Does the 4% Rule Still Work?

Ask the Compound - Summary of Show Transcript

Key Concepts:

• Diversification: The practice of spreading investments across different asset classes to reduce risk.
• S&P 500 Dominance (Recent Past): The historical outperformance of US large-cap stocks compared to other asset classes.
• Asset Allocation Cycle: The cyclical nature of asset class performance, with periods of outperformance and underperformance.
• Tax-Advantaged Accounts vs. Taxable Brokerage Accounts: The trade-offs between maximizing tax benefits and maintaining financial flexibility.
• Emerging Markets: Investments in developing economies, characterized by higher growth potential but also increased risk.
• 4% Rule: A guideline for retirement withdrawals, suggesting a 4% initial withdrawal rate adjusted for inflation.
• Sequence of Returns Risk: The risk that poor investment returns early in retirement can significantly deplete a portfolio.
• Boom-Bust Cycles: The cyclical pattern of rapid growth followed by sharp declines, particularly common in emerging markets.
• Personal vs. CPI Inflation: The difference between the Consumer Price Index (CPI) and an individual's actual spending inflation.

1. Diversification – Is it Finally Time to Pay Off?

The show begins by addressing a question about whether diversification is finally becoming worthwhile after a decade of US large-cap stock dominance. Ben Carlson acknowledges the historical trend of the S&P 500 outperforming other asset classes (foreign stocks, value stocks, emerging markets, dividend stocks) but notes a shift in 2025 and 2026. Data presented shows that in 2025, emerging markets and developed international stocks led with 30% returns, while large-cap stocks still performed well at 18%. Early 2026 data (though acknowledged as short-term) indicates continued outperformance from emerging markets, international stocks, small caps, and REITs.

Carlson highlights potential contributing factors to this shift, including a weakening dollar (beneficial for international stocks), potential interest rate declines (positive for bonds and small/mid-cap stocks), and the potential for AI to level the playing field for smaller corporations. However, he cautions that this could be a temporary blip, acknowledging the continued strength of large US corporations. He emphasizes that the core benefit of diversification isn’t predicting winners, but rather mitigating risk by being prepared for various outcomes. He uses the analogy of “clipping singles and doubles” rather than aiming for home runs. He notes that while diversification may have been missed during the period of US stock dominance, it’s not too late to rebalance and diversify now.

2. Tax-Advantaged Accounts & Flexibility

A question from Alex and his wife, with a high income ($300,000) and significant assets in tax-advantaged accounts (401k, Roth, HSA, mega backdoor contributions), explores the downsides of over-concentration in these accounts. They find their 25% post-tax savings rate is entirely absorbed by retirement contributions, limiting flexibility.

Carlson references Nick Mullie’s argument against maxing out 401(k)s, emphasizing the importance of financial flexibility. He acknowledges his initial skepticism of Mullie’s view but is now leaning towards it. He points out the inability to borrow against retirement accounts and the benefits of having a taxable brokerage account for potential margin loans or unexpected expenses. He suggests a diversified approach, avoiding putting “all your eggs in one basket,” and highlights the value of having access to funds outside of retirement accounts.

3. Investing in Emerging Markets

Chris’s question focuses on the lackluster performance of emerging markets (EM) over the past five years. Carlson presents historical data (1988-2023) showing that EM returns have been around 3% annually for US investors over that period – roughly cash-like returns.

He illustrates the cyclical nature of EM performance with a chart comparing the MSCI Emerging Markets Index to the S&P 500 since 1988. The chart demonstrates distinct boom-bust cycles, with EM outperforming the US market in certain periods (1988-1993, 1999-2010) and underperforming in others (1994-1998, 2010-2024). He notes that the current outperformance (2025-2026) could be the start of a new cycle, but cautions against assuming a long-term trend. He emphasizes that EM investing requires accepting these periods of underperformance. He also points out that definitions of "emerging markets" can vary between fund companies.

4. Real Estate – Renting vs. Rolling Equity

Jay’s question concerns whether to rent out his current home (with a 3.5% mortgage) or roll the equity into a new purchase. Carlson strongly advises against keeping the existing home as a rental, despite the attractive mortgage rate.

He argues that concentrating wealth in real estate, especially by drawing funds from brokerage accounts for a down payment, is risky. He questions Jay’s experience as a landlord and emphasizes the work involved. He stresses the importance of diversification and avoiding over-concentration in any single asset class.

5. The 4% Rule – Still Relevant?

Jeff’s question addresses the validity of the 4% rule for retirement withdrawals. Carlson acknowledges the rule’s popularity but suggests it’s overly simplistic.

He references discussions with Bill Bengen (the originator of the 4% rule) and Stephan Shansky, who proposed a more flexible approach. Shansky’s model incorporates a “growth bucket” (stocks) and a “spending bucket” (laddered TIPS – Treasury Inflation-Protected Securities). The withdrawal rate from the stock bucket is adjusted based on market performance, allowing for higher withdrawals in good years and lower withdrawals in bad years. Carlson advocates for a flexible approach, adjusting withdrawal rates based on market conditions and personal inflation rates, rather than rigidly adhering to the 4% rule. He acknowledges the difficulty in accurately calculating personal inflation but suggests it’s more relevant than the CPI for individual spending.

Conclusion:

The show emphasizes the importance of diversification, flexibility, and a long-term perspective in investing. While the S&P 500 has dominated for the past decade, there are signs that other asset classes are beginning to perform well. Investors should avoid over-concentration in any single asset class, including tax-advantaged accounts and real estate. Retirement withdrawal strategies should be flexible and adjusted based on market conditions and individual circumstances. The key takeaway is to avoid rigid rules and embrace a dynamic approach to investing.