Notes starting from January 1, 2009

Updated: January 21, 2009.

Manage Risk, Don't Tolerate It

One of the great fallacies of the day is that investors must tolerate risk. Much ado is made about risk tolerance. That is exactly the wrong thing to do.

Built into this are the false assumptions behind the Efficient Market Hypothesis and its derivatives. Ignored are the advances of Professor Robert Shiller and other researchers. They have shown that you really can measure and control risk.

We have advanced the theory. We have provided the tools that you need in order to control your own risk exposure, making sure that you never accept a risk without adequate compensation. Use the Stock Returns Predictor. Find out about fixed allocation Safe Withdrawal Rates with the Year 30 SWR and the Year 15 SWR Retirement Risk Evaluators. Then practice on the Scenario Surfer. You will soon learn how to do much better, varying allocations in accordance with valuations.

Income or Total Return?

Retirees need both income and total return. They need income for day to day needs. They need total return for major expenses.

The two concepts are related, but distinct. Selling stock at distressed prices leads to bankruptcy. Price volatility is high. Relying on dividends for income is much better. Dividends get cut now and then, but not often. Prices drops are much worse. You must avoid selling at unfavorable prices to avoid disaster.

Professor Robert Shiller’s P/E10 as well as the dividend yield equivalent and Tobin’s q provide reliable measures of valuation over the medium to long term. They allow you to avoid price shocks. They let you know the reasonable range of outcomes ten or twenty years into the future. They get you to reduce your stock allocation when valuations are sky high. You will not be caught in another October 2008 stock market meltdown.

A key to income and dividend investing is to reinvest a portion of your income if it does not grow enough on its own. Your portfolio balance will grow.

The growth of dividends is another key to growing your portfolio balance. If your holdings grow their dividends, prices follow with time. The price to dividends ratio, which is 1/dividend yield, becomes compelling. This attracts new investors.

Pay attention to valuations. They are much better today than they were a year ago. Today’s prices are fair. But price drops typically overshoot. They fall below fair value. Do not act abruptly. Ease into larger stock allocations.

Black Swan Events

I posted this at the Morningstar Income & Dividend Investing discussion board.

Black Swan Events are those that happen infrequently. They are in the tails of probability distributions. The central portion of a probability distribution may be treated as Gaussian (normal, bell shaped curve). Rare events cannot.

Too often, people mention Black Swan Events when talking about common occurrences.

You must assess risk associated with the tails of probability distributions separately, not relying on the details of probability distributions.

I usually identify the chance of being surprised as 5% to 10%, no matter how good the analysis.

There was a Black Swan Event in the second half of the 20th century. It was the run up in the late 1990s. Everything else has been within the standard range of outcomes.

Notice that a Black Swan Event does not always mean a drop in prices. It can work either way.

The October 2008 meltdown was well within the historical range. It was not a Black Swan Event.

The Hidden Flaw

The true measure of risk is the hidden flaw. We see this all the time.

The hidden flaw of traditional Safe Withdrawal Rate studies was to avoid the issue of Valuations. This was made worse by presenting data without a proper presentation of statistics.

Nothing in the October 2008 stock market meltdown was outside of the historical range. The exact timing was unique. The precipitating events were unique. But the overall result was clearly within expectations. My readers were well prepared. They are poised to benefit greatly.

Always look for a hidden flaw. Look beyond probability and statistics. Look for failure mechanisms.

The Reality Checker

The Reality Checker is looking great. We should be able to get it online before too long.

In the meantime, I am learning that a very high stock allocation is best for today. It should not be 100%. The market is more likely to go down before it goes up. Opportunities are likely to get even better. A little cash on the sidelines will help a lot.

If you sell stocks for income, be cautious about withdrawals. We need to hit a turning point, something that I find almost impossible to identify before the fact. The alternative is to rely on dividends. Dividend strategies are sound, even today. Even then, a little patience can pay off handsomely.

January 2009 Stock Allocations

P/E10 has fallen back into the normal range. This is a time for high stock allocations.

January 2009 Stock Allocations

Latching in a Gain

I used the Scenario Surfer to examine latching in a gain for the January 2009 stock market.

Latching in a Gain

Caution in January 2009

My latest two research articles into traditional retirement withdrawal strategies suggest a high stock allocation. I advise caution. My studies show little downside sensitivity at stock allocations of 50% and more. Just keep them high.

The story need not be complex. Maintain a medium stock allocation of 50% to 60% until P/E10 falls below 10. If you are willing to take more risk, you might wait for P/E10 to fall to 8. Then switch over to 100% stocks.

