From Chapter 7

Research on Safe Withdrawal Rates

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JWR1945
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From Chapter 7

Post by JWR1945 »

From Chapter 7

In Chapter 7 of our featured book, Common Sense on Mutual Funds, John Bogle once again makes a compelling argument that costs dominate all other factors, this time with bonds. John Bogle comes very close to agreeing with Peter Lynch, who sees no value in bond funds whatsoever. Fund expenses are too high compared to the interest from the bonds themselves.

John Bogle sees merit in bond funds since they allow investors to choose relatively fixed maturities. Theoretically, at least, there is value in having professional bond fund managers as well (before you offset their value added by their costs).

John Bogle allows for the possibility that low cost bond funds, especially low cost bond index funds, could be attractive. Such funds account for very little of the market. John Bogle suggests that bond funds are on the path to oblivion, considering how little value they provide.

The relative performances of bond funds track their expenses almost exactly, except for intermediate corporate bond funds. Even then, the lowest cost funds are the best.

I have noticed that even committed index fund investors are not entirely satisfied even with Vanguard's bond funds. This has come up in discussions related to name changes at Vanguard. The need has arisen to make their bond fund names consistent with their holdings.

I can't help but agree with Peter Lynch that individual investors are better off owning bonds than bond funds.

Have fun.

John R.
peteyperson
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Re: From Chapter 7

Post by peteyperson »

John,

David Swensen who runs the Yale Endowment Fund also makes a compelling point that whilst actively managed bond funds can outperform sometimes, they cannot outperform in excess of their fees. The bond market is simply too efficiently priced. Their only benefit therefore is when they are well run, affordable and focus in an area that isn't presently indexed such as EM debt.

Particular to EM debt, there is a fund that focuses expressly on risk limitation by spreading country risk around (no more than 15% in any one country) and pulls completely out of countries like Argentina way before there is a default (Both PIMCO and Payden's EM debt pulled out of Argentina a year before the default). I am referring to Payden for cautious EM debt which M* notes as " the category chicken ". You don't get to keep up with PIMCO in big EM debt return years but your capital isn't put at risk in quite the same way in comparison to most EM funds that put up to 30% in Mexico, Brazil, aiming for the best returns first and capital preservation in consideration of country default second.

David Swensen is with Lynch on the lack of incentive to invest in bonds. He only recommends investing in treasury debt that lacks credit and currency risk (DFA take the differnet approach of hedging out currency risk and seeking out the most optimal yield curve) and Swensen chooses a 10% long-term treasury holding for classic deflation protection with t-bills for minimal cash holdings (this is a common strategy amongst Yale, Harvard, Princeton etc). The low returns coupled with tax inefficiency, market price risk on interest rate increases, fixed coupons set against rising inflation and the inability of bonds to recover from periods of loss make them a poor investment. Absolute return, specifically event-driven strategies that isolate market movement which corporate events such as mergers, acquisitions, reorganisations etc take place provide superior returns with lower risk to principle. I feel you would really enjoy the book, John. (Also comes with Peter L. Bernstein's recommendation.)

http://www.amazon.com/exec/obidos/tg/de ... 684864436/

With intermediate term bonds, the credit risk doesn't deliver enough return to warrant stepping out from behind the protection of treasury issues. Treasury issues are more readily tradeable and easier to sell should one need to. Here in the UK as an example, the spread from Treasury to Corporate is around 0.6% and the cheapest actively managed fixed income fund charges 0.50%. UK Treasury brokerage costs 0.7% for a 5 year t-note, the cost spread over the 5 year period. So not much upside and much added risk, much as Swensen stated. You can of course mitigate the downside risk somewhat by buying 2-4 year t-notes instead which carry less interest rate risk as the duration & time to maturity is lower. Absolute return event driven, available via Merger Fund and Arbitrage Fund in the US without the excessive hedge fund fee structure offer an alternative for a different or blended strategy. REITs or directly held real estate holds a way to reduce common stock exposure too, but with the opportunity cost implications of avoiding common stocks.

Petey
JWR1945 wrote:From Chapter 7

In Chapter 7 of our featured book, Common Sense on Mutual Funds, John Bogle once again makes a compelling argument that costs dominate all other factors, this time with bonds. John Bogle comes very close to agreeing with Peter Lynch, who sees no value in bond funds whatsoever. Fund expenses are too high compared to the interest from the bonds themselves.

