Safe withdrawal ideas, thoughts and provocations

Financial Independence/Retire Early -- Learn How!
peteyperson
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Safe withdrawal ideas, thoughts and provocations

Post by peteyperson »

SUMMARY of posted ideas in the thread so far:

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
Last edited by peteyperson on Tue Jul 15, 2003 7:46 am, edited 4 times in total.
JWR1945
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Post by JWR1945 »

peteyperson
This strikes me as attacking the problem from the wrong direction (no offense, JWR).

No offense taken. In fact, I am delighted to see your ideas. They are interesting and they are new.
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)....
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....


Those are fighting words! But not on these boards. You have identified a different way of looking at withdrawal rate issues. I expect it to provide us with a lot of useful insights.

Have fun.

John R.
JWR1945
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Post by JWR1945 »

peteyperson
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 preceding 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.

This is similar to my adjustment for bubble evaluations. I adjusted from the bubble's peak valuations down to those from the previous highs. Since the old highs had corresponded to a 4% safe withdrawal rate (estimated), my adjustment brought it down to 2.3% (at the peak in 2000).

Your adjustment differs in that you normalize everything to the historical P/E ratio of 14.1. We do not yet have a corresponding safe withdrawal rate for scaling. It will be higher than 4% (for a 30-year portfolio lifespan).

Have fun.

John R.
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Post by JWR1945 »

peteyperson
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)....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 sustained 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.

Working incorrectly from inflated values, it is very easy for me to see how valuations affect safe withdrawal rates. [HUMOR]

When you put the cash buffer back inside of the portfolio, your stock allocations are varying over time. Technically, that is a form of market timing. Yet, done correctly along the lines that you are talking about, it is quite sensible. It is done routinely by many of the great value investors. Their emphasis is the same as yours: maintaining principal and getting good deals (by buying bargains or, at least, not paying outrageously high prices).

You have described an important strategy that needs to be investigated in depth.

Have fun.

John R.
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Post by JWR1945 »

peteyperson
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....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....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 limits the effects.

Why do we care? To help us when we shift our allocations.

Not only does this limit the effects of volatility, re-balancing and shifting allocations can actually improve overall returns. However, improved performance is usually only a secondary reason. Reducing volatility is the primary reason.

Have fun.

John R.
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Post by JWR1945 »

peteyperson
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.

I agree in a general sense. It is helpful to have only one or two numbers when you define a withdrawal strategy. The actual withdrawal amounts can vary greatly depending upon the details.

From a point of semantics, I prefer to separate the applications (which involve your personal circumstances) from a series of calculations of safe withdrawal rates (corresponding to a variety of circumstances) that together form the rules-of-thumb that constitute your actual withdrawal strategy.

Understand that risk tolerance is not limited to psychological factors. In many cases it is a very simple matter of meeting requirements subject to well defined constraints (e.g., college tuition money must be available when the person enters college instead of ten to fifteen years later).

most importantly beginning from a non-delusional level playing field of assets

Wow! Those are fighting words! But not on these boards. This sounds like common sense to me.

Have fun.

John R.
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Post by peteyperson »

JWR,

I am enjoying your multi-post responses, sometimes covering the same paragraph. Interesting to see how your mind works..

I wasn't suggesting re-investing the cash as you had mentioned in an earlier post. That indeed is one strategy to take advantage of a cheaper market to be sure, but that would deplete your cash reserves at the very time you need them the most (when P/Es are below historical lows and you desperately don't want to sell at that time). Given that we are talking about the Distribution stage and not Accumilation, I would put forward that re-investing the cash severely limits your ability to substain multi-year lows (one of the reasons for a cash buffer in the first place). I would also say that you no longer have the luxury to buy when cheap as you have no new investments. You're in the distribution phase and manage investments differently. Preservation of capital or if you're spending it down, preservation of capital :)(see, I can make jokes too) is key.

