Switching Thresholds with 50% / 20% Stocks

Research on Safe Withdrawal Rates

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JWR1945
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Switching Thresholds with 50% / 20% Stocks

Post by JWR1945 »

Overview

This is an analysis of switching allocations in a portfolio consisting of stocks (i.e., the S&P 500 index) and TIPS (Treasury Inflation Protected Securities) on the basis of P/E10. When P/E10 is below a specified threshold, the stock allocation is 50%. When P/E10 is greater than or equal to the threshold, the stock allocation is 20%.

This extends my earlier study Switching Thresholds with 80% / 20% Stocks dated Tuesday, Sep 16, 2003 at 5:57 pm CDT.
http://nofeeboards.com/boards/viewtopic.php?t=1393

One of the results of the earlier study was that there were a large number of very early failures unless the switching threshold was kept very low, no more than 13. That is the result of the high volatility associated with an 80% stock allocation. The calculator only allows us to choose two allocations. It makes more sense to reduce one's stock exposure more gradually as valuation levels (as measured by P/E10) increase. We cannot look at a three level allocation directly. By looking at a 50%-20% allocation now and an 80%-50% allocation later, we can get an idea of what might happen if we were to use a more realistic, three level allocation (80%-50%-20%).

Standard Conditions

I determined Historical Database Rates using a modified version of the Retire Early Safe Withdrawal (Rate) Calculator (i.e., a modified copy of version 1.61 dated November 7, 2002). I modified it so that its switch feature incorporated stocks and TIPS instead of stocks and commercial paper.

Today's stock market is outside of the historical range both in terms of valuations and dividend yields. That is, prices are high and dividend yields (and payout ratios) are low. To make use of the historical database, I have selected test conditions that are somewhat unusual. I have set the interest rate on the TIPS at 4% (above inflation) and I have set the withdrawal rate at 6%. The high interest rate is necessary because long-term TIPS currently yield considerably more than stocks. Yet, stocks have yielded more than today's TIPS until just recently. The high withdrawal rate is needed to ensure enough portfolio failures to permit meaningful data analysis while not being overwhelmed by portfolio failures. If I had not set the interest rate on the TIPS so high, I would have set it at 5% rate. I have left the expense ratio at the 0.20% default level of the Retire Early Safe Withdrawal Calculator. That is realistic for a low-cost stock index fund. It is much too high for TIPS. In essence, I am simulating TIPS with a 3.8% interest rate, which is 1% higher than what is available on the secondary market today.

I have restricted this analysis to the years of 1921-2002 to avoid the effects of a data anomaly associated with earlier years.

The Numbers of Failures versus Thresholds

This table lists the number of failures on or before a specified number of years when there is switching according to P/E10 at various thresholds. The withdrawal rate is 6%, the TIPS interest rate is 4% and the expense ratio is 0.20%.

Code: Select all

Threshold        20      25      30      35      40
10              0        0      21      31      38
11              0        0      15      22      29
12              0        1      16      20      21
13              0        1      16      17      18
14              0       11      15      19      20
15              0       11      16      19      20
16              0       10      15      18      22
17              0       11      19      25      28
18              0        6      17      22      27
19              0       12      18      23      26
20              0       11      17      22      26

When Failures Occur

This table shows which portfolios failed on or before 40 years. The portfolios began in the years that I have listed.

Code: Select all

Threshold = 10 has portfolio failures in the 1920s, 1930s, 1940s, 1950s, 1960s and 1970.
Threshold = 11 has portfolio failures in 1929, 1930s, 1940s, 1950s, 1960s and 1970. Threshold = 12 has portfolio failures in 1938 and 1953-1972.
Threshold = 13 has portfolio failures in 1938 and 1956-1972.
Threshold = 14 has portfolio failures in 1938 and 1956-1974.
Threshold = 15 has portfolio failures in 1938 and 1956-1974.
Threshold = 16 has portfolio failures in 1931, 1938, 1940 and 1956-1974.
Threshold = 17 has portfolio failures in 1929-1932, 1937-1941 and 1956-1974.
Threshold = 18 has portfolio failures in 1929-1932, 1938-1941 and 1956-1974.
Threshold = 19 has portfolio failures in 1930-1932, 1938-1941 and 1956-1974.
Threshold = 20 has portfolio failures in 1930-1932, 1938-1941 and 1956-1974.
Comparisons

