1. Summary
After the stock market’s rally in July, which pulled the Timing Outlook up into positive territory, August has seen a nearly equal but opposite slide. Today’s Timing Outlook is negative at 4.5, significantly down from 7.5 last time. Today’s S&P 500 value (at mid-day) of about 1048, is a value that has been crossed through several times in the last few months as the market see-saws up and down. In other words, the market has overall been sideways for three months, but with significant volatility that has looked like trend-starts, but turned out to be false hopes.
This kind of yo-yo action causes the Timing Outlook to jump around too. The last five readings, including today’s, have been Negative-Positive-Negative-Negative-Positive-Negative. Short-term (2-3 week) market reversals are the worst conditions for discerning an investable trend. The Timing Outlook is least useful under these conditions, as swings to-and-fro with the market.
My Capital Appreciation Portfolio has remained 100% in cash since early May. That means that it has gained nothing, but in so doing it has outperformed the S&P 500, which has an overall loss since that time. In the last report, the July rally led me to review the criteria for re-entering the market.
• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• Etc.
The market’s August drop has put these criteria out of reach again, at least for a while. It is hard to see the catalyst that would trigger a sustained rally. Q2 earnings came in strong: 66% of companies in the S&P 500 beat earnings estimates, and 63% beat revenue estimates. But that good news has been offset by poor economic news. Corporations are doing well, but individuals are not. It seems that every day, some negative report is issued about housing, manufacturing, unemployment, a “jobless recovery,” troubles in Europe, the possibility of a double-dip recession, or the possibility that we’ve never actually exited the Great Recession. Ben Bernanke stated recently that the economy is displaying “unusual uncertainty.” Traditionally, markets hate uncertainty.
My Dividend Portfolio is 100% invested, but I made some changes this month. I completed a Portfolio Review, which led me to sell three stocks (Diageo, Emerson Electric, and Royal Bank of Canada) and replace them with two others (added to position in Alliant Energy and initiated position in Johnson & Johnson). These are the first changes to the portfolio in a year. Hopefully they will strengthen the portfolio for its key objective: To generate ever-increasing income streams. The holdings in the Dividend Portfolio are not protected by sell stops. Risk management is accomplished by means of the Portfolio Reviews.
2. Market Performance Since Last Outlook
(“now” figures are as mid-day, Wednesday, August 25, 2010)
Last Outlook (8/5/10): 7.5 (positive)
S&P 500 last time (8/5/10): 1126
S&P 500 now: 1048 Change: -7%
S&P 500 at beginning of 2010: 1115
S&P 500 now: 1048 Change in 2010: -6%
S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1048 Change since 3/9/09: +55%
3. Indicators in Detail
• Conference Board Index of Leading Economic Indicators: The most recent report last week showed a tiny increase in this index. The index has been gyrating the past few months (displaying “unusual uncertainty” too, I guess), rendering it ambiguous. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5
• Fed Funds Rate: No change. The Fed continues to reinforce the idea that rates will not be raised anytime soon. In a nutshell, they seem to see “unusual uncertainty” in the economic recovery combined with little possibility for inflation in the next few months. With the Federal Funds rate near zero, this indicator remains positive. +10
• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 15.2, same as last time. This indicator stays in positive territory at any value below 17.4. +10
• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 0.91, down significantly from 0.98 last time and close to the 0.90 level that would move this indicator into positive territory. For now, the indicator remains in the neutral range, which is any value between 0.90 and 1.10. +5
• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter simple moving averages (SMAs). The configuration is 20-day > 50-day > Index. That is ambiguous, reflecting the yo-yoing in the market. Neutral. +5
• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day). The lineup is 200-day > 50-day > Index. This is exactly the opposite of an uptrend. Negative. +0
• DJIA Short Term Technical Trend: This chart looks similar to the S&P 500 chart. Neutral. +5
• DJIA Medium Term Technical Trend: Same as the S&P 500. Negative. +0
• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Neutral. +5
• NASDAQ Medium Term Technical Trend: Same as the other two. Negative. +0
TOTAL POINTS: 45
NEW READING: 45 / 10 = 4.5 = NEGATIVE
Wednesday, August 25, 2010
Friday, August 13, 2010
Financing Retirement V: The Cistern Model
This is the final article in my series on retirement.
