore, a final problem worth considering is that this approach assumes a zero ending-balance at the conclusion of your retirement—meaning you leave nothing behind for the next generation! If you’re interested in building generation wealth for your kids and grandkids, this is a major problem indeed.
The first problem inherent in the traditional approach to retirement investing is time—meaning life expectancy.
Bengen reached his 4% safe withdrawal rate conclusion based on modelling 30-year periods (using data from 1926 to 1992)—based on a 50/50 mix of stocks (the S&P index in his study) and bonds (intermediate bonds in his study). This is critical to understand because the rule won’t apply if your needs exceed 30 years!
While he argued for a 0% chance of failure over a 30-year period, he acknowledged that the failure rate would rise to 15% over 40 years and 30% over 50 years.
We’ll explore the validity of the 4% rate in the next section; however, what’s important at this point is the 30-year limit. Is that a reasonable assumption?
According to the Centers for Disease Control and Prevention’s National Center for Health Statistics, the average life expectancy in the US stands at 78.6 years as of 2017. However, this has declined slightly over the past three years due to the impacts of the rapid rise in drug overdoses (viz., opioids).
If you adjust for this factor (assuming you’re not at risk for a drug overdose), the average expectancy is actually closer to 80 years. And that’s the average–meaning you could live much longer.
In a paper by Ryan Edwards (2008) published in the Journal of Population Economics, he calculates a standard deviation of roughly 15 years for life span in the US—meaning there is a 68% chance a person will live to between 65 and 95.
Furthermore, it is important to understand that the average life expectancy number (78.6) is for babies born today. What you really need to look at is the remaining life expectancy for your age—which is very different.
For example, if you are 40, then your average remaining life expectancy is 40.7 years—or 80.7 years of age.
This highlights an interesting fact: as you live longer, your life expectancy grows. Stated differently, every second you live, your life expectancy increases from the 78.6-year baseline. (Statistically, your future potential is no longer being negatively impacted by those who died younger—a statistical concept known as survivorship.)
The survivorship impact is not significant until your reach 20—but after that, your life expectancy begins to steadily rise.
This means that the average person reaching the age of 80 is expected (on average) to live to 89. If you retired early at 50 and based your withdrawal rate on living 30 years (which would make sense based on an overall life expectancy of 78.6 to 80 years), you could be in big trouble!
If you made it to 80, you would have to expect to still live another 10 years—or 40 years of retirement! That safe withdrawal rate would no longer have been a safe one to use!
Thus, retirement targets are more complex than you may have originally thought! You must consider the impact of this sliding scale. The 78.6 average is just that—the average (or mean). As you reach that age, the likelihood increases that you (individually) will fall in the range above the mean—and possibly way into in the right tail!
Suddenly, those failure rates for periods greater than 30 years become very important for us! And the problem is that it is difficult for us to predict our financial need—it grows as we continue to live, and our life expectancy rises!
In fact, recent studies using Monte Carlo simulations suggest that a safe withdrawal rate may drop to as low as 2.2% for periods of 50 years or more.
To adjust for this time problem, investors must either embrace a safe withdrawal rate significantly below four percent (meaning less cash to live on) or build a much larger nest egg!
The second problem inherent in the traditional approach to retirement investing is the validity of the 4% safe withdrawal rate (SWR) itself. Is it really safe?
The problem that arises is that Bengen had to utilize historical data to model his findings. Thus, the million-dollar question is: Does his data still accurately reflect current and projected data?
It turns out that the answer is not really.
As noted, Bengen based his modeling on a 50/50 equity-to-bond portfolio allocation (mix). In terms of traditional recommendations, this is fairly aggressive. Most financial advisors recommend a 40/60 mix (or less) at retirement to reduce volatility. Either way—this portfolio strategy is highly sensitive to interest rates.
That was great in the past when interest rates where at historical highs.
However, the current reality is that bond returns are nearly 3-times lower today than during the periods analyzed by Bengen thanks to historically-low interest rates!
While exposure to bonds does reduce volatility, it also reduces your potential return—thereby increasing the rate at which you will need to liquidate portfolio assets to maintain that 4% withdrawal rate.
It’s a double-edged sword! Increasing equity exposure increases returns but also increases volatility (bad) and increasing bond exposure reduces volatility but (in low-rate environments) also reduces returns (bad). To succeed, the traditional approach needs historically-high interest rates—providing adequate returns with lower volatility.
In fact, a 2013 paper by Michael Finke, Wade Pfau and David M. Blanchett published in the Journal of Financial Planning finds that up to 32% of retirement accounts would run dry and fail prematurely based on current bond yields—or returns for bond funds!
