Notes

Updated April 18, 2006.

Great Letters

We continue to get outstanding Letters to the Editor. Mike asked about a recent article. My conclusion: Ben Stein has come up with a winning approach and we can make it even better. Don asked about visual aids and graphs. I provided the links. Bud asked about improving upon P/E10. He suggested exponential smoothing.

Deflation and I-Bonds

I ran across this from the Bureau of Public Debt web site.

Bureau of Public Debt Web Site
Frequently Asked Questions about I Bonds

5. Can I ever lose money in I Bonds?

“No. I Bonds are U.S. Treasury securities backed by the U.S. Government. I Bonds even protect you from the effects of deflation. In the rare event that the CPI-U is negative during a period of deflation and the decline in the CPI-U is greater than the fixed rate, the redemption value of your I Bonds will remain the same until the earnings rate becomes greater than zero.”

My calculators are wrong. In my calculators, I treat I-Bonds similar to TIPS during times of deflation. I placed the guard against losses on the principal component alone, not on the combination of interest plus principal. In fact, I-Bonds are much like savings accounts with variable interest rates. They have NOMINAL balances that never fall. Interest from I-Bonds is reinvested automatically.

TIPS are different. TIPS principal is allowed to fall during times of deflation. There can be an upward readjustment to par at maturity, but not prior to maturity. TIPS coupons are always paid. They are not reinvested. They are based upon the current principal.

Asset Allocation and Long-Term Returns: An Empirical Approach

It makes sense to demand that our models conform to observation. When it comes to investing, there are many elegant mathematical structures that do not.

Here is an outstanding article for those with advanced mathematical training. It addresses some important issues such as overlapping data. The authors are STEPHEN COGGESHALL and GUOWEI WU. Both are from Morgan Stanley.

Asset Allocation and Long-Term Returns: An Empirical Approach
Asset Allocation and Long-Term Returns: An Empirical Approach (Download)

Valuation-Informed Indexing (Lucky 7) Calculators

I am placing a series of simple calculators into my Yahoo Briefcase. I call them Valuation-Informed Indexing (Lucky 7) Calculators. Or Lucky 7 Calculators for short.

Unlike my research calculators, these will be simple to use. In essence, they present the formulas that I have already generated in a more convenient form.

These calculators are small, typically using 20 to 30 KBytes.

I believe that it would be easy to host these calculators at a more convenient location. Unfortunately, doing so is still beyond my software capabilities.

These are the titles of the calculators that I have placed into my Lucky 7 Calculators folder:

1) Balances with 0% TIPS
2) Balances with 1% TIPS
3) Balances with 2% TIPS
4) Dollar Cost Averaging
5) Gummy Slices Stocks
6) Safe Withdrawal Rates
7) Stock Returns
8) TIPS

Yahoo Briefcase

Remember that I have written a NOTE for those who have problems downloading calculators from my Yahoo Briefcase.

Problem Downloading Calculators? NOTE

I developed new formulas for the following calculators:

1) Balances with 0% TIPS
2) Balances with 1% TIPS
3) Balances with 2% TIPS

I have summarized the conditions and equations in Balances with TIPS Calculators.

Balances with TIPS Calculators

I have now added some pictures to my Lucky 7 Calculators folder. They show how real, annualized stock returns vary with P/E10. They are Microsoft Word documents. [Oops! I made an error in my original set of pictures. I corrected them Monday afternoon, March 13, 2006.]

Valuation-Informed Indexing (Lucky 7) SWR Translators

I am placing SWR Translators into my Yahoo Briefcase. I call them Valuation-Informed Indexing (Lucky 7) SWR Translators or Lucky 7 Translators for short. They are easy to use.

SWR Translators are an alternative to Monte Carlo models. You supply an estimate of the real, annualized, total return of your portfolio (not just your stocks).

I have put the following capabilities into my Lucky 7 Translators folder:

1) SWR Translator. It calculates 30-Year Safe Withdrawal Rates and 30-Year Coin Toss Rates (50%-50% Odds) for portfolios HSWR50 and HSWR80.

2) HSWR50T2 SWR Translator. It calculates 30-Year Safe Withdrawal Rates and 30-Year Coin Toss Rates (50%-50% Odds) for portfolio HSWR50T2.

3) Year 10 SWR Translator. This calculates 10-Year Safe Withdrawal Rates and Year 10 Percentage Balances for portfolio HSWR50.

These SWR Translators are small, typically using 20 to 25 KBytes.

Yahoo Briefcase

Remember that I have written a NOTE for those who have problems downloading calculators from my Yahoo Briefcase.

