Notes starting from August 10, 2009

Updated: September 9, 2009.

Powerful Combination

Moving averages can augment P/E10 based allocations. Read what Norberc has discovered on this thread at Morningstar’s Portfolio Design/Management discussion board.

Morningstar’s Simple Long Term Timing thread

Take Your Lumps Early

I have been looking at the Stock Returns Predictor and what happens to P/E10. It turns out that an early gain causes P/E10 to rise so much that the following periods underperform. An early loss does the opposite. The net effect is that those who suffer a low return early are most likely to come out ahead in the long run.

And it makes sense. Dividends are part of total return. When prices fall early, those dividend dollars buy a larger number of shares than when the price is high. Take your lumps early. Come out ahead in the long run.

Early Gains

It is better for the accumulator to experience lower stock market returns in the early years. He ends up with a larger balance later on.

Early Gains
Current Research P: Balances and Time

Dollar Cost Average or Lump Sum?

Should you dollar cost average or invest a lump sum immediately? My answer: neither.

Bring up the Investment Strategy Tester and look at both. You face the possibility of a serious loss at Years 5 and 10. You do much better by taking valuations into account. Valuation Informed Indexing is a winner.

Next, refine your strategy. Practice on the Scenario Surfer. You can do learn how to do spectacularly well.

Lump Sum or Valuation Informed Indexing?

I brought up the Investment Strategy Tester. I looked at investing a lump sum of $100000 into a P/E=14 Bear Market. At Year 5, the balance could fall to $64205. In contrast, Valuation Informed Indexing protected the worst case downside balance to $81140.

If you were merely Unlucky, the Year 5 lump sum balance would have been $91660. With Valuation Informed Indexing, it would be $106343.

A serious loss within 5 years is enough to discourage almost anybody into abandoning stocks. Taking valuations into account protects you against such losses.

I used P/E10 thresholds of 8-10-18 and allocations of 100%-80%-50%-20% for Valuation Informed Indexing.

Reckless Bets

One of the tragedies of the Efficient Market Hypothesis is that many people believe that high risk automatically means a high return.

Nothing could be further from the truth.

Never accept a risk without adequate compensation. My own experience has been that my best returns have come from solid investments with low risk.

Risk Adjusted Returns

Some people challenge Valuation Informed Indexing on the basis of risk adjusted returns. To the retiree, this is absolutely absurd. If a fixed allocation leads to bankruptcy and Valuation Informed Indexing does not, leveraging the fixed allocation portfolio will only lead to more busted retirements. How is this making things better?

It is laughable.

Or how about fixed allocation portfolios that beat the S&P500? Valuation Informed Indexing can help them as well. Put the words “Gummy Slices” into the search box. You will see many articles that address just this issue. Varying stock and bond allocations with valuations (as measured by P/E10) improves performance.

Keep an Eye on Your Objective

In my latest response to a Letter to the Editor, I recommend a CD ladder, possibly supplemented by TIPS and Ibonds. Why? Because Scott is already within a hair’s breadth of reaching his goals. Recommending stocks or other risky investments would put his retirement in danger.

Always keep your eye on your objective. Don’t put your money at risk if there is no need.

That having been said: I may reconsider my advice if stock prices fall in half. The odds are about 50%-50%. Even then, I would want to be very careful not to put his retirement at risk.

August 21, 2009 Letters to the Editor

Remember ElLobo’s Trick

Although it did not begin with him, ElLobo’s approach to fixed income investments and inflation made a big impression on me. He simply reinvests about 30% of the yield. This is enough to keep up with inflation for a very long time, typically 40 years.

Why Dividends Are Better

This is a classic, well worth remembering. From September 2006.

Why Dividends Are Better

The Candyland Hypothesis

This is Rob Bennett at his best. It is a true classic.

Here is RobCast #145 (63 minutes) -- August 24, 2009 -- The Candyland Hypothesis: Why Short-Term Timing Doesn't Work.

Rob Bennett’s RobCast Page Nineteen

Equal Weighting versus Capitalization Weighting

I frequently see comparisons in which equal weighting (equal dollar amounts of stocks) beats capitalization weighting (equal numbers of shares). One reason that this is so is dividends.

