December 9, 2008 Letters to the Editor

Updated: December 19, 2008.

TIPS - Individual bonds

I received this letter from Ron.

If I am more interested in buying individual TIPS [Treasury Inflation Protected Security] bonds, how do I evaluate the best one to select? Is this a good time to buy them? I'm retired and age 75.

HERE IS MY RESPONSE

Thank you, Ron.

Longer term TIPS bonds are an excellent choice whenever the yield to maturity is above 2%. Today, it is close to 2.4% (plus inflation) on the secondary market at maturities of 10, 20 and 30 years. Even at 5 years, it is close to 1.8%.

You can visit the Bloomberg web site to find the current yield to maturity in the secondary market. Scroll down to the appropriate TIPS listings.

Bloomberg web site
Bloomberg Interest Rates

You can also buy TIPS bonds at auctions as they occur. You can use any bank or Treasury Direct. If you do, you can choose to buy at a fair price without having to set a bid.

Treasury Direct

There is one important thing to keep in mind. The inflation adjustment of TIPS bonds is made to the principal. Even though you must pay Federal income taxes immediately, you will not receive this money as cash before maturity. You only receive the coupon amount as the interest payment. For that reason, you may want to hold traditional bonds to increase the immediate income, at least for the first few years.

You may already have a bond ladder, where individual bonds mature each year or two. You can do the same with TIPS. If not, it takes a while to fill the first few “rungs” (i.e., bonds that mature in the first few years). A ten year TIPS bond ladder makes sense, where you reinvest excess cash back into new TIPS at the ten year maturity.

Re "A High Stock Allocation for Today"

I received this letter from Rob Bennett.

I've been following this stuff for a long time. But it still astounds me to read a sentence like this one: "In every instance, Valuation Informed Indexing produced the highest final balance." It might be so that there aren't many things one can do in life that offer a free lunch. But taking valuations into account is surely one of them. This is all upside and zero downside. And yet it is controversial as can be. Yikes!

The full reality of the non-valuation-informed strategies ("Passive Investing") is even worse than the numbers indicate. The reality is that most Passive Investors will not be able to stick with their strategies under at least some of the scenarios that the market can dish out. Valuation-Informed Indexing not only is a better strategy, it is also a more realistic strategy (it is more possible for humans to implement the strategy successfully). Looking only at the numbers makes Passive Investing look better than it is and it still comes up losers on every test!

I give up -- I'm convinced there's something worthy of serious consideration here!

HERE IS MY RESPONSE

Thank you, Rob.

The results were different “In A Normal Market.” There were a couple of cases with higher Year 30 balances with the 80% fixed allocation. (In 8 out of 10 cases, Valuation Informed Indexing was better). I believe that this could have been different if I had altered the algorithm to suit a Normal Market as opposed to a Bear Market. I do not know for sure. I do know that Valuation Informed Indexing always produces a satisfactory result. Fixed allocations almost always produce inferior results.

I believe that, in real life, we can easily discern long lasting (secular) trends based on valuations (P/E10). We might be able to do better with Valuation Informed Indexing at all times. But I offer no guarantees. I am confident that Valuation Informed Indexing will do better most of the time.

One More Thought re "A High Stock Allocation for Today"

I received this letter from Rob Bennett.

You say: "We might be able to do better with Valuation Informed Indexing at all times. But I offer no guarantees. I am confident that Valuation Informed Indexing will do better most of the time."

My take is that Valuation-Informed Indexing will probably not do better in all scenarios. There are just too many possibilities and unusual scenarios will generate outlier results. Still, I think it is fair to say that Valuation-Informed Indexing is always better on a risk adjusted basis. You cannot know in advance that the unusual scenario is going to turn up. So you have to take on extra risk to get that outlier result. Going by what you know at the time you have to make the allocation decision, taking valuations into consideration is always a plus.

HERE IS MY RESPONSE

Thanks again, Rob.

