Diversifying Risk

I have developed a variety of worthwhile approaches. You can combine them to diversify risk.

Four Approaches

TIPS Baseline

A TIPS ladder makes an excellent baseline. If you are able to get 2.0% (real) interest, you can withdraw 4.46% of your original principal (plus adjustments to match inflation) for 30 years. Or you can withdraw 4.0% (plus inflation) for 35 years.

This approach comes with a Government guarantee. The drawback is that it consumes capital.

Allocation Shifting (Switching)

You can vary your stock and non-stock holdings in accordance with stock valuations. Stocks can be the S&P500 and/or its major segments. A TIPS ladder makes an excellent choice for the non-stock holding. Professor Robert Shiller’s P/E10 is an excellent measure of valuation for this purpose. The Stock Return Predictor includes the conversion between the current S&P500 index level and P/E10.

The SwOptT algorithm uses P/E10 thresholds of 9-12-21-24 and allocations of 100%-50%-30%-20%-0%. The SwAT algorithm uses P/E10 thresholds of 11-21 and allocations of 75%-40%-25%. For details, see Current Research A and B.

Starting from today’s valuations and using 2% TIPS, switching increases the 30-Year Safe Withdrawal Rate from 3.0% (with 80% stocks) or 3.6% (with 50% stocks) to 4.2% (with SwAT) or 4.3% (with SwOptT). These withdrawal rates are percentages of the original balance. They include adjustments to match inflation.

This offers the risks and rewards of traditional stock and bond portfolios. The SwAT algorithm incorporates Benjamin Graham’s advice to keep both stock and bond allocations between 25% and 75%. This has been found to minimize regret.

Delayed Purchases

This is a form of intermediate term timing based on market valuations. It differs from short term timing, which has a bad reputation.

Today’s market multiples are twice as high as normal. They are four times as high as bargain levels.

You can see this in P/E10 data and dividend yield data (preferably using the average of 5 to 10 years of dividends along with the current price). It is less obvious when using the single year price to earnings ratio. It is readily apparent by the time that you average three years of earnings.

A glance at history suggests that stock prices will return to normal valuations within a decade or so. History tells us that prices do not stop falling once they hit normal levels. Rather, they continue down into the bargain range.

History also tells us that the market can go up substantially from any level in any single year or two years, regardless of valuations. The odds against such occurrences increase, but the possibility remains.

The issue is whether we can exploit such information. The answer is simple: YES.

We have up to twenty years for prices to become attractive. We can draw down a TIPS ladder. If we withdraw 4% of the original principal (plus inflation) from a 2% TIPS ladder, we still have 51% of our original balance at Year 20. We will break even if prices take twenty years before returning to normal. More likely, prices will fall to bargain levels within ten years. If so, we will do exceedingly well. We will still have 75% to 80% of our principal available.

One of the best ways to exploit a delayed purchase is to buy high dividend stocks from high quality (blue chip) companies. Today, such companies pay 3% to 4% (and occasionally more). At typical valuations, these percentages double. At bargain valuations, many high quality companies will yield more than 10%.

The reason for focusing on dividends is that they are steady. Dividends are different from prices. Prices can fluctuate wildly. Dividend amounts vary little.

The primary risk with this approach is that stocks may maintain substantially higher “normal” valuations, looking forward, than they have in the past. There is evidence of a rise in valuations, but it is small: an upward adjustment of 0.7% per year (annualized) to the total return over the course of the twentieth century. Presumably, any future adjustment will be small.

High Income Blend

My latest investigations with the Income Stream Allocator show that specialized, high yielding investments can satisfy retiree needs exceptionally well. The best approach is a combination of one investment with an exceptionally high initial yield (dividends plus return of capital) and another investment with a rapidly increasing payment as well as a high initial yield.

There are three accounts: one for the higher yielding investment, one for the investment with rapidly growing dividends and a third for cash management (possibly using TIPS).

You must make an income projection for planning purposes.

You take excess dividends in the early years to build up the cash management account. You use up the cash management account during the middle years, filling in the shortfall in the income stream. In the later years, the income from the rapid dividend grower meets your needs.

Suitable investments with exceptionally high initial yield include ADVDX, many Master Limited Partnerships and some REITS.

Withdrawal rates can be 5.8% (plus inflation) and higher ASSUMING that we can characterize these investments properly.

This is a relatively unexplored area. There are hazards. I recommend that readers consult Morningstar’s Income & Dividend Investing discussion board, the Morningstar Dividend Investor newsletter (by Josh Peters) and “Yes, You Can Be a Successful Income Investor!” (by Ben Stein and Phil DeMuth).

For those desiring more safety, this approach applies to traditional dividend stocks as well. Combine a very high initial yield dividend payer from a quality company with a company featuring fast dividend growth. Be careful regarding dividend growth. It can take a lot of growth to reach a reasonable dividend amount (yield in terms of the original cost). Be sure to start with a reasonable yield, perhaps 3% minimum.

Reaching 5% is Easy

The first two approaches deliver 30-Year Safe Withdrawal Rates in excess of 4% of your original balance (plus inflation). The later two approaches deliver continuing Safe Withdrawal Rates of 5% to 6%. Finding a satisfactory mixture that delivers 5% of the original balance (plus inflation) is straightforward.

What is better is that the first three approaches start out with 100% TIPS allocations (or an 80% TIPS allocation) because of today’s high valuations. You can take your time. You can delay some of your decisions until the market is more attractive.

Each approach has its own set of assumptions. Each has its own failure mechanisms. By combining all four, you reduce your overall risk.

Have fun.

John Walter Russell
March 13, 2007