Valuation-Informed Indexing #371
By Rob Bennett
The last two columns argued that the biggest problem with Buy-and-Hold is all the questions it takes off the table. The first of the two articles made the general argument that, once an investor comes to believe that valuations don’t matter, he becomes averse to hearing otherwise because he doesn’t want to acknowledge a mistake and becomes increasingly dogmatic in his Buy-and-Hold beliefs. The second of the two articles focused on particular questions that Buy-and-Holders overlook because it makes them uneasy to dig too deep into strategic analyses that may cause them to doubt their worldview. This week I will look at some of the trade-offs that I have become aware of as a result of my examination of the sorts of questions often ignored by Buy-and-Holders.
The latest Robinhood Investors Conference is in the books, and some hedge funds made an appearance at the conference. In a panel on hedge funds moderated by Maverick Capital's Lee Ainslie, Ricky Sandler of Eminence Capital, Gaurav Kapadia of XN and Glen Kacher of Light Street discussed their own hedge funds and various aspects of Read More
I noted last week that my retirement calculator (“The Retirement Risk Evaluator”) does more than just adjust the safe-withdrawal-rate numbers used by the Buy-and-Holders for the effect of the valuation level that applies on the day the retirement begins. It also lets aspiring retirees identify how much it costs them in safe-withdrawal-rate terms to go with a higher or lower stock allocation or to insist on retaining a percentage of their starting-point portfolio value at the time of their death rather than going along with the assumption used in most Buy-and-Hold retirement calculators that the portfolio may be reduced to a single dollar of value at the end of 30 years. Going over some of the trade-offs revealed by examination of the numbers may help to show how unfortunate it is that the Buy-and-Hold way of thinking about how stock investing works takes so many interesting strategic questions off the table.
At the top of the bubble, the safe withdrawal rate for an 80-percent-stocks retirement portfolio was 2.0 percent real. This number assumes that the portfolio may be reduced to a value of only $1 over the course of 30 years. It is of course a shocking number given that stocks earn an average long-term return of 6.5 percent real. But I think it is important that people know this number because it highlights the importance of the P/E10 level that applies on the day the retirement begins. High P/E10 levels are heavily correlated with price crashes and price crashes in the early years of a retirement have a devastating effect on the long-term success of the retirement plan (because they cause a negative compounding returns effect).
Say that the aspiring retiree wants to retain his entire starting-point portfolio balance rather than accept the possibility of seeing the balance fall to $1 or something in that neighborhood (the assumption commonly used in the Buy-and-Hold retirement studies). How much must he lessen his annual withdrawal to obtain a virtual assurance of the better result?
Not that much, actually.
The safe withdrawal rate for a retiree who retired at the top of the bubble (January 2000) and who insisted on retention of his entire starting-point portfolio balance is 1.1 percent. That’s a very, very, very low number given the long-term average stock return of stocks of 6.5 percent. Intuitively, you would think that the portfolio would be growing by roughly that amount each year and that the withdrawal rate for a retiree insisting on retention of the full starting-point portfolio amount would be something less than 6.5 percent but not that much less. Certainly one would not imagine before checking the numbers that the number produced by a statistical analysis would be so discouraging.
That’s why I believe Buy-and-Holders rarely perform the tests needed to generate these sorts of numbers. A core belief of Buy-and-Holders is that stocks are always the best possible asset class. An asset class that permits an annual withdrawal of only 1.1 percent for 30 years for investors insisting on retention of the full starting-point portfolio doesn’t sound that great. So this number troubles those seeking to maintain a belief in the Buy-and-Hold mindset.
I don’t think the 1.1 percent number offers as negative a message re stocks as it appears to offer on first impression. In fact, I think it can be argued that that number is more encouraging than discouraging for the investor who views stocks as a great asset class for the long term.
The full reality here is that the 1.1 percent withdrawal rate that applies for retirees who insist on retention of the full starting-point portfolio value is not that much less than the 2.0 percent number that applies for retirees who are okay with seeing the portfolio balance reduced to $1 over the course of 30 years. That’s not much of a price to be paid for the benefit attained by paying it. Say that the investor began retirement with a portfolio of $1 million. The difference here is that the investor taking an annual withdrawal of $11,000 is assured of being able to pass along at least $1 million to heirs or charities while the investor taking an annual withdrawal of $20,000 is assured of being able to pass along nothing. The retiree who wants to pass along $1 million instead of zero needs to reduce his annual withdrawal by $9,000. That’s not a bad deal!
The numbers are shockingly low. That’s what disturbs Buy-and-Holders. But an analysis of what is causing the low numbers suggests something positive about stocks rather than something negative. The truly shocking number here is the 2.0 percent number, not the 1.1 percent number. The cause of the 2.0 percent number is the insanely high P/E10 value that applied in January 2000 (the P/E10 value at that time was 44, by far the highest P/E10 value ever achieved in the history of the U.S. market -- the P/E10 value achieved just prior to the onset of the Great Depression was only 33). The 1.1 percent number is not all that much lower. It only sounds absurdly low because the insane valuation level that applied at the time of course affects it as much as it affects the number that applies for retirees willing to see their portfolio values reduced to nothing.
The fact that retirees seeking to retain their entire starting-point portfolio values are required to pay a price of only 0.9 percent of their annual withdrawal rate shows that stocks in general offer an outstanding long-term value proposition. This can be checked by looking at the safe withdrawal rate that applies for an investor who retires when the P/E10 level is 8 who wants to be assured of retaining 100 percent of the starting-point valuation level. In that case, the safe withdrawal rate is 8.8 percent (compared to a safe withdrawal rate of 9.1 percent for the investor who retired at this valuation level and was okay with seeing his portfolio reduced to near zero).
Valuations affect the safe withdrawal rate to a huge extent. But outside of valuation issues (which the Buy-and-Holders ignore), the historical data shows that stocks perform well indeed over the long term. The price that retirees must pay to be certain of being able to pass along to heirs or charities their entire starting-point portfolio values is small. The only reason why it is hard for Buy-and-Holders to see this is because they are so reluctant to look seriously into the valuations matter, which is so dominant a matter for long-term stock investors.
Rob’s bio is here.