John Bogle sees merit in bond funds since they allow investors to choose relatively fixed maturities. Theoretically, at least, there is value in having professional bond fund managers as well (before you offset their value added by their costs).

John Bogle allows for the possibility that low cost bond funds, especially low cost bond index funds, could be attractive. Such funds account for very little of the market. John Bogle suggests that bond funds are on the path to oblivion, considering how little value they provide.

The relative performances of bond funds track their expenses almost exactly, except for intermediate corporate bond funds. Even then, the lowest cost funds are the best.

I have noticed that even committed index fund investors are not entirely satisfied even with Vanguard's bond funds. This has come up in discussions related to name changes at Vanguard. The need has arisen to make their bond fund names consistent with their holdings.

I can't help but agree with Peter Lynch that individual investors are better off owning bonds than bond funds.

Have fun.

John R.
JWR1945
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Post by JWR1945 »

It just struck me: Here is a professional money manager at Yale. He is making money hand over fist and he does things counter to what academic studies tell us to do.

What a combination! Academic purity giving way to real world investment success.

Have fun.

John R.
peteyperson
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Post by peteyperson »

This why I believe you would find it fascinating, John. :lol:

For instance, Swensen's good friend was the Late James Tobin who came up with a number of the efficient market academic stuff. This said, Yale invests in equities primarily in boutique investment firms that are not owned by larger conglomerates, who behave in a more entrepreneurial manner and focus on concentrated portfolios. By having numerous focused portfolios around the globe, Yale benefits from investors with detailed knowledge of the companies they invest in, diversification but with outperformance. (All of this is discussed in detail in the book.)

Bogle compares active to index returns but doesn't quite grasp that most active funds invest in diversified portfolios that hug indexes (he gets that) because of a flawed design (he gets this, but doesn't follow the thinking along to its natural conclusion by sourcing returns on concentrated portfolios for a fair comparison. Instead he just used the averages which are mostly diversified active funds which will never beat the indexes). Concentrated portfolios are the only ones that can outperform. They deliver higher standard deviations but when viewed over a reasonable timeframe compound money up at far greater rates. This allows an investor to better withstand market corrections because the total invested during good times climbs sufficiently. This again is a very subtle point missed by many. I am currently failing to explain this to Alec in a thread on the FIRE board. There is a great deal of psychological anchoring that goes on with index investors who have been force-fed Bogle and have stopped being able to think for themselves. As Buffett said at the BRK AGM this year, thinking is important.

Yale were the pioneers of private equity and absolute return investing and the results are detailed in the book. There is also a good discussion on survivor bias and their estimates of future returns with discounts for that bias. It is a very well balanced book. Harvard by comparison invests a large part in fixed income and other forms of arbitrage instead of directly in buy & hold bonds. There is also a book that focuses on Yale's private equity investing which came out of a Yale student's paper on the investing process. I haven't yet bought that to read.

Good summary of the book:
http://www.philanthropyroundtable.org/m ... noyer.html

P.S. Thank you for your PM on the real estate company in Florida. I refer to it when trying to understand how to value that business and its prospects over the coming decade. Very useful on the ground comments.

Petey
JWR1945 wrote:It just struck me: Here is a professional money manager at Yale. He is making money hand over fist and he does things counter to what academic studies tell us to do.

What a combination! Academic purity giving way to real world investment success.

Have fun.

John R.
hocus2004
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Post by hocus2004 »

Petey: "As Buffett said at the BRK AGM this year, thinking is important. "

I much appreciate your contributions here, Petey.
peteyperson
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Post by peteyperson »

No probs, Rob.

Just as a side comment, the reason I don't really follow the work that is done on safe withdrawal rates on the SWR board is because I feel whatever progress might be made will only have a limited effect. Markets are becoming much more correlated especially to unusual events like the past Asia crisis where all equities fell substantially even though fundamentally a listed business in Ohio that makes toys may have been completely unaffected. It would have fallen too. So in such situations and with major market corrections, any playing with numbers will not ultimately deliver much more than a 4% withdrawal rate. The return on the time invested is limited.

