Warren Buffett Moves the Goalposts!

Warren Buffett released his 2018 annual letter to Berkshire Hathaway shareholders last weekend which, of course, prompted investors and journalists to set aside their normal Saturday morning activities to analyze the Oracle’s words in great detail. Since the mid 1980s, Mr. Buffett has opened the letter with a statement regarding Berkshire’s change in book value per share. Longtime readers immediately noticed that this convention was missing from the 2018 letter. Readers quickly learned that this omission was not an oversight but driven by fundamental changes in how Mr. Buffett views book value at Berkshire:

Long-time readers of our annual reports will have spotted the different way in which I opened this letter. For nearly three decades, the initial paragraph featured the percentage change in Berkshire’s per-share book value. It’s now time to abandon that practice.

The fact is that the annual change in Berkshire’s book value – which makes its farewell appearance on page 2 – is a metric that has lost the relevance it once had. Three circumstances have made that so. First, Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses. Charlie and I expect that reshaping to continue in an irregular manner. Second, while our equity holdings are valued at market prices, accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years. Third, it is likely that – over time – Berkshire will be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value. The math of such purchases is simple: Each transaction makes per-share intrinsic value go up, while per-share book value goes down. That combination causes the book-value scorecard to become increasingly out of touch with economic reality.

In future tabulations of our financial results, we expect to focus on Berkshire’s market price. Markets can be extremely capricious: Just look at the 54-year history laid out on page 2. Over time, however, Berkshire’s stock price will provide the best measure of business performance.

Warren Buffett’s 2018 Letter to Shareholders

Those who have followed Berkshire Hathaway for many years will understand that abandoning book value as a performance metric is a very big deal. Mr. Buffett has long viewed percentage changes in book value per share over time to be a very rough proxy for changes in intrinsic value. Although he has been stating that book value understates intrinsic value for decades, the rate of change in book value was thought to be a relevant metric until now. In fact, Berkshire’s stock repurchase program was limited to only permit repurchases below 120 percent of book value until the policy was changed in July 2018.

Is the Change Logical?

Mr. Buffett points out that a growing portion of Berkshire’s value is attributable to operating businesses rather than marketable securities. Marketable securities are carried at market value on Berkshire’s books. In a hypothetical scenario where all of Berkshire’s assets consist of marketable securities, book value would represent the current market value of what Berkshire owns and would be an excellent proxy for Berkshire’s intrinsic value. However, the value of operating businesses are carried on Berkshire’s books at the original purchase price subject to being marked down if the goodwill paid for the business at the time of acquisition becomes impaired. No matter how much economic goodwill is added to an operating business, it is never marked up on Berkshire’s books. As a result, over time, successful acquisitions, such as Berkshire’s 2010 purchase of BNSF, will tend to increase the gap between book value and intrinsic value.

The situation related to repurchases is even more interesting and, perhaps, not intuitive to most observers of the company. Repurchases of stock above book value have the effect of reducing book value per share. Let’s examine why.

When a company repurchases stock, both assets and shareholders’ equity on the balance sheet declines. When Berkshire repurchased $1.346 billion of stock during 2018, that amount is directly deducted from the company’s cash balance. Shareholders’ equity also declines by $1.346 billion reflected in the treasury stock account. In exchange for the $1.346 billion, Berkshire retired 1,217 A shares and 4,729,147 B shares. Since each A share is economically equivalent to 1500 B shares, Berkshire repurchased 4,370 A share equivalents, which means that the average price paid was slightly more than $308,009 per share.

At December 31, 2018, Berkshire’s shareholders’ equity was $348.703 billion and there were 1,640,929 A equivalent shares outstanding, indicating that book value per A share was $212,503. Now, consider an alternative scenario where Berkshire did not repurchase any shares in 2018. Under this scenario, shareholders’ equity would be $1.346 billion higher at $350.049 billion and there would be an additional 4,370 A equivalent shares outstanding for a total of 1,645,299 A shares, and book value per A share would have been $212,757.

The result: If Berkshire had not repurchased any stock in 2018, book value per A share would have been $254 higher at the end of the year!

Did Warren Buffett suddenly lose his mind and purposely do something to destroy $254 of value per share? If you believe that Berkshire Hathaway is only worth book value, then value was indeed destroyed because Mr. Buffett paid a premium to book value to retire those shares. That premium is the reason that book value per share declined. However, if Berkshire’s intrinsic value is higher than the price paid for repurchases, then the intrinsic value of remaining shares actually increased even though book value decreased. The result is a wider gap between intrinsic value and book value for the remaining shares.

