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One prevalent piece of conventional investment wisdom that I have been reluctant to embrace is the notion of the "4% Rule" that advises selling 4% of total assets each year to meet retirement needs. Personally, I would much rather put together a portfolio of income generating assets that organically yields at least 4%, or spend my time coming up with ways to live off of whatever my portfolio generated at the current time, be it 3.40% or 3.60%. This is because there are two potential pitfalls that could complicate the execution of the "sell 4% of your assets rule" in real life.

The first concern should be obvious enough: the "sell 4% of your assets rule" has limited appeal during stock market down years. Looking at the 20th century and early 21st century, the major indices experienced a decline in price approximately one out of every three years. Even counting dividends, the S&P 500 fell 37.00% in 2009. Why would you want to sell some of your assets when they are only worth 2/3 of what they were the year before? Something like a dividend exists independent of the market price. If you decide to sell some Johnson & Johnson (NYSE:JNJ) as part of your 4% asset reduction plan, that means you might have to sell some shares in 2009 at $46.30, even though you saw them hit a high of $72.80 the year before. It is one thing if you experience that kind of outcome as a result of "life happens" and you do not have the assets to afford much of an alternative, but it is an entirely different matter when you engineer that kind of outcome from the start by designing a strategy that requires assets to be liquidated on an annual basis, without taking into account the fact that every third year will require you to sell assets during a downturn.

The right way, I suppose, to execute the "4% Withdrawal Rule" through the selling of shares is to engage in the practice of selling overvalued stocks while holding on to fairly valued and undervalued stocks. But there is a risk to this strategy that is seldom addressed: there is a realistic possibility that this strategy could reduce the overall earnings quality of the retirement portfolio.

Let's say that Bank of America (NYSE:BAC), BP, Colgate-Palmolive (NYSE:CL), and Hershey (NYSE:HSY) are meaningful components of your portfolio. By traditional book value metrics, Bank of America is cheap. By historical P/E metrics, BP is cheap (unless you are projecting a decline in the price of oil to below $75 per barrel, in which case the historical metrics do not matter). Hershey, meanwhile, is trading at its highest valuation since the dotcom bubble. Colgate-Palmolive is trading modestly above its typical P/E ratio over the past decade. If these are the four stocks you are working with and you have to sell, what would you do?

If your answer is to sell the overvalued stocks, then that means you are choosing to part with Colgate-Palmolive (a company that has been paying dividends since 1895) and Hershey, a company that has been gushing profits to shareholders for a century because the chocolatier continues to earn 16% on assets, regardless of how big it has gotten. Really, you are going to trade those two companies to increase your reliance on an oil company that has divested $38 billion worth of assets and a bank that has slashed its dividend by over 98% and diluted shareholders by 100% in the past five years?

The other alternative, of course, would be to hold on to Hershey and Colgate-Palmolive while selling some stock in BP and Bank of America. In that case, you are choosing to sell Bank of America at a time when it is only trading at a little over one-half of book value (the traditional Wall Street adage is to buy at one-half of book value and sell at twice of book value) and poised to give investors meaningful dividend increases in the next few years (which could further move the stock price upward). Similarly, you would be selling BP a year before it begins 15 major development projects that are expected to propel earnings upward to $6-$7 per share in 2016. If the company trades at its pre-spill multiple of 10x earnings, you'd be looking at a $60-$70 stock. Is that something you want to give up?

I mention all of these potential factors for one reason: the adage "just sell the overvalued stocks in retirement" poses a much larger dilemma than the pithy slogan suggests. Oftentimes, the highest-quality stocks (think the Colgate-Palmolives and Coca-Colas (NYSE:KO) of the world) are trading at a premium valuation because of their high earnings quality and consistent growth. Likewise, stocks tend to be undervalued because there is some headwind or headache affecting the business that prospective (and current) shareholders hope will prove temporary. The implication of this is that if you sell your overvalued stocks as part of your retirement investing strategy, you could be reducing the earnings quality of your portfolio at precisely the time you need the most dependable results.

Those are the two primary concerns with the application of a 4% withdrawal strategy in the real world. If I have 350 shares of ConocoPhillips (NYSE:COP), it is nice to know that I am going to get that $924 in annual income as long as the business fundamentals remain sound, without having to worry about how other people are valuing the stock at the time. If a strong correction hits that sends the price down from $57 to $40 per share, then you have to deal with the unpleasant reality of selling an asset for less than it is worth. And secondly, even if you do choose to follow a strategy of "selling the overvalued stocks," there is a risk that this strategy could lower the earnings quality of the businesses in your portfolio. Those are factors worth considering before deciding on which retirement withdrawal strategy you want to pursue to meet your objectives.

Source: The 4% Retirement Rule In The Real World