Year 10 Choices: Edited

This extends our investigation of intermediate-term timing. I contrast today’s actions, starting from today’s valuations, to those of the not-too-distant future, when valuations will be much more favorable.

Procedure

I have calculated the balances at year 10 of portfolios HSWR80T2, HSWR80T2n, HSWR50T2, HSWR50T2n, HSWR20T2 and HSWR20T2n for historical sequences beginning in 1923-1980. I used withdrawal rates of 3.0% (plus inflation), 4.0% (plus inflation) and 5.0% (plus inflation).

HSWR80T2 consists of 80% stocks (i.e., S&P500) and 20% TIPS at a 2% interest rate. It is rebalanced annually. Expenses are 0.20% of the portfolio's current balance.

HSWR80T2n is the same as HSWR80T2 except that it is not rebalanced. Withdrawals are taken from stocks and TIPS in proportion of their respective balances.

HSWR50T2 is the same as HSWR80T2 except that it has 50% stocks and 50% TIPS.

HSWR50T2n is the same as HSWR50T2 except that it is not rebalanced. Withdrawals are taken from stocks and TIPS in proportion of their respective balances.

HSWR20T2 is the same as HSWR80T2 except that it has 20% stocks and 80% TIPS.

HSWR20T2n is the same as HSWR20T2 except that it is not rebalanced. Withdrawals are taken from stocks and TIPS in proportion of their respective balances.

I used my Deluxe Calculator V1.1A08a. I used Excel plots to determine regression equations (i.e., linear curve fits) of balances versus the percentage earnings yield 100E10/P. I estimated confidence limits (visually) from the graphs.

I have solved the equations at today's earnings yield (of 3.5%, roughly), which is exceedingly high, and at an earnings yield of 10% (P/E10=10.0), which is favorable, but well within the historical range.

Equations

y = the (real) balance at year 10 after starting with $100000 initially.
x = the percentage earnings yield 100E10/P (i.e., 100/[P/E10]).

Comparisons at Year 10

Today's earnings yield is 3.5%.

At a future favorable valuation, the earnings yield might be 10.0% (P/E10=10.0).

Analysis

Different withdrawal rates affect offsets, but not the slopes.

The amount that a portfolio balance varies with valuations depends upon the portfolio allocation, but not the withdrawal rate. The primary influence of valuations is to change the overall return of the stocks.

There is very little difference between rebalancing versus not rebalancing.

Valuations affect the best allocation.

Here are the comparisons at today’s valuations, with rebalancing at a 4.0% withdrawal rate. The earnings yield 100E10/P is 3.5%. The best choice is 20% stocks as opposed to 50% or 80%.

HSWR80T2, Withdrawal Rate = 4.0%, y = 68.1% of the initial balance (from -1.9% to 168.1%).

HSWR50T2, Withdrawal Rate = 4.0%, y = 72.7% of the initial balance (from 32.7% to 132.7%).

HSWR20T2, Withdrawal Rate = 4.0%, y = 75.1% of the initial balance (from 65.1% to 90.1%).

Similarly, here are the comparisons at today’s valuations, without rebalancing at a 4.0% withdrawal rate. The earnings yield 100E10/P is 3.5%. The best choice is 20% stocks as opposed to 50% or 80%.

HSWR80T2n, Withdrawal Rate = 4.0%, y = 66.5% of the initial balance (from -3.5% to 186.5%).

HSWR50T2n, Withdrawal Rate = 4.0%, y = 70.0% of the initial balance (from 30.0% to 150.0%).

HSWR20T2n, Withdrawal Rate = 4.0%, y = 73.3% of the initial balance (from 53.3% to 103.3%).

At today’s valuations, the best choice overall is 20% stocks (as opposed to 50% or 80%) with rebalancing.

Here are the comparisons at a favorable, future valuation, with rebalancing at a 4.0% withdrawal rate. The earnings yield 100E10/P is 10.0%. The best choice is 80% stocks as opposed to 20% or 50%.

HSWR80T2, Withdrawal Rate = 4.0%, y = 166.1% of the initial balance (from 96.1% to 266.1%).

HSWR50T2, Withdrawal Rate = 4.0%, y = 129.0% of the initial balance (from 89.0% to 189.0%).

HSWR20T2, Withdrawal Rate = 4.0%, y = 96.1% of the initial balance (from 86.1% to 111.1%).

Similarly, here are the comparisons at a favorable, future valuation, without rebalancing at a 4.0% withdrawal rate. The earnings yield 100E10/P is 10.0%. The best choice is 80% stocks as opposed to 20% or 50%.

HSWR80T2n, Withdrawal Rate = 4.0%, y = 169.3% of the initial balance (from 99.3% to 289.3%).

HSWR50T2n, Withdrawal Rate = 4.0%, y = 134.0% of the initial balance (from 94.0% to 214.0%).

HSWR20T2n, Withdrawal Rate = 4.0%, y = 99.4% of the initial balance (from 79.4% to 129.4%).

At a favorable, future valuation, the best choice overall is 80% stocks (as opposed to 20% or 50%) without rebalancing.

Summary

At today’s valuations, the best choice overall is 20% stocks (as opposed to 50% or 80%) with rebalancing.

At a favorable, future valuation, the best choice overall is 80% stocks (as opposed to 20% or 50%) without rebalancing.

Valuations dominate everything: all choices, all effects.

NOTE: I have based my choices strictly on expected (average, mean) returns. I have not included the effect of scatter.

Have fun.

John Walter Russell
February 8, 2006