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How to Make Switching Work

 
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JWR1945
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Joined: 26 Nov 2002
Posts: 1697
Location: Crestview, Florida

PostPosted: Sun Aug 17, 2003 10:20 am    Post subject: How to Make Switching Work Reply with quote

I have tried continually to make switching work and I have been continually frustrated: until now. By switching, I am referring to shifting allocations based upon some measure of value such as P/E10. Repeated attempts, most often reported by BenSolar, have shown very little improvement in the Historical Database Rate. I was making another attempt, this time based upon TIPS (Treasury Inflation Protected Securities), when I figured out what we have been doing wrong. I know why we have failed in the past.

I was using a Safe Withdrawal Rate switching threshold. I had just failed to make 2.8% (yield to maturity) long-term TIPS improve the Historical Database Rates via switching when it occurred to me that the worst case dividend yield in the relevant period was 3%. That's right. My alternative investment did not produce as much interest as stocks provided from dividends alone.

In the past, whenever we have attempted dynamic allocation (i.e., shifting allocations), we have replaced stocks with investments that return less than the dividend yield of the stocks. For stocks to succeed and for our attempts to fail, it has been sufficient for stocks to regain their initial prices within the life spans of the portfolios that we are examining. Usually, that means 30 years or more. Failure has been guaranteed. To the extent that stocks yield more than our substitute investments, we will still fail even when stocks decline somewhat.

Making Use of the Historical Database

The Historical Database relates to stock investments that are no longer available. Until recently, stocks in the S&P 500 have yielded at least 3% and, often, much more. Our tools for examining the Historical Database are limited in how they treat investments other than stocks. The alternatives are treated strictly as short-term trading vehicles with a turnover no longer than one year. As such, we cannot use our tools directly to handle more reasonable strategies such as holding on to a long-term bond (at a favorable rate) until stocks become attractive. As far as our tools are concerned, any long-term bond vanishes forever after a single year.

We are limited in what we can do to introduce realism into Historical Sequence calculators. Today's Safe Withdrawal Rates are certainly less than in the past because dividend yields are down substantially. Dividend yields have provided a floor that has supported the safety of withdrawals. That support is no longer available. A direct comparison with Historical Database Rates is highly misleading.

What I am now doing is looking at historical parallels with today with differences clearly identified. In all cases I am looking for cause and effect relationships to support conclusions. More so now than in the past, the kinds of errors associated with any prediction are clearly visible.

Here is my Historical Parallel

I am interested in using today's TIPS to ride out the market until stocks become attractive once again. Today's TIPS yield 2.8% or so to maturity (maximum) and they last just under 30 years. Today's stocks provide a very low interest rate, roughly 1% less than today's TIPS.

My parallel is to use 4.1% 30-year TIPS when looking at the historical database. That is close to 1% more than stocks returned during the historical period.

Both 4.1% TIPS and stocks consistently yielding 3% and more have occurred in the past. Neither is outside the range of possibilities. Neither exists today.

Notionally, if 4.1% TIPS plus switching could have produced a 5% safe Historical Database Rate that lasted 50 years or more, then today's 2.8% TIPS can reasonably be expected to produce a 4% Safe Withdrawal Rate at similar levels of safety over a similar time period. (Although the Historical Database Rate is reported to be something very close to 100%, the actual level of safety is limited by a variety of factors, including many that apply most of the time.)

Notice that I have phrased the problem in terms that are both meaningful and solvable. For example, the 4.1% 30-year TIPS of the past would have had a 5% Safe Withdrawal Rate over 43 years assuming that they could be replenished. That is highly unlikely. But there would still have been up to 30 years before having to make an allocation shift. Similarly, it may or may not be possible to replace today's 2.8% TIPS in the future. However, there will be a long time before it is necessary to replace them.

Test Conditions

I identified all of the years with Safe Withdrawal Rates less than 6.0% from my previous post From Intrinsic Value. I did not add the 1% ( 0.74% to 1.36%) correction. Those years are 1928, 1929, 1930, 1936, 1937, 1939, 1946, 1955, 1956, 1957, 1959-1974. In addition, please note that 1931, 1938, 1940 and 1941 have asterisks, which indicate a sharp cut in the dividend yield within two or three years. When using the tables, use the revised headings: year, P/E10, dividend yield, safe withdrawal rate, historical database rate (80% stocks).
http://nofeeboards.com/boards/viewtopic.php?t=1220

The longest wait until the Safe Withdrawal Rate climbed above 6.0% was 16 years. That would have been in 1959.

