Paradigm shift in the approach to asset allocation during the Distribution Phase, a simplification of the safe withdrawal calculation away from methods like Monte Carlo Simulation. A move away from the unsolveable equation that is " How can we know how much we need or what our withdrawal rate will be if we don't know if the performance of investments will match or beat the historical performance? "
Key points:
- Adjust stock valuations back to historical P/E of 14.1 before FIRE.
- Any safe withdrawal rate is based on your portfolio value (corrected downwards where appropriate).
- Use historical performance information to determine the worst periods of under performance in the markets and plan cash type investments around your need to fund from cash when stock market investments are underwater/undervalued. All swr calculations based on historical returns are null and void due to a sizeable cash buffer that prevents sales during down periods, coupled with diversified asset allocation.
- Use historical information and your best take on the current investing situation to determine the return on the different asset classes.
- Safe withdrawal rate is determined by your asset mix, estimated average return, inflation, investment fees, payout term and whether you want to leave an inheritance.
- A spreadsheet needs to be developed like with multiple credit cards payment schedule, which takes into account the assets, their return, inflation, payout period, inheritance decision etc and can extrapolate the w/d rate. This only relies on history insofar as you take a position on what each select asset class with deliver on average over time and provide cash to cover stock slides.
Points of disagreement unresolved:
- Why withdrawal rates are lower on high P/E when your asset allocation already restricts stock ownership to a suggested 50% and a large cash buffer covers long term drops until to 10-15 years.
- Whether Monte Carlo type backward analysis actually helps figure a SWR.
Original post:
I've been reading ' The Great SWR Investigation - Part I '. Too old a thread to reply to, so started this one..
JWR1945 wrote: What Bernstein has done is this: He used the Gordon Model to estimate the long-term growth rate of stocks at recent valuations. His estimate was 3.5% real growth. Then he used his Monte Carlo simulation and calculated a Safe Withdrawal Rate. The answer was 2%. raddr makes similar calculations assuming 3.5%. I suspect that his Monte Carlo simulator is much more accurate than William Bernstein's.
The discussion revolved around the idea that if you have an inflated stock portfolio, you will expect lower returns (3.5% real was cited) over the next few years until the market reverts back to mean.
This strikes me as attacking the problem from the wrong direction (no offense, JWR).
I think the first mistake is that retirees don't re-calculate the stock portion of their total portfolio back to its intrinsic value before FIREing. Any safe withdrawal rate should be calculated on a total portfolio valued thus and not on one where you're counting on inflated valuations as your portfolio starting point. (This is where a number of retirees fell down having lost 40% in the market drop, leaving them with not enough to live off). Retiring on an inflated market valuation is not necessarily a problem unless you are basing your FIRE assets on that bubble. Rationally basing the valuation based on a historical 14.1x P/E would give a proper basis to proceed more securely. Over the preceeding decade, the market may correct as indeed the current market might either with one sharp correction or a gradual reversion to the mean in pricing. However, any safe withdrawal study based on inflated valuations is seriously flawed from the outset.
I do not currently see how inflated valuations reduce your safe withdrawal rate. Working correctly from intrinsic values, the value of any overvaluation or undervaluation is only relevant to coordinate well-timed withdrawals. If you keep a significant portion of assets in cash and bonds (a cash buffer), an inflated P/E is an opportunity to shore up your cash position likely depleted from times of low valuation (where you avoided selling stocks on the cheap). During low P/Es, conversely a perfect time to spend down your cash (or if you're able to, take advantage of cheap stocks). Given that the market is likely to correct over several years and is overvalued, if you're basing your withdrawals on intrinsic values, it matters not whether the portfolio is growing during that period for it was overvalued anyway. It is an irrelevancy. When you account for reasonable growth rates, less the gradual correction, the market value is going to meet in the middle and then be fairly valued at that point. You should be much more concerned with a substained low P/E that forces you to deplete your cash reserves and later require the sale of undervalued stocks to supply cash to live on. This would certainly reduce your chances of outliving your investments.
hocus wrote: Changes in valuation levels always affect SWRs, I believe. But there are times when this is relatively easy to see and there are times when this is relatively hard to see. In cases like the year 2000, there is just no question. In 2000, the valuation level was at a point it had never reached in the 130-year time-period examined in the intercst study. It is simply not possible for a study that did not even take into account those sorts of valuation levels could possibly get the SWR right for that year. On this point I am dogmatic. There is no grey area. The study is wrong.
In years in which the valuation level is within the range of valuation levels covered by the study, I still believe that the failure to take changes in valuation levels into account is a serious flaw. But it is not as serious as in a year like 2000, and it is not nearly as easy in those cases to explain the reason why there is a problem.
In theory, a high valuation would demonstrate a likely reduced return going forward until the market corrects. The point there is that you're overvalued anyway, so why do you care? You haven't been caught up in the mania of believing companies are fairly valued at P/E 30. A good example of this is a recent series of articles at the Fool on an airline company, JetBlue. Sounds like an interesting company until you discover it is trading at 60x trailing earnings. To me, to write an article raving about the company as a possible investment opportunity seems to suggest a complete ignorance of basic fundamentals which was common pre-crash. To my mind you have only lost value if during a period of inflated prices the market hasn't risen overall via dividend payments and share price gradual correction sufficient to cover inflation & your cash withdrawals. There will always be cycles in investing where you lose or you gain and this is to be expected. Indeed allocation of investments across cash, bonds, stocks and other investments reduces your return but in turn reduces the volatility to address this concern and limit the effects.
JetBlue article
http://www.fool.com/news/commentary/200 ... 0620wt.htm
I see the issue of valuation beginning to be discussed and the possibility that it affects safe withdrawal rates. I believe it is more fundamental than that. Correcting the assumed true value of your FIRE funds removes a good deal of the risk and uncertainty. Accepting that financial markets run in cycles allows you to see inflated markets as an opportunity to cash out (where needed) at a high valuation. It shouldn't necessarily mean you slash your withdrawal rate everytime you hit a bump in the road. You plan for those bumps, which does involve some modest assumptions and limiting exposure to asset classes with high deviations.
The safe withdrawal rate becomes then a decision on whether you want your assets to retain their original buying power upon death or to deplete them fully over your expect lifespan. From there, it becomes a question of forecasting the real return after inflation and investment costs, less an apportionment of the assets you are spending down (if you have decided to do so). If you are spending the assets down, the withdrawal rate will vary depending on the payout period, the real return and be calculated to be the original budgetted withdrawal plus inflation-adjustment yearly. A decent cash buffer should allow you to weather multi-year substantial drops in asset classes with multi-year high deviations without undue concern. I believe therefore that the withdrawal rate is not a single percentage figure, but more a figure derived entirely from personal circumstances including asset allocation undertaken to match your tolerance to risk, payout period, expected realistic real return and most importantly beginning from a non-delusional level playing field of assets corrected down (where appropriate) to their historical intrinsic values. If you're retiring at a period of low P/E, I would plan based on that current valuation but be hopeful of a future gradual improvement in P/E back up to historical averages where upon you would adjust up your valuation and the w/d amount would increase.
Please feel free to rip my thoughts to threads. I freely admit that I'm halfway thru the Bogle book and Bernstein's "Four Pillars" is next on the reading list. Therefore it is entirely possible that I'm completely off-base with my ideas. However I thought it might be valuable to collect my thoughts on safe withdrawal issues in one place and leave them up for discussion.
P.S. Apologies for length. I actually tried to keep it short!
Petey