The reason I began replying to John's Bogle posts was because we were moving into the realm of area where I do believe one can make a measureable difference. Outperformance. For if one's portfolio produces a higher return in the good market years, you have more funds left after a correction to survive and can lower your withdrawal rate because you made hay while the sun shined. So as I see it, focusing on improving the net worth position by careful investing rather than heavily diversified portfolios that needlessly hug the indexes gives one an advantage. This is bound to give more wriggle room in bad times than tweaking the withdrawal rate in a general manner. In car terms, it is like spending all the spare time tweaking the engine to get the last bit of efficiency out of it, rather than spending that time earning enough extra to just buy a bigger engine. Time spent on outperformance would give a larger amount of money, leaving more left after the correction in $ terms and the ability to reduce the withdrawals. This just seems far more efficient instead of trying to swim upstream.

I also see this kind of problem thinking with investors who religiously follow the modern portfolio theory, spending endless hours splitting assets and sub-asset classes and buying numerous investments, playing with efficient frontier curves, standard deviations and constantly moving correlations between them. This time could be much better spent learning about how to invest in businesses. Loved the comment by either Buffett or Munger at the BRK AGM when they said it was madness to issue a press release announcing an endowment had changed asset allocations from 60% equities, 40% bonds to 65% equities, 35% bonds. Like that really told anyone anything! ;)

That's my perspective :lol:

Petey
hocus2004 wrote:Petey: "As Buffett said at the BRK AGM this year, thinking is important. "

I much appreciate your contributions here, Petey.
JWR1945
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Post by JWR1945 »

For peteyperson:

I have just placed an order for David Swensen's book.

I am likely first to read and comment about a book related to high dividend investments.

That subject came up at dory36's Early Retirement Forum. A poster named hankjoy suggested buying high dividend investments with the intention of living off the dividends (and possibly reinvesting some of them) but never selling any shares. This eliminates the problem of selling shares at distressed prices. The issue is whether suitable investments of that type really exist and, if so, why hasn't this strategy been exploited already? The answer, which I cannot verify as being totally accurate, is that suitable investments do exist but it takes a lot of effort to identify them. There are dangers for those who do not take enough care.

Such a strategy should easily bring one's withdrawal rate substantially higher than the one percent above dividends that we have seen in the past. We could be talking about (inflation adjusted) withdrawal rates of 6% or more.

It sounds good. It may work. It takes effort. There are hazards for the unwary.

Have fun.

John R.
peteyperson
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Post by peteyperson »

I looked into this most recently. There are at least two boards on the Fool that focus on this strategy.

There are those that believe that high dividend paying stocks deliver superior returns over time. This ignores the effects of taxes on the dividend. When those are factored in, it is not a market beating return and likely underperforms the market. The kind of companies that pay out 4% dividends are past their prime, cannot use the earnings well and adopt a dividend policy to distribute the funds. In some cases this can work well, management needing to run the business with sufficient discipline to enable a steady dividend stream. It does however reduce the flexibility of management, their ability to grow the business faster, pay down debt or buy back shares. The latter being most preferable due to the elimination of personal taxation.

GM is a good example of a bad stock. Investors buy into the company for their steady dividend and ignore that the business has issues more shares and more debt to fund the capital expenditure costs of retooling their factories for each new product line. The share price hasn't moved in the past decade nor kept up with inflation because of the dillution of the shares and increasing cost of debt. The dividend doesn't get bumped up by inflation and has sat pat for a couple of years now. And yet investors blindly hold it "for its dividend".

So I remain unconvinced that high dividend paying stocks is the answer. I too thought it might be but I am interested in growing the value of investment at a fast clip and need businesses that reinvest earnings successfully. Selling those companies off later, taking the capital gains tax hit and then reinvesting the remainder into high dividend paying stocks is a costly way of working. Some companies will naturally mature and raise their dividend when they reach market saturation and growth naturally slows. This is acceptable as long as the business is still sound.

It doesn't follow that a company can pay out 6% and be fine, thus raising the w/d rate. Whilst the markets have produced an average 10% annualised and closer to 12% annualised when you include the excesses of the late 90s returns into the averages, there have been some wild decade swings in the returns. In many cases, it just wouldn't be practical for a company to pay out 6% and expept it to grow an additional 4%, comprising the 10% total return. In good times, 4% growth may be possible whilst taking 6% out as a dividend but in tough economic times growth will slow, halt or go into decline. By taking 6% out consistently, you deprive the company of the ability to reinvest enough when coming out of recession to get back into growth mode. There will also be years where the company treads water and paying the dividend would mean adding more debt to finance it or cutting the dividend to avoid this would highlight the level of the dividend being unsubstainable. Reinvestment in new product development is needed and whilst sales may rise due to inflation increases in pricing, innovation is still important to keep the business competitive.