TIPS at a 4.1% interest rate will provide a steady stream of 8.645% of an initial balance for 16 years before falling to a zero balance. This includes a return of capital (i.e., the drawing down principal) and it does not include any capital gains or losses. All amounts are adjusted for inflation.

To produce 5% of a portfolio's total initial balance for 16 years, a 4.1% TIPS account balance would fall to 80.20% of its initial value. To maintain the same withdrawal amount, the withdrawal rate at 16 years is 6.234% of the account balance at 16 years. (That is, 5% / 0.8020 = 6.234%.)

After the initial 16-year period, I switched to 80% stocks and 20% commercial paper. I used the CPI for inflation adjustments. I assumed 0.20% expenses. I assumed an initial balance of $1000 and made annual withdrawals of $62.34. I then determined the number of years that I could continue to make withdrawals according to the Historical Database. I used the FIRECalc for my calculations. http://capn-bill.com/fire/

I then determined the portfolio life span for all of the 1921-1980 portfolios that had Safe Withdrawal Rates of 6.0% or more. This tells us how many years that we could extend our retirement portfolio by waiting 16 years until we got a good buying opportunity. Anything bigger than 27 years would be an improvement over using TIPS alone. Assuming that the 4.1% TIPS could be replaced, TIPS by themselves would provide an identical income stream for exactly 43 years. (Remember that the income stream is 5% of the portfolio's initial balance.)

Success

Excluding the years with asterisks as well as those with Safe Withdrawal Rates below 6.0%, failures occurred in the following years: 1934 failed after 34 years, 1958 failed after 38 years, 1935 failed after 60 years and 1927 failed after 65 years. There were no other failures within the 80 years possible. (I.e., 1921 + 80 = 2001, which is the last entry in the FIRECalc.)

For the years with asterisks, only 1931 should be excluded automatically. It had a 5.6% Historical Database Rate. The Historical Database Rate for 1940 was 6.0%. The Historical Database Rate for 1938 was 6.6%. The Historical Database Rate for 1941 was 7.0%.

These were the failures: 1940 failed after 30 years, 1938 failed after 37 years and 1941 failed after 43 years.

We were able to extend the portfolio's life span more than 27 years every time by waiting for a good buying opportunity. In addition, we did not have to worry about running out of replacements for the TIPS that we did own.

Our earliest failure was after 46 years (from waiting 16 years and then using the additional 30 years for 1940). That data point had an asterisk, which might have influenced real-life decision-making. The second failure, with no asterisk, was after 50 years (from waiting 16 years and then using the additional 34 years for 1934).

Inferences

As indicated earlier, neither 4.1% TIPS nor an S&P 500 index yielding 3% (or more from dividends) is available today. However, 2.8% long-term TIPS are available on the secondary market. They should be able to provide a sufficient income stream while waiting for the Safe Withdrawal Rates of stocks to rise above 5%. That income stream would be close to 4% of one's initial portfolio balance. The portfolio should last at least 46 to 50 years.

We can extend our portfolio life span by using TIPS and our newly developed Safe Withdrawal Rate calculations and we can withdraw 4% of our initial portfolio balance in today's market.

Have fun.

John R.


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hocus
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Joined: 02 Dec 2002
Posts: 435

PostPosted: Sun Aug 17, 2003 11:32 am    Post subject: Reply with quote

We can extend our portfolio life span by using TIPS and our newly developed Safe Withdrawal Rate calculations and we can withdraw 4% of our initial portfolio balance in today's market.

Good stuff, JWR1945.


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peteyperson
**** Heavy Hitter


Joined: 26 Nov 2002
Posts: 525

PostPosted: Sun Aug 17, 2003 4:24 pm    Post subject: Re: How to Make Switching Work Reply with quote

Okay, it is 2am here as I've been dealing with hocus's latest posts to me first. I must confess I didn't get a lot of what you put down, may be the lateness of the hour.

Are TIPS taxable? How are they covered for inflation? These are the treasure inflation protection securities, so the 2.8% is above inflation?