Problem Downloading Calculators? NOTE

Mean Reversion Theory

I have seen many arguments against the notion of Mean Reversion. Most of them fail because words are used too loosely, without definitions. Others fail because they use definitions that are overly restrictive.

Central to the notion of Mean Reversion is the existence of a constraint. Prices cannot rise and fall entirely independent of earnings.

Mean Reversion Theory

Building Blocks

I have posted a lot of articles with lots of numbers. Those numbers are meant to help, to provide assistance, to supply insights. They tell you can do. The let you know what to look for. They do not tell you what you must do.

Lots of details are not found in numbers. Lots of details are unique to your own situation. This article helps you bring everything together.

Building Blocks
Building Blocks: Edited

Two Baselines

Just in case you missed it, I now have two distinct baseline portfolios. The first consists entirely of TIPS. The other consists entirely of High Quality, High Dividend stocks or a low cost equivalent fund such as DVY.

With TIPS, you can withdraw more income. The Government guarantees that your income will keep up with inflation. But eventually you run out of money. You withdraw principal as well as interest. With High Quality, High Dividend stocks, you withdraw only the dividends. You never sell any shares. This will last far into the indefinite future and it will grow. But you start at a much lower percentage. Judging from the S&P500, you face a slight risk that your buying power would temporarily drop up by 10% in times of high inflation.

Start by creating a satisfactory baseline. It can be all-TIPS, all-High Quality, High Dividend Stocks or any combination of the two. Build from there.

Augment your baseline to suit your personality and financial needs. We have numerous approaches. Carefully consider all of the qualifiers. Never feel bound by my assumptions.

Be sure to read my recent overview Building Blocks and/or its edited version Building Blocks: Edited.

Building Blocks
Building Blocks: Edited

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.

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

Extracting Information
Building Blocks
Building Blocks: Edited

What Do I Really Think About Dividends?

Dividends raise today’s Safe Withdrawal Rate to 5.4% (plus inflation) of the portfolio’s initial balance.

Dividends extend the portfolio lifetime indefinitely, well beyond 40 or 50 years.

What Do I Really Think About Dividends?

Allocate 25%

How much should you allocate to hobby stocks?

My answer: 25% of your stocks.

Allocate 25%
Allocate 25%: Addendum

TIPS Yields Are Moving Higher

TIPS at all maturities are yielding 2.3% to 2.4%+ according to Bloomberg.

This is good news. Read the latest Letter to the Editor from Dan.

Bloomberg Interest Rates
March 22, 2006 Letters to the Editor

Adopting a New Approach

You may have found one of my approaches compelling. In my latest, you start with an all-TIPS portfolio. Later, you buy high dividend stocks from high quality companies, but only at reasonable prices.

Here is how you go about adopting one of my approaches.

Adopting a New Approach

What If There Is A Bubble?

Our TIPS/Dividends strategy looks great, starting today. But what if you had selected a dividend-based strategy back in 1995, before the bubble? You might have had to be out of the market for 20 years.

The answer: You would have done exceedingly well. Around 1995, you could have bought TIPS with a 4% (real) interest rate.

What about today? With today’s interest rates? What will happen if you have to wait 20 years before buying stocks?

The answer: You will be sitting pretty.

What If There Is A Bubble?

Volatility and Your Timeframe

I almost glossed over something important when I wrote an addendum to Allocate 25%. It reveals a critical flaw in investment research.

Volatility and Your Timeframe

Oops!

I failed to update the Letters button after February 20, 2006. I have been answering the Letters to the Editor all along. But I have not made them available for display.

March 22, 2006 Letters to the Editor

P/Ex Data

I have calculated values of Professor Shiller’s P/Ex for 1, 5, 15, 20, 25 and 30 years to go along with P/E10. I have put annual data (that is, thinned from monthly data) into my Yahoo Briefcase. Download the file in the PEx versus Dates Folder. It is a Microsoft Word document. It includes several graphs.

Yahoo Briefcase

I intend to create a calculator that allows switching in accordance with P/Ex, where x is no longer limited to 10 years.

Earlier Notes

Here are our earlier Notes.
Notes through August 21, 2005

Be sure to read A Note about Statistics at the bottom of the following link.
Notes through November 29, 2005

This references a couple of MUST READ articles. It has a couple of its own as well.
Notes through January 13, 2006

SWR Success, Dividend-Based Design Example, Top Notch Letters, Historical Perspective: Dividends and Earnings, The Story Behind the Numbers, Individuals Pick Winners, Dollar Cost Averaging Today, More Comments about the February 5, 2006 Letter to the Editor, Diminishing Returns, Bible Study, Problem Downloading Calculators?
Notes Starting from January 14, 2006