Any Allocation

You can choose any allocation. But you need to match it with an appropriate strategy.

For a Zero Percent Stock Allocation

A TIPS ladder makes a great baseline, even today. You can do even better if you carefully invest in fixed income securities. The key is to reinvest part of your income to compensate for inflation. Consider the traditional 4% withdrawal rate as your minimum.

Use the TIPS Table button on the left. Read If Only 4% and If Only 30 Years for other details.

If Only 4%
If Only 30 Years

For a One Hundred Percent Stock Allocation

A dividend blend approach allows you to invest totally in stocks, even today. You invest in a high yielding portfolio with limited dividend growth and in a lower yielding portfolio with fast dividend growth. You set aside excessive income from the high yielding account during the early years. You use it to fill in the income shortfalls during the intermediate years. Later, the fast growing portfolio takes over and meets your income requirements.

You manage cash flows through the use of an intermediate account such as TIPS or, alternatively, you reinvest surplus funds into your basic portfolios. You never sell any shares for income.

You can use one of my Income Allocators to manage cash flow. I recommend the Simplified Automatic Allocator, at least, at first. I have made them available for free downloads from my Yahoo Briefcase.

Yahoo Briefcase

Steady Intermediate Allocations

A straight income approach relies on high yielding stocks and a junk bond fund. Dividends from some high yielding stocks such as tankers fluctuate considerably. Others simply have little dividend growth. Add special investments such as MLPs (Master Limited Partnerships) and REITS (Real Estate Investment Trusts).

The key is to reinvest part of the proceeds to keep up with inflation. In addition, expect junk bond fund net asset values to decline over time. Adequate reinvestment is key. The magic percentage is around 30%.

Although the allocation is reasonably steady, it should slow drift toward higher overall yields. Historically, this has added to the junk bond holdings.

The experts on this kind of approach post regularly at Morningstar’s Income and Dividend Discussion Board.

Morningstar

Variable Allocations

Valuation Informed Indexing VII adjusts allocations according to valuations. The best measure of valuations that I have found for this purpose is Professor Robert Shiller’s P/E10. Roughly speaking, you keep a minimum stock allocation around 20% to 30%. When P/E10 falls below the danger range (that is, when P/E10 is less than 20), you gradually increase your stock holdings. At typical valuations (P/E10=14), you favor stocks, possibly with a 50% allocation or higher. At favorable valuations, you allocate between 70% and 80% to stocks. At bargain level valuations (P/E10 below 10), you can expect to do very well if you allocate 100% of your funds into stocks.

This works with the S&P500 index and its four components (Large and Small Capitalization, Growth and Value) individually and in combination.

This approach can also work with a reasonably diversified selection of individual stocks. I could name this Valuation Informed Allocation VIA. I will not call it Valuation Informed Stock Allocation.

Although I have developed mechanically defined allocation algorithms (which I refer to as allocation “switching” algorithms), I have found that training does even better. Take advantage of the Scenario Surfer to develop your skills. See the button on the left.

Delayed Purchase

The delayed purchase approach starts out with a TIPS ladder or alternative fixed income holding (such as preferred stocks). You wait until valuations are favorable and then add stocks. You can look for P/E10 levels of 15 or lower to begin your purchases. Or, alternatively, you can focus on dividend yields from high quality dividend paying companies.

I offer this special caution. It is only about 50%-50% likely that P/E10 will fall below 10. Although great bargains may appear, you should purchase some shares earlier so as not to be out of the market entirely. P/E10 levels below 15 are nearly certain to occur within the next ten years. Plan accordingly.

The initial stock allocation with a delayed purchase is zero percent. The final allocation can be 100%.

Mixing Approaches

It is OK to mix approaches. In fact, it makes sense. It reduces your risk.

By mixing approaches, you can adjust your current allocation to any percentage. Keep in mind, though, that there is an appropriate holding for each approach. Approaches and allocations must match.

Have fun.

John Walter Russell
July 17, 2008