Notes Starting July 10, 2006
Updated: August 22, 2006.
It is about time...
I wrote the following at Rob Bennett's Financial Freedom Blog today.
"The other lesson is that those arguing that investors should ignore valuations are holding a weak hand. Otherwise, they would invite civil and reasoned exploration of their views, no?"
They are holding an exceptionally weak hand.
In a related side issue: I am hoping that we will BEGIN to see an improvement in quantitative reporting. Current reporting, even among financial experts, is atrocious.
Two improvements that I would like to see:
1) No more reporting that an investigator simply failed to see something. Always report what he should have been able to see.
2) No more rejecting an analysis outright. Always show us what the RIGHT answers are. If that is not possible, at least tell us what is needed to determine the right answer AND give us relevant information to help us understand the issue.
During my professional career, I was never allowed to get away without addressing these two points. Why do we allow "financial experts" to get away with anything less?
Rob Bennett's Web Site
Time and the Gordon Model
The Gordon Model makes its best predictions 5, 10 and 15 years into the future. It does not do as well at 20 and 30 years.
Time and the Gordon Model
It is about time...continued.
I have added two items to the list.
During my professional career, I was never allowed to get away without doing the following. Why do we allow "financial experts" to get away with anything less?
I am hoping that we will BEGIN to see an improvement in quantitative reporting. Here are some improvements that I would like to see:
1) Always report what an investigator should have been able to see. It is never sufficient to report that an investigator failed to see something.
2) Never reject an analysis without letting us know the RIGHT answer. If that is not possible, at least tell us what we need to do to determine the right answer AND give us relevant information to help us understand the issue.
3) Always include the appropriate timeframe.
4) Always include error estimates (e.g., confidence limits), no matter how rudimentary.
July 15, 2006 update.
It is about time...more.
Added July 16, 2006.
5) Use actual results as the standard, not a mathematical model.
I have asked skilled engineers what they would conclude if I were to toss a coin twenty times and it came up heads every time. What would the odds be that the next coin toss would come up heads?
Most have answered that the odds would be 50%-50%, the standard answer.
Then, I made it clear that I had not assumed the use of a fair coin. A fair coin is a mathematical fiction. It has 50%-50% odds, exactly. It has no memory whatsoever. I pointed out that I might be using a two headed coin.
A strange thing happened. About half of the engineers argued with me. The odds were 50%-50% because the coin had no memory, they insisted. All tosses were independent.
They were so conditioned to assuming a fair coin that they did not entertain even the possibility of anything else.
I have noticed such behavior concerning the stock market. It is a serious error.
The Copie Index
I participate at the Income & Dividend Investing discussion board at Morningstar. They have put together an index built around Copie’s investment philosophy. Copie is an experienced investor. He has the right temperament. His suggestions are solid and well thought out.
The Copie Index makes an outstanding baseline for dividend investors.
Morningstar Web Site
Income & Dividend Investing Discussion Board
The Copie Index Conversation 1072
It is about time...number six.
Added July 21, 2006.
6) Mix numbers carefully. Be sure to match precisions. Be sure to identify precisions.
Some numbers are rough approximations. Others are exceedingly refined and very precise. For example, I identify the (maximum) confidence level associated with my valuation (P/E10) based predictions as 90% (two-sided, 95% one-sided). It could be a little bit less, perhaps 85%, but not very much less.
In contrast, we see exotic calculations relating to extremes such as six sigma errors. Those kind of calculations require the best of Benoit Mandelbrot and Nassim Taleb as well as other researchers of their caliber.
To interpret my numbers, simply acknowledge that I allow for a 10% chance of being blindsided, good or bad. You may encounter the run up of a bubble, a good outcome provided that you leave in time, or you may encounter a crash, a horrible outcome. Base most of your planning on the most likely 90% of all outcomes. But prepare for contingencies, the remaining 10%.
Compact Variable Terminal Value Rate Calculators
I have placed compact versions of my Variable Terminal Value Rate (Compact VTVR or CVTVR) Calculators into the Big Project folder in my Yahoo Briefcase. They are CVTVR A, B and C.
