An Important Observation

I was updating Designing a 45-Year Retirement. I discovered something quite unusual. This is the lesson that I learned and what to do about it.

Background

I was updating Designing a 45-Year Retirement. I discovered that its findings are up to date for the traditional strategy based on fixed allocations. I was looking at the advantage of Valuation Informed Indexing.

I read When Price Drops Occur (Retirement). I discovered that the Year 30 balance was 18,732 (plus inflation) after starting at 100000 at a 5% per year (plus inflation) withdrawal rate in one case out of ten. The next higher balance was 25,216. Surely, I could not plan for a 5% (plus inflation) withdrawal rate over 45 years.

I brought up the Scenario Surfer to look at Year 30 balances when withdrawing 4.5% per year (plus inflation). Surely, it would allow me to withdraw 4.5% (plus inflation) indefinitely. Or so I thought.

This is what happened.

Scenario Surfer Runs

I invested entirely in stocks and 2% TIPS. I started with a $100000 balance. I selected P/E10=20 Bear Market. I withdrew $4500 (plus inflation) each year. I varied allocations in accordance with valuations as measured by P/E10. Here are the Year 30 balances.

Run 1.
20% rebalanced: 8,240.
50% rebalanced: 23,165.
80% rebalanced: 28,732.
Valuation Informed Indexing: 111,738.

Run 2.
20% rebalanced: 20,216.
50% rebalanced: 64,951.
80% rebalanced: 89,830.
Valuation Informed Indexing: 189,944.

Run 3.
20% rebalanced: 22,036.
50% rebalanced: 72,191.
80% rebalanced: 116,981.
Valuation Informed Indexing: 384,568.

Run 4. [P/E10 fell to 4.4.]
20% rebalanced: bankrupt in Year 29.
50% rebalanced: bankrupt in Year 25.
80% rebalanced: bankrupt in Year 19.
Valuation Informed Indexing: 1,268.

Run 5.
20% rebalanced: 4,921.
50% rebalanced: 20,938.
80% rebalanced: 34,556
Valuation Informed Indexing: 124,804.

Lesson Learned

Every now and then, the odds just go against you. Regardless.

The sequence in Run 4 was quite unusual. Both Switching A and Switching B have 30-year Safe Withdrawal Rates above 4.5% when P/E10=20. Valuation Informed Indexing does even better. Excluding Run 4, I might have concluded that we could withdraw 4.5% indefinitely. I believe that such would be the case in the vast majority of instances. I had previously shown that 4.5% (plus inflation) is safe for 45 years for the vast majority of instances.

It is important to prepare for unusual outcomes.

A Closer Examination

The sequence that failed had valuations that fell to P/E10=4.4 and stayed low for an extended period of time.

At P/E10=5 and below, the percentage earnings yield is 20%. This would easily support dividend yields of 15% for many quality issues. For a person easing into stocks, as with Valuation Informed Indexing, there should be enough cash available to support a 4.5% (plus inflation) dividend strategy.

Another point: too many people design a strategy with the idea of cutting back if necessary. It is much, much better to select a strategy that is likely to work in the vast majority of cases. You should plan to cut back only if something truly unusual happens.

Have fun.

John Walter Russell
September 21, 2008

Designing a 45-Year Retirement
Edited: Building On a 45-Year Retirement
Building On a 45-Year Retirement
When Price Drops Occur (Retirement)