Switching with Small Cap Value Stocks

Research on Safe Withdrawal Rates

Moderator: hocus2004

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Switching with Small Cap Value Stocks

Post by JWR1945 » Sun Jan 30, 2005 7:45 pm

I used my Gummy 03 version of the Deluxe Calculator V1.1A08 Revised: January 28, 2005. I weighted the stock allocation entirely to Small Cap Value.

Conditions

I set the starting balance at $100000. I set expenses to 0.20%. I varied the withdrawal rate. I used the CPI for inflation. I examined 30-year sequences starting in 1928-1980. There are 53 sequences. Stock allocations consisted of Small Cap Value. I used commercial paper for my non-stock allocation. I left the beginning and end of year withdrawal allocations at 50%, the default setting.

I started by collecting a baseline with fixed stock allocations of 0%, 30%, 50%, 70% and 100%.

Later, I took a brief survey. I varied the stock allocation depending upon P/E10. When P/E10 was below the lower threshold (which varied), the stock allocation was 100%. When P/E10 was between the two thresholds, I used an intermediate allocation of 30% or 50% or 70% as indicated. When P/E10 exceeded the upper threshold, which I set at 21, the stock allocation was 0%.

The best intermediate stock allocation (when there was only one intermediate allocation) from a previous survey using commercial paper was 30%. The best P/E10 thresholds were 12 and 21.

Procedure

I increased the withdrawal rate in increments of 0.1%. I recorded the highest rate at which all portfolios from 30-year sequences beginning in 1928-1980 survived. I have listed those rates as HSWR.

I continued increasing withdrawal rates in increments of 0.1%. I recorded the lowest withdrawal rate at which 1 or more, 5 or more and 10 or more portfolios failed.

This method allows me to survey a large number of conditions rapidly. By including data with 5 and 10 failures, I am able to spot difficulties associated with probability distributions.

Results

This was a brief survey. This was not a full optimization. This did not include a full sensitivity study.

Baselines

Calculator data: 1928-2000.
30-year sequences from 1928-1980.
$100000, 0.20% expenses.
[Calculator settings:
Fixed allocations. No switching, but with annual rebalancing.
Stock Allocations: 0%, 30%, 50%, 70%, 100%.]

Stock Allocation = 0%. That is, 100% commercial paper.
30-year Failures in 1928-1980:
HSWR: 2.3
First failure: 2.4
Five failures: 2.5
Ten failures: 2.6

Stock Allocation = 30%
30-year Failures in 1928-1980:
HSWR: 4.3
First failure: 4.4 in year 1937
Five failures: 5.3 in years 1929, 1936-1940, 1969
Ten failures: 5.5

Stock Allocation = 50%
30-year Failures in 1928-1980:
HSWR: 5.1
First failure: 5.2
Five failures: 6.1
Ten failures: 7.0

Stock Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 4.4
First failure: 4.5
Five failures: 5.9
Ten failures: 7.7

Stock Allocation = 100%
30-year Failures in 1928-1980:
HSWR: 2.7
First failure: 2.8 in year 1929
Five failures: 5.8 in years 1928-1930, 1937, 1969
Ten failures: 8.1

The Survey of Thresholds and Allocations

Calculator data: 1928-2000.
30-year sequences from 1928-1980.
$100000, 0.20% expenses.
[Calculator settings:
P/E10 thresholds: varies-21-24-80.
Allocations: 100-varies-0-0-0.]

P/E10 threshold = 9 and [Intermediate stock] Allocation = 30%
30-year Failures in 1928-1980:
HSWR: 4.9
First failure: 5.0
Five failures: 5.3
Ten failures: 6.3

P/E10 threshold = 9 and Allocation = 50%
30-year Failures in 1928-1980:
HSWR: 6.5
First failure: 6.6
Five failures: 7.4
Ten failures: 7.6

P/E10 threshold = 9 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.4
First failure: 7.5
Five failures: 8.1
Ten failures: 8.5

P/E10 threshold = 12 and Allocation =30%
30-year Failures in 1928-1980:
HSWR: 6.8
First failure: 6.9
Five failures: 7.2
Ten failures: 7.7

P/E10 threshold = 12 and Allocation = 50%
30-year Failures in 1928-1980:
HSWR: 7.8
First failure: 7.9
Five failures: 8.1
Ten failures: 8.6

P/E10 threshold = 12 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 8.0
First failure: 8.1
Five failures: 8.6
Ten failures: 8.9

P/E10 threshold = 15 and Allocation = 30%
30-year Failures in 1928-1980:
HSWR: 6.9
First failure: 7.0
Five failures: 7.5
Ten failures: 8.4

P/E10 threshold = 15 and Allocation = 50%
30-year Failures in 1928-1980:
HSWR: 7.5
First failure: 7.6
Five failures: 8.0
Ten failures: 8.7

P/E10 threshold = 15 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.6
First failure: 7.7
Five failures: 8.4
Ten failures: 9.0

The best intermediate stock allocation was 70%. Here is a summary of those results.

P/E10 threshold = 9 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.4
First failure: 7.5
Five failures: 8.1
Ten failures: 8.5

P/E10 threshold = 12 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 8.0
First failure: 8.1
Five failures: 8.6
Ten failures: 8.9

P/E10 threshold = 15 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.6
First failure: 7.7
Five failures: 8.4
Ten failures: 9.0

Additional conditions with an intermediate stock allocation of 70%.

P/E10 threshold = 9 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.4
First failure: 7.5
Five failures: 8.1
Ten failures: 8.5
[Repeated here for convenience.]