Based on his 2018 letter to shareholders, Mr. Buffett believes that Berkshire will be a significant repurchaser of its own shares in the years to come. The math above demonstrates that significant repurchases will, over time, increasingly distort book value. Management might be adding value for shareholders by repurchasing stock below intrinsic value, but above book value. But book value per share will decline as a result.

In 2018, Mr. Buffett promoted Ajit Jain and Greg Abel to Vice Chairman positions and it is likely that one of these men will be the next CEO of Berkshire Hathaway. Continuing to use changes in book value as a rough proxy for changes in intrinsic value would create incentives for the future CEO to NOT repurchase any stock even if shares are available below intrinsic value (but above book value). The result could be a sub-optimal situation where managers decide to pay dividends instead of repurchasing stock. This would create negative tax consequences for shareholders. Although both Mr. Jain and Mr. Abel are excellent executives, it is a bad practice to use a metric to measure performance that will be negatively impacted by value-adding moves such as repurchases of stock below intrinsic value. This is likely the main reason for Mr. Buffett’s abandonment of book value. The rate of change in book value is now very unlikely to be used as a performance metric for compensation of Berkshire’s next CEO.

The “Gotcha” Moment!

Mr. Buffett has long argued against the practice of changing the goalposts after the game has started. In other words, changing the metrics by which management is judged should be looked upon with great skepticism. However, it is not logical to say that the goalposts should never be changed regardless of changes in circumstances. The important question is whether the change is logically defensible.

Some observers have implied that Mr. Buffett’s abandonment of book value signals an abrupt shift designed to obscure the fact that book value only progressed by a modest amount in 2018 and has slowed significantly since Berkshire’s earlier decades. However, these observers probably have not carefully studied the 42 years of letters to shareholders available on Berkshire’s website. In fact, Mr. Buffett has been warning about the limitations of book value for well over three decades. The following excerpt from the 1983 letter to shareholders is a typical example:

We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value – the measurement that really counts. Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value. It is important to understand, however, that the two terms – book value and intrinsic business value – have very different meanings.

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.

Warren Buffett’s 1983 Letter to Shareholders

Those of us who have read all of Mr. Buffett’s letters know that the distinction between book value and intrinsic value has always been something he has made an effort to explain. Over the past few decades, and especially since the turn of the century, Berkshire has transformed from a company dominated by marketable securities to one dominated by operating companies. As Mr. Buffett’s letters explain, the intrinsic value of these operating businesses today have next to no relationship with the historical amount they are carried on Berkshire’s books.

As long as Berkshire was not a large repurchaser of its own shares, the concept of book value retained some utility because the rate of change in book value in any given year could serve as a rough proxy of changes in intrinsic value. However, the possibility of large repurchases in the coming years will make the utility of book value increasingly suspect. If one runs the same numbers as shown above for 2018 but assumes $13 billion of repurchases instead of $1.3 billion, the distortion in book value per share for the year will become more noticeable. It is very possible that Berkshire will deploy tens of billions of dollars toward repurchases over the next several years. Book value will become distorted and retaining its use would not only potentially mislead investors but create bad incentives for future CEOs to shun value adding repurchases. The change is justified and probably overdue.

A note on the impact of dividends on book value

Alert readers will note that if Berkshire had paid out the $1.346 billion in dividends to shareholders rather than repurchase 4,370 A shares in 2018, book value would have been even lower at the end of the year. The cash outflow on the asset side of the balance sheet would have been offset by an equal reduction to retained earnings. Each of the 1,645,299 A share equivalents would have received about $818 in dividends and book value would have been about $211,939 at the end of 2018. Would shareholders have been better off with $818 in their pockets (pre-tax) and a share with book value of $211,939? They would only be better off if Berkshire had overpaid for the shares it repurchased. As long as the repurchases are made below intrinsic value, continuing shareholders are better off than if Berkshire pays out an equivalent amount as dividends.

Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

Cultivating the State of Flow

“Where has my day gone?”

How many times have we heard people express this frustration? For many of us, it seems like there are never enough hours in the day to accomplish all that we set out to do. The day starts off in a mad rush, proceeds through a blur of activity, and ends with a sense of dissatisfaction regarding what has actually been accomplished. Then we repeat the same process the next day, a week goes by in a blur, then a month, and then a year. How is it possible to be so busy but not achieve much at all and remain dissatisfied and pressured to always “do more”?