Essentially all strategies for financing retirement—even those as philosophically opposed as maximizing capital vs. maximizing income rights—use the same “plumbing.” I like to think of it in terms of cisterns, with pipes running in and out, and leaks. The idea comes from those old algebra questions where A could fill his cistern at a certain rate, B’s cistern filled more slowly and also had a leak in it, and poor C’s cistern was a veritable symphony of problems. As a 12-year-old, you had to create formulas to figure out how long the water in each cistern would last. See Stephen Leacock’s hilarious short story, “A, B, and C—The Human Element in Mathematics.” (For younger readers: A cistern is a big barrel to collect rainwater.)
Here’s the analogy: Your retirement assets are in the cistern. There are two goals:
· The cistern must fund your retirement adequately.
· The cistern must never go empty. In fact, it must never get even close enough to empty that you worry about it or lose sleep over the possibility. You want a nice, abundant cistern that inspires confidence.
There is continual change in your cistern. It is not a static thing, which is why I prefer this analogy to the more common “nest egg.” The cistern’s contents expand and contract throughout your life, both before you retire (the so-called accumulation years) and after you retire (the decumulation years).
What goes into your cistern? Mostly assets that you decide to put in there. Some inflows to your retirement cistern begin early in life, while others come along later. Typical inflows include savings, 401(k) contributions, dividends, royalties, Social Security, pensions, interest, inheritances, etc.
Note that I count as inflows some items (such as Social Security) that a retiree may just spend directly. I will explain why I do this in a minute. Note also that, with the exception of old-fashioned pensions and Social Security, inflows require a positive decision on your part. You must decide to put assets into your cistern (or not).
Besides expanding from the contributions that you make into your cistern, the level in your cistern also goes up when you experience increases in the market value of assets already there. Examples of assets that may enjoy value expansion include:
· Stocks, ETFs, mutual funds, and the like
· Your house
· Increasing dividends from companies that raise dividends regularly
· A small business you may own
What about declines? It is important to note that declines in the level of the assets in your retirement cistern take place not only after retirement via actual withdrawals, but earlier in life as well. Some people “raid” their cistern prior to retirement to cope with emergencies or to make large purchases. Taking out a home equity loan to buy a boat, for example, decreases the level of your cistern in two ways: First, the value of the loan lowers your equity in your home and thus decreases its value in your cistern. Second, the additional debt creates interest obligations that reduce the amount you can put into your cistern for some time into the future.
The level in your cistern also goes down if the value of the assets in it declines. Significant declines in the value of your stocks or your home obviously can have a major impact on the level in your cistern. During the recent financial crisis, some people have been forced to delay long-planned retirements, because the levels in their cisterns went down so far that the two major goals—seemingly within their grasp—suddenly were moved out of reach.
And everybody’s cistern has a leak: Inflation. That is a continuing outflow, sometimes rapid, sometimes slow, that insidiously reduces the value of the contents of your cistern. Only if we go into a period of deflation would the value-of-money dynamic actually cause the value of what’s in your cistern to expand. It would become like an inflow rather than a leak.
I said that I would explain why I count as inflows monies that go directly to spending, such as Social Security payments. The reason is that if we visualize that everything runs through the cistern, even if only briefly, it puts all assets on an equal footing for analysis. The value of income rights can be directly compared to the value of capital, for example.
Viewed this way, everyone makes withdrawals from their cisterns. Thus, someone who spends his Social Security check upon arrival must acknowledge that if he did not spend all of it, he could deposit the balance in his cistern for a future day. And the debate between income-maximizing strategies and capital-maximizing strategies can be seen for what it really is, which is an assessment of two strategies, both of whose goals are the goals stated at the beginning of this article. In both cases, the retirees are betting that their strategy will both provide sufficiently for retirement and that their cistern will never run dry.