There were no failures on or before the twentieth year for either switching threshold. At the 25-year mark, the previous study (which switched between 80% and 20% stocks) had no failures with thresholds of 10-13 and 14-15 failures at thresholds of 14-17 and 19. There were 11 failures and 12 failures at thresholds of 18 and 20, respectively.

There is a minor improvement when we shift to 50%-20% allocations in extending portfolio lifespans beyond 25 years except for thresholds of 12 and 13.

There is a general degradation when we look at 30 years. It is most pronounced at thresholds of 10-13 and, to a lesser extent, from 17-20. It gets worse at 35 and 40 years.

Conclusions

From this, I conclude that getting the high growth of a large stock allocation when prices are low (using P/E10 thresholds of 13 or less) is vitally important. We had already seen that it was necessary to cut back at higher valuations. We can use a stock allocation of 50% when P/E10 is between 14-17 to our benefit.

In addition, I conclude that it is dangerous to have a high stock allocation in today's market. It would still be dangerous if the P/E10 were as low as 18. The key difference between today and yesterday is the relationship of dividend yields to the yields on long-term TIPS. Until stocks yield enough to match the yields on TIPS or until P/E10 falls below 18, a retiree should keep his (S&P 500) stock (index) allocation well below 50%.

There are investment options other than today's S&P500 index with stable growth and sufficient yields so as to merit higher allocations by someone who must withdraw from his portfolio.

Another set of guidelines that are sufficient is to be able to live almost entirely on dividends (as opposed to relying on price increases) and to make sure that the dividends increase enough to match inflation (long-term).

Have fun.

John R.
hocus
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Post by hocus »

Until stocks yield enough to match the yields on TIPS or until P/E10 falls below 18, a retiree should keep his (S&P 500) stock (index) allocation well below 50%.

This statement is most helpful, JWR1945.

As you may recall, I was asked early in the Great Debate to say what percentage allocation most investors should have made in stocks at the top of the bull market, if I did not agree with the intercst assertion that any allocation lower than 74 percent S&P stocks would cause a delay in the date at which a safe retirement date could be commenced. Since the board was still caught up in The Debate About Having a Debate at the time, I was not able to point to data to provide a definitive answer, and I was reluctant to put forward a number based on my own non-numbers guy assessment of the historical data. The demands were insistent, however, and I eventually put forward the thought that it appeared to me that an allocation of about 50 percent might make sense for investors in ordinary sorts of circumstances.

I felt vindicated in that response when BenSolar revealed that intercst's own data shows the optimal allocation to be 50 percent, not 74 percent (a point on which intercst continues to mislead the REHP board community to this day). I feel doubly vindicated that you have now used a different sort of data examination to generate a conclusion that it may have been possible for some aspiring early retirees to have gone with allocations even below 50 percent without needing to put off their retirement dates.

As I have said before, I greatly appreciate the work you are doing here. Each new post you put up is another brick in the wall. I think it is going to be a pretty darn impressive wall when we assemble all the pieces into our report (I am beginning to think that it may make sense to do the report as a joint project, presuming that is OK with you) on "The Truth About Safe Withdrawal Rates."
JWR1945
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Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 »

hocus
As I have said before, I greatly appreciate the work you are doing here. Each new post you put up is another brick in the wall. I think it is going to be a pretty darn impressive wall when we assemble all the pieces into our report (I am beginning to think that it may make sense to do the report as a joint project, presuming that is OK with you) on "The Truth About Safe Withdrawal Rates."
I will be happy to provide whatever assistance that I can.

Have fun.

John R.
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