We might think that these problems are primarily a function of modernity and advances in technology but people have been struggling with how to best use their time for millennia. Seneca’s essay, On the Shortness of Life, was written around 49 AD, nearly two thousand years ago, yet many passages make it clear that humans suffered from precisely the same problems regarding how to effectively allocate their time.

Despite talk today of potential immortality being achievable in the not-so-distant future, for now human life is still limited to several decades with very few of us living more than a century. Human beings are probably the only species that fully understands that our earthly existence will one day end, yet Seneca points out that we do not translate this knowledge into how we live our day-to-day lives:

“You are living as if destined to live forever; your own frailty never occurs to you; you don’t notice how much time has already passed, but squander it as though you had a full and overflowing supply — though all the while that very day which you are devoting to somebody or something may be your last.”

Seneca, “On the Shortness of Life”

Seneca urges people to be as vigilant in guarding their time as they are when it comes to protecting their personal property because time is truly the one resource that is limited for everyone. There are great disparities in human talent, wealth, and income in the world but there are no exceptions, so far, when it comes to our ultimate mortality. Jeff Bezos has orders of magnitude more wealth than anyone reading these words, yet his ultimate fate a century from now is the same as for all of us. But despite the inherent limitations of our lifespan, Seneca says that “life is long if you know how to use it.”

Seneca is saying that we should strive to achieve a “state of flow” rather than being tied up in an endless treadmill of engaging in activity for the sake of activity, or being mindlessly “busy”.

“A flow state, also known colloquially as being in the zone, is the mental state of operation in which a person performing an activity is fully immersed in a feeling of energized focus, full involvement, and enjoyment in the process of the activity. In essence, flow is characterized by complete absorption in what one does, and a resulting loss in one’s sense of space and time.”


One of the ironies of achieving a flow state is that, just like the unfortunate person spinning his wheels on useless activity, it feels like the hours have flown by. However, the sense of satisfaction at the end of the process is far greater for those occupied in tasks conducive to the state of flow.

The question becomes how one can structure life in a way that results in more time in a flow state and less on useless and forgettable tasks. Clearly, the way to accomplish this is to actively remove things that are keeping us busy but achieve no useful results, an approach also known as via negativa. This is far easier said than done for people who are stuck in employment that seems to require all kinds of busy work and pointless activities such as excessive meetings, endless email, and having to maintain “face time” for purposes of career advancement.

“Many pursue no fixed goal, but are tossed about in ever-changing designs by a fickleness which is shifting, inconsistent, and never satisfied with itself.”

Seneca, “On the Shortness of Life”

Achieving a state of flow might seem like an impossible task for those who feel “stuck” in routines that make focused concentration all but impossible. The problems have become far worse in recent decades due to the increasing prevalence of technology in our lives. As a college student in the early 1990s, there were certainly opportunities to get distracted from immersion in studies, but those distractions were primarily in the physical world. With some discipline, it was still possible to disappear into the library and focus on specific topics for hours at a time, free of distraction. Cell phones were not common and “going online” was something to do for brief periods of time and only possible on a computer attached to a physical network.

Contrast the experience of the early 1990s with the temptations facing everyone today. We now are connected on a 24/7 basis by default unless we take unusual steps to isolate ourselves, and even worse, it is considered unusual or eccentric to put oneself out of reach for more than brief periods of time. We are, for the most part, “expected” to be reachable all the time in our professional and personal lives.

Electronic devices are a constant cause of context switching. Context switching is the exact opposite of the state of flow that we should aspire to. In computer science, context switching refers to switching the task of working on one process to move on to another one. One process is stored in memory, the computer switches to the other process, and then eventually it may come back to the original one. Context switching has a cost in computing. The system has to store one process in memory, switch to another one, and then reload the original process when it goes back to it. However, the cost of context switching to a computer is nothing compared to the cost of switching contexts for human beings.

When we are engaged in any task requiring in depth thinking, whether it involves reading an annual report or preparing a presentation, any chance of being in a state of flow is destroyed when we allow interruptions. Unlike computers, the cost of context switching for human beings goes far beyond the need to store one thought process in our memory, switch quickly to another, and then immediately restore our prior state of mind. In fact, this is impossible to do. A context switch breaks the state of flow.