Say someone maximizes income during their accumulation years by loading up on dividend-paying stocks, then lives off the income in retirement. We can picture the dividends as flowing into the cistern through a dividend pipe, but flowing right back out through a dividend-withdrawal pipe. Such a person might say that she is not making “withdrawals” if they just take the dividends directly, but she really is, because if not taken immediately as cash, the money would flow into the cistern. The same reasoning applies to pension or Social Security income. You may take it directly, but it is helpful to view it as flowing into and out of the cistern. It provides a better picture of the dynamics of retirement funding.
Similarly, someone who loads up on growth stocks during their accumulation years, then converts those assets into income by selling portions to fund retirement, is clearly making withdrawals. The “bet” is whether the unsold assets remaining in the cistern will simultaneously expand enough to make up for the assets sold. Similar reasoning applies to someone who buys an annuity: She makes a big withdrawal to buy the annuity, but the annuity itself then creates an inflow of income that lasts the rest of her life. The “bet” is whether the income will eventually exceed what it cost to purchase the annuity.
So the cistern analogy is strategy-neutral. I believe that viewing retirement funding in this way allows for more reasoned comparisons of strategies. It’s no secret that I believe in the efficacy of accumulating assets that bear rights to receive increasing dividends, and that I think that it is a superior retirement strategy to relying principally on accumulating assets that hopefully will expand in value via increasing prices to offset withdrawals. But I do not kid myself that when I spend those incoming dividends or Social Security checks, I am not really draining a little bit out of my cistern each time too.
Essentially all strategies for financing retirement—even those as philosophically opposed as maximizing capital vs. maximizing income rights—use the same “plumbing.” I like to think of it in terms of cisterns, with pipes running in and out, and leaks. The idea comes from those old algebra questions where A could fill his cistern at a certain rate, B’s cistern filled more slowly and also had a leak in it, and poor C’s cistern was a veritable symphony of problems. As a 12-year-old, you had to create formulas to figure out how long the water in each cistern would last. See Stephen Leacock’s hilarious short story, “A, B, and C—The Human Element in Mathematics.” (For younger readers: A cistern is a big barrel to collect rainwater.)
Here’s the analogy: Your retirement assets are in the cistern. There are two goals:
· The cistern must fund your retirement adequately.
· The cistern must never go empty. In fact, it must never get even close enough to empty that you worry about it or lose sleep over the possibility. You want a nice, abundant cistern that inspires confidence.
There is continual change in your cistern. It is not a static thing, which is why I prefer this analogy to the more common “nest egg.” The cistern’s contents expand and contract throughout your life, both before you retire (the so-called accumulation years) and after you retire (the decumulation years).
What goes into your cistern? Mostly assets that you decide to put in there. Some inflows to your retirement cistern begin early in life, while others come along later. Typical inflows include savings, 401(k) contributions, dividends, royalties, Social Security, pensions, interest, inheritances, etc.
Note that I count as inflows some items (such as Social Security) that a retiree may just spend directly. I will explain why I do this in a minute. Note also that, with the exception of old-fashioned pensions and Social Security, inflows require a positive decision on your part. You must decide to put assets into your cistern (or not).
Besides expanding from the contributions that you make into your cistern, the level in your cistern also goes up when you experience increases in the market value of assets already there. Examples of assets that may enjoy value expansion include:
· Stocks, ETFs, mutual funds, and the like
· Your house
· Increasing dividends from companies that raise dividends regularly
· A small business you may own
What about declines? It is important to note that declines in the level of the assets in your retirement cistern take place not only after retirement via actual withdrawals, but earlier in life as well. Some people “raid” their cistern prior to retirement to cope with emergencies or to make large purchases. Taking out a home equity loan to buy a boat, for example, decreases the level of your cistern in two ways: First, the value of the loan lowers your equity in your home and thus decreases its value in your cistern. Second, the additional debt creates interest obligations that reduce the amount you can put into your cistern for some time into the future.
