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Best Allocations versus Time
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JWR1945
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Joined: 26 Nov 2002
Posts: 1697
Location: Crestview, Florida

PostPosted: Wed Feb 23, 2005 4:49 pm    Post subject: Reply with quote

There is a timing mismatch between when inflation occurs and when it shows up as an adjustment to the TIPS interest payment. Most workers and retirees with cost-of-living-adjustments are familiar with this. Inflation occurs first. Later, usually after a year, your income increases. Notice that your income does not increase while inflation is occurring. The adjustment is after the fact.

An ideal inflation-matched cash equivalent matches inflation when it happens, not after the fact.

In our mathematics, we use the mortgage formula and an ideal form of TIPS. We must also assume that we can sell TIPS along the way without any capital gains or losses.

This accounts for the discrepancy between the output from calculators (that use the historical sequence method) with TIPS in a portfolio and the result of direct mathematical calculation.

Have fun.

John R.


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

PostPosted: Thu Feb 24, 2005 11:33 am    Post subject: Reply with quote

Let me quote myself twice.

JWR1945 wrote:
JWR1945 wrote:
Best Allocations versus Time

I made a survey to determine the best allocations for portfolios of stocks and commercial paper when withdrawing over periods of 10, 20 and 30 years.
...
Conclusions

The traditional advice for investors is to reduce their stock allocations as they grow older. The data do not say this.

The traditional advice for investors is to maintain their stock allocations through rebalancing. The data do not say this.
...
We know from other research that rebalancing stocks and commercial paper is a bad idea except when stock valuations are exceedingly high. Today's stock valuations are exceedingly high. They are well above the pre-bubble historical range.
...


I have just completed collecting data with TIPS with interest rates of 0%, 1% and 2%.

TIPS data differ significantly from data using commercial paper.

TIPS data favor reducing stock allocations as one ages. Kind of.

TIPS data favor rebalancing always. More precisely, it is always best to rebalance when you select the best allocation at a given number of years and at a given number of failures. If you simply specify an allocation instead of selecting the best, you may be better off not rebalancing.

Commercial paper is similar to TIPS at a 1% interest rate. Kind of. But there is an important qualitative difference that changes the story regarding rebalancing.

Have fun.

John R.


I have collected data of 10, 20 and 30 year balances with stocks and 0% TIPS, with and without rebalancing, at withdrawal rates of 4%, 5%, 6% and 8%.

Even thought rebalancing produced withdrawal rates that were equal or better than not rebalancing when one specifies the number of years and the number of failures, changing what one specifies results in a different story.

If you specify the number of years, the withdrawal rate and the stock allocation, the results favor not rebalancing except under stressful conditions.

The following words from Hobby Stocks and Rebalancing dated Wednesday, Feb 16, 2005 still apply.
http://nofeeboards.com/boards/viewtopic.php?t=3414

Quote:
Analysis

Only a few conditions show a rebalancing bonus. Those with a bonus show only a small improvement. The sequences with a rebalancing bonus are those associated with high valuations and times of severe portfolio stress: a few years around 1929 and the entire decade of the 1960s.


Typically, there was a penalty for rebalancing. Typically, it was huge.

Remember that these are times of exceedingly high stock valuations.

Have fun.

John R.


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unclemick
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Joined: 12 Jun 2004
Posts: 231
Location: LA till Katrina, now MO

PostPosted: Fri Feb 25, 2005 4:27 am    Post subject: Reply with quote

JWR

Now I'm confused - nothing new there. To keep things simple, I try to use key benchmarks for enlightenment: Vanguard Balanced Index(60/40) and Wellesley managed 40/60 for the value camp - read dividends, although a 'very' loose relationship.

I am still struggling to understand what Vanguard is thinking/trying with the Target Retirement Series.

SOOOO- in light of the research runs to date and the availibility of inflation protected securities:

A mythical say 50 year old ER with at least a 50 year span(like almost forever) with nothing but a taxible portfolio retiring today(high valuations) would benchmark what? ----?

50/50 stocks/inflation protected securities as an index cat?

50/50 dividend stocks/TIPs as a value investor?

Far from 'pure' comparison for reference:

Vanguard Target - 2015(50/50) - 3.09% yield

Vanguard Wellesley(only 40/60) - 3.67% yield.

What would the poor dude do - if he ER'd like today?


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JWR1945
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Location: Crestview, Florida

PostPosted: Fri Feb 25, 2005 6:21 am    Post subject: Reply with quote

unclemick wrote:
I am still struggling to understand what Vanguard is thinking/trying with the Target Retirement Series.

Here is my guess: Vanguard is focusing on price volatility.

This dates back to a time long, long ago. But the key psychological considerations remain valid.