Petey
JWR1945 wrote:For peteyperson:

I have just placed an order for David Swensen's book.

I am likely first to read and comment about a book related to high dividend investments.

That subject came up at dory36's Early Retirement Forum. A poster named hankjoy suggested buying high dividend investments with the intention of living off the dividends (and possibly reinvesting some of them) but never selling any shares. This eliminates the problem of selling shares at distressed prices. The issue is whether suitable investments of that type really exist and, if so, why hasn't this strategy been exploited already? The answer, which I cannot verify as being totally accurate, is that suitable investments do exist but it takes a lot of effort to identify them. There are dangers for those who do not take enough care.

Such a strategy should easily bring one's withdrawal rate substantially higher than the one percent above dividends that we have seen in the past. We could be talking about (inflation adjusted) withdrawal rates of 6% or more.

It sounds good. It may work. It takes effort. There are hazards for the unwary.

Have fun.

John R.
hocus2004
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Post by hocus2004 »

Here's a link to the Early Retirement Forum thread referenced by JWR1945 above:

http://early-retirement.org/cgi-bin/yab ... 1084752712
JWR1945
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Post by JWR1945 »

For peteyperson:

I agree with your points. There are some special considerations in back of this approach.

1) The first is that you look at this as buying an income stream that lasts into the indefinite future. From this vantage point, it is OK if there is no price appreciation whatsoever, just so that the dividend amount increases at least enough to keep up with inflation.
2) The second consideration is that the company's growth does not have to be very high. In fact, a good choice might be a company with a current dividend yield of 5% and a dividend growth rate of 0% in real terms. That is, the dividend amount grows just enough to match inflation. From the Gordon equation, the long-term return (assuming a constant price to dividend ratio) should equal the dividend yield plus the dividend growth rate = 5% + 0% = 5% in real dollar amounts.
3) The third consideration, which is critical, is that you have to exert extreme price discipline. An annual price fluctuation of 2 to 1 (the ratio of the 52-week high and the 52-week low) or greater is common among stocks, even those with high dividends. Assume that the 5% yield that is typically reported comes from the middle of this range (at 1.5 times the low). If you can buy near the low price, the dividend yield relative to your purchase price could be close to 1.5 times the (typically) reported yield of 5%. That is, by waiting for a very favorable price, you can get a yield of 7+% of your investment if you can get your price. You must be willing to let an opportunity slip away for just a few pennies.
4) You should allow yourself two or three years of waiting to get the right price.
5) The tax situation depends upon individual circumstances. For those already retired, having dividends taxed is not necessarily that bad (especially at the new, lower rates). In addition, we have sheltered accounts. In most cases, however, we are talking about people in retirement or in a hocus-like semi-retirement.

I think that it is reasonable, through price discipline, to purchase a reliable income stream of 5% or 6% of your initial purchase price without too much difficulty. You would wait for an extremely favorable price on what you would normally identify as a stock with a 3% to 4% yield. It might take two or three years. Once purchased, the income stream of a properly selected company would persist indefinitely. That is in contrast to withdrawals around 1% plus dividends (or around 2.5% today) in a portfolio which is likely to grow but which might end up with a balance of zero after 30 years.

What you buy matters as well. It strikes me as plausible that (with sufficient price discipline) you could pick up some REITS with enough excess in yields so as to overcome any long-term depreciation of assets. [I am not knowledgeable about REITS. The key is that we are willing to wait for two or three years to get an outstanding price.]

In terms of who might use such a strategy, I imagine that it depends greatly upon one's individual circumstances.

Looking at investments in terms of income streams can help motivate you as well. Suppose that you were able to set aside $30K and buy an income stream of 6% of that amount (plus inflation) that would last indefinitely. That would be more than enough to pay all of my electrical bills in Florida forever. Think of it! Knock off all of your necessary expenses that way. One by one. More and more of what you take home is really yours. [I got this insight from hocus's book.]

Have fun.