The level in your cistern also goes down if the value of the assets in it declines. Significant declines in the value of your stocks or your home obviously can have a major impact on the level in your cistern. During the recent financial crisis, some people have been forced to delay long-planned retirements, because the levels in their cisterns went down so far that the two major goals—seemingly within their grasp—suddenly were moved out of reach.
And everybody’s cistern has a leak: Inflation. That is a continuing outflow, sometimes rapid, sometimes slow, that insidiously reduces the value of the contents of your cistern. Only if we go into a period of deflation would the value-of-money dynamic actually cause the value of what’s in your cistern to expand. It would become like an inflow rather than a leak.
I said that I would explain why I count as inflows monies that go directly to spending, such as Social Security payments. The reason is that if we visualize that everything runs through the cistern, even if only briefly, it puts all assets on an equal footing for analysis. The value of income rights can be directly compared to the value of capital, for example.
Viewed this way, everyone makes withdrawals from their cisterns. Thus, someone who spends his Social Security check upon arrival must acknowledge that if he did not spend all of it, he could deposit the balance in his cistern for a future day. And the debate between income-maximizing strategies and capital-maximizing strategies can be seen for what it really is, which is an assessment of two strategies, both of whose goals are the goals stated at the beginning of this article. In both cases, the retirees are betting that their strategy will both provide sufficiently for retirement and that their cistern will never run dry.
Say someone maximizes income during their accumulation years by loading up on dividend-paying stocks, then lives off the income in retirement. We can picture the dividends as flowing into the cistern through a dividend pipe, but flowing right back out through a dividend-withdrawal pipe. Such a person might say that she is not making “withdrawals” if they just take the dividends directly, but she really is, because if not taken immediately as cash, the money would flow into the cistern. The same reasoning applies to pension or Social Security income. You may take it directly, but it is helpful to view it as flowing into and out of the cistern. It provides a better picture of the dynamics of retirement funding.
Similarly, someone who loads up on growth stocks during their accumulation years, then converts those assets into income by selling portions to fund retirement, is clearly making withdrawals. The “bet” is whether the unsold assets remaining in the cistern will simultaneously expand enough to make up for the assets sold. Similar reasoning applies to someone who buys an annuity: She makes a big withdrawal to buy the annuity, but the annuity itself then creates an inflow of income that lasts the rest of her life. The “bet” is whether the income will eventually exceed what it cost to purchase the annuity.
So the cistern analogy is strategy-neutral. I believe that viewing retirement funding in this way allows for more reasoned comparisons of strategies. It’s no secret that I believe in the efficacy of accumulating assets that bear rights to receive increasing dividends, and that I think that it is a superior retirement strategy to relying principally on accumulating assets that hopefully will expand in value via increasing prices to offset withdrawals. But I do not kid myself that when I spend those incoming dividends or Social Security checks, I am not really draining a little bit out of my cistern each time too.
Thursday, August 5, 2010
July Rally Yanks Timing Outlook Into Positive Territory; Time to Wade Back In?
1. Summary
The stock market rallied strongly in July, although not a straight-line fashion. The market’s volatility continues to have the Timing Outlook jumping around too. The last five readings have been negative-positive-negative-negative-positive. Today’s value is positive at 7.5, significantly better than 4.5 last time.
To repeat a message from the last several Timing Outlooks: The Timing Outlook is least useful when the market is gyrating, as it is pretty sensitive to short-term (2 to 3-week) market moves. Despite the strong (if choppy) July, we have been in a volatile market since mid-April. If U means up and D means down, the weekly market changes since mid-April have been D-U-D-D-U-D-U-D-U-D-D-U-U-U-D. This week is too soon to call.
(click on chart to enlarge it)
My Capital Appreciation Portfolio has remained 100% in cash since early May. With the July rally, let’s look at the criteria for re-entering the market. As noted in this article, I look for:
• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• 5% rise over 5 weeks, with at least 17/25 days positive
• Etc.
