Adopting a New Approach

You may have found one of my approaches compelling. In my latest, you start with an all-TIPS portfolio. Later, you buy high dividend stocks from high quality companies, but only at reasonable prices.

How do you go about adopting one of my approaches? I recommend that you make methodical adjustments over two or three years.

As long as you have thought things through, it is OK act faster when opportunities arise.

Things to Consider

Here are some things to consider.
1) Your income needs.
2) Your planned level of income.
3) Tax implications.
4) Your experience.
5) The worst case outcome.
6) How your strategy works.
7) Failure mechanisms.
8) Monitoring progress.

Base your planning around pre-retirement spending, not income.

Distinguish between desires and needs. Make sure that you can satisfy all needs. Make preparations that will ensure that you will be comfortable. Allow for success. Allow for luxuries if things turn out well.

You need to consider taxes.

With very few exceptions, retirement study results are in terms of pre-tax income. It is difficult to add anything meaningful about taxes because of complexity. It is difficult to include taxes, regardless.

There are important details such as the tax treatment of TIPS. In a taxable account, you must pay taxes on all inflation adjustments as they occur, long before your TIPS mature. TIPS are a good choice inside a tax sheltered account. Ibonds can be a better choice in a taxable account.

If you make abrupt changes, you will incur many fees and you are likely to incur an unfavorable tax treatment as well. My own experience with individual stocks is that it makes sense to wait several years, if necessary, to get good prices. Use limit orders and wait.

Your Own Experience

One of the worst things that you can do is to ignore your own experience. Most likely, you know quite a bit about something related to investing. Take advantage of your knowledge. Don’t change everything financial overnight. If your background has involved real estate, for example, the odds are that you will do very well to continue investing in real estate. If you have been investing in stocks, the odds are that you will do best if you keep at least some of your money in stocks.

Allow yourself at least 25% of your portfolio for investments that you like regardless of the opinion of others. I have seen repeated instances where scorned approaches have turned out to be the far superior choices. My two baseline portfolios are examples.

This 25% does not have to be in stocks. In fact, it could be in TIPS or CDs. You may like the security of TIPS. You may distrust stocks and/or other investments. An examination of history shows that such distrust is well founded.

Understanding Failure Mechanisms and Assuring Success

In the traditional studies, your income comes from selling stocks as well as collecting interest and dividends. Careful analysis shows that selling stocks at depressed prices during the first few years is what leads to failure. As a rule, you will know by years 11 or 12 whether your portfolio will last 30 years. Your portfolio will have either grown enough to assure success or it will be in danger already.

You can avoid running out of money if you withdraw a percentage of a portfolio’s current balance each year instead of a percentage of its initial balance. There is still a failure mechanism. Under unfavorable circumstances, the amount withdrawn can fall below what you need.

Shifting stock and bond allocations gradually in accordance with P/E10 greatly improves the safe withdrawal rates of traditional stock and bond portfolios. We would not expect the best allocations and P/E10 thresholds looking forward to be identical to those of the past. Our research shows, however, that minor errors have only a minimal effect on the outcome. The optimal choices of the past should produce good results in the future. The most important failure mechanism is not adjusting for valuations at all. Maintaining a fixed allocation is a serious mistake.

In my most recent strategy, you start out with an all-TIPS portfolio, possibly in a TIPS ladder. Later you buy stocks from high quality companies when their dividend yields become high enough. TIPS start out producing higher levels of income but eventually run out of money. Dividend income from high quality companies is likely to start out lower, especially at today’s prices, but dividends last indefinitely and dividend income is likely to grow faster than inflation.

The worst case is that you never find suitable stocks. You end up with an all-TIPS portfolio that eventually runs out of money.

The key issue is whether you will ever be able to find suitable stocks. My key assumption is that stocks will become attractive in a reasonable amount of time.

I refer to Figure 1.3 in Professor Robert Shiller’s S&P500 database. His measure of valuation P/E10, which is the best that I have found so far, is still at 1929 levels, around 27. It was 24 in the worst years financially for new retirees, the late 1960s. P/E10 has bottomed at 5 and 6 immediately before roaring bull markets. Typically, P/E10 has been 14 to 15.

When I identify stock bargains, I focus on P/E10 levels around 10, much higher than the historical lows. I find considerable advantages even if stocks only drop to the typical valuations of 14 to 15.

Stock prices relative to (smoothed) earnings would have to drop almost in half to return to normal. Most likely, (nominal) prices will drift sideways while earnings rise and inflation continues. Should stock prices return to normal, dividend yields would double. If you buy good companies that pay high dividends, the strategy works. Stocks do not have to fall to historical lows or anything close. Success is assured. Stock prices only have to return to typical levels. If stock prices fall to bargain levels, we will enjoy spectacular success.

Many people mindlessly refer to such patience as market timing. They insist that academic studies prove that market timing never works.

Almost all of the academic studies related to timing have focused on intervals of two years or less. Almost always, the failure mechanism is the high cost of making frequent trades. The studies have not examined infrequent trades. The studies have not examined valuations in depth. Traditional, short-term timing is far different from what I am talking about.

Have fun.

John Walter Russell
April 8, 2006