P/E10 threshold = 10 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.6
First failure: 7.7
Five failures: 8.3
Ten failures: 8.7

P/E10 threshold = 11 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.6
First failure: 7.7
Five failures: 8.4
Ten failures: 8.7

P/E10 threshold = 12 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 8.0
First failure: 8.1
Five failures: 8.6
Ten failures: 8.9
[Repeated here for convenience.]

P/E10 threshold = 13 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 8.0
First failure: 8.1
Five failures: 8.6
Ten failures: 9.0

P/E10 threshold = 14 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.7
First failure: 7.8
Five failures: 8.4
Ten failures: 9.0

P/E10 threshold = 15 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.6
First failure: 7.7
Five failures: 8.4
Ten failures: 9.0
[Repeated here for convenience.]

P/E10 threshold = 16 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.7
First failure: 7.8
Five failures: 8.4
Ten failures: 9.0

P/E10 threshold = 17 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.8
First failure: 7.9
Five failures: 8.5
Ten failures: 9.1

P/E10 threshold = 18 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 7.8
First failure: 7.9
Five failures: 8.5
Ten failures: 9.0

Comparisons

These are the best results with a fixed allocation.

Stock Allocation = 50%
30-year Failures in 1928-1980:
HSWR: 5.1
First failure: 5.2
Five failures: 6.1
Ten failures: 7.0

These are the best results with switching.

P/E10 threshold = 13 and Allocation = 70%
30-year Failures in 1928-1980:
HSWR: 8.0
First failure: 8.1
Five failures: 8.6
Ten failures: 9.0

Summary

It is easy to understand why Mike has been interested in Small Cap Value stocks. They have much higher Historical Survival Withdrawal Rates than the S&P500 index and Large Cap Value stocks.

Switching stock allocations in accordance with the P/E10 of the S&P500 index is highly beneficial with Small Cap Value stocks. Compare the best results with a fixed allocation to the best results with switching. The improvement is dramatic.

With an allocation of 70% stocks, a withdrawal rate of 7.4% produced zero failures for all conditions tested. That is, when the lower P/E10 threshold was 9, 10, 11, 12, 13, 14, 15, 16, 17 or 18.

Caution: I have not made any adjustments for today's valuations. The actual improvement starting with today's valuations are likely to be less. You can still estimate relative performance when compared to the S&P500 index.

It will be interesting to see how Historical Surviving Withdrawal Rates for Small Cap Value stocks vary with the percentage earnings yield 100E10/P of the S&P500 index.

Have fun.

John R.

Mike
*** Veteran
Posts: 278
Joined: Sun Jul 06, 2003 4:00 am

Post by Mike » Sun Jan 30, 2005 8:45 pm

7.4%, not bad.

hocus2004
Moderator
Posts: 752
Joined: Thu Jun 10, 2004 7:33 am

Post by hocus2004 » Mon Jan 31, 2005 1:04 am

7.4%, not bad.

A poster named Prometheuss used to take hits at me all the time for my claim that it appeared to me that there are circumstances in which it is possible to obtain an SWR of greater than 4 percent. Sometimes, it make sense to look at what the data says prior to making dogmatic pronouncements as to what it says!

peteyperson
**** Heavy Hitter
Posts: 525
Joined: Tue Nov 26, 2002 6:46 am

Post by peteyperson » Mon Jan 31, 2005 12:01 pm

Hi John,

I am curious what the baseline fundamentals were for U.S. Small Cap Value stocks? i.e. What were the expected returns from earnings growth, dividends and PE expansion/contraction? I ask partly because Dimensional ScV offers substantially higher returns because they get deeping into the value style and into micro-cap whereas Vanguard & others as less effective. As Dimensional are not open to all, probably best not to use their returns.

Small Cap Value does not correspond well via the PE valuation model. PEs can be high for small cap. Often a valuation using book value is better suited to consideration of value levels. Thus, a cutoff using PE and/or book value would be a better test.

Small Cap Value is likely to have a higher withdrawal rate because you are benefiting from both a small cap premium and a value premium. Using the return suggestions via gordon equation from Bernstein's Four Pillars, he placed small cap at 1% premium and value at 2% premium when indexed. This boosts the real return of your portfolio and thus the withdrawal rate irrespective of whether you reduce equity exposure when market valuations go too high. The idea that there is one SWR is a nonsense, it entirely depends on the asset mix, expenses, taxation and future real returns. One has to weigh higher returns from asset class focus with the possibility that one could focus too heavily in the asset classes and sub-asset classes which whilst delivering the highest returns in the long-term, may not do so over sufficiently shorter timeframes required to fund retirement living expenses year-on-year. One also faces this choice when looking for a relatively short 15-20 year accumulation phase where stretching for better performance if timed poorly (which no one can tell other than if an asset class is overvalued and future real returns are marked down accordingly) may have you falling short of your target. One may then opt to diversify further which will likely lower returns of the portfolio as a whole but reduce the volatility & so provide more consistent ability to fund living expenses year-to-year. One pays a price for this diversification and one does when being ignorant of high market pricing vs historical averages.

I will use an example (though I'm sure you are completely clear on my meaning) which will provide a slightly different perspective from the UK I think you might find interesting. First a little background..

It is possible to buy an UK index fund for the smallest 0.50% of market capitalization here in the UK. £56m ($100m) micro-cap stocks and smaller. Annualised returns were 20.8% from 1955 to present. E/R 1.22%. The Hoare Govett Smaller Companies Index covers the small cap world in the UK and has returns of approximately 11.x% (perhaps a little more, long-term data is sketchy). There are no value index funds in the UK, however one fund does an admirable job selecting 100 stocks from the 762 stock universe at a 7-10% discount from the market. They have delivered 15.9% over 14 years vs 10% for the index. Fees: 0.82%. Property securities offer a historical return of 10%. Small property securities using higher levels of debt to get big fast typically deliver 10-15% nominal returns (US REITs are a good example of this offering anything from 15-30% annualised returns in their formative years).