To explain a little further. If you had a simplistic 60/40 stock/cash split, you would start with that. If right off the bat you entered a low P/E decade, well tough, no chance to invest for you. You quit work, no new income, sit it out. High P/Es are your safe ground now, not the other way around. So you spend down your cash until it is safe to sell some shares when they are back to historical average or hopefully overvalued. Using a cash buffer to avoid selling asset classes when undervalued, selling ones when overvalued, helps boost safe withdrawal rate by smart sales. You wouldn't rebalance the portfolio yearly to maintain the asset allocation, you do that only when the values suggest it benefits survivability. Otherwise your re-balanced asset allocation, well planned as it might be, will come at the expense of total portfolio assets. Re-balancing mechanically is simple to be sure but doesn't take advantage of market timing. Market timing maybe tricky, but you can easily time on the way out based on historical values vs. present. However if you work to historical P/E, I fail to see how market timing is difficult on the way in either. You just have to be disciplined enough to save the money anyway and find other places to invest it. I think the rule of thumb general advice has to be, don't market time. Most people won't do it successfully, however most people even stock brockers themselves, ignore the fundamentals on valuation preferring to look at the forward looking P/E forecasts which are meaningless rather than the trailing years or indeed P/E10.

Buffett did it when he closed his investing partnership when the market was overvalued. A handful of years later the opposite was true and he couldn't buy good, cheap investments fast enough. His investing success came from that point in history. In the last decade he's been focused on buying private firms more than listed ones where he could avoid paying over the odds on P/E a lot of time. (Although he does believe following Charlie Munger's prodding to buy overvalued companies where it is believed they will be a superb long term investment justifying the inflated current price. This as opposed to cigarbutt investing as advised by Graham where the risks can be higher). My fellow-expat on these boards has commented on buying UK property at a time when interest rates were 15% and people were getting foreclosed on left and right. A ripe time to hoover up cheap property to be sure. There are useful lessons here whether you plan to invest in individual stocks or just plan what asset classes to buy into when.

It's why I'm reading about efficient market theory and I'm just not buying into it. I buy into market averages over time, but a high performing company like Dell made a great investment early on. Bogle says everything reverts to the mean eventually. I think that's BS. He cites Fidelity Magellan fund are providing the point, it outperformed the indexes by 11% annually for over a decade but eventually reverted to the mean like everything else. However it did so because Peter Lynch left and there are perhaps 20 men & women on the globe who could allocate funds as well. Dell may revert to the mean market performance, much like Microsoft is beginning to, simply because of global market domination. It's just not the same thing at all.

I'm so on a roll now, it's just not funny! :lol:

Petey


JWR1945 wrote: peteyperson
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)....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 sustained 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.

Working incorrectly from inflated values, it is very easy for me to see how valuations affect safe withdrawal rates. [HUMOR]

When you put the cash buffer back inside of the portfolio, your stock allocations are varying over time. Technically, that is a form of market timing. Yet, done correctly along the lines that you are talking about, it is quite sensible. It is done routinely by many of the great value investors. Their emphasis is the same as yours: maintaining principal and getting good deals (by buying bargains or, at least, not paying outrageously high prices).

You have described an important strategy that needs to be investigated in depth.

Have fun.

John R.
Last edited by peteyperson on Tue Jul 15, 2003 1:25 am, edited 2 times in total.
peteyperson
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Post by peteyperson »

Well in order to discuss the initial point, it was necessary to give a simplistic example. Of course you can sell down from high valuations and place funds in other asset classes. That is your perogative. I have more restrictions on that because I'll get killed with capital gains taxes, so I'll be more looking for a balanced asset allocation what works over the long haul. This will make it difficult to maintain an initial asset allocation, selling down the overvalued ones over the undervalued just to maintain a specific asset allocation. Again, this is why a simple stock/cash example is easier to work with.

The considerable benefit of index mutual funds to me is that I can invest and not touch some of the money for multi-decades. This shelters from accumilated cap gains taxes at 41% and considerably boosts my income. Furthermore, it will drop my tax rate to half during FIRE rather than re-balancing during the accumumilation phase where changing allocations is more likely to come from re-directing new investments than from sales (though in the early years I have less of a problem with sales incurring taxes).

Petey


JWR1945 wrote: peteyperson
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....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....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 limits the effects.

Why do we care? To help us when we shift our allocations.

Not only does this limit the effects of volatility, re-balancing and shifting allocations can actually improve overall returns. However, improved performance is usually only a secondary reason. Reducing volatility is the primary reason.

Have fun.

John R.
peteyperson
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Post by peteyperson »

John,

The college money issue is a seperate one. Clearly you have an issue on the set withdraw time, are more sensitive to drops in value and are likely to move to less volitile investment closer to when you need the funds. The funds would also not be considered part of the FIRE package that you live off, but seperately managed / invested funds for one specific purpose. To include them would be to muddle the situation. I much prefer the Paul Terhorst approach to this which is if you have kids who have yet to go to college when you FIRE, determine the total cost of upbringing / college and put that money aside, as opposed to those working who need to put a set amount aside a year to cover it.