How many times have you been in a state of flow when your cell phone makes some sort of noise – whether a text message, a phone call, notification of a new email, or countless other interruptions? Human beings are naturally curious and the temptation to check the device is overwhelming when there is any kind of notification. So, you interrupt your state of flow to check what’s happening on your phone. Maybe it was an email. But it doesn’t end there. Now that you are interacting with your phone, maybe the email requires some further action. Or, if not, maybe it is too tempting to see how many “likes” your latest Twitter post generated. Or perhaps check in on Facebook to see how outraged your virtual friends are regarding various political issues.

Just as a large amount of information does not translate into wisdom, frenzied activity and context switching does not lead to productivity or happiness. Instead, it leads to a sense of time slipping away. The state of flow also leads to a sense of time passing quickly, but in a positive way. If you come back from lunch and sit down to a state of flow, you might look up at the clock and find that it is time to go home. Time has flown by, but in a way that might have increased your wisdom or achieved some level of productivity.

When people wish for a “long life”, few wish to be bored and watch the days, months, and years slowly pass by. That’s not the kind of “long life” people aspire to achieve. Instead, humans wish for a sense of satisfaction, or a sense of a life well-lived. This desire has existed for millennia, but has become more difficult to achieve with technology that simultaneously gives up the opportunity to access a wealth of information but also tempts most of us to waste a great deal of time.

Seneca’s prescription is clear: we need to disconnect and pursue a state of flow, even if doing so is unconventional or frowned upon by others.

Ten Years

“Life is divided into three periods: past, present and future. Of these, the present is short, the future is doubtful, the past is certain.”

— Seneca

Think back to your childhood days. Many people feel like time passed by very slowly during their youth. The prospect of finally turning sixteen and getting a driver’s license seems impossibly far away to a thirteen year old. But time seems to speed up as one gets older, to the point where a few years feels like nothing at all and a decade is only a moderately long period of time.

This website was launched ten years ago, and it does not seem like that long ago even though that span accounts for about 22 percent of my life up to this point. However, much has changed. The economic climate of February 2009 was the polar opposite of the environment we find ourselves in today. The economy was in the depths of the worst recession since the 1930s and stock prices were close to reaching their nadir, although none of us knew it at the time! Morale throughout the United States was very low, consumer confidence was non-existent, and few thought conditions would improve anytime soon. No one envisioned that we were on the cusp of a decade-long bull market that, despite nearly ending at the end of 2018, continues to this day.

When I started this blog ten years ago, I did not envision that it would still be active a decade later and I did not really have much of a vision of what it would turn into. I knew that I wanted to write about investing in general and I had some work on Berkshire Hathaway that I wanted to share with others. The stock market was down sharply and my portfolio was no exception as I tried to cope with the market meltdown. But, in general, I did not have any kind of master plan for how the site would evolve over time.

What surprised me about blogging is that it became addictive quickly. I received some positive feedback from larger sites such as Guru Focus and Seeking Alpha that wanted to syndicate my work and I ended up writing nearly every day. I wrote 279 posts in 2009 and 330 posts in 2010. Although there were many book reviews and longer articles on specific companies, for the most part I was writing about “current events”. I did not initially care too much about site traffic or monetizing the site but I soon started to watch traffic statistics and felt pressure to post frequently to “keep the numbers up”. When you write about current events, your work is relevant for a short period of time. You see spikes in website traffic and then … nothing.

Nassim Taleb has written about the “Lindy Effect” which can be applied to the life expectancy of the written word. The basic premise of the Lindy Effect is that the future life expectancy of certain non-perishable things is proportional to their current age.  For example, a book that has been in print for fifty years and has retained wide readership has a much longer future life expectancy compared to a book that has been on the New York Times bestseller list for a month.  Ideas expressed in a book that has survived for 100 years will have a still longer life expectancy, and so on.  

The vast majority of my writing, whether about current news or the quarterly results of some company I was following, had a very short life expectancy. Although the content would remain accessible as long as I paid to keep the site hosting plan active, the relevance would soon dwindle and no one would read it. There is nothing wrong with sites that provide “news”, but such content will quickly lose relevancy.

Perhaps the exception to the short shelf life of my writing was the work I did on Berkshire Hathaway and published in the form of a long report. Due to the historical perspective of the report, there are still people who occasionally download it even though the information is now many years old. However, even this work is not “Lindy” in the sense that no one will have any interest in it in fifty years.