They do not contain quite as much information as the previous calculators. You are likely to find them easier to use.
I have developed a variety of simple to use, spreadsheet calculators for the Big Project, Current Reseach H.
AFTERNOON UPDATE:
I have now added CVTVR D, which adds a graphical display to CVTVR C. When you reflect upon these results, think about how they compare with the TIPS baselines (row 56 of CVTVR D) and think about how they would compare with a dividend-based strategy.
UPDATE (Additional):
These calculators show the range of withdrawal rates that will leave you (at year 30) with a final balance of zero (that's right, completely depleted), 50% of your initial balance (plus inflation) and 100% of your initial balance (plus inflation). Portfolios consist of the S&P500 and TIPS. You can vary allocations between 20% and 80%.
The probabilities that separate each range of results are (roughly) 5%, 20%, 50%, 80% and 95%. Keep in mind that you still have a 10% chance of being blindsided, possibly to your benefit and possibly to your detriment.
When you look at the graph, think about what you could do with a dividend-based strategy or even a TIPS-only approach. Many people, especially younger retirees, would like to have their portfolios maintain at least one-half of the buying power at year 30 even if lightening strikes. Most dividend-based strategies do much better. They retain full value. They even grow.
Withdrawal rates are percentages of the initial balance. I have adjusted all withdrawals to match inflation.
JULY 25, 2006 UPDATE:
I have replaced CVTVR D with CVTVR Da. This removes an error when I tried to constrain the maximum display to 10%. I have added CVTVR Ea and CVTVR F. These replace the column display with bar displays. CVTVR Ea is similar to CVTVR D. It shows what happens with year 30 balances of 0%, 50% and 100% of the initial balance. CVTVR F has you specify the year 30 percentage balance. It shows you what happens to portfolios with 20%, 50% and 80% stock allocations. It also calculates the optimal stock allocations to reach the final percentage that you specify.
JULY 27, 2006 UPDATE:
I added CVTVR G, CVTVR H, CVTVR I, CVTVR J and CVTVR K this morning.
CVTVR K is my first two step calculator. In the first section, I assume that you invest entirely in TIPS for N years because of today's valuations. In the second section, you see what happens to withdrawal rates for the next 30 years. You can enter your guesses as to future P/E10 levels, such as 14 to represent typical valuations, 8 for bargain valuations and 18 for higher than normal valuations. The calculator displays percentages in terms of your initial balance.
Typical choices for N are 10 years, a conservative estimate of how long it takes to reach reasonable valuations, 15 years, a conservative extreme to reach bargain valuations, and 20 years, a pessimistic extreme.
For younger retirees, a good place to start is N = 10 years with a 50% terminal value percentage, which is 50% of the buying power of the initial balance at year 40. If you can get 2.3% interest from TIPS throughout the first decade (you can get 2.5% today), and if P/E10 falls to 14, which is historically typical, well above bargain levels: the calculator tells us that you can withdraw 4.0% (plus inflation) for the full 40 years and still end up with 50% of your initial balance (after adjusting for inflation).
July 28, 2006 UPDATE:
I have added CVTVR L. It is similar to CVTVR K, but I have added results for 100% stocks during the second period.
July 30, 2006 UPDATE:
I added CVTVR M last night. It adds switching portfolios SwAT and SwOptT to CVTVR L. These switching algorithms are optimized for starting at times of high valuations. Refer to Current Research A, B and C for details. They differ from Latch and Hold. They have no memory. They vary allocations strictly on the basis of the current level of P/E10.
August 2, 2006 UPDATE:
I have added CVTVR Ma and CVTVR N. CVTVR Ma corrects the portfolio labels in the graph. The lowest bar, which is very short, should be for TIPS. What I previously identified as TIPS is really a 100% stock portfolio.
CVTVR N adds another TIPS section. You can invest entirely in TIPS before and/or after investing for 30 years in portfolio that includes stocks. I report all withdrawal rates in terms of the initial balance. If you wish to bypass a TIPS-only section, simply enter 0 for the number of years (N or M).
