Bad Advice

Retirees beware. What sounds sophisticated is no more than bad advice.

Allocations

How often have you been told to set a fixed stock-bond allocation according to your risk tolerance? And then to maintain it through rebalancing?

Maintaining a fixed allocation is a horrible choice. You should vary your allocation according to valuations. You need to maintain a steady amount of risk, not a steady stock percentage.

My investigations into Safe Withdrawal Rates using the historical sequence method showed that rebalancing drags down performance. Varying allocations adds about 1% to the 30-year Safe Withdrawal Rate. Today, this lifts the rate from just below 4% to 5% of the original balance (plus inflation).

You can see this for yourself. Press the Year 30 SWR button and compare various fixed stock allocations with Switching A and Switching B. Those algorithms came from my earliest Current Research projects. Use P/E10=22 or 23. You can learn how to do even better by training yourself on the Scenario Surfer.

4% Withdrawal Rate

How often have you read that 4% is the 30-year Safe Withdrawal Rate? And that it has been tested through all kinds of markets?

Today, 4% happens to be close to the 30-year Safe Withdrawal Rate with a 50%-50% stock-TIPS allocation. It was not so during the Year 2000 stock market peak. Back then, it was 2.0%. When valuations are especially favorable, the Safe Withdrawal Rate can be 9% or even higher.

You can check this out. Press the Year 30 SWR button and read the default values for P/E10=44 and P/E10=8.

It is true that a rate close to 4% would have survived the most stressful conditions experienced in the past. But that corresponds to two or three data points. When you bring valuations into a study, you can see the effect of all of the data. You will find that the previous outcomes, although bad, were not the statistically worst case outcomes. The reason has to do with the order of returns. Previous sequences have not combined high valuations with an especially bad ordering.

Share Repurchases

Share repurchases are a bad idea. They reward the wrong people, those who sell the company instead of those who maintain ownership. Dividends and/or special dividends are much, much better.

Share repurchases allow management to side step the “Al Gore Millionaire’s Tax.” Management is rewarded through options. Share repurchases give those options value.

The rhetoric is that share repurchases allow investors to avoid the immediate taxation of dividends. The rhetoric is sometimes stated that management purchases shares when the stock price is undervalued. With today’s sky high valuations, it is hard to see how the currency of that claim, but it must work. Management still makes it.

Dividends are what retirees need. Not capital appreciation. Share repurchases come at the expense of retirees.

Retirees need a steadily increasing income stream. Dividends can do this. They are closely related to earnings, especially earnings that are smoothed over several years. Capital appreciation does not do this. Prices fluctuate at the whim of investors. At any moment, prices are only loosely related to earnings.

Timing

Short term timing is difficult, at best. Longer term timing is not. You should adjust your strategy. Take advantage of what is likely during the next decade or two. Right now, the past is telling you to be cautious. Stocks may go up, but they are much more likely to underperform.

Press the “Stock Returns” button on the left. You can see how returns vary with valuations. Even better, you can see the odds. You can know what is reasonable, based upon stable relationships of the past.

When preparing a strategy, make sure that you will do well even if everything goes against you. The good news: between preferred stock and TIPS, you can do OK for up to 20 years while waiting for favorable stock prices. That is long enough.

Misquotes

Too often, I read quotes from past experts misapplied, turned upside down. Benjamin Graham warned against timing, as such. Yet, he varied allocations according to valuations. Sir John Templeton cautioned against “it is different this time.” He was a value investor who cut back on stocks when prices were high. Yet, I have seen his words repeatedly turned on end. I have seen it argued that failing to invest heavily in stocks is the same as saying that “it is different this time.”

Dividends

Dividend income is far safer than relying on capital appreciation. Prices fluctuate at the whim of the public as well as with earnings. Dividends depend almost exclusively on earnings.

Analyzing dividend strategies is harder than analyzing capital appreciation strategies since a dividend equivalent of the S&P500 does not exist. One must make reasonable approximations. Based on the S&P500 data, nominal dividend behavior is reasonably stable. Based on S&P500 dividend behavior, real dividends could decline as much as 25% under worst case conditions (hyperinflation).

Dividends do get cut at times, but not nearly as bad as prices fall. Based on S&P500 data, a reasonable amount of diversification would protect against bad outcomes. More important, a degree of diversification helps protect against fraud.

It will be interesting to see how the dividend payout from DVY continues with time. It was heavily weighted toward financials (about 40%). Its payout has been increasing faster than trend. DVY will give us insight as to what can happen with dividend cuts and a dividend oriented investment.

Have fun.

John Walter Russell
August 5, 2008