One could choose to construct a portfolio of your picks with the highest future return expectations. Assuming all asset classes are equally valued vs historical measurements, micro cap index would come first, followed by small cap value fund and real estate pulls up the rear. Real estate returns can be boosted using more risky small companies rather than the companies that own multi-billion pound portfolios in dominant markets. The latter deliver a very reliable 10% (three negative years in the last 20). One runs risks though. Will small and micro cap continue to perform each decade in reliable fashion? Will the UK economy or the UK equity markets perform as hoped? Would international diversification be of benefit and how much would reducing the risk of underperformance impact maximum likely returns?

I face these choices. One thing I'm finding is that I'm unwilling to own an asset it if makes sense only from an academic portfolio construction perspective. Placing 5% in oil & gas because it smooths out returns just a little bit (little allocation) but returns are both more unpredictable and far lower than alternatives. If returns come too close to the almost risk-free 1% net real provided by IBonds, then I pass because even if the asset makes sense to traditionalists, I'm simply not expecting to be rewarded for taking the added risk. Poor bargain. The returns could be higher but I have to invest based on what I understand, not what I don't understand and hope for whilst in a state of ignorance. With this kind of analysis I'm finding property an attractive alternative asset class because whilst the long-term returns don't match small cap value or micro cap, income levels provide meaningful support to spending levels and returns are less reliant on capital uplift while possessing a linkage to increasing replacement values caused by inflation. Whilst it can at times correlate to small cap common stocks, the presence of a livable income stream make this a moot point. I also like international property but I won't invest where I cannot see respectable levels of return. 4%+ net real. I search for markets where these are possible without undue risk to capital to achieve them. Some markets have adopted the Australian REIT standard where almost all free cash flow is paid out as a dividend. This reduces the net real return substantially after taxes on dividends in both the foreign country and at home. So I plan to put money into asset classes and companies I have the highest confidence in, but hedging my bets with careful selection buying the cheapest quality asset available each time. I don't do diversification for diversification's sake.

Petey

JWR1945 wrote:Switching with Small Cap Value Stocks

I used my Gummy 03 version of the Deluxe Calculator V1.1A08 Revised: January 28, 2005. I weighted the stock allocation entirely to Small Cap Value.

Conditions

I set the starting balance at $100000. I set expenses to 0.20%. I varied the withdrawal rate. I used the CPI for inflation. I examined 30-year sequences starting in 1928-1980. There are 53 sequences. Stock allocations consisted of Small Cap Value. I used commercial paper for my non-stock allocation. I left the beginning and end of year withdrawal allocations at 50%, the default setting.

I started by collecting a baseline with fixed stock allocations of 0%, 30%, 50%, 70% and 100%.

Later, I took a brief survey. I varied the stock allocation depending upon P/E10. When P/E10 was below the lower threshold (which varied), the stock allocation was 100%. When P/E10 was between the two thresholds, I used an intermediate allocation of 30% or 50% or 70% as indicated. When P/E10 exceeded the upper threshold, which I set at 21, the stock allocation was 0%.

The best intermediate stock allocation (when there was only one intermediate allocation) from a previous survey using commercial paper was 30%. The best P/E10 thresholds were 12 and 21.

Have fun.

John R.

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Mon Jan 31, 2005 2:14 pm

peteyperson wrote:I am curious what the baseline fundamentals were for U.S. Small Cap Value stocks? i.e. What were the expected returns from earnings growth, dividends and PE expansion/contraction? I ask partly because Dimensional ScV offers substantially higher returns because they get deep into the value style and into micro-cap whereas Vanguard & others as less effective. As Dimensional are not open to all, probably best not to use their returns.

This will take several posts. You have a put lot of content into your post.

I have modified my calculators to accept Gummy's database for 1928-2000. The original source for most of these data are by Fama and French. Here is a link.
http://www.gummy-stuff.org/returns.htm

My calculators are modified versions of the Retire Early Safe Withdrawal Calculator, Version 1.61 dated November 7, 2002. It uses the historical sequence method to generate Historical Surviving Withdrawal Rates. FIRECalc uses the same general approach, but its details are different.

My modifications have become quite extensive.

My latest modifications allow me to replace the stocks and commercial paper investments that were originally in the calculator with any two fixed combinations of Gummy's data.

For example, one combination could be Large Cap Value and Small Cap Value, weighted 60% in the small caps and 40% in the large caps. The other combined investment could be 5-year Treasury Notes and Large Cap Growth weighted 75% in favor of the treasuries and 25% in the large caps. The two combined portfolios would rebalance themselves internally every year. But I can use P/E10 to determine the overall allocation of the two combined portfolios.

Stated more simply, I can look at several investment classes that I have not been able to look at before and I have a tremendous amount of flexibility.

Gummy's data are year-to-year total returns. His fixed income investments include single-year capital gains and losses. This is significantly better than what we have been able to do until now. Previously, all of the calculators treated fixed income investments as single-year trading vehicles drawing interest at the most recent coupon rate (but without any capital gains or losses).

[I have started looking at bond ladders as well.]

BTW, small cap, as used in academic studies, does not exist in any meaningful way. Their capitalization is limited to $25 million.

Have fun.

John R.

