Why Dividends Are Better

If you just looked at Gummy’s (Professor Peter Ponzo) Safe Withdrawal Rate formula, you would have no idea that withdrawing dividends is better than harvesting capital gains.

Gummy’s formula can be written in the form:

Balance at Year N/Initial Balance = Return(N)*(1-w/wfail(N))

where N is the number of years, Return(N) is the total return of the portfolio (cumulative) at year N, w is the withdrawal rate and wfail(N) is the withdrawal rate that would result in a balance of zero at year N. In Gummy’s nomenclature, wfail=1/gMS, where gMS is Gummy’s Magic Sum.

The formulas for Return(N) and wfail(N) depend only on the gain multipliers for years 1 through N, where a gain multiplier = 1+the return = the portfolio balance at the end of a year/the portfolio balance at the beginning of a year. Return(N) does not depend upon the sequence of returns, but wfail(N) does.

Gain multipliers do not treat dividends separately.

Gummy's Sensible Withdrawal Rates
Gummy's (Peter Ponzo's) Equation

What Destroys Retirement Portfolios

Volatility is the killer. Selling too many shares when prices are low destroys retirement portfolios.

Making steady withdrawals in retirement works against you in the same way that making steady deposits work for you during accumulation. It is dollar cost averaging in reverse.

The Dividend Paradox

Suppose that a company pays an initial dividend yield of 4.0%. Suppose that it continues to pay the same amount (plus inflation) long into the future.

You can withdraw 4.0% (plus inflation) long into the future.

No matter how much the price fluctuates, the dividend amount remains the same (after adjusting for inflation).

Yet, when we look at the total return, it fluctuates all over the place as the price fluctuates.

The price can fall 10% each year for 5 years in a row. The (real) withdrawal rate never falls below 4%. The price can stay down. Or it can soar fabulously upward. The withdrawal rate never falls below 4%.

The price can fall 80% in the first year, yet the withdrawal rate never falls below 4%.

How can this be? HINT: Gummy’s formula is ALWAYS right.

Lazy Approximations

What happens is that the statistical distribution CHANGES when there are dividends.

Sure, it is convenient to assume a lognormal distribution (i.e., percentage gains and losses follow a normal, Gaussian, bell shaped curve). Usually it makes an excellent approximation. At other times, it is a lousy choice, a lazy approximation, and it fails miserably.

In the example, after prices fall 80%, the same dividend AMOUNT, which was 4% of the original price, suddenly becomes a fantastic 20% yield.

This is why Gummy’s formula still works.

This is why dividends are better.

Have fun.

John Walter Russell
September 2, 2006