Were you suggesting parking money in TIPS at 2.8% until the markets become undervalued and / or dividend rates rise above the TIPS rate and then you switch investments? I'm assuming this would work in a tax protected account but not really outside of one (like myself).

You seemed to also be suggesting spending an extra 1% above the return and spending down some of the capital for the reason that because the market has never been down longer than 20 years, in 20 years time the value won't have dropped more than 20% with additional compounding effects. Was that one of your secondary points?

Can you remind me the fundamental differences between TIPS and the other types of investment that get mentioned with them often?

Petey

JWR1945 wrote:
As indicated earlier, neither 4.1% TIPS nor an S&P 500 index yielding 3% (or more from dividends) is available today. However, 2.8% long-term TIPS are available on the secondary market. They should be able to provide a sufficient income stream while waiting for the Safe Withdrawal Rates of stocks to rise above 5%. That income stream would be close to 4% of one's initial portfolio balance. The portfolio should last at least 46 to 50 years.

We can extend our portfolio life span by using TIPS and our newly developed Safe Withdrawal Rate calculations and we can withdraw 4% of our initial portfolio balance in today's market.

Have fun.

John R.


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JWR1945
***** Legend


Joined: 26 Nov 2002
Posts: 1697
Location: Crestview, Florida

PostPosted: Mon Aug 18, 2003 10:49 am    Post subject: Reply with quote

peteyperson wrote:
Were you suggesting parking money in TIPS at 2.8% until the markets become undervalued...? I'm assuming this would work in a tax protected account but not really outside of one (like myself).

My main point is that the dice have been loaded. They are loaded against anyone who would do anything besides maintaining fixed allocations with a high percentage of stocks. Part of the reason has been the nature of stocks over the last 70+ years. Another part of the reason has involved the built-in limitations of our tools, the retirement calculators.

In our investment calculators, our alternatives to stocks have been greatly inferior to the dividend component from stocks alone. Almost always, our alternative investments have been inferior to stock dividends by 1% per year or more. That means that stocks prices have to go down a lot and stay down before it is even possible for anything else to do better. If you turn to a cash buffer for a decade, stock prices have to go down and stay down by more than 10% for you to break even.

There have been times when stock dividends have yielded substantially more than alternative investments. However, there have also been opportunities to coast through some rough spots by putting money into a temporary account, a form of a cash buffer. One of the most important concepts for those rough spots is to lock in favorable interest rates or to stay with short-term maturities when interest rates are lousy. Our tools, the retirement calculators, exclude us from even considering such possibilities. They treat all alternative investments as trading vehicles. You always sell them after a year and buy newly issued replacements.

The primary reason that our calculators are so limited is because it is difficult to do anything else. It is possible to build better calculators, but it is far from easy and gathering sufficiently comprehensive relevant data (for the alternative investments) is very, very difficult.

Today's stocks do not have an immediate advantage over the alternatives. They do not produce dividends that are more than 1% better than anything else. The stocks of yesteryear no longer exist.

Your ideas about managing a cash buffer are (essentially) right in today's marketplace. As for the details, we will develop them more thoroughly in the days to come.

As for the switching criteria, I used my Safe Withdrawal Rate calculations to identify when "the markets become undervalued." The reason that I spend down my principal is because that is all that my tools allow me to do. The reason for not including taxes is that it is very difficult to include them in both a general and a meaningful way and my tools do not include taxes. In fact, including taxes is hard to do period.

In terms of TIPS: yes, yes and yes. They are taxable. They are taxed each year for any increase in principal. The 2.8% is the effective coupon rate. As principal increases, the same coupon percentage applies (as opposed to remaining at a fixed amount). TIPS with maturities longer than 10 years are available only on the secondary market (e.g., through brokerage houses).

The ibond is an inflation protected savings bond. It is limited to those who have a US social security number. It may not be traded. It must aways be exchanged with the Government. (? Or the Federal Reserve acting as an agent? I don't know about that kind of detail.) In contrast to TIPS, taxes on it are deferred until you cash them in.

Repeating my main points in this post:

Quote:
Today's stocks do not have an immediate advantage over the alternatives. They do not produce dividends that are more than 1% better than anything else. The stocks of yesteryear no longer exist.

Your ideas about managing a cash buffer are (essentially) right in today's marketplace. As for the details, we will develop them more thoroughly in the days to come.

Have fun.

John R.


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