Valuations and Income Streams

The Year 30 Retirement Risk Evaluator shows us why it is best to focus on the income stream in today’s market.

Total Return

The Investment Return is defined as the initial dividend yield plus the (nominal) dividend growth rate.

The Speculative Return is defined as the annualized return caused by changes in valuations (such as the price to earnings ratio).

To an excellent approximation (in years 5 through 15), the Total Return equals the Investment Return plus the Speculative Return.

Over very long periods of time, the Speculative Return fades away, leaving only the Investment Return. [This is a mathematical conclusion assuming only that valuations remain bounded.] The (real) Total Return of the stock market (S&P500) over long periods of time has been close to 6.5% after adjusting for inflation. To an excellent approximation, so has the trend line of the S&P500 with dividends reinvested.

Previous Studies

Finding 5 from Income Stream Insights reads:

“5. You can capture most of your portfolio’s investment return.”

Income Stream Insights

This was based on my research in Capturing the Investment Return and Capturing the Investment Return Follow Up.

Capturing the Investment Return
Capturing the Investment Return Follow Up

Using the Retirement Risk Evaluator

I pressed the Year 30 SWR button on the left side of the page. I looked at the Safe Withdrawal Rates at today’s valuations (P/E10=28), at high valuations (P/E10=20), at typical valuations (P/E10=14) and at favorable valuations (P/E10=10). Here are the Safe Withdrawal Rates that maintain 100% of the original balance (plus inflation) at Year 30.

P/E10=28

20% Stocks – 80% TIPS at 2%: 1.94%
50% Stocks – 50% TIPS at 2%: 2.20%
80% Stocks – 20% TIPS at 2%: 2.03%
100% Stocks: 1.46%

P/E10=20

20% Stocks – 80% TIPS at 2%: 2.15%
50% Stocks – 50% TIPS at 2%: 2.79%
80% Stocks – 20% TIPS at 2%: 3.06%
100% Stocks: 2.79%

P/E10=14

20% Stocks – 80% TIPS at 2%: 2.46%
50% Stocks – 50% TIPS at 2%: 3.68%
80% Stocks – 20% TIPS at 2%: 4.61%
100% Stocks: 4.78%

P/E10=12

20% Stocks – 80% TIPS at 2%: 2.64%
50% Stocks – 50% TIPS at 2%: 4.17%
80% Stocks – 20% TIPS at 2%: 5.46%
100% Stocks: 5.89%

P/E10=10

20% Stocks – 80% TIPS at 2%: 2.88%
50% Stocks – 50% TIPS at 2%: 4.86%
80% Stocks – 20% TIPS at 2%: 6.66%
100% Stocks: 7.44%

Comparisons

We have several dividend and income strategies that lift the continuing withdrawal rate above 5% (plus inflation). Using the minimal income stream objectives of the Morningstar Dividend Investor newsletter, the continuing withdrawal rate exceeded 5.4% (plus inflation). Read Taken At Face Value.

Taken At Face Value

The Retirement Risk Evaluator shows what it takes to match this when following the capital appreciation approach of the traditional studies.

P/E10 has to fall to half of today’s level (P/E10=28 today) to come close to a continuing withdrawal rate of 5% (plus inflation). However, if valuations were to become favorable (P/E10=10), a capital appreciation approach would be competitive and, possibly, superior.

[Under such circumstances, dividend yields and income streams would be higher than today’s levels.]

Have fun.

John Walter Russell
April 14, 2007