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Mon Jan 31, 2005 2:33 pm

peteyperson wrote:Small Cap Value does not correspond well via the PE valuation model. PEs can be high for small cap. Often a valuation using book value is better suited to consideration of value levels. Thus, a cutoff using PE and/or book value would be a better test.

Interestingly, Small Cap Value responded well to the S&P500's value of P/E10. [This is Professor Robert Shiller's P/E10. It is the current price (or index value) divided by the average of the previous ten years of earnings. The price and earnings are all adjusted for inflation.]

In terms of Historical Surviving Withdrawal Rates, staying with a constant allocation allowed a person to withdraw 5.1% (plus inflation) for 30 years. Varying allocations according to P/E10 brought this rate up to 8.0%. That's quite an improvement.

Still, I believe that David Dreman has the best overview of Small Cap stocks. In his blockbuster Contrarian Investment Strategies: The Next Generation, he devoted an entire chapter to Small Stocks, Nasdaq and Other Market Pitfalls. He looked deeply into this matter.

The Small Cap stocks turned out to be horribly illiquid, often selling only 10000 shares in an entire year. The gap between bid and asked prices averaged 45%. The academics had set up their computers simply to split the difference whether buying or selling. And they made no adjustments in terms of how many shares that their models could buy.

There are many other details. They have a similar effect. The academic numbers did not make sense.

I do not know whether Gummy's Small Cap data fall into a similar, meaningless category. I can only suggest caution.

Have fun.

John R.

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Mon Jan 31, 2005 2:54 pm

peteyperson wrote:The idea that there is one SWR is nonsense, it entirely depends on the asset mix, expenses, taxation and future real returns.
...
One thing I'm finding is that I'm unwilling to own an asset it if makes sense only from an academic portfolio construction perspective.
...
...then I pass because even if the asset makes sense to traditionalists, I'm simply not expecting to be rewarded for taking the added risk. Poor bargain. The returns could be higher but I have to invest based on what I understand, not what I don't understand and hope for whilst in a state of ignorance.
...
So I plan to put money into asset classes and companies I have the highest confidence in, but hedging my bets with careful selection buying the cheapest quality asset available each time. I don't do diversification for diversification's sake.

I agree on each of these points.

BTW, we have shown that diversification can be a mistake. A very simple example can be seen in the Historical Withdrawal Surviving Rates of high stock portfolios. There have been several instances in which the 30-year rate fell below 3.33% because of stock ownership. That is, owning stocks caused survivability to go down relative to an inflation matched cash equivalent! Another example is to compare TIPS when they were sold with a yield to maturity of 2.5% or more. This has a true 30-year Safe Withdrawal Rate of 4.78%, which is substantially higher than the 4% rate claimed for the best high stock portfolios.

Have fun.

John R.

peteyperson
**** Heavy Hitter
Posts: 525
Joined: Tue Nov 26, 2002 6:46 am

Post by peteyperson » Tue Feb 01, 2005 11:33 am

Hi John,

Maybe I am missing something. How does a 2.5% TIPS yield-to-maturity become a 4.78% w/r rate?

Under what circumstances do certain stocks or indices offer lower returns compared to an inflation-matched cash equivalent? I'm assuming here you are referring to IBonds which another colleague amusingly refers to as "super-cash". I have put up a new post today linking to some data from the London Business School which details a number of markets with subpar real returns. However, the world index was still 4-5% real over history. One does carry the risk of overowning your domestic country and hitting a pothole in future longrun returns and one does need to diversify internationally to lessen the impact of this possibility. I also particularly like listed commercial real estate with its livable yields & typical inflation-hedged capital returns (subject to local overbuilding) and am surprised these have only recently started to catch on. One also needs to globally diversify real estate so one is not stuck owning mostly equities in one country whose economy is dancin' like the Japanese.. market.

Petey

JWR1945 wrote:BTW, we have shown that diversification can be a mistake. A very simple example can be seen in the Historical Withdrawal Surviving Rates of high stock portfolios. There have been several instances in which the 30-year rate fell below 3.33% because of stock ownership. That is, owning stocks caused survivability to go down relative to an inflation matched cash equivalent! Another example is to compare TIPS when they were sold with a yield to maturity of 2.5% or more. This has a true 30-year Safe Withdrawal Rate of 4.78%, which is substantially higher than the 4% rate claimed for the best high stock portfolios.

Have fun.

John R.

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Tue Feb 01, 2005 2:59 pm

peteyperson wrote:Maybe I am missing something. How does a 2.5% TIPS yield-to-maturity become a 4.78% w/r rate?

Yes. You are forgetting about drawing down principal.

If you had a real return of 0% each year for 30 years, you could withdraw 3.33% each year with total safety. Your balance at the end of year 30 would be zero.

Similarly, a real return of 0% each year for 40 years allows you to withdraw 2.5% each year with total safety.

The math is similar to a mortgage from the lenders vantage point. You use the same equations. Unlike mortgages, we are talking level payments in terms of real dollars (with an adjustment for inflation) instead of nominal dollars (without any adjustment for inflation).

Anytime that you see a Historical Surviving Withdrawal Rate under the most frequently cited conditions [of 30 years, constant withdrawal amounts in terms of real dollars] below 3.33%, you know immediately that the withdrawal strategy is subpar.

At today's valuations, we calculate Safe Withdrawal Rates for portfolios with S&P500 stock holdings in the neighborhood of 2.5% to 3.0%.

Having a comparative baseline is helpful. These days, one should plan on at least being able to match inflation at a zero percent interest rate. You don't have to accept any inferior approach.