An astute reader has pointed out that I actually overlooked a “Buy” signal in early July. As of the close today (Thursday), we are just short of 3-week and 4-week “Buy” signals. The percentage increases are sufficient, but the number of positive trading days falls 1-2 short in each case. I will be watching the trading ranges more closely, and if a “Buy” signal comes along, I will re-enter the market with a portion of the portfolio’s cash, with any purchase protected by a sell stop.
Subjectively, this is a hard market to have confidence in. Q2 earnings reports are coming in strong, but economic factors and the general “feel” of things does not inspire confidence. Nevertheless, if the criteria generate another “Buy” signal, I will be buying. Gotta go with the system.
As usual, my Dividend Portfolio remains 100% invested. While its value has been dancing along with the market, its main goal—generating ever-increasing income streams—is still being met. None of the stocks in the portfolio has cut or frozen its dividend this year. Many have raised their dividends. The holdings are not protected by sell stops.
2. Market Performance Since Last Outlook
(“now” figures are as of close Thursday, August 5, 2010)
Last Outlook (7/19/10): 4.5 (negative)
S&P 500 last time (7/19/10): 1071
S&P 500 now: 1126 Change: +5%
S&P 500 at beginning of 2010: 1115
S&P 500 now: 1126 Change in 2010: +1%
S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1126 Change since 3/9/09: 66+%
3. Indicators in Detail
• Conference Board Index of Leading Economic Indicators: The most recent report showed a decline in this index. The index has had a couple of declines in the past few months, rendering it ambiguous. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5
• Fed Funds Rate: No change. The Fed and people speaking for it continue to reinforce the idea that rates will not be raised anytime soon. With the Federal Funds rate near zero, this indicator remains positive. +10
• S&P 500 Market Valuation (P/E): Morningstar shows the current P/E of the S&P 500 is 15.2, up from 14.3 last time. This indicator stays in positive territory at any value below 17.4. +10
• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 0.98, up from 0.93 last time. That keeps this indicator in the neutral range, which is any value between 0.90 and 1.10. +5
• S&P 500 Short Term Technical Trend: The market has rallied, in fits and starts, since the beginning of July. It has now reclaimed the value it had in early June. This short-term technical indicator uses the two shorter SMAs. The configuration is Index > 20-day > 50-day. That is the best configuration to indicate a rising market. Positive. +10
• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day). The lineup is Index > 200-day > 50-day. This is an ambiguous configuration. Neutral. +5
• DJIA Short Term Technical Trend: This chart looks basically like the S&P 500 chart. Positive. +10
• DJIA Medium Term Technical Trend: Same as the S&P 500. Neutral. +5
• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Positive. +10
• NASDAQ Medium Term Technical Trend: Same as the other two. Neutral. +5
TOTAL POINTS: 75
NEW READING: 75 / 10 = 7.5 = POSITIVE
The stock market rallied strongly in July, although not a straight-line fashion. The market’s volatility continues to have the Timing Outlook jumping around too. The last five readings have been negative-positive-negative-negative-positive. Today’s value is positive at 7.5, significantly better than 4.5 last time.
To repeat a message from the last several Timing Outlooks: The Timing Outlook is least useful when the market is gyrating, as it is pretty sensitive to short-term (2 to 3-week) market moves. Despite the strong (if choppy) July, we have been in a volatile market since mid-April. If U means up and D means down, the weekly market changes since mid-April have been D-U-D-D-U-D-U-D-U-D-D-U-U-U-D. This week is too soon to call.
My Capital Appreciation Portfolio has remained 100% in cash since early May. With the July rally, let’s look at the criteria for re-entering the market. As noted in this article, I look for:
• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• 5% rise over 5 weeks, with at least 17/25 days positive
• Etc.
An astute reader has pointed out that I actually overlooked a “Buy” signal in early July. As of the close today (Thursday), we are just short of 3-week and 4-week “Buy” signals. The percentage increases are sufficient, but the number of positive trading days falls 1-2 short in each case. I will be watching the trading ranges more closely, and if a “Buy” signal comes along, I will re-enter the market with a portion of the portfolio’s cash, with any purchase protected by a sell stop.
