Take 6% with Valuation Informed Indexing

This is what happens at Year 20 if you withdraw 6% of your portfolio’s CURRENT balance each year and adjust allocations according to P/E10.

Conditions

I determined the (real) Year 20 balance after starting with $100000. I examined a portfolio with stocks and TIPS. I varied allocations in accordance with Professor Robert Shiller’s P/E10. The P/E10 thresholds were 10-18-30. The allocations were 100%-80%-20%-0%, respectively. These are optimized for a P/E10=14 Bear Market. The TIPS (real) interest rate was 2%. Each year, I withdrew 6% of the portfolio’s CURRENT balance. I plotted the Year 20 withdrawal amounts (in real dollars) using four year smoothing.

Graph

This picture shows the Year 20 withdrawal amounts (smoothed over four years) versus the initial percentage earnings yield of the S&P500 (100E10/P) starting from 1923-1980.

Observe that the amount withdrawn can fall to very low levels when the starting valuations are high (P/E10=20 or above, 100E10/P=5% or lower). Notice that the amount withdrawn at today’s valuations (P/E10=16 and 100E10/P=6%) generally stays above 4% of the original balance (plus inflation). It almost always does much better.

Observations

My original investigations showed that withdrawing a constant percentage of the portfolio’s CURRENT balance could result in very low income levels at Year 20. [Portfolios did better at other times.] This is only true when starting at times of high valuations. At other times, the strategy can make sense.

More recently, I examined fixed stock allocations of 50% and 80%. Valuation Informed Indexing lifts the Year 20 balance more consistently.

Those who withdraw 6% of their portfolio’s CURRENT balance today can expect to do well. The downside risk is roughly that their income will fall to 4% of the original balance (plus inflation).

Have fun.

John Walter Russell
July 1, 2009