Building Blocks: Edited

Lots of details are unique to your own situation. This article will help you bring everything together.

Portfolios and Safe Withdrawal Rates

Baseline Portfolios

A 100% TIPS portfolio makes an excellent baseline inside of a tax sheltered account. I-Bonds do well in taxable accounts.

A 100% TIPS portfolio with a 2% (real) interest rate produces an income stream of 4.0% of the original balance (plus inflation) for 35 years. This comes with a true, 100% Government guarantee. The disadvantage of using 100% TIPS is that you will run out of money.

There are some practical details. Building a TIPS ladder gets around most of them.

An alternative baseline is to purchase high dividend stocks from high quality companies and never sell. DVY was an early choice. It currently yields 2.90%. It is an Exchange Traded Fund (ETF).

This alternative is attractive because the income stream should last far into the indefinite future. Judging from the S&P500 index during stagflation, you can always expect the (nominal) dividend amount to grow. After adjusting for inflation, the (real) dividend amount may dip by 10% before recovering.

You can mix these baseline portfolios together. TIPS provide a true guarantee over a limited number of years. High quality, high dividend stocks offer a continuing income stream at reduced percentage.

Fixed Stock Allocations

The amount that you can withdraw safely from a portfolio varies tremendously with its initial valuation. Rebalancing helps when valuations are high. Rebalancing hurts considerably when starting valuations are typical or low.

When you rebalance, you should withdraw a larger amount from an investment that has increased its percentage in your portfolio. It is doubtful that rebalancing helps when it increases costs. The advantage of rebalancing is small, even under favorable circumstances. Researchers seldom, if ever, include costs when it comes to rebalancing.

Central to rebalancing is the notion that you cannot measure relative value in a meaningful way. This notion is seriously flawed. Most of the research that is cited applies only to very short periods of time, typically no longer than two years. When you look at longer periods of time, of the order of 10 to 20 years, the story is different.

Perhaps the most important flaw in stock market research is the mechanical treatment of time without regards to valuations. If you have ever established prices to buy and prices to sell, you are aware of the tremendous advantage of price discipline. If you have multiple stock holdings, be patient. You will be amazed at how well you will be rewarded.

High, fixed stock allocations at times of high valuations are reckless.

Variable Stock Allocations

Varying stock allocations in accordance with P/E10 works well. It is not critically sensitive to the precise details such as P/E10 thresholds and allocations.

These are gradual changes. I am NOT talking about getting 100% into stocks or 100% out of stocks except under the most extreme circumstances. I am NOT talking about selling stocks that you purchased last year just because P/E10 increases by one or two points (e.g., from 19 to 21). I am talking about reducing your stock allocation to low levels when valuations are sky high, as they are today, adding stocks when valuations return to normal (about one-half of today’s prices relative to 10-year earnings), and loading up on stocks when they fall to bargain levels (about one-third of today’s prices relative to 10-year earnings).

Variable Withdrawals

Two basic approaches are to withdraw a fixed percentage of a portfolio’s initial balance plus inflation or to withdraw a fixed percentage of the portfolio’s current balance.

The danger of withdrawing a fixed percentage of the INITIAL balance plus inflation is that you may run out of money. The danger of withdrawing a fixed percentage of the CURRENT balance is that your income after twenty years can be much lower than you need.

There are a variety of approaches to vary withdrawal rates. Gummy’s (retired Professor Peter Ponzo’s) Sensible Withdrawals is among the best. He sets a floor that matches inflation and withdraws a percentage of the excess when his investments do well.

Variable withdrawal methods are disappointing. In essence, they take income from the future and move it to the present (or vice versa).

As a general rule, you will have a very good idea of how well your retirement portfolio is doing within the first eleven or twelve years. Either your portfolio will have grown dramatically or it will be clearly in danger.

Valuations

Measures of Valuation

I have found Professor Robert Shiller’s P/E10 to be the best single measure of valuation so far. It is the current (real) price of the S&P500 index level (price) divided by the average of the most recent (trailing) ten years of (real) earnings. Professor Shiller credits Benjamin Graham with the basic idea.

The S&P500 tells us about the market as a whole. P/E10 is helpful even when looking at portfolios built from various combinations of market segments.

What I actually use is the reciprocal of P/E10 in the form of the percentage earnings yield 100E10/P or 100%/[P/E10]. Using the percentage earnings yield 100E10/P has been spectacularly successful for making predictions.

One reason is dividends. The percentage earnings yield 100E10/P gives us better information about dividends than the dividend yield of the market. Because it (100E10/P) includes ten years of earnings, it protects us against the effects of surprise dividend cuts.

In a recent breakthrough, I discovered that the payout ratio (dividends/earnings) based on the percentage earnings yield 100E10/P tells us a lot about the dividend growth rate. Today’s payout ratio (based on 100E10/P) is at the lower end of its historical range. Today’s dividends, miniscule as they are, are more secure than they have been in the past.

History and the Gordon Equation

The Gordon Equation is based on the Dividend Discount Model. The total return of stocks equals the Investment Return plus the Speculative Return. The Investment Return equals the initial dividend yield plus the (annual) dividend growth rate. The Speculative Return annualizes the effect of different prices at the beginning of a period and at the end of a period to pay for the same income stream. There are many variants.

The Gordon Equation has been a spectacular success. History shows that it works.

History and mathematics show that the Gordon Equation cannot possibly be right. History shows that there is consistent long-term growth in the stock market. It is of the order of 6.5% to 7.0% (real, after adjusting for inflation). This is in the very long-term, 50 or 60 years.

Resolving this paradox is easy enough. The investments that are available after 10 or 20 years are seldom the same as were available at the start.

Taking Advantage of Valuations

If we visit Professor Shiller’s web site, download his S&P500 data and look at his plot of the price to earnings ratio (which is actually P/E10, not the single year P/E ratio), we can see the historical story about the Speculative Return. Today’s multiples are very close to those just before the Great Depression (and higher than those in the worst years for starting retirement, the mid-1960s).

If we allow ourselves ten years, we can expect to see reasonable valuations. If we allow ourselves 15 to 20 years, we are almost certain to see outstanding bargains.

Putting It All Together

We have two baselines and a lot of information. The building blocks are in place.

Start with a baseline portfolio that meets your needs. This can be all-TIPS, all-dividends or a combination.

Build on this portfolio by taking advantage of intermediate-term timing.

In my original investigations, I developed a single algorithm. I added to and reduced stock allocations regardless of how well the portfolio was doing. Modify this by converting (at least, a portion of the portfolio) to a dividend-based strategy as soon as yields among high quality companies are high enough. Lock them in. Never sell. Harvest their income stream. You can expect dividends to grow faster than inflation.

There are other factors. If you can get better returns than the S&P500, you are likely to do better when making withdrawals. If you can get more consistent returns than the S&P500, you are likely to be able to increase your withdrawal rate safely.

There are lots of people who can help you in this regard. I recommend the books by David Dreman, Lowell Miller and James O’Shaughnessy as among the best. My only caution is that the historical models have reported the performance of small capitalization, value stocks to be so high that they may have become too popular.

The key is having a solid baseline in place. The worst case would be if valuations never become favorable. You would be stuck with your baseline. This would not be a bad outcome. We have excellent baselines.

Have fun.

John Walter Russell
March 21, 2006