In this instance, I made no provision at all for a strong upward trend. The allocations were 100%-80%-20% depending upon valuations. I could add another allocation for the Normal Market at high valuations. Or something else. Variants are worth looking into. Still, you are probably right.

Further data questioning whether Valuation Informed Indexing is really the best

I received this letter from Michael.

I posed a question a few weeks ago: if Valuation Informed Indexing really is superior (and I had been convinced from this site that it in fact was) then why was I getting higher Year 30 SWRs with 80% or 100% stock allocations rather than Switch A or B?

After reading Rob Bennett's recent letters to John, I ran some further numbers. Assume $100,000 balance, a TIPS yield of 2.5% (those were the days!), a Yr 30 balance of 100%. If stocks fall and you are invested in stocks, you lose money (bad) but P/E10 levels fall and as a result SWR levels rise (good). My initial question was which of those two effects mattered more.

My starting point: I assumed the return of the % NOT invested in stocks was flat. So, assuming a P/E10 of 15.3, my SWR with 80% stocks was $4,291 SWR and for Switch A it was 3,930. Assuming a 50% allocation to stocks and a shock to P/E10 = 6 (implying a 60.78% fall in the market or a 30.39% in my portfolio since I am only 50% invested) results in a SWR of 11.62% for 80% equities and 8.45% for Switch A implying a 8,088 SWR for 80% equities or 5,882 for Switch A (100,000*(1-60.78%*50%)*11.62%). Clearly I am "better off" being 50% invested and a 60% fall in the market.

Other extreme: let's assume a positive sock to the market to a 24 P/E10, implying a 56.86% increase. Using the same logic I get a SWR of 3,262 for 80% equities and 3,673 for Switch A. Clearly I am "worse off".

Next, as an (ex?) trader, I posed the following question: what if I wanted to "hedge" changes in my SWR (in $ terms) by varying my % invested in stocks today so that my SWR (again, in $ terms) was as little changed as possible across a range of stock price shocks. Turns out, I can't ever do it but get closest at 100% invested. I.e., being 100% invested and a shock down to PE10 = 6 or up to PE10 = 24 results in 4,557 SWR for the shock down or 3,984 for a shock up - not exactly "hedged" but close.

So, again, this seems to imply that the "best" allocation strategy is 100% equities which exactly is COUNTER to VII....

Comments? Is my logic flawed? Would be curious on Rob's view on this as well...

HERE IS MY RESPONSE

Thank you for your excellent letter. It is very interesting. You bring up several good points. Your analysis is accurate.

Let me broaden your outlook.

By limiting yourself to the Year 30 SWR Retirement Risk Evaluator, you have limited your options to liquidation strategies. That is, at times, you sell shares for income.

Your analysis focuses on a continuing withdrawal rate that keeps up with inflation. This is an excellent choice for early retirees. It is a comforting choice for traditional retirees.

You have constructed your hedges assuming equal weighting, regardless of likely outcomes. Consider setting a floor for less likely outcomes such as P/E10 = 24 within the next decade. Seek higher incomes for more likely outcomes.

A well timed switch to a dividend strategy can make a lot of sense. Many of today’s blue chip stocks have dividend yields above 5%. Others have a lower current yield but they have a history of good dividend growth. You should be able to beat a 4.5% (plus inflation) continuing withdrawal rate even today.

And YES. That is with a 100% stock allocation even today.

In many instances, I have found that switching to 100% stocks after waiting for a price drop makes a lot of sense. The biggest issue is knowing what to do while waiting. That is your specialty.

Valuation Informed Indexing does not demand any particular strategy. It simply requires you to take valuations into account, as you have done. Sometimes the best answer is to stick with 100% stocks. Whether you choose indexing is a second issue. It makes sense for many individuals with little time available for stock selection.

Rob Bennett is already on record. He applauds your effort and encourages more and more people to join in.

ADDED REMARK

Here is a new article. It can help you with your planning.

Looking into the Future

Letters to the Editor in 2008

Letters to the Editor in 2007

Letters to the Editor in 2006

Letters to the Editor in 2005