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One of the main principles of investing is the Risk vs. Return trade-off, which according to investopedia.com:
Risk vs. Return trade-off states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns.
It is a principle that every investor needs to understand before they buy their first stock or preferably their first broad-based low-cost index fund (BBLCIF).
What I always found interesting about Risk and Return is that while the latter is easily calculated and even more easily understood, the former is a little bit of an enigma for even the most seasoned investor.
As you read this I challenge you to write down the formula for Risk. I’ll give you a hint: the most basic way to measure stock market Risk is to calculate a stock’s beta.
And to calculate a stock’s beta you’re going to need the formula for the stock market’s standard deviation. I’ll give you another minute to write that one down.
What I’m trying to get at, is that measuring Risk is difficult. And even trying to have a basic understanding of it is almost as difficult. This is the main reason almost all investors just focus on Return, as I stated above it “is easily calculated and more easily understood.” At least that is what I thought until I was recently texting with a friend.
I’ve known my friend, let’s call him “Frank,” for about 20 years, ever since we bowled together in the company league. While he was a terrible bowler, he had gone quite far in the company and was a knowledgeable investor. In between frames and beers, I enjoyed discussing with him the finer points of stocks, bonds, real estate, and office politics.
He was really into selling covered calls on company stock. While it wasn’t my bag, he seemed quite knowledgeable. He subsequently bought some undeveloped land, subdivided it, and built himself a large house. There’s little doubt he has a fair amount of business acumen. He even ran for a statewide political office and has an MBA from Rutgers.
Then last week he texted that he wanted to visit, that he thought my recent blog post was impressive, disagreed with my index fund advice, and that he had a “14.9% cash draw last year before taxes.” He went on to text “Notice I did not say ‘return’ but ‘cash draw’. In retirement it is all about the cash.”
I mentioned that I looked forward to a visit, and then asked “What is the definition of “cash draw?” as I had never heard that term when it came to investing.
We went back and forth with him eventually defining it as “Take total cash pulled divided by average of 1/1/2024 balance and 12/31/24 balance.”
I was quite confused by this new (to me) term of “Cash Draw” and its formula. It was a real head-scratcher. I replied that the only way to measure Return was: (Dec 31 2024 value – Dec 31 2023 value) / Dec 31 2023 value (adjusted for any withdrawals or additions).
To which he replied “lol.”
I decided not to argue anymore but to confirm his “Cash Draw” formula. So I emailed him this example:
Portfolio Value (Dec 31, 2023): $100,000
Portfolio Value (Dec 31, 2024): $135,000
Cash Withdrawal 2024 (BT): $14,500
Portfolio’s Cash Draw = $14,500 / (($135,000 + $100,000) / 2)) = 12.34%
To which he replied, “Now you have got it.”
“Got what?” I thought and was tempted to reply to him that by doubling his Cash Withdrawal to $29,000 (and correspondingly reducing his Dec 31, 2024 Portfolio Value) he could more than double his Cash Draw, but sensed that further discourse would be fruitless.
Quite simply my friend has created his own measure of (retirement) investment success and is using it to manage a multi-million dollar portfolio.
I reviewed all our texts and emails numerous times and still found it all a little unsettling, as while I always knew that investors could not properly calculate or define Risk, now I wonder if many could not even calculate or define Return.
I thought about asking him for his take on compound interest, but I’m worried it might make my head explode.
Note: I thought I’d include the formula for beta and standard deviation at the bottom of this article, but they are so complicated that they cannot be accurately represented in the HumbleDollar Forum.
It is amazing what one can do with a little arithmetic. Interpreting the answer is apparently not so straight-forward.
Still puzzled by this but maybe I see the angle. Frank was possibly boasting in some way that he could afford to draw 12+% of his portfolio and remain unconcerned. I guess if you had high net worth you could have a year where your cash draw was unusually high (a new supercar, a new holiday condo, a blowout trip) yet you remained unconcerned because in “ordinary” years you be drawing 2% or less cash.
Mike, thanks for writing this article. I read it a few days ago but knew I had to revisit and see if I could make sense of it. Here is what I came up with.
The cash withdrawal rate is not a return rate. It represents the percentage of the portfolio that was withdrawn for the year. IMO, you should calculate both portfolio return rate AND cash draw rate.
I think Frank is emphasizing that in retirement, what matters most is how much money you can safely withdraw to support your lifestyle rather than the investment return. I hope he doesn’t believe a 12.34% cash withdrawal rate will last very long. He uses the average value between start and end of year to smooth for portfolio fluctuations.
Cash draw % matters a lot in retirement because if your withdrawal rate exceeds your portfolio return you’re eating into your principal.
Use investment return % when you are determining if an investment strategy is working as you planned. Use cash draw when you need to ensure your withdrawals are sustainable.
I think the target of 3%-5% cash draw rate is still considered sustainable. If the market does well and your returns are high you can take a larger cash draw and vice-versa.
