How Does the 4 Year Rule Work?

Key Concepts

• Return Stacking: A strategy involving the use of modest leverage to combine multiple sources of return on top of a traditional portfolio (stocks and bonds). The aim is to increase expected returns while maintaining or reducing overall portfolio risk.
• Portable Alpha: An older institutional strategy similar to return stacking, dating back to the 1980s.
• Leverage: Borrowing money to increase investment exposure.
• Futures Markets: Markets where participants buy and sell contracts for the future delivery of an asset, often used to gain exposure to asset classes like bonds with less capital outlay.
• Derivatives: Financial contracts whose value is derived from an underlying asset.
• Collateral: Assets pledged as security for a loan.
• Cost of Leverage: The interest paid on borrowed funds, typically tied to short-term rates like the Fed Funds Rate or T-bills.
• Diversifiers: Assets or strategies that have low correlation with traditional stocks and bonds, aiming to reduce overall portfolio volatility. Examples include gold, managed futures, and long/short equity.
• L.I.C.E. Framework (for responsible leverage): Avoid Liquid, Illiquid, Concentrated, and Excessive leverage.
• Four-Year Rule: A retirement strategy where a cash reserve equivalent to four years of living expenses (net of guaranteed income) is accumulated before retirement. This reserve is used to cover living expenses during market downturns, allowing investments to recover.
• Time Value of Money: The concept that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
• Buy Now, Pay Later (BNPL): A short-term financing option that allows consumers to make purchases and pay for them over time, often with no interest if paid within a specified period.
• Target Date Funds: Mutual funds or ETFs that automatically adjust their asset allocation to become more conservative as the target retirement date approaches.
• Index ETFs: Exchange-traded funds that track a specific market index, such as the S&P 500 or the Nasdaq 100.
• Blue Chip Stocks: Stocks of large, well-established, and financially sound companies with a history of stable earnings and dividends.
• Drawdowns: The peak-to-trough decline during a specific period for an investment, fund, or market.
• Asset-Liability Mismatch: A situation where the duration or characteristics of assets do not align with those of liabilities, potentially leading to financial risk.

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Return Stacking and Responsible Leverage

This section addresses the concept of "return stacking," a strategy that aims to enhance portfolio returns by layering multiple return streams, often with modest leverage.

• Definition and Goal: Return stacking involves using a small amount of leverage to add diversifiers to a traditional stock and bond portfolio. The objective is to boost expected returns while potentially reducing overall risk.
• Example: A 90% equity and 60% treasury futures allocation, resulting in a 150% notional exposure, is cited as an example.
• Historical Context: The term "return stacking" is relatively new, coined by Rodrigo Gordo, but the underlying concept is similar to "portable alpha," a strategy used in the institutional space since the 1980s (e.g., by PIMCO).
• Mechanism of Leverage: Leverage is often achieved through futures markets. For instance, gaining $100 of bond exposure might only require $5 of collateral. This provides full exposure to the asset's total return minus the cost of leverage.
• Cost of Leverage: The cost is typically linked to short-term interest rates, such as the Fed Funds Rate or T-bills.
• Two Use Cases for Return Stacking:
  1. Adding Diversifiers to a 100% Equity Portfolio: This approach, supported by research from Cliff Asness (AQR) and replicated by Jeremy Schwartz (WisdomTree), suggests that a diversified portfolio with modest leverage can offer similar risk to equities but with better returns.
  2. Freeing Up Capital: This involves using leverage to maintain core stock and bond exposure while introducing diversifiers. This can free up capital that would otherwise be allocated to traditional assets, allowing for investment in alternatives without sacrificing core holdings.
• Product Offerings: New Found Research offers a suite of "return stacked ETFs," including pre-packaged alternatives (e.g., equities plus managed futures) and core-plus-bond funds.
• Investor Choice: For funds that offer flexibility (e.g., stocks plus bonds), investors can choose which diversifiers to "stack" on top. The key is to select liquid diversifiers with strong conviction that offer positive returns above cash and are uncorrelated to stocks and bonds.
• Addressing Fear of Leverage: Leverage is often feared due to its role in financial crises. However, the L.I.C.E. framework (avoiding Liquid, Illiquid, Concentrated, and Excessive leverage) is proposed for responsible use. Leverage should be used to introduce diversifiers, not just to increase exposure to existing assets like stocks or bonds.
• Impact of Bond Market Changes: The changing nature of the bond market, particularly the yield curve, can affect the cost of leverage. However, the strategy's benefit isn't solely dependent on bonds outperforming cash. If leverage is used to maintain bond exposure while freeing up capital for alternatives, the cost of leverage is offset by the performance of the alternative asset.
• Simplification and Flexibility: Return stacking funds offer flexibility by allowing investors to incorporate alternatives without sacrificing core stock and bond exposure. They can also simplify portfolios by combining multiple exposures into a single product.
• Example of a 3x Leveraged ETF: Using a third of a portfolio in a 3x leveraged Nasdaq 100 ETF effectively results in 100% Nasdaq 100 exposure with the remaining two-thirds in cash, which can then be managed.
• Resources: Further information can be found at returnstack.com or returnstacketfs.com.

