Letters to the Editor

From A Novice in Investing

I have read a number of your articles. However, I hope you will forgive the novice status when I say, you are just over my head in your calculations.

I am 63 yrs. old and would like to retire in a couple of years. I will have when I sell my house about one million in cash. I have never been in the stock market. I have just read several books about it though, and considering all of the different approaches, I feel most confident in the "buy low" theory. When I look at PE's now, they are very high and I don't feel comfortable risking my retirement money (and my son's future) on the current market.

I have a compounded problem in that I have a handicapped child (I am alone) that I want to preserve my capital for when I die, so I plan on reducing all my expenditures to live on an income of about $40,000. Social Security will provide $20,000 of that. As inflation will do a number on my current assets that I need for my son, I am faced with needing both growth and income at the same time. Not an easy do, at this time.

I read your analogy of TIPS versus Dividends, but I can't make heads or tails of your numbers. I don't know much about how dividends and TIPs respond when the market evaluation goes up or down. Though I bought a book on Dividends, it did not explain that part of it.

Any help would be appreciated.

This is my response

Congratulations

You have met your savings requirement. I commend you.

You do not have to invest in stocks to reach your goals. For example, if you were able to invest in I Bonds with a 1.0% fixed rate of return (this is added to the inflation adjustment), you could withdraw 1.993% of your initial investment for 70 years before running out of money. Or 2.003% for 69 years. Your one million dollars is enough to return $20K per year (plus inflation) for 69 to 70 years.

Currently, I Bonds provide a fixed rate of 1.2%. At 1.2%, you could withdraw $21.2K (plus inflation) per year for 70 years.
Treasury Direct
Treasury Direct for Individuals
Treasury Direct TIPS
Treasury Direct I Bonds at a Glance

Read my response to Natalie. It has additional links and information on TIPS and I Bonds.
True Buy-and-Hold Investing, TIPS and I Bonds

Establish a baseline first

Then make adjustments.

There are lots of details.

If you have tax sheltered accounts, consider building a TIPS ladder. To make a ladder, you purchase bonds at fixed intervals (usually, one year intervals). When the bond with the shortest maturity is redeemed and you receive your principal back, you reinvest at the longest maturity of the ladder. This way, money is available every year, but all of the bonds are purchased with the interest rate of the longest maturity of the ladder, which is usually the highest interest rate available. For example, a ten-year bond ladder would consist of 10-year bonds coming due in 1 year, 2 years, 3 years and so on through 10 years.

The advantage of a TIPS ladder is that you do not have to sell any bonds into the secondary market. Enough money comes due each year to cover your withdrawals (beyond what you receive from interest), including any draw down of principal.

Be advised that you are limited buying $60000 of I Bonds per social security number (or $120000 for you and your son) per year.

I think that you will be very happy once you have established your baseline. You will have actual numbers instead of vague notions about your retirement income.

Stocks

You have learned the right lessons about stocks. Prices are extremely high. Today's market is dangerous. Growth is NOT guaranteed. There is a good chance of loss during the next two decades.

We can expect valuations (e.g., price to earnings ratios) to drift downward for the next 5 to 20 years.

I have identified two ways of handling the situation:
1) Step aside. Wait for attractive valuations.
2) Follow a dividend-based strategy.

You can combine the two.

I have consistently found it to be worthwhile to wait for valuations to improve.

Many people are uncomfortable with waiting.

If you focus on dividend income, you need not be overly concerned about price fluctuations. Only if you are forced to sell in an emergency might you realize a loss. This gives us an idea of when it makes sense to invest in today's market.

Suppose that you need a 2% return in today's dollars. It would take 7.5 years of 3% inflation to lift your nominal amount to 2.5%. It would take 5.7 years of 4% inflation to lift the nominal amount to 2.5%. It would take 13.7 years of 3% inflation or 10.3 years of 4% inflation for the nominal amount to rise to 3.0%.

[The mathematical equations: 2*1.03^N=2.5 when N=7.5 and 2*1.04^N=2.5 when N=5.7 and 2*1.03^N=3.0 when N=13.7 and 2*1.04^N=3.0 when N=10.3.]

Let me restate this in more meaningful terms:

If you buy a company with a 2.5% dividend yield and if the dividend amount remains constant, you will collect more money than 2% plus inflation throughout the first 5 to 8 years (if inflation is between 3% and 4%). If you buy a company with a 3.0% dividend yield and if the dividend amount remains constant, you will collect more money than 2% plus inflation throughout the first 10 to 14 years (if inflation is between 3% and 4%).

If your company increases its dividend, you will receive more than 2% plus inflation even longer.

Do such stocks exist in today's market?

These are the dividend yields on Mark Hulbert's list of stocks most recently recommended for purchase by 10-year market beaters (in the Hulbert Financial Digest) among newsletters: Citigroup C 3.87%, General Electric GE 2.55%, Hewlitt Packard HPQ 1.13%, Pfizer PFE 2.93% and Merck MRK 5.26%.

Yes. There are attractive stocks with dividend yields above 2.5% even in today's market.

Using history as a guide, you are still better off if you wait for valuations to improve. Dividend yields increase as prices fall. The total return of dividend paying stocks increases even more than the dividend yield.

Watch expenses, especially if you invest in mutual funds. Even a one percent (annual) fee is expensive. It is one-half of a two percent income stream.

Proceed Cautiously

It is your decision as to whether you put any money into stocks. You already have a sufficiently large stream of risk free income within your grasp. However, you mentioned that you plan to cut back. A dividend-based strategy might be appropriate.

Take your time. There is no need to hurry.

History tells us that it is best to wait for favorable valuations. History also tells us that the wait can last as long as twenty years (fifteen years from today). I recommend proceeding cautiously.

I think that there is merit in putting a little bit of money into stocks just to learn what owning stocks is like. It is an unusual experience. Reading is not enough. Prices fluctuate a lot, often by double-digit percentages. Even during an extended bear market, stock prices increase about one-half of the time. Most people react to losses more than gains. Many investors who do well feel miserable.

I think that $10K to $20K is sufficient for learning. I recommend that you keep your exposure to stocks below 10% of your portfolio until you are comfortable with stocks.

Earlier Letters

Historical Index Data
True Buy-and-Hold Investing, TIPS and I Bonds
Letter about You Can’t Count on 7% Articles
Mortgage Backed Securities
P/E10 Graph, Zvi Bodie's Book and more
TIPS and taxable (non-qualified) accounts
SAFE and HAZARDOUS REGIONS
Safe Withdrawal Rates and Historical Surviving Withdrawal Rates

Have fun.

John Walter Russell
September 18, 2005Updated: April 5, 2007