Extracting Information

I go into the details when I calculate numbers. This is never enough. I search for insights that will stand even if everything else fails.

At another level, I seek information that will help you. I do not try to put everything into a single, detailed, step-by-step procedure. I doubt that many would use such a procedure. I prefer to supply useful information. You can draw on it when appropriate. Consider, as an example, my all-TIPS baseline. Two years ago, very few people would even consider it. One year ago, many people complained even if I mentioned it away from this site. Today, most people accept it as a solid baseline. Few want to end up with an all-TIPS portfolio. But many see its value as a starting point.

The discussion at the end of Building Blocks supplies an example of what I am trying to achieve.

Building Blocks

The Strategy

I identify two baseline portfolios. The first is a TIPS ladder. The other consists of high dividend stocks from high quality companies.

Assuming that TIPS interest rates remain close to 2.0%, a TIPS ladder would supply an income of 4.0% (plus inflation) for 35 years before running out of money. With a TIPS ladder, you make your withdrawals from TIPS that mature. You reinvest what remains at the longest maturity of the ladder.

The high dividend, high quality stock portfolio should be able to supply an income of 2.9% based on DVY (an exchange traded fund).

The TIPS ladder produces a higher income, but only for a limited amount of time. This income matches inflation. The dividend portfolio produces less income at first, but it lasts for a long time (indefinitely) and it grows. The income may fall 10% behind inflation momentarily, but it will recover fully and continue to grow.

Here is the strategy. First, you construct a retirement portfolio from these baselines. It must satisfy your own personality and your individual needs. Later, you divert reinvestment money from maturing TIPS into your dividend portfolio when yields are attractive.

The worst case outcome is that you never add to your dividend portfolio. This is not bad, in view of how well the TIPS ladder performs by itself.

Features

Notice that I have stripped the analysis details from my strategy. You do not have to agree with me about any of my predictions except that dividends are likely to rise in the future. You can use your own method to evaluate the quality of dividends. You are in an attractive position even if I am wrong on every detail.

Hidden Details

My analysis shows that stock prices are still excessive. Based on Professor Robert Shiller’s measure of valuation P/E10, today’s valuations are almost identical to those just before the Great Depression and higher than those of the worst time financially for starting retirement, the late 1960s.

In addition, I have found that P/E10 does the best job when calculating Safe Withdrawal Rates. It does better than the standard, single-year P/E. It does better than Tobin’s Q, an advanced form of the price to book ratio. It does better than initial dividend yields.

It also makes sense. Looking closely at the data, I found that using P/E10 avoids the problem of dividend cuts. When dividend yields are higher than earnings yield (100/[P/E10]), dividend cuts are likely. Similarly, when dividend yields are low as compared to the earnings yield, as they are today, dividends are secure. They are likely to grow faster than inflation. Theory tells us to look at dividends and dividend growth. P/E10 tells us a lot about the quality of dividends.

In my detailed analysis, the Dividend-Based Design Outline, I showed that it is safe to withdraw 4.8% (plus inflation) if you start today entirely in TIPS.

Dividend-Based Design Outline

Even if I have made a serious mistake, I have still provided a usable strategy. It should last far into the indefinite future. If you limit withdrawals to 4.0% (plus inflation) in the early years, your income stream is guaranteed to last 35 years. If you disagree on any of my details, make your own adjustments. Make your own assessment of the quality of dividends.

[You can calculate the adjustments if TIPS fail to yield 2.0%. Refer to the Letters to the Editor, Updated: October 15, 2005.]

I Bonds versus TIPS

Have fun.

John Walter Russell
March 26, 2006