SWR Success

We have successfully brought the Safe Withdrawal Rate (SWR) up to the long-term return of stocks, based on today’s valuations.

Using John Bogle’s variant of the Gordon equation (or dividend discount model), the total return of stocks equals the investment return plus the speculative return. The investment return equals the sum of the dividend yield and the percentage growth of earnings or dividends. The speculative return is an adjustment for changes in valuations (e.g., P/E10). In the very long-term, the speculative return becomes a smaller and smaller percentage.

Gordon Model Summary

The total return of stocks in the very long-term is 6.8% (plus inflation). Today’s valuations, as measured by P/E10, are twice the historically typical level of 14 to 15. Converting today’s P/E10 into an annualized return, we take the Nth root of 2 as the adjustment factor, where N is the number of years that it takes to restore P/E10 to its long-term level.

[With a 6.8% real, annualized, total return, in the very long-term stocks multiply an initial balance by 1.068^N. In addition, 1.068^N = 2*(1+today’s rate)^N. This means that (1+today’s rate) = (1.068)/(Nth root of 2). When N equals 10, the Nth root of 2 is 1.0718. When N equals 20, the Nth root of 2 is 1.0353. When N equals 30, the Nth root of 2 equals 1.0234. When N equals 40, the Nth root of 2 equals 1.0175.]

We have brought the Safe Withdrawal Rate up to 4.8% (plus inflation) with a time period extending well into the future.

Dividend Sound Bite
Dividend-Based Design Outline

The formula calls for us to scale our 4.8% Safe Withdrawal Rate by the Nth root of 2. When N equals 30, the product equals 1.0725 (and an annualized return of 7.25%). That is, 1.048*1.0234 = 1.0725. When N equals 40, the product equals 1.0663 (and an annualized return of 6.63%). That is, 1.048*1.0175 = 1.0663.

In view of today’s high prices, our income stream is much higher than we would calculate until almost 40 years.

Stock prices fluctuate, but because we never sell any shares, we can expect to recover any losses in principal.

We have captured today’s long-term return of the stock market.

Have fun.

John Walter Russell
February 6, 2006