Many readers are interested in retirements that last longer than 30 years. Back when TIPS were yielding 2.5% to maturity [as they were last year] and assuming that you could still buy and sell them at the same rate for the entire period, TIPS had a 40-year Safe Withdrawal Rate of 3.98%. That is better than the 3.9% that is typically mentioned for high stock portfolios but only over 30 years.

[Dividend-based strategies can be another attractive choice for retirees in times of severe market overvaluation.]

Have fun.

John R.

peteyperson
**** Heavy Hitter
Posts: 525
Joined: Tue Nov 26, 2002 6:46 am

Post by peteyperson » Tue Feb 01, 2005 8:45 pm

Ah! I see what you're getting at.

I've looked at that aspect. What I found was that if you get a series of poor returns, then the 20 year's worth of spend down capital doesn't survive the 30 years. It sort of collapses somewhere between 15-25 years. It is late so I may not be thinking clearly on this but I assume you would need to gradually sell off your TIPS in order to release the principle much as one would have to do with stocks? Due to the volatile market pricing on any market investments one would face similiar risks. Certainly TIPS will likely be less volatile than stocks in that regard but I think one is still hoping the returns series won't detonate your FIRE plan. Not sure I've ever been comfortable with that approach. That said, if short of funds at 55 and wanted to FIRE, then I could see myself saying, "Sod it!" and taking the leap anyway. Stetching the capital over the intended payout period and crossing your fingers & hoping. Hmmm.. This kind of thing would allow Rob to pull more out of his portfolio and take the "dream leap" TM (trademark usage fees apply) sooner.

As to how much time to allow, that is tricky. If one were to want to be financially free at 50, how long will one live? Technically the outlook might be 30 years but we all know one could happily live to 100 with modern mediciine. So does one allow 30 years or 50 years? If allowing 30 years and spending down capital, then one is running two risks, both of a poor return series eating thru capital faster than 30 years or outliving your 30 years expected lifespan. The worst risk I suppose is that you would end up too old to work and broke. Gee.. that's not so bad. :o

How many multiples of one's budget is needed for the 30, 40 or 50 year spend down plan? Is there an online calculator one can use to calculator depleting capital much like there are for compounding positively? (Bad ones, not fancy FIRE using a range of asset classes?) Just thinking about UK IBonds which have no market price volatility (so cuts out poor return series issues) and provides 1.01% real return tax-free. One could gradually sell-off certificates if bought in small enough lots (no fees to buy or sell each one and can have as small as £100 certificates). I dismissed this idea because I wanted to FIRE at 50 and couldn't see using much less than maximum poss. lifespan (rather than actuary tables which many people outlive). But you've at least got my brain ticking over on this one. Tell me more, son, tell me more! :lol: :lol: Good to have a secondary plan for if I'm not able to compound enough soon enough to go with Plan A.

Is the reason that stocks have a 3.9% w/r even when spending down capital on an asset that despite possessing a far higher long-term return, price volatility in the sequence is far wider and this drops the w/r rate? And your (implied) suggestion is that TIPS (or I suppose IBonds) don't have as much volatility and so fall more within a closer range? Given the decade long stretches where large cap can do well and small cap can do badly, wouldn't heavy common stock diversification improve this problem as the newer papers suggest? So what does one do? Compound via stocks and then sell-off to switch to other assets and incur capital gains taxes early? One would want to plan future AA ahead of time but it may be necessarily different if one finds capital is short and one needs the spend down plan and not the renewable capital plan. That could be problematic.

Why don't you in addition explain your logic on asset class/portfolio construction to me for this kind of spend down plan. I'm sure you have a different set of assets in order to try to reduce the price volatility issue and specific weightings that may surprise! I guess you want to get into dividend stocks, low volatility stuff and load-up on TIPS/IBonds? Broadly speaking, this could be a plan that works for a great many people as most will be retiring near age 65 with no more than 35 year max. lifespan remaining and limited capital to use to live. Hit me with your best shot, John! I'm all ears. :lol:

Petey

JWR1945 wrote:
peteyperson wrote:Maybe I am missing something. How does a 2.5% TIPS yield-to-maturity become a 4.78% w/r rate?

Yes. You are forgetting about drawing down principal.

If you had a real return of 0% each year for 30 years, you could withdraw 3.33% each year with total safety. Your balance at the end of year 30 would be zero.

Similarly, a real return of 0% each year for 40 years allows you to withdraw 2.5% each year with total safety.

The math is similar to a mortgage from the lenders vantage point. You use the same equations. Unlike mortgages, we are talking level payments in terms of real dollars (with an adjustment for inflation) instead of nominal dollars (without any adjustment for inflation).

Anytime that you see a Historical Surviving Withdrawal Rate under the most frequently cited conditions [of 30 years, constant withdrawal amounts in terms of real dollars] below 3.33%, you know immediately that the withdrawal strategy is subpar.

At today's valuations, we calculate Safe Withdrawal Rates for portfolios with S&P500 stock holdings in the neighborhood of 2.5% to 3.0%.

Having a comparative baseline is helpful. These days, one should plan on at least being able to match inflation at a zero percent interest rate. You don't have to accept any inferior approach.

Many readers are interested in retirements that last longer than 30 years. Back when TIPS were yielding 2.5% to maturity [as they were last year] and assuming that you could still buy and sell them at the same rate for the entire period, TIPS had a 40-year Safe Withdrawal Rate of 3.98%. That is better than the 3.9% that is typically mentioned for high stock portfolios but only over 30 years.

[Dividend-based strategies can be another attractive choice for retirees in times of severe market overvaluation.]

Have fun.

John R.

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Wed Feb 02, 2005 6:15 am

The killer for stock portfolios is having to sell lots of shares when prices are low. Avoid doing that and you are likely to succeed.