At present I see the safe withdrawal calculation something like an Excel spreadsheet covering multiple debts at different interest rates leading to a payoff date. Except it is reversed. You choose a selection of asset classes, their return (you choose how conservative you want to be here), their asset allocation, the inflation rate and come up with a yearly income generated beyond inflation. If you were reducing your balance over time, you would have a mathematical formula that would help come to an inflation-adjusted figure that works over time. The interest works a bit like a loan, more interest generated in the early years when you have a large principle to work from and less in the latter years where you're spending down more of your principle. A loan in reverse.

The important points here are that the return rate is an achieveable one given the ups and downs of various returns on volitile assets like stocks and a sizeable cash buffer avoids the need to sell at poor valuations. This smooths out the return over the decades and allows for the peaks & valleys of the market where returns are underperforming one decade, but overperforming the next. I don't see that so much as a negative that drags down the withdrawal rate, but merely something you include in your planning as an investing reality. Smart allocation with sizeable cash amounts does this adequately.

The safe withdrawal rate would then indeed be a mathematical formula, but based around a collection of assets and their overall returns. It would allow people to change their allocation and still be able to see how things turn out, much like a multi-credit card spreadsheet would. People talk of the problems of relying on historical data, the sharp substained drops in the market and the corresponding problems of how to maintain good asset values over the long term. I believe you simply have to take a view on what you believe the different asset classes will deliver on average over the long term. For stocks, this may be more like 3.5% real instead of the historical 7% real. No amount of data mining can help you there, nor can it cover the volatility correctly. Allocate enough to cash type instruments to make 5-10 year low stock valuations irrelevant because in the words of Warren Buffett, " I don't care if you close the markets for a decade and I cannot sell at all " ad libbed. i.e you don't care because you're not selling low and you can afford to take that attitude because you have enough cash to substain you. You're not fully invested in the market where a strictly temporary 40% drop will cripple you/your plans, nor are you basing whether you have enough money to FIRE on valuations at 50% or 100% higher than their intrinsic value blinding holding forth that you have plenty enough.

This also helps move away from the arguements on historical vs. actual and your inability to know what will happen moving forward, the uncertainty it creates and how it makes it hard to impossible to judge if you have enough. This then helps simplify matters considerably. Your withdrawal rate is function of your determinations on how well each asset with deliver on average over time. Ignore data mining as a method to get your answer - it won't. It will tell you how long the market has been down before returning to the previous value + inflation. This helps determine the length of cash cushion required. It will help you get an idea of what assets historically deliver. You use historic valuations and performance as a guide to make your own judgements on the future. The tail isn't wagging the dog that way. It also nicely uses John Bogle's idea of simplicity in all forms of investing. Accentuate the positive, limit the negative as much as possible. I believe this plan does just that.

It would be helpful to allow for some padding in your budget to cover those rare occasions when the markets are down for more than a decade. I worked out in a few seconds that I could remove 11% of my annual spending just by cutting out the yearly vacation and a few other non-essentials while things looks uncertain. You could even include a specific amount of financial padding in your budget that is there just for that purpose, almost like an emergency fund. The alternative is to take less monthly but given your inability to calculate how much over the worst case scenario you've planned for, it would seem counterproductive. I'd work more on several versions of your budget, bare bones, comfortable, luxury as some have mentioned before. Ultimately you will always be at risk of a market or other investments that don't perform as you planned, whether that is via increased volatility, lower returns or longer substained drops than the prior worst case. With the markets this can be counteracted to some extent usually by outperformance later. However, the only way to minimize those risks is to have a multiple of your longest possible lifespan in your portfolio and invest modestly to deliver inflation + investment costs. Most people will never earn enough to save that kind of sum. Indeed if I had twice what I needed, I would likely allocate 50% to cash type investments that matched inflation removing almost all worry of running out of cash, the other 50% invested a bit more aggressively (but not too much) as a hedge against inflation. That's how those wealthy beyond their immediate funding needs keep getting wealthier. Safe overall asset allocation with a component they simply don't need above the total assets required to fund personal needs. So they just keep accumilating more cash than they need, like Buffett. It becomes a zero sum game.