John R.
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Post by Mike »

It doesn't follow that a company can pay out 6% and be fine, thus raising the w/d rate.
So there is no free lunch. I kind of thought that this would be the case, since the market seldom leaves free money sitting at the table for long periods of time. The TSM is still the best for the majority in times of normal valuations, since it includes all types of companies. However, the constant inflation policy destruction of bonds as an asset class has put equities at risk by virtue of the sheer mass of investors trying to live off of them. Legal pension plan investment restrictions, and the size of the boomer cohort have magnified this effect. A dividend yield of 1.7% is not enough for most people to live off of, and it may go lower before it goes higher. If Presidend Bush passes his plan for part of the payroll tax to be placed in private accounts, with equity being the only option offered that holds hope of keeping up with inflation, expect valuations to climb even higher for a while.
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Post by JWR1945 »

So there is no free lunch. I kind of thought that this would be the case, since the market seldom leaves free money sitting at the table for long periods of time.
Actually, there usually is. Prices fluctuate much more than makes sense in any given year.

Real estate is an especially good example. People who are willing to exert extreme price discipline can lock in a future price return when they make their initial purchase. Doing it right is not trivial. Nor is it impossibly difficult to learn how.

I have not read the book. Some of the investments mentioned can require quite a bit of research. Otherwise, you could end up with a disaster. Many are illiquid. That is a killer if you wish to sell sometime in the future. If you goal is an income stream, it is not necessarily a problem.

I think that some of the advantages of this kind of approach are marketable enough to attract professional interest. Some of the advantages are likely to disappear with time (especially after the INFOMERCIALS appear). I think that some will persist because effort is needed to do it right.

Have fun.

John R.
Mike
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Post by Mike »

Some of the investments mentioned can require quite a bit of research. Otherwise, you could end up with a disaster.
There are always opportunities for those who are gifted with financial wisdom, but the majority cannot outperform itself.
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Post by peteyperson »

Interesting long thread, Rob.

I would have thought that moving some or all of your CD cash maturing into REITs would make some sense. It provides similar inflation matching returns with a good yield. REITs recently corrected back to close to NAV. I would imagine that is better than sitting in low returning CDs.

Inflation protected investments that pay a real return of 3.4% or 3.5% are only good if you buy that the govt. inflation rate is realistic and comes close to matching your personal inflation rate. As a retired friend of mine in America has discovered, despite watching expenses closely, the increasing cost of medical insurance has eaten away his budget for vacations to the point where they can only travel for a few days and never go abroad. As health insurance and other costs continue to rise, these will encroach more and more on the other parts of his budget. Clearly as many Americans are now only starting to wake up to, the govt inflation figures come nowhere close to matching the reality (in the UK, the official rate is 2.5% but the reality is first time buyers cannot afford a basic apartment and are having to save for 8+ years to secure a large enough deposit on homes that rise 10%+ a year. The reality and the data make no sense to even an untrained eye, hence why govt issued inflation protected bonds are an amusement to me!). We can say that 2 car families etc have raised living expenses enough to mess with the true cost of living, but health insurance, utilities etc are essentials that don't connect to this. Places like Wal-Mart seem essential to a retiree in holding down the cost of the basics. So, inflation protected investment IMHO don't yield 3.5% real because the inflation number is fudged. The real return is far lower and this highlights how poor an investment bonds are, inflation protected or no. With so much govt expenditure linked to the inflation rate, there will be an increasing temptation for govts to meddle further with the official inflation rate to hold govt spending down, be it medical workers or inflation protected government securities (this will become a larger problem when twice as many people retire, fewer people in the workforce and govt spending jumps due to the cost of the national health care service, govt pensions and less taxes reaching the treasury - the problem will get more acute and inflation data will get even more unreliable). Perhaps I am missing something but even ignoring my points about the inflation number fudging, I don't get how you were saying research shows that 3.5% delivers over 4.8% s/w rate. If it paid 3.5% real, that is the w/d rate surely? :?

There are some good points in the thread, some of which I've hit upon here. Someone said that their balanced approach had beaten their dividend stock approach after accounting to dividend taxes. This is what I understood to be true. Others said that higher yielding stocks are usually higher risk (because it means their PE has fallen because it is in trouble and the yield is boosted for new buyers at that point) and many go bankrupt. One upside to some of the 4% dividend payers is that they tend to be valued at a far lower PE multiple, banks 10-12 etc, because they often lack a powerful consumer monopoly, powerful brands to distinguish them in the market place and good growth prospects. HankJoy is making the considerable mistake of treating a commodity investment with no substainable pricing power like oil royalty trusts and their yield of 8-12% as spendable. As one cannot know whether oil or natural gas will increase by inflation over the next several decades, one would need to reinvest some money to cover the possibility that it won't. Personally, I believe the price of oil will deliver good cashflow over time but it is possible that prices settle lower and don't get rich until a decade before oil runs out and a worldwide panic sets in. I would choose to reinvest to try to keep the yield up with inflation, but be mindful that cash flow comes from oil prices which can go thru decade long lows where inflation can kill the capital value remaining by the end of that decade. With real estate, rents tend to increase to reflect the increasing replacement cost of the real estate and to keep yields within a range of that increasing replacement cost. Oil doesn't have that same linkage.

