Recency,the nephew, the brother in law, skinning the cat.

Research on Safe Withdrawal Rates

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unclemick
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Recency,the nephew, the brother in law, skinning the cat.

Post by unclemick »

Is it possible to take three giant steps back and sum up some rough guidelines - in the current environment, what does the research here tell us to date, and perhaps even more importantly - what don't we know?

1. Youngest nephew, age 25, single, career Navy pilot, just starting to save.

2. Brother in law, age 55, kids grown and gone, scarced of the market, maybe 400k in cash/fixed instruments. Has a little grass is greener syndrome - lives in Pacific NW and looking at the Coffee House portfolio. Him and my sister expect to work - "like forever". SS only - no pension from any company (Mining Engineer).

Gave oldest nephew Bogle's 1994 book - he did well. Ten more years to military retirement, TSP early and often, now switching to short term instruments to save for a house.

That was then (1994), this is now.

So what does SWR Research have to say in today's investing climate. I'm sure Coffee House and Bernstein's Four Pillars deserve their current raging popularity - but I'm still leery of switching disciplines that require doing the opposite of emotions - they often fail in the execution.
hocus2004
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Post by hocus2004 »

"So what does SWR Research have to say in today's investing climate?"

It says that TIPS and ibonds can be used as strategic assets. So long as you are doing better than keeping up with inflation, you are moving ahead. And by protecting yourself from big portfolio drops, you are positioning yourself for the better investing opportunities that the historical data says are likely to be available in stocks in the not-too-distant future.

It also says that you should be placing more focus on dividends than has been the common practice in recent years.

It does NOT say that the average investor should be totally out of stocks today. At least it's not my view that it says that.

"I'm still leery of switching disciplines that require doing the opposite of emotions - they often fail in the execution."

I think you are making a good point here. I have some thoughts re how to deal with the "it's hard to do the opposite of what your emotions say to do" question that I will be putting forward at a later time. It's fair to observe that it is not an easy thing to pull off. If it were easy, there would be a lot of people taking advantage of the sorts of strategies we discuss here. While I think there are more who do so than some seem to think, it is clear that the strategies we talk about at this board are not today's conventional wisdom by any stretch of the imagination.
Mike
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Post by Mike »

...what does the research here tell us to date...
That it is a potentially dangerous time to invest in traditional asset classes. Be really careful.
JWR1945
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Post by JWR1945 »

unclemick wrote:2. Brother in law, age 55, kids grown and gone, scared of the market, maybe 400k in cash/fixed instruments. Has a little grass is greener syndrome - lives in Pacific NW and looking at the Coffee House portfolio. Him and my sister expect to work - "like forever". SS only - no pension from any company (Mining Engineer).
Your 55-year-old brother in law is in reasonable shape.

First, make sure first that he has paid off all debts including his mortgage. Owning a house free and clear reduces his need for income, makes planning easier and lets him sleep well at night. [There are others who recommend interest rate arbitrage because of today's low mortgage interest rates. I have never been comfortable with such a strategy. The investment time frames and likely range of returns never line up well enough to compensate for the added risk and the added cost of borrowing money.]

I am assuming that he will retire around age 65 and that he will receive $12000 or more from Social Security. If he can get 4% from his $400000 in investments, his annual income will be $28000, which is sufficient to live well, if not luxuriously, throughout most of this country. The key is having zero debt, including no mortgage payments, and having all of his kids out on their own. Medicare will help him at age 65. He is likely to buy supplemental health insurance, including something covers catastrophes.

Psychology plays a large role in making investments. Fortunately, his aversion to the stock market comes at an excellent time, when the risks in the stock market are exceedingly high. I will still want him to make some investments in stocks, but only with modest amounts and only in your own area of expertise: high dividend stocks that are likely to increase dividends for the next few years.

From the historical record, we would expect P/E10 to fall to one-fifth of its current level. Or maybe only as far down as one-fourth of its current level, which would still be unpleasant. Some of this will be from earnings growth, which is consistently in the neighborhood of 1.5% above inflation. Most of this reduction will come from falling prices. There was a time within both of our memories when a P/E ratio of 8 was high and when some high quality stocks could be picked up with P/E ratio around 3.

Fortunately, a dividend-based strategy can get you through such unpleasant times. Remember that earnings continue to increase even when price-to-earnings multiples contract. Dividends can continue to rise and provide a steadily growing income stream even if stock prices crash.