I am reminded of the recent World Wealth Report 2003 (www.ml.com) that indicated that the US$ millionares around the globe avoided a 40% market slide in assets by being heavily diversified. This should be a useful lesson to us all.

Petey

JWR1945 wrote: peteyperson
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.

I agree in a general sense. It is helpful to have only one or two numbers when you define a withdrawal strategy. The actual withdrawal amounts can vary greatly depending upon the details.

From a point of semantics, I prefer to separate the applications (which involve your personal circumstances) from a series of calculations of safe withdrawal rates (corresponding to a variety of circumstances) that together form the rules-of-thumb that constitute your actual withdrawal strategy.

Understand that risk tolerance is not limited to psychological factors. In many cases it is a very simple matter of meeting requirements subject to well defined constraints (e.g., college tuition money must be available when the person enters college instead of ten to fifteen years later).

most importantly beginning from a non-delusional level playing field of assets

Wow! Those are fighting words! But not on these boards. This sounds like common sense to me.

Have fun.

John R.
Last edited by peteyperson on Tue Jul 15, 2003 1:32 am, edited 2 times in total.
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Post by peteyperson »

To be a little unfair, I would say that the downward movement of the withdrawal rate is purely because you took the complete wrong valuation of your assets at the time. The w/d rate hasn't changed in that sense, as per my longer posted reply I just made.
JWR1945 wrote: This is similar to my adjustment for bubble evaluations. I adjusted from the bubble's peak valuations down to those from the previous highs. Since the old highs had corresponded to a 4% safe withdrawal rate (estimated), my adjustment brought it down to 2.3% (at the peak in 2000).


It is certainly a very different way of looking at things. I remember reading several articles in the last 12 months having sympathy for those in their 50s/60s who retired. They bemoaned the fact that they were having to go back to work because their assets had falled by 40% and they no longer had enough. My reaction was different. I thought they had been blindsided not by the market but by a lack of understanding. They did not appreciate that the market has substained those kinds of drops before. They did not appreciate for a minute how to determine if the market is overvalued or undervalued and what that means for their assets. I anticipate meeting many people in a similar situation when I retire and not being able to explain it to them in a way they'll understand. They suffered because of what they didn't know. I see no discussion of that here nor have I ever read it in a book and I think it is a basic mistake which means all previous calculations via Monte Carlo etc are null and void.

I see it somewhat like knowing how much below or above sea level you are, or the moment in Die Hard where the bad guy adjusts the airplanes reading on what ground level is and they fly right into the ground too fast. You have to have the correct ground level first aka a portfolio valued on historical mean. For many this will not cause too many adjustments as they are heavily diversified already. One of my concerns buying into a market overvalued by up to 50% is that following my own counsel, I would need to rachet down the value of my portfolio all the way along the accumilation path in order to get a solid take on my true position. This would take an initial $1,000 investment and reduce it to $666.66 immediately. I would feel robbed. But it serves to highlight what I'm doing, I'm buying in at inflated prices and am willing to sit out however long it takes until the market is valued correctly. At that point I'm back to zero and I pay the opportunity cost of where my money could have been invested instead during the time it takes to do this. It makes me think that timing purchases even into an index fund might be smart, buying new units in the fund only at times when the market is low on P/E. If the market never comes that way in 20 years of investing horizon, then you have a whole nother problem but heavily invested via dollar cost averaging you had that problem anyway with needing to readjust your porfolio to its true intrinsic value.

Petey
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Post by ataloss »

- 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).


Since overvaluation to the extent of previous p/e highs has been taken into account by the historical swr I think JWR's approach (reduction to level of previous highs makes a lot of sense )

I am not comfortable with the suggestion hocus made to increase the swr substantially in the case of under valuation. I think factors other than valuation (war, political instability, unknown cataclysmic events) could affect returns and swr.
Have fun.

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Post by peteyperson »

Hi Ataloss,

Previous highs is very different from historical mean. Previous highs could be inflated valuation even if not be so much. For my own thinking I reject that idea as only half good.

I too cannot see the sense in increasing the swr in times of low valuation. Logic would clearly suggest the opposite action. You have the choice to either vary withdraws, lower for low valuation, higher for high valuation, or a better approach (IMHO) is to use a multi-year cash buffer, avoid selling during low valuation and keep the withdrawal rate steady throughout. If you're running up against limited remaining cash following a substained drop, you would reduce your withdrawals by cutting your budget some to allow the markets longer to return to mean valuation. This would either reduce the losses selling lower by not at the lowest point or stem losses entirely by selling later at fair valuation. It's a balance between historically higher returns in stocks vs. the relative safety but lower performance of cash, bonds and fixed income instruments.

