Fixed Stock Allocations and Valuations
I made a sensitivity study of fixed stock allocations and changes in valuations in terms of Safe Withdrawal Rates.
Approach
I determined the optimal fixed stock allocations as a function of the valuation. I used Professor Robert Shiller’s P/E10 as the measure of valuation. I used the Year 30 SWR Retirement Risk Evaluator and the Year 15 SWR Retirement Risk Evaluator to determine Safe Withdrawal Rates with final balances of 0% and 100%.
In all instances below, I used a 60% stock allocation with Scenario 1, a 70% stock allocation with Scenario 2, an 80% stock allocation with Scenario 3 and a 100% stock allocation with Scenario 4.
Year 30 SWR Retirement Risk Evaluator
P/E10=8
60%-70%-80%-100% allocations
2% TIPS
Year 30 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…7.90
Scenario 2…8.52
Scenario 3…9.13
Scenario 4…9.98
CONCLUSION: 100% is best for a 0% final balance at P/E=8.
100% final balance
Safe Withdrawal Rate
Scenario 1…6.76
Scenario 2…7.61
Scenario 3…8.46
Scenario 4…9.76
CONCLUSION: 100% is best for a 100% final balance at P/E=8.
P/E10=14
60%-70%-80%-100% allocations
2% TIPS
Year 30 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…5.18
Scenario 2…5.30
Scenario 3…5.41
Scenario 4…5.21
CONCLUSION: 80% is best for a 0% final balance at P/E10=14.
[BUT for a Reasonably Safe outcome, 100% is best.]
100% final balance
Safe Withdrawal Rate
Scenario 1…4.02
Scenario 2…4.33
Scenario 3…4.61
Scenario 4…4.78
CONCLUSION: 100% is best for a 100% final balance at P/E=14.
P/E10=20
60%-70%-80%-100% allocations
2% TIPS
Year 30 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…4.09
Scenario 2…4.02
Scenario 3…3.92
Scenario 4…3.30
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=20.
[The best choice shifts toward higher allocations at lower levels of safety.]
100% final balance
Safe Withdrawal Rate
Scenario 1…2.92
Scenario 2…3.01
Scenario 3…3.06
Scenario 4…2.79
CONCLUSION: 80% is best for a 100% final balance (of those allocations tested) at P/E10=20.
[BUT for a Likely Success outcome, 100% is best.]
P/E10=26
60%-70%-80%-100% allocations
2% TIPS
Year 30 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…3.50
Scenario 2…3.32
Scenario 3…3.12
Scenario 4…2.28
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=26.
100% final balance
Safe Withdrawal Rate
Scenario 1…2.34
Scenario 2…2.31
Scenario 3…2.23
Scenario 4…1.72
CONCLUSION: 60% is best for a 100% final balance (of those allocations tested) at P/E10=26.
Year 15 SWR Retirement Risk Evaluator
P/E10=8
60%-70%-80%-100% allocations
2% TIPS
Year 15 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…10.83
Scenario 2…11.27
Scenario 3…11.68
Scenario 4…12.97
CONCLUSION: 100% is the best fixed allocation at P/E10=8.
100% final balance
Safe Withdrawal Rate
Scenario 1…7.28
Scenario 2…8.03
Scenario 3…8.72
Scenario 4…10.08
CONCLUSION: 100% is the best fixed allocation at P/E10=8.
P/E10=14
60%-70%-80%-100% allocations
2% TIPS
Year 15 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…7.48
Scenario 2…7.36
Scenario 3…7.21
Scenario 4…7.38
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=14.
100% final balance
Safe Withdrawal Rate
Scenario 1…2.69
Scenario 2…2.69
Scenario 3…2.63
Scenario 4…2.53
CONCLUSION: 60% or 70% is best for a 100% final balance (of those allocations tested) at P/E10=14.
P/E10=20
60%-70%-80%-100% allocations
2% TIPS
Year 15 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…6.13
Scenario 2…5.80
Scenario 3…5.42
Scenario 4…5.14
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=20.
100% final balance
Safe Withdrawal Rate
Scenario 1…0.86
Scenario 2…0.56
Scenario 3…0.20
Scenario 4…0.00
CONCLUSION: 60% is best for a 100% final balance (of those allocations tested) at P/E10=20.
P/E10=26
60%-70%-80%-100% allocations
2% TIPS
Year 15 SWR Retirement Risk Evaluator
0% final balance
Safe Withdrawal Rate
Scenario 1…5.41
Scenario 2…4.96
Scenario 3…4.46
Scenario 4…3.93
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=26.
100% final balance
Safe Withdrawal Rate
Scenario 1…0.00
Scenario 2…0.00
Scenario 3…0.00
Scenario 4…0.00
CONCLUSION: none of these allocations were satisfactory for a 100% final balance (among those allocations tested) at P/E10=26.
Data Summary
Here are the conclusions with the Year 30 SWR Retirement Risk Evaluator.
CONCLUSION: 100% is best for a 0% final balance at P/E=8.
CONCLUSION: 100% is best for a 100% final balance at P/E=8.
CONCLUSION: 80% is best for a 0% final balance at P/E10=14.
CONCLUSION: 100% is best for a 100% final balance at P/E=14.
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=20.
CONCLUSION: 80% is best for a 100% final balance (of those allocations tested) at P/E10=20.
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=26.
CONCLUSION: 60% is best for a 100% final balance (of those allocations tested) at P/E10=26.
Here are the conclusions with the Year 15 SWR Retirement Risk Evaluator.
CONCLUSION: 100% is the best fixed allocation at P/E10=8.
CONCLUSION: 100% is the best fixed allocation at P/E10=8.
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=14.
CONCLUSION: 60% or 70% is best for a 100% final balance (of those allocations tested) at P/E10=14.
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=20.
CONCLUSION: 60% is best for a 100% final balance (of those allocations tested) at P/E10=20.
CONCLUSION: 60% is best for a 0% final balance (of those allocations tested) at P/E10=26.
CONCLUSION: none of these allocations were satisfactory for a 100% final balance (among those allocations tested) at P/E10=26.
Remarks
At favorable valuations, you are much better off with a 100% stock allocation. At high valuations, you are better off with a lower stock allocation.
The reason is simple: the fixed income portion (2% TIPS) has a low return when compared to stocks when stocks are priced reasonably. When stock prices are sky high, the TIPS help out or do better.
A higher stock allocation does better if the final balance needs to equal the initial balance. This is because stocks eventually provide strong growth. TIPS provide a constant, low level of growth (the coupon rate).
Keep in mind that stocks have a high amount of volatility. The Safe Withdrawal Rate corresponds to what happens under unfavorable circumstances.
The Year 15 SWR Retirement Risk Evaluator shows a very rapid reduction in the stock allocation as P/E10 increases. This is because it has no knowledge of what has happened immediately before. It “forgets” history. If you place two Year 15 results back to back, you do not know what valuation to assume at the midpoint. You know the starting valuation, but not the likely Year 15 valuation given the starting point. (That is, you do not know conditional probabilities.)
In contrast, the Year 30 SWR Retirement Risk Evaluator automatically has the correct valuations at the midpoint of a 30-year interval. It has the same issue, however, if you try to connect two 30-year segments to determine the Year 60 outcomes.
Have fun.
John Walter Russell
December 26, 2008
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