Notes starting from January 22, 2008

Updated: February 25, 2008.

Approaching Retirement

You are approaching retirement. You haven't thought through your finances. What should you do?

Approaching Retirement

Regarding Monthly Data

At times, I have mentioned that using monthly data hides the effect of valuations. More specifically, it is the use of a short amount of monthly data that causes the problem. Five years of monthly data does not tell the same story as 60 years of annual returns.

I have encountered eloquent, sophisticated algorithms such as bootstrapping that extend a short sequence of returns far into the future. They truly are marvelous. Yet, somewhere, buried within the details of the historical record, is information that such approaches suppress. At some level, a critical approximation or a subtle assumption fails. What happens over periods of a decade or more eludes data analysis based on a handful of years.

Dividend Disaster

You rely on dividends in retirement. Everything goes wrong. How bad might it be?

Dividend Disaster

Dividend Cuts

So far, dividend cuts have been limited to the financial sector. It seems as if one half of the bigger institutions are going to cut dividends by 50%. This translates to a 25% overall cut for those with wide diversification.

This is consistent with what we have seen in the broader market since 1950. The worst case outcome was a 25% reduction in buying power, followed by dividend growth. This is a much, much better outcome than those following capital appreciation strategies. They face the danger of bankruptcy when they have to sell shares at depressed prices.

How Far We Have Come!

It is amazing to see how far we have come.

I just re-read the article “Dividends and Constant Terminal Value Rates” dated May 11, 2006. Among the final paragraphs:

“The issue is whether it makes sense to sell stocks to make up the S&P500’s income deficit (its dividend is less than 2%). Assuming a fixed stock allocation and today’s valuations, selling stocks introduces an unnecessary risk. Dividends alone can match the coin toss (50%-50% odds) constant terminal value rate associated with the S&P500. There is no need to introduce any element of risk. The S&P500 fixed allocation Safe Withdrawal Rate is 2.41%.”

Look at those numbers. We can do much, much better. With a dividend blend, you can safely withdraw 5%+ of your original balance (with increases to match inflation) far into the indefinite future. It is a matter of managing cash flows.

Dividends and Constant Terminal Value Rates

Worth Repeating

Here is another winner from the past, dated September 24, 2006.

The Wrong Lessons

Assertion: Valuations are Meaningless
Assertion: Monte Carlo Models Are Right (TIPS Volatility)
Assertion: Investment Workarounds Are Simple
Assertion: Short Histories are Sufficient

The Wrong Lessons

Index Fallacy

From the past: indexes do NOT deliver average returns. Nor should retirees want average returns.

Capitalization Weighting of What?

Not There Yet, Today

Prices are falling. Before long, we can expect P/E10 to fall to 20. Can we withdraw 6% (plus inflation)?

No. We are not there yet. Not using a traditional approach.

Not There Yet, Today

Is the Stock Market a Closed System?

See the January 16, 2008 Letters to the Editor.

January 16, 2008 Letters to the Editor

Failure Mechanism

The Gordon Equation (and other forms of the Dividend Discount Model) helps explain why stock prices will decline over the next few years (after adjusting for inflation).

Total Return = Investment Return + Speculative Return

The Investment Return is tied to the economy and smoothed earnings. It is relatively stable, especially when measured over a number of years. The Speculative Return of stocks depends on multiples such as the price to earnings ratio P/E or the price to dividends ratio (1/dividend yield). It fluctuates a lot.

The Investment Return = initial dividend yield (percentage) + dividend growth rate (the increase in the dividend amount per year as a percentage).

The Speculative Return = the final P/E ratio divided by the initial P/E ratio converted to an annualized percentage. For most accurate results, use smoothed earnings (e.g., use Professor Robert Shiller’s P/E10).

When the initial P/E ratio is high, as it is today, the Speculative Return over a period of years is less than one. The Speculative Return drags down the total return.

A long period of subpar returns causes investors to look elsewhere. This causes stocks to fall below fair value. They fall to bargain levels. They fall so far that it pays to wait on the sidelines, preserving capital.

6% is NOT Normal

There are times when you can withdraw 6% of your original balance (plus adjustments to match inflation) safely using a traditional approach. Such times are unusual.

Read the related letter about The Trouble with "Mechanically Defined Algorithms" as well.

6% is NOT Normal
January 16, 2008 Letters to the Editor

Full Circle

Early in my career I learned that older people were more interested in dividends and income streams than capital appreciation and total return. I did not understand why. Now I do.

Selling shares when prices are down can lead to bankruptcy. Living off dividends and interest will not.

The mathematics is different when you make withdrawals.

Combine this with the poor outlook for stocks during the next decade. [Refer to the Stock Returns Predictor.] The old timers got it right. The outlook for dividends is consistent growth, usually faster than inflation, with an occasional glitch along the way. Today’s outlook for capital appreciation is poor, possibly with a long lasting sharp drop or a prolonged sideways market until earnings catch up. Focusing on dividends and safety is the winning combination.

Dividend Growth Versus Inflation

Dividends generally grow faster than inflation, especially when the payout ratio is low. There are exceptions. Regarding the S&P500 index:

“Any failure to maintain at least a 1% [real] dividend growth rate would be by discretion, not necessity. We have already seen such a choice. The 5-year growth rates after 1998 and 2000 came about because of sharp earnings shortfalls (about 50%) seen in the (January) 2002 and (January) 2003 data. Yet, the single-year payout ratio never exceeded 57% in 2002 and 2003.”

Subdued Dividend Growth
Edited: Subdued Dividend Growth

Almost 5%

I made another attempt to reach a 30-year safe withdrawal rate of 5% (plus inflation) using a liquidation strategy. It came close.

In contrast, a Dividend Blend easily reaches a continuing withdrawal rate above 5% (plus inflation).

Almost 5%

Delayed Purchase Withdrawals

Close examination of Almost 5% data directs our attention to the waiting period as valuations return to normal. We must prepare for an extended period to assure safety.

Delayed Purchase Withdrawals
February 12, 2008 Letters to the Editor

Continue to Shun Rebalancing

I have added a paragraph to Current Research K, regarding dividends and rebalancing. My message: continue to Shun Rebalancing.

Current Research K: Dividend Slices
Shun Rebalancing

Notes Index Starting from November 23, 2007