Petey


ataloss wrote:
- 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).


Since overvaluation to the extent of previous p/e highs has been taken into account by the historical swr I think JWR's approach (reduction to level of previous highs makes a lot of sense )

I am not comfortable with the suggestion hocus made to increase the swr substantially in the case of under valuation. I think factors other than valuation (war, political instability, unknown cataclysmic events) could affect returns and swr.
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Post by hocus »

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.

You are absolutely correct, Pete. Those who have found it a struggle to understand why the issues raised in The Great Debate are of such earth-shaking importance should take a moment to think through just what it is you are saying here, and the implications of what you are saying here.

What you are saying is that people are basing their retirements on funny numbers. Someone who retired on January 1, 2000, with a portfolio of $1,000,000 did not possess assets worth $1,000,000, but of some number far smaller than that.

The confusion is the result of the way that stock prices are calculated. There is an extent to which stock prices reflect underlying real economic values. When you own a stock, you own a piece of a company, and the value of the stock certificate to the extent that it reflects your ownership interest in a business entity is real.

But that is not all that is involved in the calculation of a stock price. The other element is the "fluff" element, the part of the price that reflects nothing more than the madness of crowds willing to bid up prices to levels that have no connection to the reaonable earnings expectations of the underlying businesses.

That part is not real at all. You can benefit from the madness of crowds if you are willing to sell your shares during the limited time-frame in which the madness prevails. But long-term buy-and-hold investors give up the prospect of making a killing by taking advantage of the madness of crowds (for perfectlly good strategic reasons, in my assessment) and content themselves with being able to participate in the real price increases of the stocks they own.

The problem is, most people do not do what you suggest here, Pete. Your way of addressing the fluff issue is a perfectly valid one. I proposed this myself in a post to the REHP board a few months prior to the May 13, 2002, post that kicked off The Great Debate. If everyone did what you suggest here, marked down their portfolios to reflect the fluff factor contained in them, that would be an alternate means of addressing the valuation issue.

I did not get much of a reaction when I put forward the idea at the REHP board. My sense is that most people do not like the idea of marking down their holdings to reflect true long-term value. That's why I became so excited when I read Chapter Two of "The Four Pillars of Investing." Bernstein is putting forward there an alternate approach to doing exactly what you propose in your post--marking down the value one gives to one's porrtfolio to bring it into conformity with reality.

He is adamant on saying that the Gordon Equation does not predict short-term price changes. But he says that, for the long-term investor, short-term price changes are not that big a deal anyway. What matters is knowing what sort of returrns your investments will provide in the long term. This he says the Gordon Equation tells you with a high degreee of accuracy. And this is what you most need to know.

Incorporate what the Gordon Equation tells you about the returns you can reasonably expect to obtain in the future, and the SWR is 2 percent. That's what Bernstein tells us on Page 234. If you want to go with a 74 percent stock allocation, you may do so, but you must understand that there is a big price to be paid for doing so. It means delaying your retirement for years and years. If you want the quicker retirement, you have to go with alternate asset classes that provide a higher SWR. This is exactly the opposite of what the convetional SWR methodology tells you. That's why I say that the convetional methodology is invalid. It provides the wrong answer to the most important question you are trying to grapple with, whether it will take longer to retire safely with a high stock allocation or not.

All of this was discussed in some detail in the early days of The Great Debate, Pete. Go back to posts that appeared at the REHP board back in May and June of 2002, and you will see a good number of posts by me addressing the "fluff" issue. It is a matter of absolutely critical importance. A lot of community members there expressed a desire to come to terms with it, and then the individual who did the study frequently referred to there flipped his lid and the discussion over time turned into a circus event.

What you are saying is of profound importance, Pete. You are indeed on a roll. You have unlocked for yourself the most important door. What you are saying is just common sense, but it is a form of common sense that has been much criticized during the recent bubble years. People are shocked to hear that their portfolios do not have a real long-term value of anyrthing close to the short-term value indicated by the numbers printed in the newspaper accounts, and there are some who do not now want to examine the question too closely.