The frequency of my writing fell after early 2011 as I decided to devote more time to my own investing work, but I still posted occasional content and there were years of greater activity such as 2016 and 2017. However, for the most part, the site became an occasional endeavor after 2011. It was unsatisfying to be on a self-imposed “treadmill” of writing a large number of articles with a short shelf life.

I have great admiration for sites such as Farnam Street where nearly all of the content will be highly relevant even fifty years from now. It seems more satisfying to write about topics that have some permanence. When I have written content such as this article about Marcus Aurelius, the text remains as relevant today as when it was published. I was also very surprised when instructional articles, such as this one regarding how to read 10-Ks, proved to be very popular over longer periods of time. Providing tips on reading SEC documents isn’t going to have the staying power of Marcus Aurelius, but such articles appear to serve a useful function for many readers.

Perusing my archive, I see hundreds of articles that have no permanence and a just a few that might have a longer life expectancy. It is likely that future articles will focus more on topics that will have more permanent appeal and less on current events. A decade is a reasonably long period of time, and a writer’s interest is bound to change over that length of time. I am still interested in investment topics, and always will be, so book reviews and articles on broader investment topics are likely. In addition, I have an interest in personal finance, especially the massive problem of financial illiteracy in America, and would like to focus more in that area. Finally, Charlie Munger’s work on worldly wisdom has been an inspiration and I plan to try to add some value in that area. Life is about more than investing, narrowly defined, but the great thing about investing is that the more worldly wisdom we absorb, the better we perform as investors as a result.

I am not planning to write many articles about specific companies in the future. One of the great things about the value investing community is that investors are often generous about sharing their best ideas. However, going public with ideas has many very serious problems. Most importantly, good ideas are very rare and valuable. As an investor, if you have an actionable idea, you naturally want to act on it for your own account. When you also write about it, you are naturally biased and can fall prey to numerous cognitive biases that could sabotage your position and hurt your financial results. If you make your living from investments, that can be a serious concern.

I would like to thank readers of The Rational Walk for spending some of your valuable time on the content here. Seneca wrote that “nobody works out the value of time: men use it as lavishly as if it cost nothing.” Your time is valuable and the fact that the site has attracted nearly 1,200 email subscribers and a similar number of RSS subscribers is a great compliment. Those are small numbers in the world of online publishing but it is still satisfying to hit the “publish” button and know that a couple thousand people might decide to read what I have written.

Reaching Financial Independence

When can you give up the security of a regular paycheck?

This is a fundamental question that everyone must eventually answer in the context of their own “retirement”.  I put “retirement” in quotes because what we are really talking about is not necessarily retirement in the conventional sense. Instead, the goal might be better stated as attaining the level of financial independence that is needed to make a regular paycheck optional.  You might like your job and have great relations with your boss today, but that could always change tomorrow or next month.  A recession could result in layoffs and you might find yourself involuntarily out of work.  Illness has been the cause of many premature exits from the workforce.

At what point are you immune from having to worry about drawing a paycheck?

Nassim Nicholas Taleb should be credited with the concept of “F*** You Money” that he developed in The Black Swan and has elaborated on numerous times since the book was published.  To state the obvious, not everyone works for a pointy-headed boss and hates their job as much as Dilbert and Wally, and plenty of people actually love their job and enjoy the people they work with.  Whether or not you like the language used by Scott Adams, Nassim Taleb, or John Goodman, the point is obvious:  When can you declare independence from paid employment if you choose to do so?

At the risk of stating the obvious, there are two major factors that we need to look at:

  1. How much money is needed to fund your lifestyle every year?  The answer is not as simple as looking at what you are currently spending every year.  There will almost certainly be expenses related to work that will entirely disappear from your budget if you choose to leave paid employment.  You will no longer have to commute to work so the cost of driving or public transit will disappear.  Maybe you can even give up your car entirely.  It will be unnecessary to purchase clothing specifically for work.  If you aren’t packing a lunch for work almost every day, you are probably spending a lot of money on eating out and that could be eliminated as well.  This list isn’t exhaustive.  On the other side of the equation, you will incur new expenses in “retirement” such as the cost of health insurance, which is likely to be the largest new big ticket item.  Also, you will have more time to travel and pursue recreational activities.  You could very well end up spending more money in “retirement”!
  2. How much money have you saved?  This is obviously simpler to answer but I don’t think that it can be distilled into a single number.  Most importantly, it is critical to differentiate between assets that are accessible and assets that are locked up for an extended period of time.  If you are 40 years old and contemplating giving up your paycheck, what matters for the foreseeable future is the amount of liquid assets that you have in non-retirement accounts.  You do not want to even contemplate touching retirement funds in a 401(k) or IRA because early withdrawal penalties are significant for anyone who is younger than 59 1/2 years of age.  You also do not want to consider any form of home equity as a source of liquidity unless you are planning to downsize to a smaller home in retirement.