Subjectively, this is a hard market to have confidence in. Q2 earnings reports are coming in strong, but economic factors and the general “feel” of things does not inspire confidence. Nevertheless, if the criteria generate another “Buy” signal, I will be buying. Gotta go with the system.
As usual, my Dividend Portfolio remains 100% invested. While its value has been dancing along with the market, its main goal—generating ever-increasing income streams—is still being met. None of the stocks in the portfolio has cut or frozen its dividend this year. Many have raised their dividends. The holdings are not protected by sell stops.
2. Market Performance Since Last Outlook
(“now” figures are as of close Thursday, August 5, 2010)
Last Outlook (7/19/10): 4.5 (negative)
S&P 500 last time (7/19/10): 1071
S&P 500 now: 1126 Change: +5%
S&P 500 at beginning of 2010: 1115
S&P 500 now: 1126 Change in 2010: +1%
S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1126 Change since 3/9/09: 66+%
3. Indicators in Detail
• Conference Board Index of Leading Economic Indicators: The most recent report showed a decline in this index. The index has had a couple of declines in the past few months, rendering it ambiguous. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5
• Fed Funds Rate: No change. The Fed and people speaking for it continue to reinforce the idea that rates will not be raised anytime soon. With the Federal Funds rate near zero, this indicator remains positive. +10
• S&P 500 Market Valuation (P/E): Morningstar shows the current P/E of the S&P 500 is 15.2, up from 14.3 last time. This indicator stays in positive territory at any value below 17.4. +10
• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 0.98, up from 0.93 last time. That keeps this indicator in the neutral range, which is any value between 0.90 and 1.10. +5
• S&P 500 Short Term Technical Trend: The market has rallied, in fits and starts, since the beginning of July. It has now reclaimed the value it had in early June. This short-term technical indicator uses the two shorter SMAs. The configuration is Index > 20-day > 50-day. That is the best configuration to indicate a rising market. Positive. +10
• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day). The lineup is Index > 200-day > 50-day. This is an ambiguous configuration. Neutral. +5
• DJIA Short Term Technical Trend: This chart looks basically like the S&P 500 chart. Positive. +10
• DJIA Medium Term Technical Trend: Same as the S&P 500. Neutral. +5
• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Positive. +10
• NASDAQ Medium Term Technical Trend: Same as the other two. Neutral. +5
TOTAL POINTS: 75
NEW READING: 75 / 10 = 7.5 = POSITIVE
Tuesday, August 3, 2010
Financing Retirement IV: Asset Allocation
In the previous article in this series (immediately below this one), I stated that in conventional retirement planning, there are three critical steps:
Under Modern Portfolio Theory (MPT), it is said that proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. It is commonly accepted that your selection of individual securities is secondary to the proportions in which you allocate your investments in stocks, bonds, and cash. I believe that the rule of thumb is that 70% of your investment results will come from asset allocation, not from what securities you pick.
Asset allocation for retirement is a hot topic. On June 18, The Department of Labor and SEC held a joint hearing related to target date funds, many of which underperformed the S&P 500 in 2008-09. Target date funds have rapidly gained popularity since they were introduced in 1996. At the moment there are nearly 300 of them, with $176 Billion in assets. Their attraction is that, once you designate your retirement date, they offer the automatic achievement of the first two bullet points above.
In MPT, the hypothesis is that stocks are riskier than bonds, but that they hold the promise of better long-term returns. As the AAII says in its beginning investor series, “Stocks are more volatile than bonds, but have historically provided higher long-term returns.” Historical data supports this. It is hard to find a 30-year period, ever, that stocks have not outperformed bonds. But at shorter timeframes, stocks are considered riskier because of their price volatility. Thus the conventional wisdom is that the way to make your portfolio safer as you approach (or are in) retirement is by switching from stocks to bonds in your overall allocation.
As I stated in the last article, the problem I have with that thinking is that (1) it presumes that all retirement income will come from selling off assets, and (2) it ignores the fact that some stocks generate income themselves.