I would recommend that your brother-in-law invest about 70% to 80% of his money in TIPS and ibonds. Remember that TIPS produce an income similar to that of a mortgage lender (but with adjustments to match inflation). TIPS with a 2.0% real interest rate can provide an income stream of 4.46% for 30 years or 4.00% for 35 years or 3.66% for 40 years. [It takes an interest rate between 2.5% and 2.6% to provide an income stream of 4.00% for 40 years.] The final balance is zero with each of these calculations. Admittedly, there are some minor qualifiers such as being able to sell some bonds without capital losses and adjusting withdrawals to match coupons instead of inflation itself. [This is what happens with cost of living increases in general. Income rises, but only after inflation has had its effect for six months or longer.]

In terms of stocks I would set the lower limit on dividend yields at 3.0%. I would require high quality companies. I would prefer companies that satisfy additional criteria for value. I would demand a strong balance sheet as reflected by a company's bond rating. It is reasonable to look for yields up to 4.0%. In some unusual instances, such as with Merck, the dividend yield can be as high as 5.0% while the company retains an outstanding AAA bond rating.

I would have him move only gradually into stocks, no more than 5% to 10% per year for the next few years. There may be some dramatic drops in stock prices that can make nice opportunities to buy within the next ten years.

In any event, he still has up to ten years during which he can add to his investments. If he really looks into his situation, however, he may find that he can cut back his amount of work in the near future without too much of a penalty.

Have fun.

John R.
hocus2004
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Post by hocus2004 »

"From the historical record, we would expect P/E10 to fall to one-fifth of its current level. Or maybe only as far down as one-fourth of its current level, which would still be unpleasant."

My sense of things is that the data provides greater support for an expectation that PE10s will fall within not too long a time to moderate levels than for an expectation that they will fall within not too long a time to low levels. I believe that the usual pattern is that, the farther out things stretch on the high side, the greater is the snap back to the low side. That pattern suggests that we may indeed be seeing some low PE10 levels in day to come. But we have little experience with snapbacks from valuations even in the same neighborhood as what we have seen in recent years. So, while I don't think it is unreasonable to expect the usual pattern to repeat, I think that an argument could be made that we might see a return to moderate PE10 levels and then a holding period or even a move back up.

I think that greater confidence is justified in an expectation that PE10s will be returning to moderate or near-moderate levels in the not-too-distant future. What is the alternative? That we will go to PE10s even higher than the highest ever seen? That we will indefinitely stay at PE10s near the highest ever seen? Either of those two scenarios may play out for a few years. But it seems highly unlikely to me that the extreme will become the norm. We do not know anything about the future for certain, of course. But if I were betting, I would feel confident in a bet that PE10s will be returning to moderate or near-moderate levels in the not too distant future. The odds may favor a move to PE10s a good bit lower than that, but I would not feel as confident in a bet that we will see PE10s very much on the low side anytime soon.

These are tentative thoughts. I have not studied the numbers in sufficient depth to feel at all sure of what I am saying here. It's an issue we might want to look at a bit at some later time in the event that there are others interested in trying to identify rough odds that might apply to various sorts of future returns-sequence scenarios.
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Post by JWR1945 »

Here is a picture of P/E10 data.

Visit Professor Robert Shiller's web site and look at his (updated) Stock Market Data from Irrational Exuberance. I visited his site using the following three links in the sequence shown.

http://www.econ.yale.edu/~shiller/
http://www.econ.yale.edu/~shiller/data.htm
http://www.econ.yale.edu/~shiller/data/ie_data.htm

See Figure 1.2. Click on the appropriate tab in the lower left hand corner of your screen.

I am reluctant to draw too much in the way of conclusions about the detailed behavior of P/E10 as valuations return to normal.

Have fun.

John R.
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Post by JWR1945 »

unclemick wrote:1. Youngest nephew, age 25, single, career Navy pilot, just starting to save.
..
Gave oldest nephew Bogle's 1994 book - he did well. Ten more years to military retirement, TSP early and often, now switching to short term instruments to save for a house.

That was then (1994), this is now.

Dollar cost averaging early and often into the TSP is still a winning approach. Putting money into a Roth IRA is also a good idea.
I would have your youngest nephew invest in the C fund, which tracks the S&P500 index, and the G fund, which is similar to a money market fund but with much higher interest rates.

In normal times and at normal valuations, I would have recommended his being invested entirely in the C fund. These are not normal times and valuations are sky high.

I have never been enthused about the F fund (fixed income, bond index fund).

