Denial Is Expensive

Ignoring our cutting edge research can be expensive.

We have established:

1) It is possible to measure stock market valuations in a meaningful way. Actually, we have identified three excellent methods.
2) It is possible to relate Safe Withdrawal Rates and valuations.
3) It is possible to take advantage of valuations by varying allocations. Doing so improves Safe Withdrawal Rates. In terms of today’s rhetoric, this is intermediate-term timing. In terms of Benjamin Graham’s writings, it is not. It is the action of an intelligent investor.
4) TIPS and ibonds make great baseline portfolios.
5) Rebalancing makes sense only if it is impossible to measure valuations in a meaningful manner.
6) At today’s valuations, even dollar cost averaging can be a bad idea.
7) Dealing with human emotions is, by far, the most important factor in successful investing. This is NOT simply a matter of increasing an investor’s willingness to accept risk. "Close your eyes and grit your teeth" is a formula that leads to bankruptcy.

Here are some reactions to our key findings:

1) Treat the 4% withdrawal rate as a rule of thumb. Pretend that this was always so.
2) Treat the 4% withdrawal rate as a historical result which, because it refers only to the past, is absolutely true.
3) Acknowledge, belatedly, that TIPS provide a Safe Withdrawal Rate greater than 4% over 30 years.
4) Acknowledge, reluctantly, that valuations may influence Safe Withdrawal Rates but quickly jump in to claim that nobody can do anything about it.

Along with reaction #4 comes the single solution:

1) Adjusting withdrawal amounts by itself is the best response to an unfavorable market.

Adjusting withdrawal amounts is a good response. It is a natural response. It need not be the only response.

Consider the high cost of ignoring valuations:

At today’s valuations P/E10=28 and TIPS interest rate of 2.2%, withdrawing 4% of the initial balance (plus inflation) from a fixed, high stock allocation is far from safe. At Year 30:

1) With an 80% stock allocation, the probability of success is close to 60%.
2) With a 50% stock allocation, the probability of success is 80%.
3) With a 20% stock allocation, the probability of success is 95%.
4) By varying allocations in accordance with a simple formula, the probability of success is 95%+.
5) With an all-TIPS, 0% stock allocation, the probability of success is 100%. In fact, the principal balance is 25%.

At the peak of the bubble with P/E10=44, assuming a TIPS interest rate of (2.2%), withdrawing 4% of the initial balance (plus inflation) from a fixed, high stock allocation was dangerous. At Year 30:

1) With an 80% stock allocation, the probability of success was 25%.
2) With a 50% stock allocation, the probability of success was 40%.
3) With a 20% stock allocation, the probability of success was 80%.
4) By varying allocations in accordance with a simple formula, the probability of success was 90%.
5) With an all-TIPS, 0% stock allocation, the probability of success was 100%. In fact, the principal balance is 25%.

Here are some dangerous reactions of those in denial:

1) Make long-term claims based upon short-term results.
2) Reject any action for today that differs from what worked best during the extended Bull Market that led to the bubble.
3) Claim that diversification among asset classes and rebalancing solves all problems.
4) Pretend that asset classes that have had great returns over short periods of time will necessarily outperform far into the future.

The single issue that demands our greatest attention has to do with multiple asset classes:

1) Only the S&P500 (and its components) and the CRSP database (of individual stocks since 1951) have a long enough history for us to have confidence when making extrapolations.
2) In particular, the stock market as a whole goes through 30 to 35 year cycles from peak to peak or valley to valley. Anything shorter includes less than a single cycle of investor behavior.
3) In particular, all of the newer asset classes have short histories. How they will work out, looking forward, is hard to judge. To gain confidence requires exceptionally strong, theoretically based rationale. TIPS and ibonds satisfy this requirement. Other new asset classes do not.
4) Differences in expected returns dominate security selection. Adding inferior asset classes drags down returns. Only if an investor has no means whatsoever to evaluate relative prospects does rebalancing help. It helps by lowering volatility. [Reference: articles related to Gummy Slices.]
5) There are reasons to doubt whether Small Capitalization Value stocks really do outperform the market and, if so, by how much. The issue centers around prices, liquidity and availability. [Reference: David Dreman’s “Contrarian Investment Strategies: The Next Generation.”]

We have identified three attractive investment approaches. They can be combined:

1) Using a TIPS and/or ibond baseline portfolio.
2) Varying stock allocations in accordance with valuations (total return approach).
3) Varying stock allocations in accordance with valuations to purchase high quality stocks with high dividends (dividend strategy).

We have learned from our Retirement Trainers that we can do learn how to do even better than following our simple formulas.

Have fun.

John Walter Russell
October 2, 2006