In the two AAII articles, there is not a single mention of dividend stocks as a separate asset class that may have different risk characteristics from all stocks as a class or bonds as a class. There is not even a suggestion that they might form a different category of stocks. The omission is puzzling, because stocks are traditionally sliced and diced into so many categories that supposedly offer different risk/reward profiles within the broad classification of “stocks.” Thus you get categories like U.S. Large-cap, Mid-cap, Small-cap; Foreign stocks, often nowadays themselves divided by size, country or region of the globe; Emerging markets; Value vs. Growth; and so on. But the simplest, most obvious categorization of all—do they pay a dividend?—is ignored.
It’s an important distinction. Dividend-paying stocks tend to move less (in both directions) than the market, meaning that they have a different risk/reward profile. Their dividends yield positive income even when their prices are falling. The companies that raise their dividends regularly tend to keep doing so even when the market as a whole is falling. The dividends themselves, being always positive (there is no such thing as a negative dividend), change the risk/reward profile. And studies show that the best overall returns come from dividend-raising stocks.
So the question begs to be asked: If the goal of a retirement nest egg is to provide its owner with sufficient income in retirement, and some stocks provide rising income streams by their very nature without the necessity of selling them, then why are those facts ignored in conventional retirement planning? Why are they ignored in asset allocation discussions?
It is certainly a paradigm shift to think of dividend stocks as a separate asset class, but for purposes of this article, that’s just what I am going to do. Here’s why: Traditional methods of classifying assets divide them into three major realms: Stocks, bonds, and cash. Stocks are evaluated on their prices; and bonds are evaluated on their yields. But dividend stocks have both characteristics: Their prices vary (but in a more muted fashion) with stocks generally. And their yields provide income, but with a growth kicker that most bonds don’t have—dividend-growth stocks are rising income instruments rather than fixed income investments. (In some texts, you will see the phrase “fixed-income investment” used interchangeably with “bond.”)
It’s almost like MPT has a huge hole in it. It does not miss the obvious income-producing ability of bonds—after all, that’s what a bond is, a debt instrument. The income it produces is interest on the money lent. MPT does not miss the price-appreciation potential of stocks, nor the short-term volatility they have displayed over the years. So why does MPT miss the income-producing ability of dividend stocks, the rising income-producing ability of habitual dividend-raisers like the Dividend Champions, or the muted price volatility that is characteristic of dividend stocks?
I cannot answer that question. But my conclusion is that for those who get it, dividend stocks, especially dividend-growth stocks, should not be lumped in with all stocks when it comes to making asset allocation decisions. A retiree’s portfolio can safely contain a higher percentage of dividend stocks than is normally associated with the low level of risk tolerance of a retiree. And the reason that is true is precisely because the dividend stocks throw off a continuing income stream and do not have to be sold to produce retirement income. Thus, maintaining a fairly high percentage of your retirement portfolio in well-selected dividend stocks is not too aggressive or risky for a retiree. It is safer.
- Maximize your capital before you retire.
- Make your capital a lot “safer” as you approach retirement.
- In retirement, withdraw capital at a “safe” rate, typically figured to be 4% in the first year, then raised each year by 3% to account for inflation. That withdrawal converts what was capital into retirement income by the process of selling assets.
Under Modern Portfolio Theory (MPT), it is said that proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. It is commonly accepted that your selection of individual securities is secondary to the proportions in which you allocate your investments in stocks, bonds, and cash. I believe that the rule of thumb is that 70% of your investment results will come from asset allocation, not from what securities you pick.
Asset allocation for retirement is a hot topic. On June 18, The Department of Labor and SEC held a joint hearing related to target date funds, many of which underperformed the S&P 500 in 2008-09. Target date funds have rapidly gained popularity since they were introduced in 1996. At the moment there are nearly 300 of them, with $176 Billion in assets. Their attraction is that, once you designate your retirement date, they offer the automatic achievement of the first two bullet points above.
- They maximize your capital via diversification and an ideal stock/bond ratio while you are in the accumulation years of your life. Investors with different risk profiles can select from among funds that are more or less aggressive. “Aggressiveness” is always equated with what percentage of stocks the fund contains. At a young age, the most aggressive fund may contain 90% or more stocks. Even at retirement, an aggressive fund may still contain 75% stocks.