I report quite a bit of information. Just remember that I include boxes for all calculator entries. For example, you need to enter P/E10 only once. [To make this easier, I translate P/E10 to the equivalent current value of the S&P500 index.]
Current Research H: The Big Project
Yahoo Briefcase
Orders of Magnitude
The rebalancing bonus exists because of a misleading definition. It is an illusion. Very often, rebalancing lowers returns.
Returns from individual market slices add or subtract 2% to 3% from the market as a whole.
Variations caused by valuations are huge. At today’s prices, with P/E10=26, the most likely (real) return ten years from now is 1.3%. At historically typical prices, with P/E10=14, the most likely return after ten years is 6.3%. At bargain levels, but well above market bottoms, with P/E10=8, the most likely return after ten years is 14.5%.
Orders of Magnitude
Edited: Orders of Magnitude
Using Stock Return Predictions
According to the Stock-Return Predictor, the most likely return of stocks will be 1.3% (plus inflation) ten years from now. Today’s TIPS yield 2.5% (plus inflation).
Does this mean that we should invest entirely in TIPS?
No. Not necessarily.
Using Stock Return Predictions
Eye Opening Calculations with Compact CVTVR L
I have placed Compact Calculator CVTVR L into my Yahoo Briefcase. It is great for long-term planning.
Here are some examples of what it can do.
Eye Opening Calculations with Compact CVTVR L
New Standards for Financial Reporting
During my professional career, I was never allowed to get away without doing the following. Why do we allow "financial experts" to get away with anything less?
This is based on my “It’s about time...” series of notes.
New Standards for Financial Reporting
A Tip about my Yahoo Briefcase
Often, I have to press refresh several times to get my Yahoo Briefcase to display a page.
Rational Pessimism and Tobin’s q
I found out about Rational Pessimism: Predicting Equity Returns using Tobin's q and Price/Earnings Ratios only in the last few days. I am impressed.
In this review, I show how this fits into my own research. In addition, I am opening up Current Research J: Tobin’s q.
AUGUST 9, 2006 UPDATE:
I am continuing my investigations. I am now using the Smithers and Co. database. I have confirmed that, in some instances (tentatively 10 and 20 years), several variants of Tobin's q are good candidates to improve stock return predictions. P/E10 is still best when calculating Safe Withdrawal Rates.
Rational Pessimism and Tobin’s q
Current Research J: Tobin’s q
Super Variable Terminal Value Rate SVTVR Calculators
I have now developed two Super Variable Terminal Value Rate SVTVR calculators. Each consists of four Compact Variable Terminal Value Rate (Compact VTVR or CVTVR) Calculators side by side, in a single spreadsheet. Each has its own set of inputs at the top.
Making comparisons is easy.
I have placed these calculators into the Big Project folder in my Yahoo Briefcase. They are SVTVR A and B.
AUGUST 9, 2006 UPDATE:
I am continuing to make improvements. My latest is Super Variable Terminal Value Rate Calculator SVTVR I1. It is very easy to use.
AUGUST 12, 2006 UPDATE:
I have added Super Variable Terminal Value Rate Calculator SVTVR J to the Big Project folder in my Yahoo Briefcase. It is very easy to use.
AUGUST 19, 2006 UPDATE:
I have added Super Variable Terminal Value Rate Calculators SVTVR K and L. They are easy to use.
Current Research H: The Big Project
Yahoo Briefcase
What does “3% + inflation” mean?
I got a great letter last night. It asks a simple question that needs to be asked. It asks a question that I answered wrong the first time that I tried.
Letters to the Editor (starting May 1, 2006)
Tobin q Survey
Here are my initial findings about Tobin’s q using Smithers and Co. Ltd. data.
I am still screening. This analysis is almost entirely based on numbers alone.
AUGUST 13, 2006 UPDATE:
Tobin q Errors identifies the most important findings.
Tobin q Survey
Tobin q Survey Follow-On
Tobin q Errors
Tobin q Backup Material
Current Research J: Tobin’s q
Turning Points
History verifies that the stock market rises higher than expected and falls lower than expected. Our investigations of Tobin’s q and stock market returns tell us more. They tell us about the turning points.