Here is a post that answers your question. It includes references to the mathematical formulas. You can use them for today's interest rates.
Interim Withdrawal Rates dated Tue Feb 24, 2004.
http://nofeeboards.com/boards/viewtopic.php?t=2158

Here is an important post related to a frequently mentioned withdrawal strategy. We have to be careful.
The 4% Shocker dated Tue Jan 04, 2005.
http://nofeeboards.com/boards/viewtopic.php?t=3238

Read this post [second link] on this thread [top link]. It is important for those in the accumulation stage during times of high valuations.
Accumulation is Different dated Tue Oct 19, 2004.
http://nofeeboards.com/boards/viewtopic.php?t=3016
http://nofeeboards.com/boards/viewtopic ... 269#p24269

I have put together quite a bit about dividend-based strategies. But I do not have everything put together in one or two places. Dividend-based strategies can be attractive, especially for people who wish to be retired for a long time.

Have fun.

John R.

Mike
*** Veteran
Posts: 278
Joined: Sun Jul 06, 2003 4:00 am

Post by Mike » Wed Feb 02, 2005 7:36 am

JWR1945 wrote:The killer for stock portfolios is having to sell lots of shares when prices are low. Avoid doing that and you are likely to succeed.

Minimizing expenses in the critical first few years would seem to be sensible.

MacDuff
* Rookie
Posts: 31
Joined: Wed Jun 18, 2003 8:20 pm
Location: Centralia, WA

Post by MacDuff » Wed Feb 02, 2005 10:53 pm

JWR1945 wrote:Switching with Small Cap Value Stocks

I used my Gummy 03 version of the Deluxe Calculator V1.1A08 Revised: January 28, 2005. I weighted the stock allocation entirely to Small Cap Value.

Conditions

I set the starting balance at $100000. I set expenses to 0.20%. I varied the withdrawal rate. I used the CPI for inflation. I examined 30-year sequences starting in 1928-1980. There are 53 sequences. Stock allocations consisted of Small Cap Value. I used commercial paper for my non-stock allocation. I left the beginning and end of year withdrawal allocations at 50%, the default setting.

I started by collecting a baseline with fixed stock allocations of 0%, 30%, 50%, 70% and 100%.

Later, I took a brief survey. I varied the stock allocation depending upon P/E10. When P/E10 was below the lower threshold (which varied), the stock allocation was 100%. When P/E10 was between the two thresholds, I used an intermediate allocation of 30% or 50% or 70% as indicated. When P/E10 exceeded the upper threshold, which I set at 21, the stock allocation was 0%.

The best intermediate stock allocation (when there was only one intermediate allocation) from a previous survey using commercial paper was 30%. The best P/E10 thresholds were 12 and 21.

Procedure

I increased the withdrawal rate in increments of 0.1%. I recorded the highest rate at which all portfolios from 30-year sequences beginning in 1928-1980 survived. I have listed those rates as HSWR.

I continued increasing withdrawal rates in increments of 0.1%. I recorded the lowest withdrawal rate at which 1 or more, 5 or more and 10 or more portfolios failed.

This method allows me to survey a large number of conditions rapidly. By including data with 5 and 10 failures, I am able to spot difficulties associated with probability distributions.

Results

This was a brief survey. This was not a full optimization. This did not include a full sensitivity study.

I know you must say somewhere in here- but exactly what index or price series did you use for the"Small Cap value" proxy?

Mac

MacDuff
* Rookie
Posts: 31
Joined: Wed Jun 18, 2003 8:20 pm
Location: Centralia, WA

Post by MacDuff » Wed Feb 02, 2005 11:06 pm

JWR1945 wrote:Caution: I have not made any adjustments for today's valuations. The actual improvement starting with today's valuations are likely to be less. You can still estimate relative performance when compared to the S&P500 index.
It will be interesting to see how Historical Surviving Withdrawal Rates for Small Cap Value stocks vary with the percentage earnings yield 100E10/P of the S&P500 index.

Oh-oh, here comes that confused feeling again. Was not what you just reported how HSWR for small cap value stocks varvaries with the percentage earnings yield 100E10/P of the S&P500 index? If not, what have you shown here?

Also, what does this statement mean? "Caution: I have not made any adjustments for today's valuations. The actual improvement starting with today's valuations are likely to be less." Isn't the whole purpose of this variable allocation to adjust for today's or any other day's valuation by varying the allocation committed to stocks? So if you haven't adjusted for value, what have you done? How would you propose to adjust for today's valuations?

I don't want to be annoying, but I have a strong sense that there is something here, but it is being said rather inscrutably.

Mac

peteyperson
**** Heavy Hitter
Posts: 525
Joined: Tue Nov 26, 2002 6:46 am

Post by peteyperson » Thu Feb 03, 2005 3:08 am

MacDuff wrote:
JWR1945 wrote:Caution: I have not made any adjustments for today's valuations. The actual improvement starting with today's valuations are likely to be less. You can still estimate relative performance when compared to the S&P500 index.
It will be interesting to see how Historical Surviving Withdrawal Rates for Small Cap Value stocks vary with the percentage earnings yield 100E10/P of the S&P500 index.

Oh-oh, here comes that confused feeling again. Was not what you just reported how HSWR for small cap value stocks varvaries with the percentage earnings yield 100E10/P of the S&P500 index? If not, what have you shown here?

Also, what does this statement mean? "Caution: I have not made any adjustments for today's valuations. The actual improvement starting with today's valuations are likely to be less." Isn't the whole purpose of this variable allocation to adjust for today's or any other day's valuation by varying the allocation committed to stocks? So if you haven't adjusted for value, what have you done? How would you propose to adjust for today's valuations?