- They make your nest egg safer as retirement approaches by automatically shifting from equities to bonds as you grow older, theoretically arriving at a perfect mix just in time for your retirement. “Safety” is always equated with holding more bonds and fewer equities.
In MPT, the hypothesis is that stocks are riskier than bonds, but that they hold the promise of better long-term returns. As the AAII says in its beginning investor series, “Stocks are more volatile than bonds, but have historically provided higher long-term returns.” Historical data supports this. It is hard to find a 30-year period, ever, that stocks have not outperformed bonds. But at shorter timeframes, stocks are considered riskier because of their price volatility. Thus the conventional wisdom is that the way to make your portfolio safer as you approach (or are in) retirement is by switching from stocks to bonds in your overall allocation.
As I stated in the last article, the problem I have with that thinking is that (1) it presumes that all retirement income will come from selling off assets, and (2) it ignores the fact that some stocks generate income themselves.
In the two AAII articles, there is not a single mention of dividend stocks as a separate asset class that may have different risk characteristics from all stocks as a class or bonds as a class. There is not even a suggestion that they might form a different category of stocks. The omission is puzzling, because stocks are traditionally sliced and diced into so many categories that supposedly offer different risk/reward profiles within the broad classification of “stocks.” Thus you get categories like U.S. Large-cap, Mid-cap, Small-cap; Foreign stocks, often nowadays themselves divided by size, country or region of the globe; Emerging markets; Value vs. Growth; and so on. But the simplest, most obvious categorization of all—do they pay a dividend?—is ignored.
It’s an important distinction. Dividend-paying stocks tend to move less (in both directions) than the market, meaning that they have a different risk/reward profile. Their dividends yield positive income even when their prices are falling. The companies that raise their dividends regularly tend to keep doing so even when the market as a whole is falling. The dividends themselves, being always positive (there is no such thing as a negative dividend), change the risk/reward profile. And studies show that the best overall returns come from dividend-raising stocks.
So the question begs to be asked: If the goal of a retirement nest egg is to provide its owner with sufficient income in retirement, and some stocks provide rising income streams by their very nature without the necessity of selling them, then why are those facts ignored in conventional retirement planning? Why are they ignored in asset allocation discussions?
It is certainly a paradigm shift to think of dividend stocks as a separate asset class, but for purposes of this article, that’s just what I am going to do. Here’s why: Traditional methods of classifying assets divide them into three major realms: Stocks, bonds, and cash. Stocks are evaluated on their prices; and bonds are evaluated on their yields. But dividend stocks have both characteristics: Their prices vary (but in a more muted fashion) with stocks generally. And their yields provide income, but with a growth kicker that most bonds don’t have—dividend-growth stocks are rising income instruments rather than fixed income investments. (In some texts, you will see the phrase “fixed-income investment” used interchangeably with “bond.”)
It’s almost like MPT has a huge hole in it. It does not miss the obvious income-producing ability of bonds—after all, that’s what a bond is, a debt instrument. The income it produces is interest on the money lent. MPT does not miss the price-appreciation potential of stocks, nor the short-term volatility they have displayed over the years. So why does MPT miss the income-producing ability of dividend stocks, the rising income-producing ability of habitual dividend-raisers like the Dividend Champions, or the muted price volatility that is characteristic of dividend stocks?
I cannot answer that question. But my conclusion is that for those who get it, dividend stocks, especially dividend-growth stocks, should not be lumped in with all stocks when it comes to making asset allocation decisions. A retiree’s portfolio can safely contain a higher percentage of dividend stocks than is normally associated with the low level of risk tolerance of a retiree. And the reason that is true is precisely because the dividend stocks throw off a continuing income stream and do not have to be sold to produce retirement income. Thus, maintaining a fairly high percentage of your retirement portfolio in well-selected dividend stocks is not too aggressive or risky for a retiree. It is safer.
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