I am cautious about the S fund (small caps). A lot of money has been put into small caps. How much more money can small caps absorb and still represent value as opposed to being overwhelmed by the effects of illiquidity? [BTW, emerging markets are much worse when it comes to liquidity concerns.]

I am reluctant to invest in the I fund (international EAFE index fund) because of my own ignorance of foreign markets. I do not trust myself to discern correctly when experts know what they are talking about. [I remember when the experts were telling us that the price to earnings ratios of Japanese stocks should be much higher than for US stocks because of accounting differences. Not long after than, the Japanese bubble burst.]

BTW, the TSP does not automatically rebalance itself. I would not have him automatically rebalance his holdings. It takes effort and it clips off the potential rewards on the upside. He can always make changes when he does not like his investment mix.

I would have him put 20% to 50% into stocks right now. He does not have enough money invested to be hurt too bad if stocks underperform, which I expect to happen, AND he needs to learn about his own risk tolerance the only way that I know of that works: the hard way, living through a falling market.

Have fun.

John R.
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Post by JWR1945 »

hocus2004 wrote:What is the alternative? That we will go to PE10s even higher than the highest ever seen? That we will indefinitely stay at PE10s near the highest ever seen? Either of those two scenarios may play out for a few years. But it seems highly unlikely to me that the extreme will become the norm.
High P/E10s mean low levels of earnings yield (E10/P). When P/E10 equals 20, the earnings yield is only 5%.

In addition, the historical growth in real earnings has been fairly stable at 1.5% per year.

This limits dividend payouts. At some time or other, we would expect stock prices to be related to income streams. Combine a reasonable payout ratio and the typical earnings growth and stocks should underperform in the absence of multiple expansion. If stocks underperform, what will justify buying stocks at today's high multiples?

Combined, these effects should lower the price component of P/E10 (which will enhance dividend yields as prices fall).

From the late 1960s to 1982, stock multiples fell and the S&P500 index did poorly. From 1982 through the 1990s, multiples expanded and the S&P500 index did great. But throughout the entire era, the real earnings growth rate was the (almost) the same. It varied only a little.

Stock market returns are only loosely related to earnings growth.

Have fun.

John R.
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Post by hocus2004 »

"Combine a reasonable payout ratio and the typical earnings growth and stocks should underperform in the absence of multiple expansion."

From time to time I have considered trying to put together a post that would make the case for a 74 percent S&P allocation at today's valuation levels. I obviously don't believe that's a reasonable allocation for the typical investor. But my experience is that you can gain insights by trying to make a strong case for an opposing point of view. So it might be a useful experiment to see what I could come up with in favor of that viewpoint.

One argument that I find not entirely unreasonable is the argument put forward by James Glassman in his book "Dow 36,000." I have not read the book itself, only brief descriptions of the argument, so my understanding of it is limited. My sense of things is that what he says is that investors today possess an enhanced understanding of the comparative risks of stocks and bonds, that stocks are less risky for long-term investors than most people once thought they were, and that the discovery of this reality justifies a permanent reduction in the risk premium for stock ownership. If the risk premium goes permanently down, the "normal" PE10 level can go permanently up. Small changes in the risk premium can have a big effect on prices, more than most of us would intuitively expect. Glassman goes through the numbers and argues that the DOW should head to 36,000 in the not-too-distant future.

I don't buy it. I tend to think that the fundamental rules apply as time goes by, and I think of the historical norm PE10 number as being one of the fundamentals of this game. Still, it's possible that it isn't. One of the strongest arguments that those arguing for a permanent adjustment upward put forward is the way in which the old rule that stock dividends should generally be larger than the interest rate paid on long-term bonds seemingly went kerplooey in the late 1950s. Sometimes the fundamental rules DON'T apply as time goes by. There's support for that proposition in the historical data too.

I don't personally buy the Glassman argument. What I like about it is that it is an argument rooted in analysis of the numbers. I dislike arguments in which extreme pro-stock proponents just put forward their subjective impressions that stocks always are and always will be the best choice. At least when people put forward numbers, those trying to check out the claims have something that they can sink their teeth into in trying to make sense of the claims. Glassman put forward numbers, so investors who want to inform themselves as to the strengths and weaknesses of his claims are able to do so as long as they are willing to do the work.