(Their paper “The 4 Percent Rule Is Not Safe in a Low-Yield World” is a must read)
The below chart shows the trend in total returns from the aggregate bond index from 1980 to 2018:
They also authored a Morningstar paper that found, with a 40% equity portfolio, a withdrawal rate of only 2.8% still produced a 10% failure rate over just a 30-year period.
Will interest rates revert to the historical range? It’s difficult to know—but it will have a tremendous impact on the safe withdrawal rate for future retirees!
Bengen argued for a 0% failure rate over 30 years (even more recently increasing that to a 4.5% rate with the inclusion of small-cap stocks). However, most studies find a 6-10% failure rate with withdrawing an inflation-adjusted 4% of retirement-date assets over a 30-year period based on historical data.
Worse yet, based on 2013+ intermediate-term real interest rates, current studies suggest the reality is a failure rate of between 30-60% for 50/50 portfolios over just 30 years!!!
For example, Finke, Pfau and Blanchett posit:
Again, that failure rate increases for longer retirement periods and/or higher bond allocations.
I don’t know about you, but I don’t want to head into a retirement characterized by a 30-60% failure rate! As such, I completely agree with Finke, Pfau and Blanchett when they assert:
To adjust for this return problem, investors must embrace a safe withdrawal rate significantly below four percent—meaning again, you guessed it, a much larger nest egg!
As we’ve seen, there are significant issues with the traditional approach to investing for retirement. Namely, life expectancies are increasing, folks are retiring earlier, and safe withdrawal rates are shrinking.
These problems are joining forces to create a perfect storm for those working towards their retirement—based on a traditional approach.
If you take the traditional approach, here is what you will likely need to retire on $50K a year:
That’s a significant amount of money—especially for those in the struggling middle-class. The pressure to hit numbers like these can greatly contribute to the frustration and stress experienced by many folks trying to get there!
The only options with the traditional approach are (1) increase your income (viz., work more jobs and/or hours), (2) live on a shoestring budget (i.e., sacrifice quality of life now to survive retirement later), or (3) delay retirement (no bueno for most folks).
However, thankfully, the story does not end there. There are other options if you change your thinking and approach to investing for retirement.
Let’s now look at what Joule’s law can teach us about investing for and enjoying retirement…
There is a powerful alternative to the traditional approach to retirement investing—income investing.
By income investing, I’m not referring to fixed-income (viz., bonds) but, rather, to an equity-based dividend-growth approach that is predicated on a value framework. Our Wicked Capital site is dedicated to teaching this approach, as well as sharing valuable ideas, tips, and encouragement along the way.
Passive-income investing requires an entirely different mindset—one focused on building income rather than portfolio capitalization (appreciation). It is very similar in nature to those who take the real estate investing approach to financial independence and retirement.
Joule’s law provides us with some great insights into how this approach works.
Let’s look at the law and then how it applies to investing for retirement. Finally, we’ll contrast it with the traditional approach and answer the big question—how much will you need with this approach?
In the early 1800s, James Prescott Joule provided the world with an equation to calculate power—part of what became known as Joule’s Law or the Joule Effect.
In short, it states that power equals voltage times current.
Let’s look at each of those three components…
Power (P) represents the amount of work done over a unit of time—typically measured in watts.
Voltage (V) represents the difference in electrical potential between two points. Think of it as “pressure.”
Voltage is similar to the concept of mechanical potential energy. If you hold a bowling ball over your head, it has potential energy—which would be converted to kinetic energy if you let go of it!
Now, if you hold that same bowling ball off the top of the Empire State Building, it will have a lot more potential energy.
The higher the voltage, the higher the pressure or potential energy.
Current (I) represents the rate of flow of an electric charge. Obviously, this flow must be directed through something—like a wire. The bigger the wire (gauge), the greater the potential flow (or current) that can pass through it.
Let’s now take a look at how we can apply Joule’s law to investing.
Power relates to investing in terms of passive-income. It is a measure of how much passive-income we can generate over a given period of time (e.g., a year).
Voltage relates to investing in terms of the size of your portfolio. The larger your portfolio is, the more potential financial energy—or pressure—it has.
Current relates to investing in terms of yield. The higher the yield your portfolio produces, the bigger the current (cash flow) that can flow through your financial “wiring.”
Thus, the amount of passive-income you can generate (financial power) is determined by the product of your portfolio size (voltage) and yield (financial current). Power doesn’t care whether you have a lot of financial voltage or a lot of financial current—the product (power) is the same.
Furthermore, your portfolio only represents potential financial energy—it doesn’t provide you with “kinetic” energy or produce financial power (passive-income) until that pressure is released into a flow (current) via dividends at a rate defined by your yield.
