Avoiding Disaster

A retiree should avoid selling stocks. Upgrading his portfolio is an exception.

Failed Strategies

Conventional studies include selling stocks to boost the estimated Safe Withdrawal Rate. The improvement is miniscule. The risk of disaster jumps dramatically. Selling shares when prices are depressed leads to bankruptcy.

Trying to wait out the bad times with a cash buffer is not enough. The bad times can last a decade (e.g., the stagflation era).

Strategies that depend on appreciation are flawed. Such studies ignore valuation. Prices are set by the whims of the market. Today’s prices are twice as high as has been typical, historically.

Winning Strategies

Focusing on dividend income produces a continuing withdrawal rate that keeps up with inflation, although erratically, with a gentle failure mechanism.

Dividends depend on earnings, not the whim of the marketplace. Monitoring the quality of dividends is much easier and much more accurate than predicting prices. Monitor smoothed earnings and earnings growth.

The dividend blend fills this need.

Enhancements

Flawed research has led to a mantra of fixed allocations and rebalancing. Careful investigation shows that there are several ways to measure stock valuations meaningfully: P/E10, Tobin’s q and dividend yield. The key is allowing sufficient time and calculating confidence limits. Even the Safe Withdrawal Rates of conventional strategies jump substantially (from 4% to 5% over 30 years, for example) when valuations are taken into account.

With training, retirees can do even better than the models indicate. The Scenario Surfer will provide that training. In the meantime, readers can download spreadsheet prototypes, my Retirement Trainers, from my Yahoo Briefcase. A 4.5% continuing withdrawal rate that keeps up with inflation is easily within one’s grasp. A 5% continuing withdrawal rate (plus inflation) requires little effort. The key is having a meaningful measure of value. These are for portfolios of the S&P500 index and TIPS.

Yahoo Briefcase

Dividend strategies that take valuations into account can do even better. Exceeding a 5% withdrawal rate that keeps up with inflation is straightforward. Reaching 6% is reasonable. But I urge caution. I recommend limiting withdrawals to 5% (plus inflation) for the first five years just in case there is a hidden flaw in my analysis.

Quality Upgrades

Stocks go in and out of favor. Routinely, some stocks are under priced relative to the market and some are ahead of themselves.

When pursuing a dividend strategy, it makes sense to replace a holding that has gotten far ahead of itself (now having a low dividend yield) with a solid company that pays a higher dividend yield.

This is the right reason to sell shares: to upgrade one’s portfolio to exploit an opportunity, not as a matter of necessity.

Have fun.

John Walter Russell
August 19, 2007