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Toward Slice and Dice
(Updated 3/23/09)
It may be instructive to follow my journey from a Total Stock Market investor to a ‘slice and dice’ stock investor. So what follows are a series of message board posts I replied to in the March-April 2004 timeframe.
Retirement withdrawals after attaining CM (pdf)
Author: pbradford6
Date: March 30, 2004
The year 2004 will mark the beginning of withdrawing 4% annually from my rollover IRA. For those who are already removing money or have ideas how to do it, please give me your thoughts on the mechanics of rebalancing and taking an annual withdrawal, i.e. take the money from the category that has performed the best before you rebalance? Or if equities tank in a given year is it best to take the withdrawal from fixed income only? Is there a recognized accepted method/strategy for making withdrawals? Does it matter?
Thanks.
Re: Retirement withdrawals after attaining CM (pdf)
Author: Bob
Date: March 30, 2004
In response to message posted by pbradford6:
I've been working on the following article for the past 2 weeks or so that tries to answer your question. So since you asked, here's what I've come up with so far.
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In my research, I’ve encountered four approaches to investing during retirement. Each has advantages and disadvantages. The first approach is to withdraw a fixed percentage from each asset class each year. The disadvantage is that when stocks are down, more shares need to be sold to meet the fixed withdrawal percentage amount. While declining prices helps a dollar cost average investor accumulate more shares, it has the opposite effect for the retiree. Declining prices forces the retiree to instead sell more shares. And even though prices will eventually recover, it will be very difficult to recover those extra shares that were sold during the downturn. A declining stock market is now detrimental to the retiree’s withdrawal strategy.
Click the following link for an article that follows the fixed percentage approach:
Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable
The second approach seeks to remedy the drawback from the first approach. Instead of withdrawing a fixed percentage from each asset class each year, the second approach would withdraw first from only cash and bonds. This approach is the basis of The Grangaard Strategy and Buckets of Money Strategy. During the years that cash and bonds are spent, stocks are not touched and allowed to grow. At some future point, profits from stocks are taken to replace the cash and bonds that were partially or all spent. The disadvantage of this second approach is that during the latter part of the holding period, the asset allocation becomes increasingly weighted toward stocks. Thus, the overall portfolio may potentially become more volatile.
Click the following link to view the Buckets of Money demo:
Buckets of Money
A third approach can be considered to be a variant of the Grangaard Strategy. This third approach attempts to navigate a middle course. I’ve seen this approach referred to as Dynamic Rebalancing. In this strategy, a decision is made each year whether to take a normally fixed percentage from each asset class. As long as stocks were up in the preceding year, funds would be redeemed from all sources including stocks. However, if stocks were down, then funds would be withdrawn only from cash and bonds. I’ve only seen one source that presents data for this strategy. I would be eager to see more research done on this third approach as it probably would keep to a more traditionally conservative asset allocation.
Click the following link for an article that describes the Dynamic Rebalancing approach:
Dynamic Rebalancing (pdf)
A fourth approach can be called the Dividend Distribution strategy. I've thought up this approach, but I haven't yet fully developed it. Instead of reinvesting dividends from stock and bond funds like one does while accumulating a retirement nest egg, the retiree will now spend those dividends. The rate of dividend income will depend on the asset allocation. But a simple conservative allocation could be
10% Money Market
40% Total Bond Index Fund
35% Total Stock Index Fund
15% REIT Index Fund
If the retiree assumes a 4% withdrawal rate (and the other three approaches are also in the range of 4%), about 2.5% to 3% can come from dividends. The remainder can come from selling shares of stock funds.
Investing during retirement will be the most important and most difficult task for most every person with a self-directed retirement account. Given this, it's surprising that very few books or articles are written about it. That should change as more and more baby boomers head into retirement and face the task of managing their nest egg to last them the rest of their life.
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So if you ask me which is best, I honestly don't know. There are trade-offs in each strategy. As in all cases relating to money, seek an approach that you are most comfortable with.
Dynamic Buckets Distribution (pdf)
Author: Bob
Date: April 1, 2004
In response to message posted by Bob:
O.K. here's another brainstorm. How about combining 3 strategies? I will call it the Dynamic Buckets Distribution system. We'll start with the following asset allocation:
10% Cash
30% Total Bond Index fund
10% Large Growth
10% Large Value
10% Small Growth
10% Small Value
10% REIT Index fund
10% International
Assuming a 4% annual withdrawal rate, around 2% can come from dividend distributions. We won't be re-investing them. For those stock funds that show a gain for the year, take profits. If the gains are large, don't spend more than the other 2%. Stash the rest in cash. If the gains are small, then take what you can get. And then dip into cash for the rest.
