What Should You Do?

You will be retiring soon. You haven't thought through your finances. What should you do?

The Critical First Step

There is one thing that you absolutely MUST do immediately. Do not delay. Follow John Bogle's advice: Do nothing.

Investment Baseline

Now that you have passed the emergency stage, you need to make a baseline. This is a PAPER baseline. TIPS and ibonds make a powerful baseline. Use a mortgage calculator (or read some of my articles).

Buying TIPS and ibonds is similar to giving the Federal Government a mortgage on your money. A mortgage calculator will tell you how long that you can withdraw a specified amount (plus inflation) over a specified period. The principal in TIPS and ibonds adjust to match inflation. The fixed rate is a real interest rate.

There are lots of details. For example, you should keep TIPS inside of tax sheltered accounts. Adjustments in TIPS principal to match inflation are taxable immediately. Place ibonds into taxable accounts. Unless you choose otherwise, you are not taxed on ibonds until you cash them. You can purchase any amount of TIPS. Ibond purchases are limited to $60000 per social security number per year. Half of this is in paper bonds. Half is in electronic form.

Interest rates fluctuate. Today, Bloomberg reports that TIPS of all maturities yield just above 2.0% on the secondary markets. The latest ibond interest rate is 1.0% (fixed component). Ibonds are available only through the Federal Government.

Assuming that you can continue to buy TIPS at a 2.0% interest rate, you can withdraw 4.0% of your initial balance for 35 years before you run out of money with an all-TIPS portfolio. The United States Government provides the GUARANTEE.

Your final balance would be zero.

Portfolios with high stock allocations have NOT ALWAYS lasted beyond year 30 when withdrawing 4.0% of the initial balance (plus inflation).

You never have to accept a retirement approach inferior to a portfolio consisting entirely of TIPS and/or ibonds.

Two Letters to the Editor

Here are two Letters to the Editor that can help.

From A Novice in Investing
I Bonds versus TIPS

Expense Baseline

You need to estimate your retirement needs.

The wrong way to do this is to base your retirement income requirements on your working income.

The right way to do this is to base your retirement income requirements on your expenses. The most important expense that you are likely to overlook is HEALTH INSURANCE. It is an important expense. It is a rapidly growing expense.

Some expenses disappear, such as Social Security deposits. Many other expenses decrease. Your automotive expenses are likely to decline sharply. Even if you travel a lot, you will not be driving to work every day and under all conditions.

Many people identify three levels of income. The first covers your actual NEEDS. At this level, you might want to work part-time to pay for an occasional luxury. The second level of income covers a comfortable life style. The third level includes many luxuries, appropriate if your investments do well.

Take Deliberate Steps

Remember how you got to where you are.

If you have invested in real estate, you will probably do well to keep investing in real estate. If you have invested in stocks, you can probably do well continuing to hold stocks. If you have invested in mutual funds, you are likely to do well continuing to hold mutual funds.

Your experience helps you know how you react to investments. Reading about stock market fluctuations is not the same as owning stocks while living through stock market fluctuations.

Your experience helps you avoid serious mistakes. Your lack of experience as you move into a new area can cost you dearly. There are many investment products with very short histories. They sound great. Some are great. Many will fail. The history of the financial markets is littered with great investment products that failed.

What is frustrating is that the same words are used on both sides of an investment issue.

Some of Our Findings

We have identified three good approaches:

1) A portfolio consisting entirely of TIPS (and/or ibonds).
2) A portfolio that varies allocations between stocks and TIPS gradually, according to valuations as measured by Professor Robert Shiller’s P/E10.
3) A dividend-based strategy.

You can combine these approaches.

Our baseline portfolios of TIPS and/or ibonds are powerful baselines. Very few approaches are likely to do better. Traditional, fixed allocation approaches are likely to do worse.

Two decades of a bull market in stocks have caused people to forget the advice of Benjamin Graham to allocate no less than 25% nor more than 75% in either stocks or bonds. [This is for a portfolio of stocks and bonds.] My research shows that this costs up to 0.3% in the Safe Withdrawal Rate, but it is much, much better than the one-decision fixed allocation advice we see so often. [Reference: Current Research B, Keeping In Tune with the Human Element.] My research shows that an optimized approach without Benjamin Graham’s constraint would currently hold 100% TIPS.

Do not despise Benjamin Graham’s suggestion. What if the stock market were to increase by 30% or 40% in the year right after you had bought your TIPS? How would you feel? What would you do? The stock market rises about half of the time during bear markets. Large, single-year advances are common even in bear markets.

I have calculated the optimal switching algorithm with stocks and TIPS. It will not be EXACTLY right, looking forward. I have constructed sensitivity studies. Being a little bit off does not make much of a difference. This is in line with the historical notion that you should take a little money off the table (i.e., out of stocks) when valuations are high.

I use Professor Robert Shiller’s P/E10 to measure valuations. It is the (real) index level (price) of the S&P500 divided by the average of the previous ten years of (real) earnings. It is our best predictor so far. It works with the Large Capitalization Growth, Large Capitalization Value, Small Capitalization Growth and Small Capitalization Value segments as well as the S&P500 itself. It performs better than single-year P/E, Tobin’s Q, dividend yield and several combinations. I have supplied theoretical support in the FOUNDATIONS section.

Professor Shiller posts P/E10 as well as other S&P500 information at his web site.

Professor Shiller’s Web Site

Dividend-based strategies are inherently sound. I have summarized the general approach and a few important points. Of interest, it is a good idea to combine a dividend-based approach with switching. Falling prices already imply increasing dividend yields (since dividend amounts normally remain the same). Waiting for falling prices has a double benefit. You end up with more shares of stock at higher dividend yields. [Reference: Dividend Strategies section.]

Browse Around

This is a research site. You should not be upset if you don’t understand everything. Even if you do not understand the calculations, you are likely to understand the more important points.

Don’t be afraid of the numbers. They are there to help, not to intimidate. They allow you to make comparisons.

There is a lot of uncertainty in investing. One of the most important skills is to recognize the reliability of numbers.

One of the early contentions about investing was whether anybody could beat the market. Early researchers claimed NO. Their research was flawed. David Dreman showed that people could not accurately and precisely predict corporate earnings. It was stock picking based on earnings projections that failed. It is possible to beat the market consistently. Recognizing where the shortcoming lay, David Dreman was able to explain and exploit the Value premium. Later researchers have added more details, supplying even more insights as to why it continues.

Have fun.

John Walter Russell
November 14, 2005