Numbers for Transition Planning

Preserving capital becomes more and more important as you approach retirement.

I have collected 5-year and 10-year balances for portfolios with 0%, 20%, 50%, 80% and 100% stocks (as represented by the S&P500) with the remainder invested in TIPS with a 2% interest rate.

These data are based on 1923-1980 returns without any deposits or withdrawals. Portfolios are rebalanced annually. I set expenses at 0%. All balances are adjusted for inflation. That is, they are in real dollars. The starting balance is $100000 in all cases.

This information should help those who are close to retirement to assess the risk in their portfolios.

I have included curve-fitting equations and (eyeball estimates of) confidence limits relative to the percentage earnings yield 100E10/P.

[The percentage earnings yield is 100 / [P/E10] where P/E10 is the current price of the S&P500 index and E10 is the average of the most recent ten years of earnings. Professor Robert Shiller has shown that P/E10 is helpful in predicting stock market returns in the intermediate term (of ten years). He posts P/E10 values at his website.]
Professor Shiller's web site

5-Year Balances

Here are the curve-fitting (regression) equations derived from the data at year 5. y is the balance in real dollars. x is the percentage earnings yield 100E10/P. Today’s value of P/E10 is around 28 to 29. Today’s percentage earnings yield is close to 3.5%.

When the portfolio has 0% stocks and 100% TIPS, the balance at year 5 is $110408.

When the portfolio has 20% stocks and 80% TIPS, the balance at year 5 is y = 2436.8x +98949 and R-squared is 0.3857. The confidence limits are plus and minus $10000.

When the portfolio has 50% stocks and 50% TIPS, the balance at year 5 is y = 6617.3x +78199 and R-squared is 0.3845. The confidence limits are plus and minus $40000.

When the portfolio has 80% stocks and 20% TIPS, the balance at year 5 is y = 11435x +53146 and R-squared is 0.3788. The confidence limits are plus $90000 and minus $60000.

When the portfolio has 100% stocks and 0% TIPS, the balance at year 5 is y = 15005x +34029 and R-squared is 0.3728. The confidence limits are plus $100000 and minus $80000.

Putting today’s earnings yield into these equations, a $100000 portfolio is likely to grow (or decline) to the following balances:

1) With 0% stocks and 100% TIPS, the balance at year 5 will be $110408.
2) With 20% stocks and 80% TIPS, the balance at year 5 will be between $97000 and $117000. The most likely balance at year 5 will be $107478.
3) With 50% stocks and 50% TIPS, the balance at year 5 will be between $141000 and $61000. The most likely balance at year 5 will be $101360.
4) With 80% stocks and 20% TIPS, the balance at year 5 will be between $183000 and $33000. The most likely balance at year 5 will be $93169.
5) With 100% stocks and 0% TIPS, the balance at year 5 will be between $187000 and $7000. The most likely balance at year 5 will be $86547.

Comparing these numbers with the tables, the worst case balances for 1923-1980 were:

1) With 0% stocks and 100% TIPS, the balance was $110408.
2) With 20% stocks and 80% TIPS, the worst case balance at year 5 was $100796.
3) With 50% stocks and 50% TIPS, the worst case balance at year 5 was $86760.
4) With 80% stocks and 20% TIPS, the worst case balance at year 5 was $73321.
5) With 100% stocks and 0% TIPS, the worst case balance at year 5 was $64764.

10-Year Balances

Here are the curve-fitting (regression) equations derived from the data at year 10. y is the balance in real dollars. x is the percentage earnings yield 100E10/P. Today’s value of P/E10 is around 28 to 29. Today’s percentage earnings yield is close to 3.5%.

When the portfolio has 0% stocks and 100% TIPS, the balance at year 10 is $121899.

When the portfolio has 20% stocks and 80% TIPS, the balance at year 10 is y = 3567.1x +109846 and R-squared is 0.3927. The confidence limits are plus and minus $20000.

When the portfolio has 50% stocks and 50% TIPS, the balance at year 10 is y = 9910.6x +86051 and R-squared is 0.3724. The confidence limits are plus $70000 and minus $50000.

When the portfolio has 80% stocks and 20% TIPS, the balance at year 10 is y = 17374x +55774 and R-squared is 0.3435. The confidence limits are plus $130000 and minus $80000.

When the portfolio has 100% stocks and 0% TIPS, the balance at year 10 is y = 22906x +32397 and R-squared is 0.3206. The confidence limits are plus $200000 and minus $100000.

Putting today’s earnings yield into these equations, a $100000 portfolio is likely to grow (or decline) to the following balances:

1) With 0% stocks and 100% TIPS, the balance at year 10 will be $121899.
2) With 20% stocks and 80% TIPS, the balance at year 10 will be between $142000 and $102000. The most likely balance at year 10 will be $122331.
3) With 50% stocks and 50% TIPS, the balance at year 10 will be between $191000 and $71000. The most likely balance at year 10 will be $120738.
4) With 80% stocks and 20% TIPS, the balance at year 10 will be between $247000 and $37000. The most likely balance at year 10 will be $116583.
5) With 100% stocks and 0% TIPS, the balance at year 10 will be between $313000 and $13000. The most likely balance at year 10 will be $112568.

Comparing these numbers with the tables, the worst case balances for 1923-1980 were:

1) With 0% stocks and 100% TIPS, the balance was $110408.
2) With 20% stocks and 80% TIPS, the worst case balance at year 10 was $111743.
3) With 50% stocks and 50% TIPS, the worst case balance at year 10 was $96368.
4) With 80% stocks and 20% TIPS, the worst case balance at year 10 was $81149.
5) With 100% stocks and 0% TIPS, the worst case balance at year 10 was $71269.

Conclusions

When valuations are very high, as they are today, the stocks have a substantial downside risk and they are likely to do about the same as a 100% TIPS portfolio.

Looking very closely at the data, one can argue that [my eyeball estimate of] the downside risk is somewhat exaggerated. [The amount of scatter increases with earnings yield. I have reported confidence limits that do not vary with earnings yield.] This is only a matter of degree. The worst case historical balances for high stock portfolios have been fortunate. Bad luck caused by randomness and poor returns caused by overvaluation have not occurred simultaneously.

Looking at the charts, the critical threshold seems to be an earnings yield just above 6%, which corresponds to P/E10 = 16 or 17. The median or typical historical value of P/E10 has been around 14.

Translating this into plain language: you should pay attention to preserving capital as you approach retirement unless stocks are cheap. They are not cheap right now. They are expensive.

Have fun.

John Walter Russell
I wrote this on 2-05-05.