I don't want to be annoying, but I have a strong sense that there is something here, but it is being said rather inscrutably.

Mac

Hi MacDuff,

When valuations are high, future expected returns are lower. This is typically because cash dividends as a percentage of the stock price are low. Dividends have historically provided 4.5% of returns, the S&P 500 now offer just 1.7% dividends approx. If valuations are above historical averages, then the market will eventually revert to the mean valuation. This reduces the growth in capital value one will experience, so even if US stock earnings actually grow by 5% as they have historically, you may not see that in market price improvements. Earnings may grow yet the market price multiple of those rising earnings may fall. This is the P/E price to earnings multiple.

See the 70s and 80s - The Tin Decade and The Golden Decade - for example:

Components of Stock Returns 1970s | 1980s
Investment component
Dividend yield 3.4% | 5.2%
Earnings growth 9.9% | 4.4%
Total fundamental return 13.3 | 9.6

Speculative component -7.6 | 7.8

Calculated return 5.7% | 17.4%
Actual market return 5.9% | 17.5%

The speculative component, otherwise known as the P/E compression/expansion, is the change in investors' acceptance of different valuation levels. The price to earnings ratio fell from 15.9x to 7.3x in the 70s as investors' said, "We don't want no stinkin' stocks". In the 80s, starting in 1982, this changed tack and P/Es rose from 7.3x to 15.5x.

When looking at the data therefore, earnings growth was 9.9% in the 1970s partly due to inflation-induced price rises in the good companies were selling, but yet economic success did not translate into stock market success. Conversely, in the 1980s the earnings were half as good and yet the investment returns were better. Reflecting on this Warren Buffett has previously said (I'm paraphrasing) "anyone who thinks that the economy and the stocks market are connected is misinformed".

What John is therefore alluring to is that high market valuations despite respectable earnings growth, can lead to market declines which reduce substantially the nominal returns achievable. This would be the 'speculative component' in the above example. Whilst the safe withdrawal papers written over the past few years do use returns data from all years showing what has happened and what portfolios with what asset mix would have survived & provided x% of withdrawals safely, this excludes specific consideration of valuation levels. The thinking being that this is what actually happened and so consideration of valuation levels is unnecessary. This is true only as far as it goes.

If one had retired in 2000 with the S&P 500 offering just 1.2% cash dividend on your stocks, a historical S&P 500 earnings growth of 5% and very high valuations at P/E 34.. verses historical mean PE of 14.1x.. then your likely returns are 5%+1.2%=6.2% Nominal, less any P/E decline over time to correct the onerous P/E 34 down to something more realistic. A quick calculation tells me that reducing P/E from 34 to 16 over a 20 year period would provide a negative 3.6% for the speculative component (like the 1970s). Thus, +5% Earnings growth plus +1.2% Dividends less -3.6% Speculative component = 2.6% Calculated return over the next 20 years. That is nominal, before investment fees, taxes on dividends and inflation is taken into account. The latest US CPI-U was I believe at least 3% with commodities surging ahead pushing the CPI-U up despite Oil being only a small component of the inflation indicator. So inflation is likely to stay at those levels, if not rise further. So real returns around -0.50% per year for 20 years.

John's point from this data (my numbers but I'm sure his own are much the same) is that it is quite one thing to cite in academic papers what has worked in the past and that is useful, but one has to apply this knowledge to a realistic assessment of whether the future differs from the past. It is also important to note as I've explained in my long post to you elsewhere this morning, that real returns are theoretical anything because it depends what prices one received up the sale of shares to fund living expenses each year. If prices were volatile, then sometimes you'll be selling cheaply and your money will run out faster. Those who retired in 2000 with a $1,000,000 nest egg all invested in the S&P 500 "because stocks can't fail" got caught short because they had no way to realistically value businesses or the markets. It was a lack of knowledge on an entirely predictable sequence of events that hurt people who retired in 2000. Early retirees like raddr at raddr-pages.com where I also post (good bunch of people here and there) are totally out of the S&P 500 index fund because of the numbers above. He knows it won't deliver a reasonable return. He instead placed money into asset classes that looked more positive and has achieved far superior returns to those who held on to the S&P 500. Capital gains issues may prevent one from switching between assets but wide asset class size/style/geography diversification allows for the mitigation of many of the risks that any one asset class with work itself into a position where future expected returns are disastrous. As has happened to the S&P 500 index and the Wilshire 5000.

Petey

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Thu Feb 03, 2005 8:18 am

MacDuff wrote:
JWR1945 wrote:Caution: I have not made any adjustments for today's valuations. The actual improvement starting with today's valuations are likely to be less. You can still estimate relative performance when compared to the S&P500 index.
It will be interesting to see how Historical Surviving Withdrawal Rates for Small Cap Value stocks vary with the percentage earnings yield 100E10/P of the S&P500 index.

Oh-oh, here comes that confused feeling again. Was not what you just reported how HSWR for small cap value stocks varies with the percentage earnings yield 100E10/P of the S&P500 index? If not, what have you shown here?

Also, what does this statement mean? "Caution: I have not made any adjustments for today's valuations. The actual improvement starting with today's valuations are likely to be less." Isn't the whole purpose of this variable allocation to adjust for today's or any other day's valuation by varying the allocation committed to stocks? So if you haven't adjusted for value, what have you done? How would you propose to adjust for today's valuations?

I don't want to be annoying, but I have a strong sense that there is something here, but it is being said rather inscrutably.

Mac

I have not read peteyperson's response carefully yet. But he is on the right track.