Petey
hocus2004 wrote:Here's a link to the Early Retirement Forum thread referenced by JWR1945 above:

http://early-retirement.org/cgi-bin/yab ... 1084752712
Last edited by peteyperson on Sat Jun 12, 2004 3:28 am, edited 1 time in total.
peteyperson
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Post by peteyperson »

Hi John,

There are very few businesses that pay out 6%. Very few that do so and raise their dividend by inflation. The inflation figure is not accurate but they will peg their increases to it. A company whose earnings do not grow cannot keep increasing the dividend. A company that never sees increases in market price is a problem child.

There are some investments like banks that pay 4%. REITs historically have paid at least 4% and do tend to grow with inflation overall though not consistently ever year and are subject to boom and bust cycles. Canadian Royalty Trusts pay 8-12% but you must pay taxes on that, they use some cash flow to buy more oil wells and natural gas deposits to keep their undrilled reserves to 10 years plus and you need to reinvest some of the dividend to keep the value of the investment up with inflation. The cash flow depends on the price of oil rather than an adjustment yearly for inflation. So slightly different equation there. US oil trusts cannot to my knowledge add new reserves and so bleed out over time.

Investments generally just do not generate 6-10% dividends and do so on a substainable basis sufficient to keep raising the dividend with inflation, innovate and stay in business. Most product lines die. There are a few exceptions like Coca Cola and other businesses that Buffett has sought out because he wants to avoid the capital gains tax consequences for as long as possible and sees desired products that don't change as the best way. Those kinds of businesses pay minimal dividends in most cases and wouldn't be a candidate. This only leaves you with companies that don't have substainable business models and products indefinitely. Companies like the US oil trusts would run out of steam and if it didn't keep up with inflation, then you'd lose capital when buying something better. It is not as simple as you like the think! Retirees certainly move to stocks like utilities that pay higher dividends and they like the income stream to be sure. The problem is most of these kinds of businesses, also like GM as a good dividend stock many retirees own, are regulated and/or just don't do all that well and don't increase in value. This ties your hands if you need to change strategies later.

It is possible to buy into solid banks, hope they don't go down in a heavy recession and hold a lot of commercial leveraged real estate via REITs. This would generate 4% or more assuming the banks didn't cut the dividend. The problem is a recession that can turn into a depression. REITs may reach a point where because property falls 50%, rents too fall 50% and so they are forced to renegotiate their leases or lose many tenants. Also many business tenants will go bust leaving far higher vacancies. The combination can mean that pretty soon they are unable to continue paying their 50% leveraged bond debt. Ultimately, the bond holders can grab the real estate, sell it at the market rate (if they can even sell it), pay off the bonds and the shareholders have nothing left. Meanwhile, banks suffer from mortgages going unpaid and even if they take the homes and try to sell them, the depressed residential real estate market will mean heavy losses for them. The owners won't have the funds to repay the balance owed and many banks will fail. The money center banks are likely to fair better and will be supported by the federal government but even so, there will be major problems (it is worth noting here that when Buffett bought part of Wells Fargo Bank, the investing community thought it was nuts because there was concern over its large mortgage portfolio, vulnerability to California, the real estate market as well as more earthquakes). Most of this happened follow 1929 in a spiral effect, except the real estate crashed 80%. Some of this happened in the last real estate crash when REITs mostly used 80% leverage and many went to the wall.

