The Best Allocations versus Time

I have made a survey to determine the best allocations for portfolios of stocks and commercial paper when withdrawing over periods of 10, 20 and 30 years.

The data generally favor stock allocations close to 50%. There are minor differences that vary with the time period and whether one rebalances his portfolio. In fact, the surviving withdrawal rates with 10 and 20-year time periods were the same with and without rebalancing.

The data shout at us that a portfolio of stocks and commercial paper is a horrible idea, especially as one grows older. The biggest culprit is commercial paper. In most cases, it drags surviving withdrawal rates below that of an inflation-matched cash equivalent (such as TIPS at a zero percent interest rate).

But stocks are guilty as well. If commercial paper were alone in dragging withdrawal rates down, the best allocations would always have a high percentage of stocks.

Only when the time remaining is very long (in this case, thirty years as opposed to twenty years) does a portfolio of stocks and commercial paper compete with inflation-matched cash equivalents.

I did not make any adjustments for valuations in this survey. We have learned from other studies that it is best to rebalance portfolios when valuations are very high, as they are today. A better alternative for today might be to move into inflation-matched cash equivalents until valuations improve and/or to adopt a dividend-based strategy.

The Survey

I used my Deluxe Calculator V1.1A08 to determine surviving withdrawal rates for portfolios beginning in 1921-1980. I varied the withdrawal rate in increments of 0.1%. I recorded the highest surviving withdrawal rate with zero failures. And I recorded the lowest withdrawal rates at which there were 1 or more, 6 or more and 12 or more failures.

I looked at stock allocations of 0%, 20%, 50%, 80% and 100% with and without rebalancing. I looked at time frames of 10, 20 and 30 years.

I set the initial balance to $100000. I set expenses at 0.20%. I varied withdrawals to match inflation according to the CPI. The portfolios all consisted of stocks (as represented by the S&P500) and commercial paper. Other conditions were left at their default settings.

Tables

I made tables of my results.

Data Analysis

With a 10-year period, the best stock allocation was always 50%. Rebalancing improved the surviving withdrawal rate of the worst case sequence by 0.1%. Rebalancing made no difference when comparing rates with 6 (or more) and 12 (or more) failures.

TIPS at a zero percent (real) interest rate allow you to withdraw 10% annually for ten years. You can match this rate only by allowing the number of failures to exceed 6 (out of 60 conditions).

With a 20-year period, the best stock allocation without rebalancing was 50%. With rebalancing, there were some conditions that require an 80% stock allocation instead of 50%. The best surviving withdrawal rates were identical with and without rebalancing.

TIPS at a zero percent (real) interest rate allow you to withdraw 5% annually for twenty years. You can match this rate only by allowing at least one failure, but less than 6 failures (out of 60 conditions).

With a 30-year period, the best stock allocation at the first failure always included 50%. Rebalancing improved the surviving withdrawal rate of the worst case sequence by 0.1% with stock allocations of 50% and 80%. Rebalancing worsened the surviving withdrawal rate at 6 (or more) failures by 0.1%. The best stock allocation with 6 (or more) failures was 80% with rebalancing. Both 50% and 80% were best without rebalancing. If you are willing to accept the risk of 12 (or more) failures (out of 60 conditions), it is usually best to allocate everything into stocks. [This is not true today. We know this because we can now discern the effects of valuations.]

TIPS at a zero percent (real) interest rate allow you to withdraw 3.33% annually for thirty years. The historical surviving withdrawal rate of a 50% stock and 50% commercial paper allocation was 3.9% with rebalancing. It was 4.0% without rebalancing.

With a portfolio made up entirely of TIPS at a real interest rate of 1.3%, you can withdraw more than 4.0% safely each year for 30 years.

Conclusions

The traditional advice for investors is to reduce their stock allocations as they grow older. The data do not say this.

The traditional advice for investors is to maintain their stock allocations through rebalancing. The data do not say this.

The traditional advice by Benjamin Graham was for investors is to start with a 50% stock allocation and then to make adjustments depending upon the attractiveness of their investment choices. These data are consistent with such advice. They are not sufficient in themselves to prove this.

A portfolio of stocks and commercial paper is a horrible idea, mainly because commercial paper is a bad choice. Inflation-matched cash equivalents are far superior to commercial paper.

We know from other research that rebalancing stocks and commercial paper is a bad idea except when stock valuations are exceedingly high. Today’s stock valuations are exceedingly high. They are well above the pre-bubble historical range.

In the absence of my other findings, I would have recommended starting with a 50% stock allocation, but without rebalancing. In light of those other findings, I recommend preserving capital and focusing on income streams.

Have fun.

John Walter Russell
I wrote this on February 20, 2005.