If you read enough personal finance articles, you probably have already come across discussions of “safe withdrawal levels”.  The idea of a safe withdrawal level is to calculate the amount of money that can be withdrawn from an investment portfolio on an inflation adjusted basis over a specific period of time without running a significant risk of depleting all of your assets.  There are usually a number of embedded assumptions that are made in studies of safe withdrawal levels, such as the percentage of assets invested in stocks versus bonds and whether the stocks are invested in an index fund.  Typically, safe withdrawal levels are contingent upon a certain stock/bond mix and broad diversification of a portfolio.

The Four Percent Rule

Over the past two decades, the idea of the “Four Percent Rule” has spread quite widely.  The idea is that one can withdraw four percent of an investment portfolio in the first year of retirement and subsequently withdraw the same amount adjusted for inflation every year.  The inverse of the four percent rule is that one needs to have savings equivalent to 25 times annual spending requirements in order to safely retire.  So, if you have calculated that you need to have $50,000 available for spending in the first year of retirement, you would need to have an investment portfolio of $1,250,000 to support that level of withdrawal in a “safe” manner.

When I first started thinking about the concept of early “retirement”, I spent quite a bit of time researching the topic of safe withdrawal rates and came upon a study that went quite a bit deeper than the four percent rule.  I am not going to link to the study because it has not been updated since 2001 and generated some subsequent controversy regarding the methodology that was used.  However, at the time it was the most comprehensive look at safe withdrawal levels that I had come across.  The study looked at financial market returns from 1871 to 2000 and projected the safe withdrawal level for various payout periods based on past history.  A reader could pick their projected payout period and find the optimal mix of stocks versus bonds that would generate a “100% safe” withdrawal level.

The payout periods ranged from ten years, which would only be appropriate for someone who is either already very old or in poor health, to sixty years which was more appropriate in my situation since I was in my thirties at the time.  I found that the safe withdrawal rate for a sixty year payout was 3.24 percent with a 85%/15% split between stocks and bonds.

The study examined 70 periods from 1871 to 2000 in order to come to the conclusion that a 3.24 percent withdrawal level could be safely sustained for sixty years, with withdrawals rising each year with inflation.  In the vast majority of cases, there would be a very substantial portfolio left at the end of the sixty years. In fact, the median result was that every $1,000 of value in the initial portfolio would end up being worth nearly $43,000 after 60 years assuming a yearly withdrawal of 3.24 percent of the initial portfolio rising each year with inflation.  The worst possible result was that the portfolio would be effectively depleted.

But the main problem with safe withdrawal level studies is that they are backward looking.

It is a major logical fallacy to assume that the next sixty years will look like the period that spanned 1871 to 2000, or anything like it at all!  This is obvious, but it is tempting to look at an overly precise number like “3.24 percent” and assign it with more certainty than it deserves.

No one has any idea what the future will bring or what investment returns will look like, but if we want to make any kind of estimate regarding financial independence, we have no choice but to at least try.  This exercise calls for a great deal of conservatism.  I am not comfortable with the four percent rule, and not really comfortable with the 3.24 percent figure that came out of the study.  Part of this is because of the fact that interest rates have been at an unusually depressed level in recent years.  In addition, the level of the stock market implies an “earnings yield” that is below average.  In a world of savings deposits earning next to nothing, a ten year treasury note yielding just 2.7 percent, and stocks trading at high valuations relative to the past, is it really conservative to look at a four percent withdrawal rate as a sure thing?  Would you bet your financial future on it?

The Three Percent Rule

I am not going to propose any specific rule for readers to follow, but I will say that I am comfortable with a three percent withdrawal rate and that is the rate that I initially used when considering my own financial independence, although my present withdrawal rate is far lower.  This rule implies that you would need to save a little bit over 33 years of annual expenses in order to consider yourself financially independent.  That’s obviously more than the 25 years that is implied by the four percent rule, but it is much more conservative.

