Edited: You Can’t Count on 7%: Dollars

While putting this together, I discovered that I had focused entirely on the downside. I had omitted the most important condition: what happens if you are just a little bit lucky, but well within a reasonable range of outcomes? What is the upside?

The upside leaves you with twice as much as buy-and-hold. It is much safer. It has a good chance of happening.

What-if calculations using dollars

These are the final balances and the income streams that they can generate. All of these are in today’s dollars.

[I am assuming that we can generate an income stream of 4% of the initial balance (plus inflation) that lasts at least 40 years. References: The Rule of 25 and TIPS Ladders for Today.]
The Rule of 25
TIPS Ladders for Today

The initial balance is $100000. All dollar amounts scale. To find out what happens when starting with $200000, multiply all balances and income streams by 2. To find out what happens when starting with $50000, divide all balances and income streams by 2.

Buy-and-hold for 30 years. Starting from today’s stock valuations, your annualized, real, total return will be between 3.2% and 7.2%. Your most likely return will be 5.22%.

In terms of dollars, your final balance will be between $257K and $805K. Your most likely final balance will be $460K.

This would throw off an income stream between $10.3K and $32.2K each year for at least 40 years. Your most likely income would be $18.4K per year.
..
Buy 2% TIPS for (up to) 10 years and buy stocks when P/E10 = 14.6. Hold the stocks for 20 years. Starting from today’s stock valuations, your annualized, real, total return will be between 2.00% and 7.27%. Your most likely return will be 4.65%.

In terms of dollars, your final balance will be between $181K and $821K. Your most likely final balance will be $391K.

This would throw off an income stream between $7.2K and $32.8K each year for at least 40 years. Your most likely income would be $15.6K per year.

An initial comparison and a reflection

So far, the buy-and-hold approach looks best. But that is because of the constraints that I have put around the other numbers.

A P/E10 level of 19.9 simply means that valuations have retreated from bubble territory..A P/E10 level of 14.6 simply means that valuations have returned to normal..In fact, all of these valuation levels are easily within reach (as far as we can tell from the historical record).

Now consider what I learned from Professor Robert Shiller’s data:

“P/E10 was 8.7 in 1983..The last time that it was 15 was in 1989..If the rise and fall of P/E10 were symmetrical, P/E10 would fall below 15 around 2011. P/E10 would continue down to 8.7 in 2017. Historically, declines have been faster than rises.”

It is a little bit optimistic, but reasonable and realistic, to assume that we will be able to buy 2% TIPS for ten years and then buy stocks when P/E10 = 8.7. This is an attractive valuation. But it is comfortably within the historical range.

The Upside Potential of Waiting

Now we look at the alternative calculation: Buy 2% TIPS for (up to) 10 years and buy stocks when P/E10 = 8.7. Hold the stocks for 20 years. Starting from today’s stock valuations, your annualized, real, total return will be between 5.31% and 10.49%. Your most likely return will be 7.92%.

[When P/E10 = 8.7, the most likely 20-year return is 11%. The confidence interval is from 7% to 15%.]

In terms of dollars, your final balance will be between $472K and $1994K. Your most likely final balance will be $984K.

This would throw off an income stream between $18.9K and $79.8K each year for at least 40 years. Your most likely income would be $39.4K per year.

Final Comparisons

Buy-and-hold is likely to deliver a final balance of $460K. The confidence interval is from $257K to $805K.

Waiting ten years for a bargain has an excellent chance of delivering a final balance of $984K. The confidence interval is from $472K to $1994K.

An alternative calculation shows that waiting ten years to buy stocks at their typical valuations (not at bargain levels) is likely to deliver a final balance of $391K. The confidence interval is from $181K to $821K. These amounts are very similar to those of buy-and-hold, but this approach causes much less stress.

Have fun.

John Walter Russell
August 15, 2005