I believe that over time that is going to change. It has to change because there is no way to invest effectively without coming to terms with the most important question--what is my portfolio worth? How can any reasonable person hand in a regination from a job at an early age without possessing some sort of reasonable idea as to what his portfolio is worth? It is an insane proposition.

I don't agree with you that it is simpler to reflect the markdown needed for fluff on an individual basis than by incorporating the effect into one's SWR analysis. The two approaches would produce similar results, but I think that you are going against some long-ingrained habits in asking people to adjust down their portfoio values to reflect the effects of changes in valuation levels. I believe that the more practical solution is to incorporate this factor into SWR analysis, since it clearly has a huge effect on the determination of what is safe.

That said, I do not say that you approach is invalid. The conventional SWR methodology is invalid, but your approach is a reasonable one. The only major difference I have with you is that I think that a more practical way to take account of this critical factor in assessing the safety of one's retirement plan is by looking to a SWR analysis that incorporates it into its calculations.
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Re: Safe withdrawal ideas, thoughts and provocations

Post by BenSolar »

That is an interesting tack you are taking, Petey. I like it. :) I think it provides a conservative approach to retirement withdrawals and investing that would do people good.

ataloss and JWR1945 both note the following:
ataloss wrote: Since overvaluation to the extent of previous p/e highs has been taken into account by the historical swr I think JWR's approach (reduction to level of previous highs makes a lot of sense )


However I will point to the graph at the bottom of this page on REHP and note that 'average' valuations have also produced actual hSWRs in the vicinity of 4%. If we had more data points at higher valuations, I think we would see more scatter, and the SWR from PE-10 of 25, for instance, would be found to be lower than yet seen. JMO.
"Do not spoil what you have by desiring what you have not; remember that what you now have was once among the things only hoped for." - Epicurus
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Post by hocus »

If we had more data points at higher valuations, I think we would see more scatter, and the SWR from PE-10 of 25, for instance, would be found to be lower than yet seen.

I agree, BenSolar.

Is there a numbers doctor in the house? Someone who could demonstrate what you are saying here with data?

Here is how I would go about it if my facility with numbers was greater than it is. What I suggested in my May 13, 2002, post that kicked off The Great Debate is that we caluculate three SWRs, not one: (1) a SWR that applies at times of low valuation; (2) a SWR that applies at times of modetate valuation; and (3) a SWR that applies at times of high valuation.

If valuation levels affect long-term returns, as Bernstein says, then this reality should reveal itself in the historical data. The Dory 36 section of the intercst study provides the data we need to get started with the analysis.

Look for a withdrawal rate that provides 90 percent safety rather than 100 percent safety. That would mean that, of 100 retirement start years, there would be ten start years that resulted in busted retirements. What we need to find out to determine whether Bernstein knows what he is talking about or not is the answer to this question: Is there a connection between starting a retirement in a year of high valuation and going bust?

If Bernstein is right, it would seem to me that, when looking at retirements beginning in one of the years included in the one-third of the total data set with the highest valuations, you would get a higher number of busted retirements than you would get looking at the one-third of moderate valuation start years or the one third of low valuation start years.

If the busted retirements just pop up randomly, that suggests to me that Bernstein is all wet. If there is a pattern, if the busted retirements tend to show up for retirements beginning in years of high valuation, that suggests strongly to me that Bernstein is on to something very, very important. JWR1945 did an analysis early in The Great Debate indicating very strongly that there is indeed a connection between busted retirements and high-retirement start years. I think it might be a good time to spell out in more detail just how significant a connection the historical data reveals.

If it turns out that there is indeed a connection between starting your retirement in a year of high valuation and having your retirement go bust, I can see no reason why that connection would not hold at various withdrawal rates. If there is a connection when looking at a withdrawal rate that generates 90 percent safety assessments under the conventional methodology, I think it is reasonable to believe that there is also a connection at the withdrawal rate that generates 100 percent safety assessments under the conventional methodology.

If the conncection is indeed demonstrated, then I would conclude that you are right in what you say above, BenSolar. It would be reaosonable to conclude at that point that the only reason why no busted retirements turn up in the historical data when examining a 4 percent withdrawal is that the data set being used is too small to generate statistically meaningful results.

