More about Imperfect Allocation Switching
Posted: Tue Oct 26, 2004 6:06 am
This extends my investigation into the effects of switching allocations between stocks (i.e., the S&P500 index) and TIPS according to P/E10 (i.e., the current price of the S&P500 index divided by the average of the last ten years of earnings) in a less-than-perfect manner.
These investigations let you know the penalty of buying high and selling low as well as the rewards of investing properly.
This particular investigation shows what can happen in the accumulation stage.
Procedure
I set up my latest Deluxe Calculator V1.1A07 (which is a modified version of the Retire Early Safe Withdrawal Calculator version 1.61 dated November 7, 2002) for switching allocations between stocks and TIPS. I set the expense ratio at 0.00%. I rebalanced all portfolios annually. I selected the CPI for making inflation adjustments.
I made deposits of $1000 per year for 30 years. To do this, I set the initial balance to $1000 and I set the withdrawal rate equal to (100%), which means minus 100%, of the initial balance. I recorded portfolio balances.
I set the P/E10 thresholds to 3-12-20-80. The thresholds of 3 and 80 eliminate the effects of allocations other than the three programmable selections. [The allocation with P/E10 less than 3 was 100%. The allocation with P/E10 greater than 80 was 0%. The software sets both of these extreme conditions. They never occur because P/E10 has always been between 3 and 80 throughout the historical record.]
I collected data for TIPS with interest rates of 0.0%, 2.0% and 4.0%.
Conditions Examined
In this investigation, I set the stock allocation equal to 50% when P/E10 was below 20 and either 100% or 10% when P/E10 was above 20. Both conditions are selected to highlight the effects of emotional decisions on long-term investment results. The first condition shows what happens when an investor is caught up in the euphoria of high stock returns and jumps in when valuations are high. The second condition shows what happens when an investor is reluctant to invest when valuations are high but still wants a little bit of exposure to the market at all times.
P/E10 is not perfect for revealing these effects. The best comparisons would be made strictly on price drops. However, the earnings part of P/E10 varies slowly (since it is the average of the most recent ten years of earnings) while the price component (or index value) is current. If prices drop 25% or 30%, P/E10 will not change by an identical amount but it will come close.
Summary
I have included tables that show real balances at 10, 20 and 30 years in the post that follows this one.
When the TIPS interest rate is 4.0%, the data generally favor keeping stock allocations at 10% when valuations are high.
There are exceptions, however. There are instances that favor 100% stock allocations while prices are continuing to rise. We see the effect of the 1960s in the data. At 10 years, 1955-1956 and 1958-1959 show the effect of rising prices during the late 1960s. At 20 years, we can see the same thing for sequences beginning in 1945-1946 and 1948-1949. At 30 years, we can still see this in 1936 (but not 1935) and 1938-1939.
We see the effect of the recent bubble in the 1966-1972 data at 30 years.
We see similar effects when the TIPS interest rate is 2.0%. There are a few more conditions favoring the 100% stock allocation when P/E10 exceeds 20.
When the interest rate of the TIPS is set to 0.0%, there are numerous conditions favoring the 100% stock allocation.
This is the story behind these numbers. The return of alternative investments must be considered when making comparisons such as these. The data generally favor lowering stock allocations when prices are high (e.g., when P/E10 is greater than 20). But the data will favor the 100% stock allocation if the investment alternative is sufficiently poor.
Have fun.
John R.
These investigations let you know the penalty of buying high and selling low as well as the rewards of investing properly.
This particular investigation shows what can happen in the accumulation stage.
Procedure
I set up my latest Deluxe Calculator V1.1A07 (which is a modified version of the Retire Early Safe Withdrawal Calculator version 1.61 dated November 7, 2002) for switching allocations between stocks and TIPS. I set the expense ratio at 0.00%. I rebalanced all portfolios annually. I selected the CPI for making inflation adjustments.
I made deposits of $1000 per year for 30 years. To do this, I set the initial balance to $1000 and I set the withdrawal rate equal to (100%), which means minus 100%, of the initial balance. I recorded portfolio balances.
I set the P/E10 thresholds to 3-12-20-80. The thresholds of 3 and 80 eliminate the effects of allocations other than the three programmable selections. [The allocation with P/E10 less than 3 was 100%. The allocation with P/E10 greater than 80 was 0%. The software sets both of these extreme conditions. They never occur because P/E10 has always been between 3 and 80 throughout the historical record.]
I collected data for TIPS with interest rates of 0.0%, 2.0% and 4.0%.
Conditions Examined
In this investigation, I set the stock allocation equal to 50% when P/E10 was below 20 and either 100% or 10% when P/E10 was above 20. Both conditions are selected to highlight the effects of emotional decisions on long-term investment results. The first condition shows what happens when an investor is caught up in the euphoria of high stock returns and jumps in when valuations are high. The second condition shows what happens when an investor is reluctant to invest when valuations are high but still wants a little bit of exposure to the market at all times.
P/E10 is not perfect for revealing these effects. The best comparisons would be made strictly on price drops. However, the earnings part of P/E10 varies slowly (since it is the average of the most recent ten years of earnings) while the price component (or index value) is current. If prices drop 25% or 30%, P/E10 will not change by an identical amount but it will come close.
Summary
I have included tables that show real balances at 10, 20 and 30 years in the post that follows this one.
When the TIPS interest rate is 4.0%, the data generally favor keeping stock allocations at 10% when valuations are high.
There are exceptions, however. There are instances that favor 100% stock allocations while prices are continuing to rise. We see the effect of the 1960s in the data. At 10 years, 1955-1956 and 1958-1959 show the effect of rising prices during the late 1960s. At 20 years, we can see the same thing for sequences beginning in 1945-1946 and 1948-1949. At 30 years, we can still see this in 1936 (but not 1935) and 1938-1939.
We see the effect of the recent bubble in the 1966-1972 data at 30 years.
We see similar effects when the TIPS interest rate is 2.0%. There are a few more conditions favoring the 100% stock allocation when P/E10 exceeds 20.
When the interest rate of the TIPS is set to 0.0%, there are numerous conditions favoring the 100% stock allocation.
This is the story behind these numbers. The return of alternative investments must be considered when making comparisons such as these. The data generally favor lowering stock allocations when prices are high (e.g., when P/E10 is greater than 20). But the data will favor the 100% stock allocation if the investment alternative is sufficiently poor.
Have fun.
John R.