The best way to visualize this is by thinking of a waterfall…
The power produced by a waterfall is equal to the product of its voltage (height) and its current (rate of water flowing over it). A tall but thin waterfall will produce the same power as a short but wide waterfall.
Income investing is no different. Your power (passive-income per period of time) is determined by both the size of your portfolio and its yield. Thus, you can increase your financial power by not only building a bigger portfolio but also by creating a bigger current (higher yield).
Joule’s Law is a powerful reality for those investing for retirement. It means that by increasing your yield, you can reduce the size of the nest egg required!
How big of a difference can this make? Let’s look at the numbers…
Understand, a 3-4% yield is highly conservative when it comes to income investing. Typical portfolio yields range from 6% to 10% and we target 8-9% with our public Wicked Capital passive-income portfolio (PIP).
For example, let’s compare the two approaches for a 25-year old. This person plans to invest for 25 years and then retire at age 50. They anticipate a possible life expectancy of 90—requiring their retirement funds to last for 40 years.
Here’s what the difference looks like:
This is just an example (based on simple estimates) but the exact numbers don’t matter… the point is that by embracing a different approach to retirement investing and spending (viz., an income approach), you can significantly reduce the size of the nest egg you will need—and, therefore, the amount you will need to invest!
In this example, that equals a 68% reduction!
[Again, your actual numbers may vary—but whether your potential reduction is 30%, 40%, or even 70%… it can be very significant]
That’s the power of an income-investing approach to long-term investing and retirement.
Passive-income investing provides a virtual cornucopia of benefits and advantages over traditional retirement investing; however, here are my top three…
First, with a passive-income approach, volatility is your friend rather than your enemy.
Prior to retirement, market declines are opportunities to buy at lower prices—decreasing your cost basis and enabling you to deploy your capital more efficiently. You simply get more cash flow for less money.
After retirement, volatility is irrelevant to you because you are focused on the passive-income your portfolio generates—not capital appreciation. As long as dividends aren’t cut, your income will remain stable regardless of what the market is doing. In fact, your income will increase as dividend growth continues to occur.
This is akin to owning a rental property. You don’t care if the value of the property drops in the short run—you aren’t selling it. Rather, you simply care about how much you can rent it for and if you can maintain occupancy.
This is very different from a traditional approach that utilizes a safe withdrawal rate. Remember, with a safe withdrawal rate, you are consuming (selling) your assets to produce cash flow. This is why advisors (correctly) push traditional investors to increase their bond exposure as much as possible as they age—volatility becomes your enemy (and a very costly one). A decrease in your portfolio value will require you to sell more assets to generate your needed withdrawal amount—increasing your burn rate. Furthermore, it will be very difficult to earn such losses back (1) with less money and (2) over a now compressed retirement time-horizon.
Second, with a passive-income approach, you will need a much smaller portfolio—especially with a higher-yield approach.
Remember, with a traditional approach, you would need a nest egg of roughly $2 million to safely survive a 30 to 40-year retirement based on $50K withdrawals each year. However, with a passive-income approach, you would only need around $600K with an 8% yield. That’s a big difference!
A $600K investment portfolio is much more achievable and less discouraging to tackle for the average person!
Finally, the third benefit with a passive-income approach is the ability to preserve generational wealth. Again, with a traditional approach, your safe withdrawal rate is predicated on depleting your assets. If you successfully survive retirement (which, as we’ve seen, could be a real challenge), you will die with little to no assets left to pass-on to your children or grandkids.
However, with passive-income investing, you are living off the income generated by your assets. This not only provides you with a massive margin of safety, but it means you can pass on your assets to your heirs when you pass. They can then use those assets to continue building wealth and income for the next generation.
Finally, I hear a lot of people ask, “Yes, but can’t I just transition to an income-investing strategy when I retire?”
Yes, you can certainly do that. However, I would highlight three important facts:
First, you will sacrifice years of potential cost-basis lowering opportunities and dividend growth. This means you will pay more for the same level of passive-income than someone who was investing for passive-income for decades.
For example, while you may have to pay $625K for $50K in annual passive income (an 8% yield)… someone who has been implementing an income-investing strategy for twenty years may have only had to invest $460K for that same $50K of passive income!
Second, passive-income investing requires a very different mindset and process—one that takes time to learn and develop. Retirement can be a difficult transition and occurs at a point in your life when you may be facing elevated stress levels, potential health distractions, and diminished financial judgement.