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The Case Against Individual Stock Picking

This section delves into why the speaker, Ben Carlson, primarily invests in ETFs rather than individual stocks.

• Personal Strategy: Ben Carlson has largely transitioned to investing solely in ETFs, moving away from picking individual stocks.
• Temptation and Trade-offs: While acknowledging the temptation to buy seemingly undervalued or temporarily mispriced stocks (like Google in early 2023), Ben highlights the trade-off: missing out on potential home runs but also avoiding ginormous losses.
• Examples of Large Drawdowns: The transcript provides examples of significant drawdowns from all-time highs for well-known blue-chip companies:
  • Nike: -65%
  • Boeing: -60%
  • Pfizer: -60%
  • Intel: -50%
  • Disney: -50%
  • Oracle: -36% These drawdowns are presented as comparable to a 2008-level crisis for individual stocks, while the S&P 500 was down less than 5% at the time of recording.
• Reduced Brain Damage: Ben emphasizes that an indexing strategy leads to less "brain damage" and a simpler investment process. He recounts spending excessive time worrying about a small portion of his portfolio (10%) allocated to individual stocks and crypto, which was not worth the mental overhead.
• Current Holdings: Ben currently holds only tiny positions in Nvidia and Nike, with the vast majority of his brokerage account in index funds.
• The "Boring" Portfolio: He embraces a "boring" portfolio, finding satisfaction in its simplicity and the fact that winners eventually find their way into broad market index funds.
• Trade-offs of Stock Picking: The trade-off for stock pickers is a wider range of returns, including the potential for significant daily or annual losses, even when the market is performing well.
• Benchmarking: The speaker suggests that many individual stock pickers do not accurately benchmark their performance against index funds.
• Panic and Market Volatility: Ben reiterates that there is "never a good time to panic" as an investor, unless one is invested in highly leveraged products that could be wiped out in a market downturn. Sticking to a plan is crucial.
• Mind Share of Losses: He notes that negative stock performance (e.g., a stock down 20% on earnings day) tends to occupy more mental space than positive performance (a stock up 20%).
• Analogy to Fantasy Sports: Ben compares his past engagement with fantasy baseball to stock picking, highlighting the detailed research and management involved. He contrasts this with his current preference for a more passive approach.
• "On-Base Percentage" vs. "Slugging Percentage": Ben's strategy is characterized as an "on-base percentage" approach (consistent, diversified gains) rather than a "slugging percentage" approach (swinging for home runs with higher risk).

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The Four-Year Rule for Retirement Planning

This section details a retirement strategy known as the "Four-Year Rule," shared by a listener named John Feast.

• Origin of the Strategy: The strategy was shared by John Feast, who taught young people about saving and investing and had personal experience retiring at the peak of the dot-com bubble in 2000.
• Core Principle: The rule is based on the observation that major stock market downturns typically last 8-24 months, while upturns last 4-8 years.
• Accumulating a Cash Reserve: Five years before retirement, individuals should accumulate a cash reserve equivalent to four years of living expenses. This reserve should be held in safe, liquid assets like money market funds, CDs, or T-bills, net of any guaranteed income from pensions or Social Security.
• Retirement Withdrawal Strategy:
  • Market Upturn: If the stock market is performing well at retirement, withdrawals are taken from the stock market.
  • Market Downturn: If the stock market is in a downturn, withdrawals are taken from the cash reserve.
• Replenishing the Cash Reserve: When the stock market turns around and experiences an upturn for approximately 18-24 months, the cash reserve is replenished.
• John Feast's Experience: John Feast successfully navigated retiring at the "worst entry point in stock market history" (dot-com bubble peak) and the subsequent three-year bear market by utilizing this four-year bucket. He also applied it during the 2008 financial crisis.
• Publication of the Strategy: Ben Carlson plans to publish John Feast's full "Four-Year Rule" on his blog, wealthofcommon sense.com, for wider access.
• Value of the Framework: The strategy's strength lies in framing retirement spending in terms of the number of years of expenses covered by the cash/bond portion of the portfolio. This provides a more intuitive understanding of financial security during retirement, even in the face of market volatility.
• Focus on Spending: The rule emphasizes thinking about spending needs in retirement rather than solely optimizing for stock market returns.