Leveraged real estate and banking do have their specific risks and relying on them for a dividend paying strategy leaves you vulnerable to a bad economy. Following the ES route of all US all of the time, you'd be even more vulnerable unlike someone who invested in global leveraged commercial real estate which have different cycles at different times and lowers the odds some (1929 also happened to the UK stock market and real estate took a tumble too, so it wasn't a single country isolated incident). With single family homes owned privately with mortgages paid off going into retirement, other than the risk of owning one type of property leased/rented to one type of tenant, usually a selection of properties all owned in the same area that could suffer a Texas, Florida or New England type real estate/industry bust and other issues, you do have the ability to weather the storm. As you have minimal maintenance costs and no financing, you have more flexibility to reduce the rent for a time and still get some cash flow coming in. Again, you would not want 50% of your income coming from this source as that makes you overly dependent on a single source of income, one type of property, the local community/economy. But not having leverage would allow you to ride out the boom & bust cycles of real estate and avoid a lot of the worst described above. (There was concern over the viability of Wells Fargo even thought it was a money center bank and Buffett weighed up the odds of a healthy return vs the potential loss of a bank failure much like he would when evaluating a merger arbitrage trade when he would weigh the potential return against the possibility that the merger would fail, stocks would fall lower before he could sell his position. But as you can tell, he considered failure as a very real risk and the market knocked Wells Fargo Bank down by 50% because of the perceived risk in the investment.)

BTW, did you mean hocus's Fool report from several years ago or the book that hocus had been writing. If it the later, I would be interested to see what he's come up with.

Petey
JWR1945 wrote:For peteyperson:

I agree with your points. There are some special considerations in back of this approach.

1) The first is that you look at this as buying an income stream that lasts into the indefinite future. From this vantage point, it is OK if there is no price appreciation whatsoever, just so that the dividend amount increases at least enough to keep up with inflation.
2) The second consideration is that the company's growth does not have to be very high. In fact, a good choice might be a company with a current dividend yield of 5% and a dividend growth rate of 0% in real terms. That is, the dividend amount grows just enough to match inflation. From the Gordon equation, the long-term return (assuming a constant price to dividend ratio) should equal the dividend yield plus the dividend growth rate = 5% + 0% = 5% in real dollar amounts.
3) The third consideration, which is critical, is that you have to exert extreme price discipline. An annual price fluctuation of 2 to 1 (the ratio of the 52-week high and the 52-week low) or greater is common among stocks, even those with high dividends. Assume that the 5% yield that is typically reported comes from the middle of this range (at 1.5 times the low). If you can buy near the low price, the dividend yield relative to your purchase price could be close to 1.5 times the (typically) reported yield of 5%. That is, by waiting for a very favorable price, you can get a yield of 7+% of your investment if you can get your price. You must be willing to let an opportunity slip away for just a few pennies.
4) You should allow yourself two or three years of waiting to get the right price.
5) The tax situation depends upon individual circumstances. For those already retired, having dividends taxed is not necessarily that bad (especially at the new, lower rates). In addition, we have sheltered accounts. In most cases, however, we are talking about people in retirement or in a hocus-like semi-retirement.

I think that it is reasonable, through price discipline, to purchase a reliable income stream of 5% or 6% of your initial purchase price without too much difficulty. You would wait for an extremely favorable price on what you would normally identify as a stock with a 3% to 4% yield. It might take two or three years. Once purchased, the income stream of a properly selected company would persist indefinitely. That is in contrast to withdrawals around 1% plus dividends (or around 2.5% today) in a portfolio which is likely to grow but which might end up with a balance of zero after 30 years.

What you buy matters as well. It strikes me as plausible that (with sufficient price discipline) you could pick up some REITS with enough excess in yields so as to overcome any long-term depreciation of assets. [I am not knowledgeable about REITS. The key is that we are willing to wait for two or three years to get an outstanding price.]

In terms of who might use such a strategy, I imagine that it depends greatly upon one's individual circumstances.

Looking at investments in terms of income streams can help motivate you as well. Suppose that you were able to set aside $30K and buy an income stream of 6% of that amount (plus inflation) that would last indefinitely. That would be more than enough to pay all of my electrical bills in Florida forever. Think of it! Knock off all of your necessary expenses that way. One by one. More and more of what you take home is really yours. [I got this insight from hocus's book.]

Have fun.

John R.
peteyperson
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Post by peteyperson »

This is why a good approach is to invest in individual stocks that grow by 10% a year and to plan to sell them down. Ones that perform sensible share buybacks with shareholder money can boost lower growth rates thereby increasing earnings per share and this will be reflected in the share price in time. With a 1.7% dividend, you only need to sell down 2.3% a year. If you have some money in cash, CDs, T-bills or other investments that pay some income, then this allows you to mitigate some of the risk of needing to sell down annually by being able to live off those other assets and not suffering capital losses due to timing. This does carry an opportunity cost but adds some diversification and balances the risk of capital loss due to being forced to sell equities annually at a range of PE multiples over the years to live. REITs will at times pay more than 4% dividend and this can be lived on to reduce needing to sell common stocks etc. It isn't necessary to asset allocate till the cows come home, but taking an overview of what you need to achieve can give clues to the way forward.

