For starters, let’s talk about what the 4% rule is. The 4% rule describes how much money you can withdraw from your investment portfolio each year so that you never run out of money. This is where the title of this article comes true — it’s not clickbait, this rule can actually provide you with infinite, endless passive income.
The whole idea behind this rule is based on several studies. One of them, maybe the most important of them, is the “Trinity Study” done by three professors at Trinity University — Texas in the 20th century. They calculated the 4% rule for different periods from 15 to 30 years. The result was that there is a 95–96 percent chance for success — that you would never actually run out of money. And that’s not bad, right?
The success rate is nicely illustrated in this table:
Photo from earlyretirementnow.
On the far left, we see the composition of the portfolio, next to that are the years you can be using your portfolio according to the rule. At the top, we see the percentages that we withdraw from that portfolio annually, and below that is the success rate.
For example, if you be using 3% of your stock portfolio for 30 years it is a 100% chance, that you will not run out of money.
Of course, you do not have a 100% chance of not running out of money. All sorts of situations CAN happen and the market CAN crash.
You can set the percentages to suit yourself. Someone set 2% per year, others, 3%, 4%, and so on. It’s all about some sort of balance of risk and reward.
Just remember that this is infinite passive income based purely on withdrawing your portfolio. People who are and will be interested in having extra money in retirement will most likely still have some other passive income streams set in retirement — whether they rent out apartments, or they started a business during their lifetime that brings them income even though they are no longer working.
So in the end, when you combine the 4% rule with the remaining income I wouldn’t be afraid to say you’ll have truly infinite money.
How does the 4% rule work?
Let’s say your portfolio got a 7% average annual return on your portfolio.
By the way, the S&P 500 got according to historical data approximately 10.5% average annual return.
Subtract 3% inflation and the 4% you withdraw annually according to the 4% rule.
7%-3%-4% = 0%
The result is an annual change in the value of your portfolio. Zero therefore means that the value of your investment portfolio will not change. Simply said.
Let’s put the 4% rule into a real example.
Suppose you want your passive income to be $2 000 per month. 2000*12 is 24 000 yearly. In this case, 24000 is your 4%. If you divide 24,000 by 0.04 you will come out with a result of $600,000.
In order to have a monthly passive income of $2 000, you would need to have at least $600,000 invested in total using the 4% rule.
You’ve probably already figured out that the money won’t passively rain from the sky. To get to such an invested amount probably the most important helper is compound interest — getting interest on interest.
Look at this graph:
Photo from calculator.net/investment-calculator
It would take you approximately 22.3 years to reach the target of $600,000 with $600 a month invested…
Conclusion
4% rule is only a guide not a guarantee. But it is supported by real human experience and extensive studies based on different historical horizons.
The main idea is that probably all of us will eventually want to use the money we work so hard for to save and invest, and it guides us on how to do it safely. I said it once in the course of this article and I’ll say it again. 100% chance doesn’t mean it’s inevitable to run out of money, but it’s highly improbable.
This article was originally published on medium.com