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Time Value of Money and Buy Now, Pay Later (BNPL)

This section discusses a young investor's question about using Buy Now, Pay Later (BNPL) to leverage a purchase and invest the saved money.

• The Question: A 20-year-old college student asks if using BNPL for a purchase (iPhone/Apple Watch) with no interest over a year is a smart way to leverage money, allowing them to invest the funds and profit from the time value of money.
• Speaker's Initial Reaction: The speaker finds the idea of "gaming the system" appealing but is hesitant about BNPL as the primary tool.
• Critique of BNPL for Investment:
  • Short Timeframe: BNPL payment plans are typically short-term (months, not years). Even a year-long plan is considered too short for investing in the stock market, creating an asset-liability mismatch.
  • Risk of Loss: There's a risk that the invested money might not be available when the BNPL payments are due, especially if the market experiences a downturn.
  • Taxes: Investment gains are subject to taxes, which can erode potential profits.
• Alternative: Rewards Credit Cards: The speaker suggests using a cashback credit card as a better alternative.
  • Credit Building: Using credit cards responsibly helps build credit history (FICO score).
  • Rewards and Perks: Credit cards offer cashback (e.g., 3%) and other perks.
  • Investment Integration: Some credit card rewards can be directly deposited into investment accounts.
• Broader Application of the "Time Value" Mentality: The speaker questions why, if this is the philosophy, the student wouldn't use BNPL for every possible purchase to keep more money in their bank account.
• Personal Experience with Credit Cards: The speaker uses credit cards for most purchases, paying off the balance monthly. This provides a float of about a month, offering a similar, albeit less aggressive, benefit.
• Zero-Percent APR Credit Cards: For larger purchases, using a 0% APR credit card and paying it off over time can be a viable strategy, especially for unexpected expenses.
• Key Personal Finance Rule: A crucial piece of advice is to never carry a balance on a credit card, as the interest charges (compounding against you) are detrimental. Credit cards are valuable tools when managed properly.

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Long-Term Investment Strategy: Target Date Funds and ETFs

This section addresses a question about the long-term viability of a simple investment strategy using target date funds and index ETFs.

• The Investor's Situation: Luke, in his late 20s/early 30s, has turned his financial habits around since 2020 after a period of not saving. He invests consistently in Vanguard target date funds in his Roth IRA and other index ETFs in a brokerage account. He has approximately $21,000 in his Roth and $35,000 in his brokerage.
• The Question: Luke asks if sticking with this setup until age 65 to make up for lost time is a rational long-term plan, with projections suggesting around $900,000 based on a 7-9% annual return.
• Speaker's Endorsement: Ben Carlson views Luke's current strategy as "perfectly reasonable."
• Flexibility and Evolving Plans: The speaker emphasizes that life plans change. The person Luke is now will likely be different in his 40s and 50s. His career aspirations, desire for a different job, or relocation plans might alter his financial needs and goals.
• Key Advice:
  • Continue Saving: The most important action is to keep saving consistently.
  • Increase Savings Over Time: Luke should look for ways to increase his savings rate as his income potentially grows.
  • Buffer: Giving himself a buffer is important, as future needs and desires are unpredictable.
• Kudos for Turning Around: The speaker commends Luke for turning his financial habits around, acknowledging that not everyone does.
• Simplicity of the Strategy: The strategy of investing in Vanguard target date funds and index ETFs is described as a sound approach for long-term wealth accumulation.
• Potential for Higher Returns: While $900,000 is a significant sum, the speaker implies that with increased savings and potentially higher income over time, the final amount could be even greater.
• Job Considerations: The discussion briefly touches on the nature of working at a golf course (potentially easy, outdoor work) and the speaker's past experience as an adjunct professor with no benefits, highlighting the importance of securing retirement savings.

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Conclusion and Thanksgiving Message

The episode concludes with a message of gratitude and well wishes.

• Gratitude to Viewers/Listeners: Ben expresses thanks to the audience for sending in questions, noting that the volume of questions has increased over time, which is a positive sign for the show's longevity.
• Contact Information: Questions can be sent to [email protected].
• Thanksgiving Wishes: Happy Thanksgiving to all viewers and listeners.
• Travel Safety: Well wishes for safe travels for those who are traveling.
• Team Appreciation: Ben thanks his team (John, Nicole, Dan, and Travis) for their work on the podcast.