Let me contrast your way of looking at things with that of a typical retiree, especially one who had to be sold on the idea of investing in the stock market.

You are comfortable with dividend streams. Even though one or two companies may disappoint, you are confident that your dividend income will remain solid as stock prices fluctuate.

[More recently, we have become aware that dividend amounts can fall behind inflation. But that is atypical and nominal dividend amounts have remained solid.]

Many investors are unfamiliar with this aspect of investing. They have been trained about the accumulation phase of investing. They know almost nothing about the distribution phase.

It is true that only the real, total return has any bearing on the results of a portfolio that is left untouched. The components that make up the real, total return become important only when adding or removing funds. They become important in opposite ways.

New investors have been taught to focus only on the real, total return. They have been taught, incorrectly, that risk equals return and volatility equals risk. They are likely to have learned about dollar cost averaging.

All of this leads new investors to seek volatility. They see nothing that contradicts this. Even dollar cost averaging works better with higher volatility. Until very recently, the favorable tax treatment of long-term capital gains encouraged new investors to seek gains in prices instead of dividends.

Given this training, it is reasonable for retirees to think of all stock market investments as volatile and dangerous in the short-term. Some will learn, later on, that dividends can provide a secure and attractive income. Typically, they will learn about this through sales pitches. They do not realize this before it is explained. They believe that high dividends mean low returns. It is a logical conclusion based on the false assertions that volatility equals risk and risk equals reward.

A retiree wants to avoid running out of money and, usually, he wants to pass an inheritance to his kids. Given his general ignorance about the true nature of dividends, he concludes that decreasing his stock allocation as he grows older makes sense. As his expected lifespan decreases, his need for an inflation hedge decreases and bonds look more attractive.

This aligns retirees with the basic Vanguard approach, with inflation indexed bond representing a sophisticated value-added choice by professionals.

Have fun.

John R.


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

PostPosted: Fri Feb 25, 2005 6:47 am    Post subject: Reply with quote

unclemick wrote:
A mythical say 50 year old ER with at least a 50 year span(like almost forever) with nothing but a taxable portfolio retiring today(high valuations) would benchmark what? ----?

50/50 stocks/inflation protected securities as an index cat?

50/50 dividend stocks/TIPs as a value investor?

Far from 'pure' comparison for reference:

Vanguard Target - 2015(50/50) - 3.09% yield

Vanguard Wellesley(only 40/60) - 3.67% yield.

Most important, he should guard against changing benchmarks in a way that always makes him look bad.

Given the long-time desired lifespan of his portfolio, his benchmark should be his inflation-adjusted (real) income provided by his portfolio. He should include a constraint on his portfolio's inflation-adjusted (real) balance. Typically, his constraint would be to maintain at least 50% of his initial buying power.

[He might want to select a later reference time, especially if he has increased his (real) withdrawal amount.]

The two Vanguard funds probably make good benchmarks. I am not aware of how much they are willing to let their net asset levels fall, especially in terms of a 2015 target date.

The index choice is OK provided that you identify the index and stick with it. A vague definition of dividend stocks is unsatisfactory. Perhaps the Dow Jones Utility Average or the iShare's ETF that Alec mentioned (DVY?) would do the job.

There may be a problem with how you choose the inflation-indexed securities since replacements are not guaranteed. You would probably select a TIPS index fund for that purpose. Alternatively, you might do what our calculators do stick with a single number or with whatever yield is currently available. I would hate to think of your always holding yourself to a standard of 3.5% to 4.0% TIPS as part of your baseline.

Have fun.

John R.


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

PostPosted: Sat Feb 26, 2005 6:15 pm    Post subject: Reply with quote

I was wrong when I wrote this at the beginning of this thread:

Quote:
The data shout at us that a portfolio of stocks and commercial paper is a horrible idea, especially as one grows older. The biggest culprit is commercial paper. In most cases, it drags surviving withdrawal rates below that of an inflation-matched cash equivalent (such as TIPS at a zero percent interest rate).

I have been reminded of an earlier study.

Refer to my thread about some Surprising results with Commercial Paper dated Wednesday, Mar 17, 2004.
http://nofeeboards.com/boards/viewtopic.php?t=2234

Commercial paper has turned out to be a very complex investment. It was great at the end of the 19th century. It was lousy from just before the Great Depression until shortly after World War 2. It was better than stocks in the worst years of the 1960s. That is, in 1965, 1966, 1968 and 1969.

Commercial paper will always look like a horrible investment whenever the years from 1930-1950 are included in a study.

TIPS and I-Bonds generally make a better choice, at least when used as inputs to a calculator. There can be a problem in finding find suitable replacements as they mature.

Have fun.

John R.


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