Turning Points
A Helpful Theorem
To calculate withdrawal rates for various final balances, it is sufficient to know the withdrawal rates for final balances of zero and 100% of the initial balance. Rates for intermediate balances maintain the same proportions.
I have incorporated these findings into Super Variable Terminal Value Rate SVTVR calculator L. It is a simplified version of SVTVR K.
A Helpful Theorem
Year 15 Calculator A
I have placed Year 15 Calculator A into my Yahoo Briefcase. It is the same as Super SVTVR Calculator L except for its 15-year timeframe.
Enter P/E10, your stock allocation, TIPS interest rate and final balance percentage for four portfolios. See how likely you will be of reaching your final balance percentage as a function of your withdrawal rate.
You can combine the results of SVTVR Calculator L and Year 15 Calculator A to see what happens at Year 45. When doing so, it is best to use the longer time period first. That is, look at a 30 year segment followed by 15. You can see what happens at the midpoint with a 30-year retirement portfolio.
In addition, I have added special Year 15 data summary software to my main calculator. I call the modified version Deluxe Calculator V1.1A08b. I have added it to the Deluxe V1.1A08a folder in my Yahoo Briefcase.
Year 15 Calculator Equations
Yahoo Briefcase
Designing a 45-Year Retirement
Here is an example of how you can use my 15-Year and 30-Year calculators back-to-back.
How about a 4.5% (plus inflation) withdrawal rate?
Designing a 45-Year Retirement
Earlier Notes
Here are our earlier Notes.
Notes through August 21, 2005
Be sure to read A Note about Statistics at the bottom of the following link.
Notes through November 29, 2005
This references a couple of MUST READ articles. It has a couple of its own as well.
Notes through January 13, 2006
SWR Success, Dividend-Based Design Example, Top Notch Letters, Historical Perspective: Dividends and Earnings, The Story Behind the Numbers, Individuals Pick Winners, Dollar Cost Averaging Today, More Comments about the February 5, 2006 Letter to the Editor, Diminishing Returns, Bible Study, Problem Downloading Calculators?
Notes Starting from January 14, 2006
Great Letters, Deflation and I-Bonds, Asset Allocation and Long-Term Returns: An Empirical Approach, Valuation-Informed Indexing (Lucky 7) Calculators, Valuation-Informed Indexing (Lucky 7) SWR Translators, Mean Reversion Theory, Building Blocks, Two Baselines, Extracting Information, What Do I Really Think About Dividends?, Allocate 25%, TIPS Yields Are Moving Higher, Adopting a New Approach, What If There Is A Bubble?, Volatility and Your Timeframe, Oops!, P/Ex Data.
Notes through April 18, 2006.
Revisiting P/E10, Revisiting P/E10: Dividends, NFB Closed, Links Repaired, The Big Project, Calculator D, Long-Term Stock Returns, My Most Recent Articles, Dividend Calculators A and B, Dividend Growth Sensitivity Study, Three Powerful Advantages of Dividend Strategies, Calculator H, CTVR Calculator A, Dividends and Constant Terminal Value Rates, HCTVR Calculator A, May 2006 Highlights, Investment Traps, Variable Terminal Value Rate Calculator A, Variable Terminal Value Rate Calculator B, Why People Ignore Valuations, Latching Calculators, Latched Threshold Survey, Investing for Dummy --The Six "Must Know" Rules, Early Success with Latch and Hold, Continued Success with Latch and Hold, Adding Constraints to Latch and Hold, Time To Catch Up Calculator
Notes through June 12, 2006
The Lower Latch and Hold Threshold, Additional Constraints with Latch and Hold, Current Research I: Latch and Hold, Dividend Investors, The Accumulation Stage, Idiot Switching, Latch and Hold Spreadsheet A, Typical Values of P/E10, Growth with Switching, Special Note about Mean Reversion, No New Discovery This Time, Looking a Little Bit Harder, The Stock-Return Predictor, Calculator I.
Notes starting June 13, 2006.