Starting at 5% with Risk

This is a variant of Starting at 5%. I changed the tradeoff between risk and reward.

This time, I allocated 50% of the portfolio to a Dividend Blend and the other 50% to a Delayed Purchase.

The First Decade

Once again, I prepare for the possibility that intermediate term timing fails. That is, I allow for the possibility that we really have reached a permanently higher plateau. Valuations continue to stay in record territory (P/E10=20).

I changed to this allocation:

I allocated 50% of the portfolio to the Dividend Blend portfolio, which has a continuing withdrawal rate of 5.5% (plus inflation) at its minimum. [This original Dividend Blend has an allocation of 20% Investment A and 80% Investment B.]

I allocated 50% of the portfolio to a TIPS ladder at 2% (real) interest. For the first decade, I withdrew 4.5% of the original balance (plus inflation).

The combined withdrawal rate was 5.0% (=5.5%*0.5+4.5%*0.5) of the original balance (plus inflation).

If Successful

If prices have fallen, replace the TIPS ladder with a Dividend Blend. Referring to Building On Success, the new Dividend Blend would have a continuing withdrawal rate of 11.18%. [This new Dividend Blend has an allocation of 15% Investment A and 85% Investment B. The change is because of improved yields after the price drop.] The TIPS ladder will still have 73% of its original balance (plus inflation) at Year 10.

This portion of the portfolio has a withdrawal rate of 8.16% (=0.73*11.18%) of the original balance (plus inflation).

Since the special portion was 50% of the original allocation, the new continuing withdrawal rate is 6.8% (=5.5%*0.5+8.16%*0.5) of the original balance (plus inflation).

This is a very nice boost from 6.1% (plus inflation). It is your reward for accepting risk and being patient.

If Not Successful

At this time, I reduced my withdrawals to 4.5% of the Year 10 balance (plus inflation) from TIPS. I can do this for another 30 years (actually 29.6 years) before running out of money. This takes us to Year 40.

The income from the TIPS only portfolio is 3.3% (=4.5%*0.73) of 50% of the original balance (plus inflation).

The Dividend Blend contributes 5.5% of its 50% of the original balance (plus inflation).

Combined, the income from Years 10 through 40 is 4.4% (=3.3%*0.5+5.5%*0.5) of the original balance (plus inflation).

At Year 40, the TIPS portion of the portfolio is depleted.

At Year 40, the Dividend Blend portfolio has a withdrawal rate of 7.965% (plus inflation). It produces a growing income stream equal to 4.0% of the original balance (plus inflation) in Year 40.

Outcomes

If successful, reducing withdrawals to 5.0% of the original balance (plus inflation) results in a continuing withdrawal rate of 6.8% (plus inflation) and growing after year 10. This is a nice boost from 6.1% (plus inflation) that you would have received by assuming that intermediate timing would have worked all along. You get paid for withdrawing only 5.0% during the first decade.

To get this boost, you would have allocated 50% of your portfolio to a Delayed Purchase Dividend Blend.

If intermediate term timing were to fail, you would withdraw 5.0% during the first decade, a minimum of 4.4% for the next 30 years and a minimum of 4.0% after that.

Opinion

I believe that intermediate term timing will work. I believe that the risk is not as bad as I have identified in this study.

Even if intermediate term timing were to fail to produce bargain portfolios along the way, most likely you would have opportunities to begin a second Dividend Blend portfolio under favorable conditions. Today’s P/E10 is close to 30. Is it reasonable to expect valuations to continue above 20 throughout the entire next decade? I think not. Assuming I am right, the starting dividend yields at Year 10 would be 50% higher than they are today. That would bring the overall continuing income stream above 5.5%. In my opinion, that is good enough to justify taking a risk.

Have fun.

John Walter Russell
May 30, 2007