HDBR versus SWR
Posted: Sun Jan 11, 2004 10:14 am
The historical sequence method calculates the survivability of a hypothetical portfolio based upon the actual sequence of investment returns that took place in the past. Those are Historical Database Rates (HDBR). This is what FIRECalc generates. This is what the Retire Early Safe Withdrawal [Rate] Calculator generates, including all of my modified versions.
A Safe Withdrawal Rate (SWR) is the result of a mathematical calculation that predicts the survivability of a hypothetical portfolio. It is based entirely upon information up to and including a specified date and none thereafter. Since an SWR is a mathematical calculation, there is, at least notionally, such a thing as a single, correct solution (or a single, correct set of solutions). Since it is a prediction, that answer is described in terms of probability theory.
There are many ways to calculate an SWR. Some are better than others, as is the case with any prediction. Consider an example consisting of coin tosses. You might start out by assuming that the probability of heads is 50%. But it is highly unlikely that the true probability of heads is exactly 50%. If you were to flip the coin 10000 times, it is highly likely that you would have a better estimate. You could even show, at a high level of confidence, that the probability is not exactly 50%. You will never be able to calculate it exactly. But the idea that a single, true probability exists is meaningful and helpful.
It is meaningful to speak of a Safe Withdrawal Rate that applied to a year in the past. The calculation must be made only with information available up to that year and none thereafter. We can even talk in terms of a Safe Withdrawal Rate during a historical sequence. For example, we might talk about the Safe Withdrawal Rate in 1958 for the historical sequence that began in 1953. The calculation would use information up to 1958 including the actual sequence of returns from 1953-1958. That could include information related to reversion to the mean. [Reversion to the mean is based on the notion that stock returns are related to earnings and earnings growth (over several years). This means that prices are not entirely independent (over several years) but are somewhat predictable. raddr has provided a precise definition of reversion to the mean and he has proved that it exists.] The calculation would not use information after 1958. Nor should its value be judged strictly in terms of the particular sequence of returns that occurred after 1958.
The conventional methodology assumes that the lower bound of Historical Database Rates is also a lower bound of Safe Withdrawal Rates. We have proved conclusively that this is false. There have been numerous contributors using a variety of methods that have led to this conclusion.
The conventional methodology never even applied during the bubble. Market conditions put the conventional approach out of range. The future was worse than the past from the get go. In fact, raddr's sensitivity studies have raised serious doubts as to whether the conclusions from using the conventional methodology were ever true. It may well be that the historical sequences that we have experienced were lucky in that the lowest Historical Database Rates were not typical. That suggests that the Safe Withdrawal Rates (which are related to probabilities), when properly calculated, would have been lower than the actual outcomes.
It is critically important for the purposes of this board to understand that Historical Database Rates and Safe Withdrawal Rates are quite different. In addition, Safe Withdrawal Rates are not rules of thumb. Of course, different withdrawal strategies and different portfolio mixes can have different Safe Withdrawal Rates because the mathematical problem is specified differently in all of these cases.
Have fun.
John R.
A Safe Withdrawal Rate (SWR) is the result of a mathematical calculation that predicts the survivability of a hypothetical portfolio. It is based entirely upon information up to and including a specified date and none thereafter. Since an SWR is a mathematical calculation, there is, at least notionally, such a thing as a single, correct solution (or a single, correct set of solutions). Since it is a prediction, that answer is described in terms of probability theory.
There are many ways to calculate an SWR. Some are better than others, as is the case with any prediction. Consider an example consisting of coin tosses. You might start out by assuming that the probability of heads is 50%. But it is highly unlikely that the true probability of heads is exactly 50%. If you were to flip the coin 10000 times, it is highly likely that you would have a better estimate. You could even show, at a high level of confidence, that the probability is not exactly 50%. You will never be able to calculate it exactly. But the idea that a single, true probability exists is meaningful and helpful.
It is meaningful to speak of a Safe Withdrawal Rate that applied to a year in the past. The calculation must be made only with information available up to that year and none thereafter. We can even talk in terms of a Safe Withdrawal Rate during a historical sequence. For example, we might talk about the Safe Withdrawal Rate in 1958 for the historical sequence that began in 1953. The calculation would use information up to 1958 including the actual sequence of returns from 1953-1958. That could include information related to reversion to the mean. [Reversion to the mean is based on the notion that stock returns are related to earnings and earnings growth (over several years). This means that prices are not entirely independent (over several years) but are somewhat predictable. raddr has provided a precise definition of reversion to the mean and he has proved that it exists.] The calculation would not use information after 1958. Nor should its value be judged strictly in terms of the particular sequence of returns that occurred after 1958.
The conventional methodology assumes that the lower bound of Historical Database Rates is also a lower bound of Safe Withdrawal Rates. We have proved conclusively that this is false. There have been numerous contributors using a variety of methods that have led to this conclusion.
The conventional methodology never even applied during the bubble. Market conditions put the conventional approach out of range. The future was worse than the past from the get go. In fact, raddr's sensitivity studies have raised serious doubts as to whether the conclusions from using the conventional methodology were ever true. It may well be that the historical sequences that we have experienced were lucky in that the lowest Historical Database Rates were not typical. That suggests that the Safe Withdrawal Rates (which are related to probabilities), when properly calculated, would have been lower than the actual outcomes.
It is critically important for the purposes of this board to understand that Historical Database Rates and Safe Withdrawal Rates are quite different. In addition, Safe Withdrawal Rates are not rules of thumb. Of course, different withdrawal strategies and different portfolio mixes can have different Safe Withdrawal Rates because the mathematical problem is specified differently in all of these cases.
Have fun.
John R.