At that point, we would need to generate some additonal data points with a Monte Carlo analysis.. If examination of the new data points shows that high-valuation start years causes an increased chance of a busted retirement at a 4 percent withdrawal rate too, that means that a 4 percent rate was not safe for retirements that began at the high end of valuation levels for the pre-bubble years. There are no failures showing up in the historical record only because the number of data points is so slight. But retirees who started out retirements in those years had no reasonable basis to feel safe about a plan using a 4 percent withdrawal rate. Their plans survived because they happened to get lucky, not because what they did was safe.

I believe that your comment goes to something of great significance, BenSolar. I think that it is not only in the bubble years that the conventional methodology turned out wrong numbers. The numbers were wrong in the pre-bubble years too. Changes in valuation levels always affect SWRs. It would be helpful at this point if we could put together some data showing with numbers why this is so.
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Post by peteyperson »

I don't know if I believe this to be true at all.

If the valuation of your portfolio is re-calculated to take full account of overvaluation, then how does overvaluation matter? Are you thinking that the period of slow correction delivers historically less growth during that period?

Petey

hocus wrote: I believe that your comment goes to something of great significance, BenSolar. I think that it is not only in the bubble years that the conventional methodology turned out wrong numbers. The numbers were wrong in the pre-bubble years too. Changes in valuation levels always affect SWRs. It would be helpful at this point if we could put together some data showing with numbers why this is so.
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Re: Safe withdrawal ideas, thoughts and provocations

Post by peteyperson »

Hello Mr Solar,

Thank you for your comments.

I see we are in agreement but I would have worded it differently which perhaps changes the understanding somewhat. I wouldn't say it is a conservative approach, though it may seem that way. To base your current net worth on inflated values (whether the current value or reduction to a level of the previous high) is just poor methodology and will likely bite you in the ass, once when the market corrects, perhaps twice when the market overcorrects and you plunge from P/E 30+ to P/E 10. At that point you are desparing having seen a 2/3 collapse on a line with 1929, however unlike 1929 your inflated portfolio value won't return subsequently. The average is P/E 14.1, sometimes it will be higher, sometimes lower, creating a certain standard deviation in stocks that is higher than bonds. Not assessing your portfolio in the middle range, the historically accurate range, is plain wrong.

So I know we agree on the facts, but I would say it is not a conservative viewpoint simply a correct one. I'm not splitting hairs but I think it is an important distinction. In many ways I like the fact that using this methodology would demand I auto-correct any investments I made in the Accumilation stage to reflect true value and thus would highlight when I was buying into the market as an inflated valuation. It would set off alarm bells, as well it should unless you plan to dollar cost average for 30+ years to smooth the effect out.

It's worth pointing out that people cannot time purchases if they are buying actively managed mutual funds. They can appreciate the average P/E ratio but will not precisely know the average P/E of the stocks chosen, particularly on investment strategies that aim (however impractically at present) to buy only stocks at low P/E. This works on low cost index fund strategy where you're buying the market as a whole and know what price approx that you're buying in at. It also works on individual share purchases where you have the same choices. This links to my mention of the airline article at P/W 60 where I fail to see how starting at that price you can get a good return in almost all investing situations.

As for the actual safe withdrawal rate based on a historical P/E corrected valuation, I haven't begun to consider what rate is valid based on this new paradigm other than the suggested approach to assess what asset classes to invest in, what their expected returns are going forward etc and see what that delivers overall. I don't think the Monte Carlo stuff can spit out meaningful numbers in this vain as hocus hopes for. That's relying on the old paradigm. You can get performance information from Jeremy Siegel's book including the longest periods of undervaluation (where Bogle got his info from), do your allocations, assessment of return on each asset class and do the calculation from there. No amount of Monte Carlo simulations can do that to the best of my knowledge.

Petey


BenSolar wrote: That is an interesting tack you are taking, Petey. I like it. :) I think it provides a conservative approach to retirement withdrawals and investing that would do people good.

ataloss and JWR1945 both note the following:
ataloss wrote: Since overvaluation to the extent of previous p/e highs has been taken into account by the historical swr I think JWR's approach (reduction to level of previous highs makes a lot of sense )


However I will point to the graph at the bottom of this page on REHP and note that 'average' valuations have also produced actual hSWRs in the vicinity of 4%. If we had more data points at higher valuations, I think we would see more scatter, and the SWR from PE-10 of 25, for instance, would be found to be lower than yet seen. JMO.
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Post by BenSolar »

peteyperson wrote: I don't know if I believe this to be true at all.