I don't think it is likely that the risk premium has permanently changed, but I think it is possible. My acknowledgment that that is possible does not cause me to soften my view that the conventional methodology is analytically invalid, however. SWR analysis is supposed to be rooted in the presumption that stocks will perform in the future as they have in the past. If you presume that the risk premium will be something different in the future than what it has been in the past, you are presuming a future different than the past and that takes you out of the scope of a pure SWR analysis. I see no problem with us running scenarios at this board in which we presume futures different than anything we have seen in the past. But, if we do so, we should be careful to make note of that so that people know that we are predicting significant changes in how stocks perform, something that is not done in a pure-form SWR analysis.
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Post by unclemick »

Aluding to JWR's comment on foreign stocks - what can we say about "what we don't know yet'? I dinked around with taxable/IRA (not my 50/50 401k) money in eight or more asset classes 1980's up thru 1994 (before Bogle) - including foreign bonds( via Putnam closed end), REITs', Vanguard PM, Emerging markets, Vanguard Trustee's International, private timberland, etc.

Other than my difficulty of maintaining discipline comment - what can we say about 8 or more asset class portfolio's - that being the rage now - MPT and all that.
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Post by JWR1945 »

hocus2004 wrote:One argument that I find not entirely unreasonable is the argument put forward by James Glassman in his book "Dow 36,000."..My sense of things is that what he says is that investors today possess an enhanced understanding of the comparative risks of stocks and bonds, that stocks are less risky for long-term investors than most people once thought they were, and that the discovery of this reality justifies a permanent reduction in the risk premium for stock ownership. If the risk premium goes permanently down, the "normal" PE10 level can go permanently up. Small changes in the risk premium can have a big effect on prices, more than most of us would intuitively expect. Glassman goes through the numbers and argues that the DOW should head to 36,000 in the not-too-distant future.
The long-term real return in bonds has been around 3.5%, but only rarely so in recent times. A real return of 2.0% to 2.5% has been typical.

If the long-term return of stocks were to fall to 4.0% AND if people could count on getting that much by waiting 20 (or even 30) years, then buying stocks could make sense even with a long-term real return of only 4.0% as opposed to 6.5% to 7.0%.

If stocks paid out 50% in dividends and if they continued to grow by 1.5% per year, then stocks could return 4.0% overall (which equals 2.5% + 1.5%) even with P/E10's permanently staying at 20.

[The earnings yield is 5.0% when P/E10 = 20. A 50% payout ratio means that the dividend yield would be 2.5%. Add the 1.5% earnings growth (since dividend growth is likely to follow earnings growth) to the 2.5% dividend growth and you get 4.0%.]

On a comparative basis, investing in stocks that reliably return 4.0% (plus inflation) in the long-term can make sense. Why would prices be bid up that high? I think that Mike has the answer: demographics. Too many people are seeking the same thing.

Eventually, investment dollars would start pouring out into other places. In fact, this has already begun to happen. Thus, the mention of international stocks, emerging markets and so on.

For this to happen, however, would mean that the very long-term return of the stock market (from 1800-2000) would change dramatically. There would be a major change (i.e., a major reduction) in the slope (as plotted on semilog paper) of those graphs showing what $1.00 would be worth if invested in 1800 until today.

Have fun.

John R.
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Post by JWR1945 »

unclemick wrote:Other than my difficulty of maintaining discipline comment - what can we say about 8 or more asset class portfolio's - that being the rage now - MPT and all that.
After having read what John Bogle, David Dreman and Lowell Miller (and even Benoit Mandelbrot) have had to say about Modern Portfolio Theory, I have no confidence in it whatsoever. The case against the general theory is incredibly strong. I consider all of the arguments in favor of selected strategies open to question. Some of them will hold up, at least, in part. IMHO, everything has to be reexamined carefully.

Have fun.

John R.
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ben
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Post by ben »

Unclemick; a well diversified portfolio in both asset classes and currencies is certainly the way to go in my book (and I know in yours too - Vanguard does most of it for you besides the Reits).

The several different (some of which being non-correlated) asset classes will make for a smoother ride and also higher return.

Using the SP500 and US gov bonds for studies to decide on a historical SWR is practical as we have long periods of data, but why would anyone limit him/herself to those 2 asset classes (both being overvalued by most measures)?

Cheers!
Normal; to put on clothes bought for work, go to work in car bought to get to work needed to pay for the clothes, the car and the home left empty all day in order to afford to live in it...
unclemick
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Post by unclemick »

Yep - no two investors need to apply what the data is indicating in the same way. They can use the implications and apply it to their own situation.
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