Petey
Mike wrote:
It doesn't follow that a company can pay out 6% and be fine, thus raising the w/d rate.
So there is no free lunch. I kind of thought that this would be the case, since the market seldom leaves free money sitting at the table for long periods of time. The TSM is still the best for the majority in times of normal valuations, since it includes all types of companies. However, the constant inflation policy destruction of bonds as an asset class has put equities at risk by virtue of the sheer mass of investors trying to live off of them. Legal pension plan investment restrictions, and the size of the boomer cohort have magnified this effect. A dividend yield of 1.7% is not enough for most people to live off of, and it may go lower before it goes higher. If Presidend Bush passes his plan for part of the payroll tax to be placed in private accounts, with equity being the only option offered that holds hope of keeping up with inflation, expect valuations to climb even higher for a while.
Mike
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Post by Mike »

With a 1.7% dividend, you only need to sell down 2.3% a year.
In the past, people did not need to sell down at all. They just spent the dividend. Keeping the principal intact kept the dividend flowing at the original rate. This was a much more secure situation, and my original plan. I have adapted to the new dividend yield (and unexpected retirement 5 years earlier than I originally planned) by employing risk reduction strategies in the equity portion of my portfolio, and keeping my withdrawal rate below 1%. I hope to keep my portfolio intact or growing, in inflation adjusted terms, until the yield moves back above 4%. At this point, an index fund, or an individual stock do it yourself index fund may tentatively be the way to go.
JWR1945
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Post by JWR1945 »

Mike wrote:In the past, people did not need to sell down at all. They just spent the dividend. Keeping the principal intact kept the dividend flowing at the original rate. This was a much more secure situation, and my original plan.
I wrote A Bright Future, specifically because of this concern. This should help keep everything in context. It presents one approach that is guaranteed to work. I doubt that it is your only alternative.
http://nofeeboards.com/boards/viewtopic.php?t=2598

Have fun.

John R.
JWR1945
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Post by JWR1945 »

Mike
There are always opportunities for those who are gifted with financial wisdom, but the majority cannot outperform itself.
Let me put this into the kind of context that John Bogle presents in his book.

The average market performance is the average performance of those in the market. Because of fees, nobody can buy the market. From John Bogle's view point, the goal is to make sure that the average investor gets a large percentage of the returns of the market.

John Bogle points out that a very large percentage of actively managed mutual funds do a poor job of harvesting returns for their investors. Many managers have a very short-term focus. They engage in excessive trading. Portfolio turnover is around 100% per year. Fees and other costs are very high (and often well hidden).

He draws attention to the problem of a fund's size. A fund manager may have skill. He may be outstanding. But if his assets grow above $100 million or so, (with a very few exceptions) he will no longer perform well enough to offset his costs.

John Bogle recommends index funds for mutual fund investors. On average, they would do much, much better than they are doing. Even if one concedes that the are mutual fund managers with a skill, investors quickly lose any advantage because of their funds grow too big.

Have fun.

John R.
JWR1945
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Post by JWR1945 »

I have frequently mentioned price discipline. Here are some numbers.

Suppose that you are able to get a price advantage relative to the typical buyer of 30%. This corresponds to buying at the top of the lower third of prices and selling at the bottom of the upper third of prices.

This affects your annualized return in the following manner:
To see the effect of one transaction per twenty years, which should be typical, you take the twentieth root of 1.3, subtract one and then convert to a percentage (i.e., multiply by 100%).

You can do this on a scientific by taking the 0.05 power of 1.3. The result is 1.0132046. This is what gummy calls a gain multiplier. The increase in the annualized return is 1.32046% per year.

Using the same numbers over a single decade (and using 0.10 as the power), the multiplier is 1.0265836 and the increase in the annualized return is 2.65836%.

You can make these calculations using logarithms if you prefer.

I consider an increase in one's annualized returns of 1.3% as outstanding and an increase of 2.65% as incredibly good. [Obviously, I am not among those who tout beating the market by double digits.]

Compounded this simple kind of price discipline offers a huge advantage.

Have fun.

John R.
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