I’ve enjoyed your articles. Hope you continue.
Cheers.
Steve Webster! First of all (and most of all), thanks for the kind words contained in your last paragraph. While I agree that investors “should calculate . . . portfolio return rate . . .” based on its rate of return, I think the “cash draw rate” is pure voodoo, so bad it is infinitely worse than investing based on dividends.
Absent the details of how he got to his cash withdrawal, but my initial reaction would be that it doesn’t measure return at all because withdrawals are user specified not driven by the marketplace.
It reads like a measure of how he perceives his portfolio such that it allows him to take such large withdrawals. I’m not sure what real purpose this serves unless he needs a boost to his confidence.
Frank is calculating the average value of his portfolio during the past year, then utilizing the average value for withdrawal percentage calculations. Sounds good to me, especially if pulling money out multiple times during the year. Frank is doing a year end review. However, not so good to pull money out of the portfolio without calculating the portfolio changes, meaning, better to do this at the time of cash withdrawal. For example, a January ’25 cash withdrawal calculated with a desired 4% withdrawal rate = 12*.04/12 *(portfolio start value+portfolio end value/2). Using mjflack’s numbers mentioned below .0033×12*$67750 = $2,682.90 for January ’25 withdrawal given the desire for 4% annual withdrawal rate. Note when the portfolio has dramatic changes better to do monthly withdrawal calculations and add these monthly totals for what ever time period.
flleeb, It doesn’t sound good to me. If the value of his portfolio dropped to zero over the course of a year and his withdrawal rate remained at $14,500, then his Portfolio’s Cash Draw would equal a very respectable 29%.
Though your calculating Portfolio’s Cash Draw at the time of withdrawal might have some value. Either way, I still think calculating Return via the change in portfolio value / initial portfolio value is the only calculation that makes sense.
Call it cash draw or rate of withdrawal or call it Fred, the name doesn’t matter. I believe “Frank” wanted you to compare his 14.9% rate to the 4% withdrawal rate that seems to be beaten into our heads.
Mark Eckman, so in the example above: if the Cash Withdrawal 2024 (BT) remains at $14,500, but the Portfolio Value (Dec 31, 2024) = $35,500, then the Portfolio’s Cash Draw = 21.4%. Your investments have decreased in value by 50%, but your Portfolio’s Cash Draw has increased by 43.6%. I’m not sure what you’d call it, but I know what I would.
Yep don’t get it. I can sort of see the benefit as a guardrail which makes more sense with big numbers. Say you have $2m and it compounds 5% after drawing $100k along the way.
100/2050= 4.9% so maybe that makes sense in times of growth
But say it falls 5% on top of your drawing 100/1900 = 5.3%
and then next year stays flat 100/1750 = 5.7%
Those cash draw rates still seem modest but you’re rapidly depleting the portfolio. The calc must need a negative sign somewhere to signal peril.
Your discussion with Frank did make my head explode, but I enjoyed your blog post about Machu Picchu. We leave on Feb 6 for a South America trip, and the tour has us in Belmond hotels for the first two stops—Copacabana Beach in Rio and the one in Iguazu Falls. Sounds like they’ll be nice!
Dana, I am glad it wasn’t just my head that exploded. Have fun on your trip. Chris
Dr., if my friend “Frank” can lead to a better visit to Iguazu Falls, then his newfound financial math will have all been worth it. Last year I spent 48.75 hours visiting “the largest waterfall system in the world” and this my Report on it. Safe travels.
Have a great trip! The Iguazu falls are spectacular. (I slept much, much more cheaply, but you will be inside the park on the Brazilian side,)
Thanks, Kathy! We also get to see them on the Argentina side!
I thought about this a bit last night. Is your friend trying to redefine a safe withdrawal rate? I was wondering if he was saying his portfolio return was so high he could withdrawal almost 15% safely.
Maybe if Frank sees this post he’ll leave a clarifying comment?
Ben Rodriguez, I think if he sees this post he’ll end our friendship.
But please post a follow up after he clarifies this system. Was it something of his own devise or from business school?
phenomenal8f6ba2e774, this just in from “Frank:”
“First off, how old are you? I will soon be 73. The amount of cash I am pulling out reflects my age – I really do not need to reinvest even though I did reinvest $100,000 last year. I think anything around 10% is really good cash draw if overall balances remain flat or increase slightly. I have a huge chart that keeps track of my historical numbers. Nice to see improvemt (sic) year over year.”
Ah, so cash draw is simply the amount he chooses to pull out while trying to maintain the same or slightly higher account total from year to year. Two comments: 73 is not that old, and good luck in those years when the market dips below the previous years’ balance.
Ah the IF condition is doing a lot of work. If your portfolio remains up after drawing 10% then happy days but doesn’t really work in downturn which your 10+% return years are supposed to cover for.