Many people would criticize this approach as far too conservative, but is that such a bad thing?  Sure, you might have to save for a longer period of time to achieve independence, but once you do, the level of stress over withdrawal rates will be much lower.  Also, I’ve read criticism of low withdrawal rates along the lines of ending up with “too much” savings at the end of the withdrawal period.  This line of criticism is based on the idea that something big is being given up by under-spending for many years and that ending up with a large account balance in old age is a negative.  I think this is somewhat absurd for a number of reasons.  First, old age involves facing vicissitudes that younger people might not think of, especially when it comes to nursing care.  Having a pile of cash available to make life comfortable would hardly be unwelcome.  Second, most people want to leave some kind of legacy to family members and providing financial security to others in old age is hardly a negative.  Finally, you can always give away money.  There’s value in generosity and the knowledge that one’s savings can generate benefits beyond personal consumption.

The Bottom Line

The subject of safe withdrawal levels has not been a personal concern for quite some time as the level of my annual spending has declined well below any plausible “danger zone” as a percentage of my available investment assets.  I would suggest that using a three percent initial withdrawal level is far more reasonable than the much more commonly advocated four percent level and this would imply setting a target of about 33 times annual expenses as a goal for financial independence.

The other factor that should be noted here is that the lower your annual spending requirements, the sooner you can reach financial independence.  Perhaps that is obvious, but it might not be widely understood.  Too many people think about financial independence in terms of replicating their current income in retirement.  This is the wrong way to look at it.  For example, let’s say that you earn $150,000 per year but are only consuming $40,000 per year, which you expect to remain relatively constant in retirement.  You do not need to replicate a $150,000 income in retirement.  You only need to ensure that you can safely withdraw $40,000 per year from your portfolio, and that you can increase this figure each year at the rate of inflation.  Using a three percent rule, this would imply a required portfolio of a little over $1.3 million, which is less than nine times your current $150,000 annual income.

Obviously, no one want to live some horribly restrictive lifestyle either while employed or in retirement, but what is “horribly restrictive” for one person might represent luxurious living for another. Even for those who enjoy their paid employment and plan to continue working for others for decades could benefit greatly from financial independence and the peace of mind that makes work optional.

Note to readers: A version of this article originally appeared on The Spartan Spendthrift which I created a few years ago. I am planning to merge some of the existing content of The Spartan Spendthrift into The Rational Walk and to post future articles on personal finance here. It is easier to maintain only one website for all of my writing. 

Jack Bogle: Crusader for Investment Professionalism

“If you want to be trusted, be trustworthy. If you demand hard work, work hard. If you want your colleagues to level with you, level with them. It’s not very complicated!”

— John C. Bogle, Enough: True Measures of Money, Business, and Life

John C. Bogle (1929-2019)

John C. Bogle, who died on January 16, 2019 at the age of 89, was hardly universally well liked within the investment community. Visionary leaders who disrupt comfortable industries rarely escape the ire of those who have been displaced. On the other hand, Mr. Bogle was a hero to millions of investors at The Vanguard Group, the investment company he founded in 1975, as well as to the broader community of cost-conscious individual investors known as “Bogleheads“. Through Mr. Bogle’s tireless efforts to lower the cost of investing, investors have saved billions of dollars that would have otherwise gone to various “helpers” in the investment community.

Warren Buffett had the following to say about Mr. Bogle two years ago:

If a statue is ever erected to honor the person who has done the most for American investors, the hands- down choice should be Jack Bogle. For decades, Jack has urged investors to invest in ultra-low-cost index funds. In his crusade, he amassed only a tiny percentage of the wealth that has typically flowed to managers who have promised their investors large rewards while delivering them nothing – or, as in our bet, less than nothing – of added value.

In his early years, Jack was frequently mocked by the investment-management industry. Today, however, he has the satisfaction of knowing that he helped millions of investors realize far better returns on their savings than they otherwise would have earned. He is a hero to them and to me.

Berkshire Hathaway Annual Letter, 2016

Mr. Bogle’s crowning achievement was the invention and proliferation of low cost index funds that are designed to simply match the investment results of unmanaged indexes such as the S&P 500. These funds do not attempt to beat the market through selection of securities or timing the movement of funds based on macroeconomic factors.

