A Story for Accumulators

I collected two sets of data on the Scenario Surfer. They tell a story. Listen closely.

The Data

I dollar cost averaged for 10 years. I started with $1000 and added $1000 each year thereafter. I invested entirely in stocks when P/E10 fell below 20 and entirely in 2% (real interest) TIPS when P/E10 rose above 20.

[Explanatory note: when P/E10=20, the odds of a loss ten years into the future is around 20%. The upside potential has a 20% chance of exceeding 6% (plus inflation).]

I looked at a P/E10=26 Bear Market and a P/E10=8 Normal Market. I took 5 runs at each condition.

Balances are at Year 10. I include fixed stock-TIPS allocations for purposes of comparison.

P/E10=26 Bear Market

Run: 1
Varying allocations: 13407
20% stocks: 12646
50% stocks: 12774
80% stocks: 12615

Run: 2
Varying allocations: 15312
20% stocks: 12512
50% stocks: 12592
80% stocks: 12563

Run: 3
Varying allocations: 13731
20% stocks: 12380
50% stocks: 12298
80% stocks: 12129

Run: 4
Varying allocations: 15131
20% stocks: 12289
50% stocks: 11737
80% stocks: 10741

Run: 5
Varying allocations: 6022
20% stocks: 10992
50% stocks: 8931
80% stocks: 6925

*Run: 5 Year 9
Varying allocations: 11146
20% stocks: 11011
50% stocks: 10784
80% stocks: 10529

P/E10=8 Normal Market

Run: 1
Varying allocations: 21433
20% stocks: 13833
50% stocks: 16341
80% stocks: 19259

Run: 2
Varying allocations: 21906
20% stocks: 13958
50% stocks: 16606
80% stocks: 19643

Run: 3
Varying allocations: 20834
20% stocks: 13768
50% stocks: 16111
80% stocks: 18809

Run: 4
Varying allocations: 25400
20% stocks: 14473
50% stocks: 18066
80% stocks: 22252

Run: 5
Varying allocations: 29646
20% stocks: 14841
50% stocks: 19358
80% stocks: 25063

Observations

It was looking as if varying stock allocations was always the best way to go until run 5 of the P/E10=26 Bear Market. A horrible price drop in Year 10 wiped out a substantial amount of money. There really is such a thing as risk.

In the P/E10=8 Normal Market, my plans to vary allocations ended up with my being 100% in stocks at all times. This was always the best decision. Valuations were so favorable that the right decision was always 100% stocks.

Rule of Thumb

The rule of thumb is that you should think about preserving capital when you have capital to preserve. There is a bitter contrast between Years 9 and 10 of Run 5 in the P/E10=26 Bear Market.

The downside risk showed up at the least opportune time. This is why it pays to vary allocations in accordance with valuations. This is why you should vary allocations in accordance with valuations as soon as you have a big enough nest egg to protect. Downside risk is real. Losses are real.

Have fun.

John Walter Russell
October 19, 2007