To understand this unique mindset and process better, I encourage you to read our articles: Paradigm Shift: The Dividend vs. Growth Investing Mindset, Dividend-Growth Investing Success Is All About the Process, The Brutal Truth about Dividend-Growth Investing, and Caution: Dividend-Growth Investing Isn’t for Everyone.
Third, passive-income investing with a value framework significantly outperforms traditional strategies in the first place! It produces higher total returns over the long run—and does so with far less volatility. To read more about this, I recommend reading my article What Does the Value-Growth Spread Really Mean for Long-Term Investors?
I know you’re hearing those voices saying, “Yes, but you could kill it in the markets with growth investing—that’s what all smart, capable, younger folks do!”
I’ll simply share this pesky little reality check with you again:
Average investors don’t kill it in the markets over the long-run with growth investing… they get killed!
Don’t mistake one or two years of amazing returns as long-run success—that’s not how the markets work.
If you can systematically invest in an index over the long-run without touching it, then that’s fine. Passive growth investing may be a great option for you. However, most people can’t and don’t. They handle the proverbial soap in the shower way too much and find themselves left with less in the end.
Furthermore, if you are (or are going to be) an active investor, then I highly recommend utilizing a passive-income approach predicated on value and dividend-growth. Growth investing is not all rainbows and unicorns—don’t believe the hype! The facts simply don’t support the creative (and deceptive) marketing activities you will be bombarded with—including from the financial industry itself.
To be honest, income investing is an approach you should take from the start of your investing. Yes, you can transition to it—but always at an inherent discount (cost). My advice is don’t wait—do it… and do it now.
Successful retirement investing doesn’t start at or just before retirement… it starts when you’re young and have time!
As we’ve seen, there are inherent problems with the traditional approach to retirement investing and spending:
These problems make it increasingly difficult to determine (1) how much money we need to retire and (2) what our safe withdrawal rate would need to be to avoid retirement failure. The old rules simply no longer apply.
We can also add the fact that the traditional approach to spending in retirement assumes we will liquidate most (if not all) of our portfolio assets—eliminating the ability to preserve generation wealth.
This all leads to the need to build portfolios of ever-increasing values—an endeavor that adds stress, pressure, frustration, and discouragement for hard-working everyday folks striving to deliver on their retirement dreams.
However, there is a powerful alternative—income investing.
Joule’s law provides us with an equation to calculate power—the amount of work performed over a period of time. While this formula pertains specifically to electrical energy, we can think outside the box and apply it to the financial power we can generate through income investing.
By doing so, we understand that financial power (passive income) will equal the product of our portfolio size (voltage) and yield (current).
This means that if we want to increase our financial power to achieve a given level of retirement output, we aren’t limited to having to build a larger portfolio (which is not always an option)—we can also increase our portfolio yield (intelligently) with income investing.
With the proper mindset and appropriate process, we can significantly reduce the size of the nest egg we’ll need for retirement.
Additionally, the income-investing approach outperforms traditional approaches over the long run—with less volatility.
Finally, income investing enables you to preserve your assets and pass them on to future generations.
Simply put, it’s a no-brainer… and yet the vast majority of retail investors fail to understand its power and benefits—succumbing to the “growth” hype, false narratives, and misinformation disseminated through deceptive marketing by the financial industry and the sharks looking to profit off the misfortune of others.
Rather than positioning themselves well for retirement, they end up with an average return of 1.9% over a twenty-year period!
If you’re interested in dividend-growth investing predicated on a value framework—you’re in the right place! We focus exclusively on helping others be as successful as possible with this income-based approach to investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!
Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that portfolio with a solid process and winning mindset!
We also encourage you to follow along with our public Wicked Capital Passive-Income Portfolio (PIP) through our monthly updates on the website and by viewing the portfolio on M1 Finance at https://m1.finance/1zUclN2JL
It’s a great way to learn from a real-world example of building and managing a dividend-growth portfolio predicated on a value investing framework!
Finally, if you’re interested in starting your own portfolio using the M1 Finance platform (which we highly recommend), please consider using our referral link https://mbsy.co/sZVS3 and we’ll both get some free cash!
That’s just one more reason to start your dividend-growth investing today! It’s never too soon to start working towards your financial freedom!
Arias, E., & Xu, J. (2017). United States life tables, 2017. National Vital Statistics Reports, 68(7).
Bengen, W. P. (1994). Determining withdrawal rates using historical data. Journal of Financial Planing, 7(4), 171-181.
Edwards, R. D. (2008). The cost of uncertain life span. Journal of Population Economics. doi:10.1007/s00148-012-0405-0
Finke, M., Pfau, W. D., & Blanchett, D. M. (2013). The 4 percent rule Is not safe in a low-yield world. Journal of Financial Planning, 26(6), 46–55.
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