The highest third of the dividend payers are the best companies, on average. With capitalization weighting, you take away the dividends and redistribute them according to stock prices. With equal weighting, you reinvest the dividends back into the companies that produced them. Equal weighting rewards the best stocks: the high quality dividend payers.

Money on the Sidelines

There is no such thing as money on the sidelines.

Money on the Sidelines

Mental Exercise

Suppose you had a fixed number of shares of stock in your account with a fixed level of cash. You neither buy nor sell, but stock prices vary.

You would notice that your percentage of cash varies along with stock prices. When stock prices are high, your cash percentage would be low. It would be reported that you hold little money on the sidelines. When stock prices are low, your cash percentage would be high. It would be reported that you are holding lots of cash on the sidelines.

Your cash amount never varies. You neither buy nor sell. But reports of your cash on the sidelines would vary dramatically.

Dangerous Market

With P/E10 above 18, we are in a dangerous market. It is prudent to cut back when P/E10 ranges between 18 and 20. Still, we never know what the market will do in the short term. It could continue its recent bull run.

Characterizing ADVDX

ADVDX has always been hard to characterize. Treated conservatively, it looks like an excellent high yielding component for a dividend blend.

I offer no guarantees. You must conduct you own due diligence.

Characterizing ADVDX

Adjustments for Taxes

I do not include the effect of taxes in my calculations, mainly because it is very difficult to do. It is also very difficult to do something meaningful. This is OK for sheltered accounts. You simply assess taxes later, as you normally do with a work check.

In a taxable account you need to make adjustments to Safe Withdrawal Rate and Continual Withdrawal Rate calculations. Taxation reduces your investment returns.

This is easier with dividend approaches where you are making a spreadsheet. It is much more difficult with Valuation Informed Indexing and the conventional, fixed allocation Safe Withdrawal Rate approach.

Income Streams

Pensions, social security and single premium immediate annuities SPIA all generate reliable income streams that last for life. Usually, there is no value for heirs beyond a survivor annuity.

Retirees need to focus on income streams. They need to know the reliability of dividend and interest payments. This is much more important than price appreciation. If the income stream is solid, retirees can be comfortable.

Not Simply Total Return

Total return tells only part of the story. Volatility and the sequence of returns are important as well. This is true not simply in retirement portfolios when making withdrawals. It is also true when making deposits.

Dividend strategies often offer the best results for retirees even when total returns are below those of other investments. This is because dividend income is much more stable than total return, which includes the effect of price fluctuations. Quite often, however, dividend strategies are best all around: offering lower volatility and superior capital appreciation as well.

Something Subtle

Accumulators should want to take their lumps early. But why should this matter? Because their total return is higher. Thank you, reinvested dividends.

Don’t Get Caught

Those following a dividend strategy need to drop a stock as soon as there is a dividend cut. Don’t do as I have done as well as countless others. Don’t wait, hoping for things to get better. It does happen, sometimes, but not often.

A dividend cut signals serious financial problems or a change in management policy. Both are bad news for today’s early retirees.

Intrinsic Value

Skilled investors seek to find the intrinsic value of a company. There is also the intrinsic value of the market as a whole. In terms of P/E10, it is the price level that would make P/E10=14, the historically typical value of P/E10.

P/E10 varies slowly. The market may remain overpriced for years. Yet, if you normalize your stock prices to P/E10=14, you know what you can depend on. You also know when the market is a bargain.

You can determine the intrinsic value of stocks by using the Stock Returns Predictor. Simply move the slider to 14 and press the Calculate button. Read the S&P500 level. It is the intrinsic value.

Primitive Monte Carlo Simulations

Monte Carlo simulations have a bad reputation. Even though they have the merit of generating probabilities, primitive versions fail to include Mean Reversion and they fail to simulate fixed income securities properly. Many have no ability to introduce the effect of valuations. Even fewer come with the information needed to make the results meaningful.

The next time that you see a Monte Carlo Safe Withdrawal Rate model, ask what happens with an all TIPS portfolio. The TIPS Table [button on left] tell the accurate story. With 2% TIPS ladder, you can withdraw 4.46% of the original balance (plus inflation) for 30 years. Many Monte Carlo models will report that you are in serious trouble and that you need to add stocks. Nothing could be further from the truth. Your safety comes with a Government guarantee.

Notes Index Starting from June 25, 2009

Notes Index starting from November 23, 2007