This allows you to out wait the worst of the Bear Market if it occurs. It gives you a real boost if prices continue to fall. It does little harm if it does not.

Income and dividend investors will do well to wait for better prices as well. Today’s dividends are juicy. Even then, history tells us that they could be a whole lot better.

Allow P/E10 to fall to 10 before committing your last investment dollar to stocks.

A Dividend Advantage

If you look at our retirement practice portfolio (equal portions of Exchange Traded index Funds DVY and PFF) on the Simplified Automatic Allocator, you will find that you can continually withdraw 8% of your original balance (with an inflation adjustment of 3% per year). Could this be wrong? If so, it is because Yahoo Finance is reporting too high an interest rate for PFF, which consists of preferred stock (at zero income growth). If the rate really is 11.5%, then 8% is in the bag. If the interest rate were only 8%, then the withdrawal rate would be 6.7%. The downside risk is hyper-inflation, which could reduce the buying power by 25% temporarily—down to 5%.

Both numbers are much, much better than relying on the traditional S&P500-TIPS combination, which provides a 30-year Safe Withdrawal Rate close to 5% in today’s market through the sale of stocks.

The Wrong Portfolio

The old Safe Withdrawal Rate studies broke new ground. They showed that retirees could not depend on withdrawing 7% (plus inflation). The villain was selling stocks when prices were low. You sell too many shares. Your portfolio will not survive.

Having learned this vital bit of information, the experts promptly stopped learning, except minimally and around the edges.

They did not even introduce valuations.

The portfolio consisted of the S&P500 index and a fixed income investment. This is not what traditional retirees invested in. Traditional retirees invested for income. The S&P500 is not income portfolio. It is a growth portfolio.

Today, looking at the right kind of portfolio, we can talk about a continuing withdrawal rate of 8% of the original balance along with an increase of 3% per year to cope with inflation. Worst case, assuming that inflation gets out of hand, the buying power should still be 6% of the original balance (plus inflation). It should return to 8% within a few years.

Preliminary Stock Allocations

From the Reality Checker prototype, here are today’s stock allocations for an S&P500-2% TIPS portfolio:

When P/E10 is below 8, allocate 100% to stocks. When P/E10 is between 8 and 10, allocate 80% to stocks. When P/E10 is between 10 and 18, as it is today, allocate 60% to stocks. When P/E10 is above 18, allocate 20% to stocks.

These allocations allow you to withdraw 5.2% of today’s balance (plus inflation) safely for 30 years. This assumes a long lasting (secular) Bear Market. In a Normal Market, the withdrawal rate would be 5.7%.

For the latest:

January 14, 2009 Letters to the Editor

Idiot Switching in Today’s Market

This is the latest from my checkout of the Reality Checker prototype.

Idiot Switching is where you invest 100% or 0% into stocks. The alternative to stocks is 2% TIPS. You set a single threshold. In this market, P/E10=13 is the best choice.

It turns out that Idiot Switching makes sense in today’s market (P/E10=14 Bear Market).

For those using dollar cost average: it does better than 100% stocks during accumulation.

For retirees: it provides a 4.6% 30-year Safe Withdrawal Rate.

I do not recommend Idiot Switching. Alternatives are better. Still, many people insist on characterizing any kind of allocation shifting in terms of all or none. Valuation based long term timing works even then.

Determining Today’s P/E10

I am often asked how to determine P/E10.

Use my Stock Returns Predictor (see button on the left side). I keep it updated. Enter various values of P/E10, press calculate and then read the corresponding S&P500 index levels. This is a little bit awkward, but it does the job.

Rob Bennett and I use the same calculator. He owns the PassionSaving.com web site and “A Rich Life blog.”

Rob Bennett’s Web Site
Rob Bennett’s Blog

Professor Robert Shiller’s S&P500 online data is the original source for P/E10 calculations. Professor Shiller updates his data once or twice a year.

Professor Shiller’s Web Site

The relationship between P/E10 and the S&P500 index level (price) drifts slowly with time because of the growth of the S&P500’s smoothed earnings (E10).

Sensitivity Studies and the Reality Checker

Here is an example that uses the Reality Checker prototype. It drives home a key point. Use a sensitivity study to help you interpret results.

Sensitivity Studies and the Reality Checker
Sensitivity Studies and the Reality Checker Addendum

Comfortable with $300K

Has your nest egg fallen in half, from $600K to $300K? Even if so, you will be able to retire in comfort. Depending upon your situation, this could be today or it might take a decade, but not longer.

Comfortable with $300K

Notes Index starting from November 23, 2007