If the valuation of your portfolio is re-calculated to take full account of overvaluation, then how does overvaluation matter? ...
hocus wrote: Changes in valuation levels always affect SWRs.


Let's be careful that we don't start talking past each other. Hocus, IINM, was speaking from his traditional viewpoint of adjusting SWR, not the valuation. The end result is the same either way.

Ben
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Post by BenSolar »

hocus wrote: If valuation levels affect long-term returns, as Bernstein says, then this reality should reveal itself in the historical data.


Shiller and Cambell have already done the statistical heavy lifting here. They've demonstrated to my and their satisfaction that valuation levels affect long term returns.

Technical details available in various papers here: http://www.econ.yale.edu/~shiller/online.htm
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Post by peteyperson »

Hi hocus,

The "fluff" element is generally referred to as "speculation" by Keynes and Bogle too.
hocus wrote: The other element is the "fluff" element, the part of the price that reflects nothing more than the madness of crowds willing to bid up prices to levels that have no connection to the reaonable earnings expectations of the underlying businesses.



Technically the valuation is "real" at any given moment in the sense that you could choose to sell all your shares and they would get the best price on the open market at that time. They may not all sell for that price but it would likely be a fair representation. This I believe is where people fall down in comprehending the point being made, fore it is a subtle one. But as I mention to Ben Solar, during an investing lifetime you will likely see overvaluation, fair valuation and undervaluation. If you start with a position that P/E 30 (for example) is a fair valuation and we'll use that, then when the market corrects (sometimes overcorrecting according to historical record), then you portfolio will drop by 2/3rds. The early retirees not understanding these issues were "lucky" to only see a 40% slide. It could have in fact been much worse.
hocus wrote: The confusion is the result of the way that stock prices are calculated. There is an extent to which stock prices reflect underlying real economic values. When you own a stock, you own a piece of a company, and the value of the stock certificate to the extent that it reflects your ownership interest in a business entity is real.



I think it will be interesting now to discuss (whispers: battle it out) over the issue of safe withdrawal using historic simulations like Monte Carlo vs. my belief that what is needed is a basic understanding of historic returns via Siegel's book (taking into account any feeling that perhaps stocks won't perform as well moving forward). I've yet to grasp how starting from an overvalued market, your w/d rate goes down. If your stock portfolio is balanced around 50/50 between stock and other more liquid investments, your exposure/need to sell cheap is severely cutdown. If you take your valuation as P/E 14.1, then it should not matter than you're sitting at P/E 30. Future growth is included in that valuation and the intrinsic value of the business base will rise over time to meet the inflated value (and perhaps the inflated value will have some air let out of it too). I don't understand how any of this means starting from a high valuation, your w/d rate is cut. I can see how in the Accumilation phase it is a problem! So I think that is a big area that is now in dispute and will need to be resolved. Its a worrying fundamental difference of opinion on this part.

You're referring to a high stock allocation restricting your options when it is undervalued and selling out low will knock your portfolio down severely. I don't see how you can have that. I think a 50/50 portfolio as Bogle suggests himself makes sense. You need the built in flexibility to use cash rather than redeeming shares at bad times. This also has capital gains tax benefits to offset the delays in selling.
hocus wrote: Incorporate what the Gordon Equation tells you about the returns you can reasonably expect to obtain in the future, and the SWR is 2 percent. That's what Bernstein tells us on Page 234. If you want to go with a 74 percent stock allocation, you may do so, but you must understand that there is a big price to be paid for doing so. It means delaying your retirement for years and years. If you want the quicker retirement, you have to go with alternate asset classes that provide a higher SWR. This is exactly the opposite of what the convetional SWR methodology tells you. That's why I say that the convetional methodology is invalid. It provides the wrong answer to the most important question you are trying to grapple with, whether it will take longer to retire safely with a high stock allocation or not.



BTW, thank you for your compliments on my post. I feel this is the first major one where I've been able to contribute something meaningful to the discussion and may have taken things off in a new direction. It also helps bolster your case in some ways which is an interesting turnaround in itself, but I had to start with the market fundamentals in order to get there. It was akin to needing to not have someone answer the questions for you, you had to do it yourself and see where that led. In the middle of the market dot com boom I was bemoaning that I didn't have any money to invest at the time. My father mentioned railroads and bubble at the time and it meant little. The fundementals opens your eyes to so much.

Petey
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