I like this strategy the best so far. By slicing your stock funds into separate categories, there should be 1 or more funds giving you opportunities to take profits every year.
Merriman interview with John Bogle (pdf)
Author: Bob
Date: April 3, 2004
This is an interesting article suggesting that the Vanguard Total Stock Market Index fund may not be what it purports to be.
Where's the 'total' in Vanguard fund?
Short shrift for small caps in Total Stock Market portfolio
By Paul Merriman, CBS.MarketWatch.com
Last Update: 12:02 AM ET March 31, 2004
SEATTLE (CBS.MW) -- John Bogle, founder and retired chairman at Vanguard Group, has done a great deal for individual investors over the past 30 years.
Back in the 1970s, Bogle pioneered index funds and no-load mutual funds, and his actions put pressure on many other fund families to keep costs low and offer no-load funds. I think it's safe to say that because of John Bogle, individual investors have kept billions of dollars that would otherwise have been eaten away by the investment industry.
Vanguard remains true to Bogle's vision of keeping costs down and shareholders in the driver's seat. And you haven't found Vanguard implicated in any of the mutual fund scandals of the past six months.
Nevertheless, Bogle does appear to have a blind spot -- or at least it's fair to say he and I disagree on one very fundamental premise: wide diversification is in the best interests of investors.
I was asked about this in a message from Donald in Connecticut, who had listened to a recent radio show interview I had with Bogle. In the interview, I challenged Bogle on his tireless promotion of the Vanguard Total Stock Market Index Fund (VTSMX: news, chart, profile) as essentially the only investment vehicle investors need.
Donald wrote: "How can a person of John Bogle's knowledge and experience believe that the Total Market Index Fund has enough small-cap representation to give the average investor the correct equity diversification?"
Donald pointed out that the Total Stock Market Fund is about 65 percent invested in large-cap companies, 25 percent in mid-cap companies and 9 percent in small-cap companies. Actually, Morningstar breaks it down this way: giant companies, 40 percent; large companies, 30 percent; medium companies, 20 percent; small companies, 7 percent; and micro-cap companies, 2 percent.
My own recommendation, based on market returns that go back nearly 80 years, is that investors split their U.S. equity investments equally, having half in large-cap funds and half in micro-cap funds. By that standard, John Bogle's favorite fund has far too much large-cap exposure and far too little small-cap exposure.
In answer to Donald, I can say only that while I admire Bogle immensely, his attitude seems to be that he believes what he believes, and that is essentially the end of the story.
When I interviewed John, we talked about value funds, which over the years have generated returns of 2 to 5 percentage points per year higher than the Standard & Poor's 500 Index.
Bogle said the Total Stock Market Index Fund "is half value and half growth. You own every value stock in America."
But he then went on to argue against value investing, saying he doesn't think there are many "great value managers out there, and they charge a lot of money" in fees. Even if value stocks were dominant in the past, he said, their popularity has bid up their prices so much that "They won't be dominant in the future."
Bogle apparently believes millions of other investors can't be wrong. He maintains most of his own money in index funds that mimic the composite choices of all other investors.
Bogle doesn't have much use for balancing large with small, dismissing that approach as "other things" that some investors try in order to get ahead. "Work your special strategies at the margin," while keeping 80 percent of your equity investments in the total market index, he said.
When I cited statistics showing how small-cap stocks have out-performed large-cap ones over long periods, Bogle dismissed this. Every comparison of past investment returns pertains only to the specific period chosen for the study, he said. That's true, but it's no reason to ignore the facts.
I doubt that John and I are ever going to agree on this topic, and that's OK. But I think he is leaving money on the table by not using a few of the Vanguard index funds he helped to start.
For years, my firm has recommended that a U.S. equity portfolio be divided equally into four asset classes: large-cap, large-cap value, small-cap and small-cap value. Each of those is represented very well by a Vanguard index fund. (These include the Index 500 (VFINX: news, chart, profile), Value Index (VIVAX: news, chart, profile), Small-Cap Index (NAESX: news, chart, profile) and Small-Cap Value Index (VISVX: news, chart, profile).