In exchange for giving up the prospect of beating the market, investors gain the certainty of knowing that they will at least match the market prior to investment costs. And due to the lack of a need to hire active managers and to Vanguard’s investor-owned fund structure, costs are vanishingly small. Today, the expense ratio of the Vanguard S&P 500 Index Fund (Admiral Shares) is a mere four basis points, or 0.04%, meaning that one only pays $4 annually for every $10,000 invested in the fund. In contrast, the famous Fidelity Magellan Fund, which is actively managed, has an expense ratio of 0.69%, or $69 annually for every $10,000 invested in the fund.

Over the decades, the expense ratio of Vanguard’s funds have dropped due to increasing scale and this has pressured the expense ratios prevailing throughout the mutual fund industry. Mr. Bogle also did away with fund loads, or sales charges, early in Vanguard’s history. These sales loads, which were often up to 7 percent of assets invested in a fund, have become much less common in the mutual fund industry. Between lower expense ratios and the decline of sales loads, no wonder Mr. Bogle’s popularity within the investment community wasn’t universal!

Much has been written regarding Mr. Bogle’s legacy with a focus on the massive sums he has saved for individual investors. However, anyone who has read Mr. Bogle’s book, Enough:  True Measures of Money, Business, and Life, realizes that cost savings were only one part of his overall philosophy toward business and life. One chapter of the book is entitled “Too Much Business Conduct, Not Enough Professional Conduct“. The distinction between professional conduct and business conduct may seem confusing to many people, at a surface level. After all, in our free enterprise system, isn’t a profession simply one of many means to the end when it comes to achieving business success?

Take a step back from thinking about finance, narrowly defined, and consider the field of medicine. A doctor goes through many years of education and residency prior to achieving meaningful income potential. This seems like a classic investment calculation: The prospective medical student compares the cost of his or her education (and the opportunity cost of many years of foregone wages in some other field) to the lucrative riches that can be expected once established as a fully trained physician. If the present value of the expected income earned as a doctor exceeds the costs of the education, then become a doctor. If not, enter some other more lucrative field.

But does anyone really believe that this is how a prospective medical student thinks about his or her decision to become a doctor? Of course not. The decision to enter medicine has an economic component, but it also has many completely non-economic factors. Although encounters with jaded doctors who have been in practice for many years may obscure this truth, the reality is that the vast majority of doctors almost certainly enter the field in order to help patients and save lives! They are entering a profession and a calling, not merely seeking to maximize their economic outcome.

Mr. Bogle believed that the same fundamental professionalism should exist in the field of investment management. But should it? After all, those of us who are in the investment industry aren’t here to save lives, are we? We are here to make money. So we should maximize our economic outcomes at all costs, right?

Mr. Bogle would have completely disagreed with that all-too-common sentiment, as his book makes crystal clear. Investment professionals are agents acting on behalf of owners of capital. Looking at the numbers, one can easily forget that these owners include millions of ordinary individuals who are saving for various life goals such as sending their children to college, purchasing a home, and funding retirement. Looking after the financial health of individuals should be viewed as a calling, as a profession, and not merely as a business.

In our consumer driven culture, wealth is often thought of as the ability to purchase goods and services, and this is obviously one use of money. However, what money really represents is financial freedom and independence. Money can buy control over the one thing we all have a limited supply of: Time. Poor returns, whether driven by bad investment choices or high costs, shows up as a lower balance on account statements, but the real effect is that financial freedom is deferred for those who are affected. There are very real consequences for those who have to defer retirement or find that their activities in retirement are highly constrained.

Mr. Bogle was a capitalist and acknowledged that the primary requirement for any business is to earn a profit. However, he insisted that business should operate within a context of ethical and professional conduct, and was particularly critical of the investment industry. He argues that business principles have been compromised in recent decades:

It wasn’t so many decades ago that the standards in the conduct of business were close to absolute:

There are some things that one simply doesn’t do.

But today we place our reliance on relative standards:

Everyone else is doing it, so I can do it, too.

Our society cannot and should not tolerate the substitution of moral relativism for a certain form of moral absolutism, and its debasement in the ethical standards of commerce.

Enough: True Measures of Money, Business, and Life, p. 139

Mr. Bogle was a wealthy man but he left billions of dollars on the table compared to other founders of large financial institutions. It does not seem like this bothered him very much, although he does acknowledge that he did not have any premonition regarding the massive wealth he was giving up by creating Vanguard’s structure. He comes across as a man who had more than enough in terms of financial wealth and was highly satisfied with the fulfillment of his professional calling.


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