My wording is beginning to get better. (See my Sanity Check post about the S&P500 index.) It is far from perfect.

I have shown that the HSWR varies with earnings yield 100E10/P. I have shown that using earnings yield 100E10/P to vary stock allocations improves withdrawal rates substantially.

It is highly significant that P/E10, which is derived from the entire S&P500 index, helps us allocate stocks that constitute only a fraction of the index. We do not have to do a lot of number crunching. We can go to Professor Shiller's website and use his numbers.

I have not shown how much to adjust these numbers when starting from today's valuations. That is, if I had a fixed allocation, the Safe Withdrawal Rate starting today would be less that what has survived in the past. In addition, the improvement would be from something less than 4% to something a lot bigger, but it don't know exactly how much bigger.

Have fun.

John R.

MacDuff
* Rookie
Posts: 31
Joined: Wed Jun 18, 2003 8:20 pm
Location: Centralia, WA

Post by MacDuff » Thu Feb 03, 2005 10:51 am

JWR1945 wrote:It is highly significant that P/E10, which is derived from the entire S&P500 index, helps us allocate stocks that constitute only a fraction of the index. We do not have to do a lot of number crunching. We can go to Professor Shiller's website and use his numbers.

OK, got that .I assumed that was what you were demonstrating here.

JWR1945 wrote:I have not shown how much to adjust these numbers when starting from today's valuations. That is, if I had a fixed allocation, the Safe Withdrawal Rate starting today would be less that what has survived in the past.

Let my check this understanding with you. The fixed or non-switching allocations show no adjustment for S&P 500 levels. This is just the baseline, the system that is being used as a control.

However, by it's very nature, the variable allocation system dynamically adjusts for valuation. For example, at today's level on the S&P, one would assign a 0 allocation to any equity position that you were timing based on the S&P. (ie. equity groups that were highly enough correlated with S&P to use Shiller's existing S&P data.

Is this accurately stated?

Thanks for your response to my other question above.

Mac

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Thu Feb 03, 2005 10:59 am

About my disclaimer (or caution):

I should not have referred to the S&P500 Sanity Check post. I improved my wording with the Large Cap Growth and Small Cap Growth posts:
Large Cap Growth responded well to switching according to the P/E10 of the S&P500. It increased the Historical Surviving Withdrawal Rates at all levels of failure by 1.0% or more.

Caution: I have not made any adjustments for today's valuations. The actual results starting with today's valuations are unlikely to be as good. You can still estimate relative performance when compared to the S&P500 index.
Small Cap Growth responded well to switching according to the P/E10 of the S&P500. It increased the Historical Surviving Withdrawal Rates at all levels of failure by 1.4% to 1.5%.

Caution: I have not made any adjustments for today's valuations. The actual results starting with today's valuations are unlikely to be as good. You can still estimate relative performance when compared to the S&P500 index.
As to the effect of valuations, I have collected data using Small Cap Value and commercial paper in a 50-50 mix. I buried my results in the SCV50 Tables thread dated Mon Jan 31, 2005. See the post at the second link.
http://nofeeboards.com/boards/viewtopic.php?t=3340
http://nofeeboards.com/boards/viewtopic ... 739#p26739
Today's value of 100E10/P is around 3.5%. (P/E10 is around 28 to 29.) Using the 1928-1970 data, the Calculated Rate is 6.08%. Using the 1928-1980 data, the Calculated Rate is 6.07%.

In both cases, according to eyeball estimates, the upper confidence limit is plus 2.0% and the lower limit is minus 1.8%.

These are the rates:
Safe Withdrawal Rate 4.3%
Calculated Rate: 6.1%
High Risk Rate: 8.1%.
My post includes the formula for Calculated Rates versus the percentage earnings yield based on P/E10 (that is, with x = 100/[P/E10] and y = the Calculated Rate). [The Calculated Rate is our best estimate of what the future will record as the 30-year Historical Surviving Withdrawal Rate when today's future becomes tomorrow's history.] Subtract 1.8% to get the lower confidence limit. The result is the Safe Withdrawal Rate as a function of the percentage earnings yield.

When making your plans, you may decide to wait for a more favorable valuation (that is, wait until P/E10 comes back to earth). Depending upon your investment alternatives, it may or may not be worth the wait.

Have fun.

John R.

JWR1945
***** Legend
Posts: 1697
Joined: Tue Nov 26, 2002 3:59 am
Location: Crestview, Florida

Post by JWR1945 » Thu Feb 03, 2005 11:05 am

MacDuff wrote:
JWR1945 wrote:It is highly significant that P/E10, which is derived from the entire S&P500 index, helps us allocate stocks that constitute only a fraction of the index....

Let my check this understanding with you. The fixed or non-switching allocations show no adjustment for S&P 500 levels. This is just the baseline, the system that is being used as a control.

However, by it's very nature, the variable allocation system dynamically adjusts for valuation. For example, at today's level on the S&P, one would assign a 0 allocation to any equity position that you were timing based on the S&P. (ie. equity groups that were highly enough correlated with S&P to use Shiller's existing S&P data.

Is this accurately stated?

Thanks for your response to my other question above.

Mac

Yes. Exactly.

Have fun.

John R.

MacDuff
* Rookie
Posts: 31
Joined: Wed Jun 18, 2003 8:20 pm
Location: Centralia, WA

Post by MacDuff » Thu Feb 03, 2005 11:17 am

JWR 1945,

It will take me a while to work through the stuff you cited in your post above at 10:59, February 3, 2005.

It looks as though all the questions I have been wondering about are probably answered in one or another of these posts.

Thanks for your work and your efforts to make it accessible to me.

Mac

Post Reply