It's easy to compare this very simple four-fund strategy with the total stock market fund. To do so, I looked back to the start of 1999 for a five-calendar-year period that includes a raging bull market, then three years of the worst bear market in most people's memory and finally a strong recovery last year.
The table below shows year-by year comparisons of the returns of the total stock market fund with the four-index-fund approach we recommend. These returns go back to 1999, the first full calendar year in which the Vanguard Small-Cap Value Index Fund was operational.
| Comparing Annual Returns |
Year | Total Stock
Market Fund | Four-Fund
Mix |
1999 | 23.8% | 15.1% |
2000 | -10.6% | 4.1% |
2001 | -11.0% | -1.3% |
2002 | -21.0% | -7.2% |
2003 | 31.4% | 35.9% |
The Total Stock Market Fund outperformed this four-fund combination in only one of these years. A $20,000 investment in the Total Stock Market Fund at the start of 1999 would have grown to $20,450 by the end of 2003. The same investment in the four-fund combo, with annual rebalancing, would have grown to $29,829.
The combination I advocate is not fancy or expensive. It is built on four Vanguard index funds. Why John Bogle doesn't like it remains a mystery to me.
Re: Merriman interview with John Bogle (pdf)
Author: Bob
Date: April 3, 2004
In response to message posted by Bob:
I think Merriman's message is significant. I went back to Bogle's book Common Sense on Mutual Funds. In chapter 10, Bogle discusses reversion to the mean. He displays 3 great charts showing relative performance over the preceding several decades. The first chart is on Growth vs. Value, another on Large-cap vs. Small-cap and a third on U.S. stocks vs. International. Bogle makes the point that over the full sweep of history, no style ultimately wins out. Each style ebbs and flows between out-performance and under-performance.
So given that, Bogle seems to prefer the Total Market fund as the only stock fund an investor needs. However, the typical investor's timeframe to hold stocks is much shorter. And as Kirk writes in his articles on Asset Allocation, rebalancing non-correlating funds will add value to one's portfolio. The 5 year results of Merriman's 4-fund combination portfolio illustrates the value of rebalancing most dramatically.
So why am I writing about all this? Well, because Bogle's Total Market fund recommendation made sense to me when I read his book a few years ago. However, now that I've recently read Grangaard's books on investing during retirement, I've come around to Merriman's point of view. During retirement, the idea of having a choice of stock funds to take profits from has greater appeal to me.
Re: Merriman interview with John Bogle (pdf)
Author: SteveT
Date: April 3, 2004
In response to message posted by Bob:
Bob wrote: "During retirement, the idea of having a choice of stock funds to take profits from has greater appeal to me."
I can see where that may work if it is your plan to take profits as part of your retirement income since it would not involve an extra tax bite. You would simply sell down to your allocation targets.
I still wonder if those of us in wealth accumulation mode that would have to pay taxes when we rebalance might be better off in the total market index.
Re: Merriman interview with John Bogle (pdf)
Author: Bob
Date: April 3, 2004
In response to message posted by SteveT:
That's a very good point, Steve. My thinking goes like this. If my end goal is to reach retirement with separate stock funds like Merriman's portfolio, at what point do I re-position my one TSM (Total Stock Market) fund? If I near retirement with the bulk of my stocks in just TSM, and I want to then switch to a portfolio similar to Merriman's, then there will be much more selling involved slicing that TSM. Just thinking about all that selling and the tax bite gives me the willies.
For a wealth accumulating investor using separate stock funds in a taxable account, one way to rebalance is just to direct new money to the laggard funds. I agree that taking profits just for the sake of rebalancing doesn't hold much appeal. Perhaps give wide latitude to winners and only consider taking profits if that fund exceeds its target allocation by a certain amount.
Re: Buckets of Money (pdf)
Author: Bob
Date: April 12, 2004
In response to message posted by pbradford6:
I've decided that the Grangaard/Buckets strategy using long stock fund holding periods is not for me. I did a bit of soul searching and felt that an aggressive asset allocation beyond 55/45 stocks/bonds would not provide the sleep factor I desire in retirement.
One idea I did like from the Grangaard/Buckets strategy is to slice your bucket 3 into several stock sectors. This way, there probably will be one or more sectors from which to take profits every year.
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