Budgeting skills are as important as what your portfolio is doing—probably, more important really, because budgeting is an everyday issue. If a person can scale back appropriately so that they can actually survive on a 4 percent withdrawal rate, they’re good. Any reasonably designed retirement portfolio will last with a 4 percent withdrawal rate. Eight percent? You’re going to have to get really lucky in your investments.

We love reading his work and he’s a very sharp, knowledgeable finance maven. But his claim about the 4 percent withdrawal rate seems a tad glib–there are many assumptions built-in to this claim that need explanation. Would you really like to bet on such a simple number for your retirement? We think not.

Intuitively, at 4% withdrawal rate,  if your return is 4%/YR and inflation is nil, then in fact you can simply withdraw the gain each year and never deplete the principal. But if, for example, inflation is 2%/YR and your return is 4%/YR, then we can show 4% withdrawal rate would last you 34 years. Not bad. But if your return is 3%/YR and inflation is 4%/YR, then this account will deplete after 22 years if withdrawals are at 4%/YR.  That’s probably a big difference. We show you how to handle all these “What Ifs”.

This post introduces the idea of the Safe Withdrawal Rate (SWR), a concept that has recently captured the attention of many investment advisors and publications. We introduce our own focus on this topic now. We announce two initiatives. First, we published a descriptive piece in Advisor Perspectives, a highly respected and popular website for investment professionals. This piece explains SWR ideas without math for the average investor. Second, we published our full research results in detail here, in our permanent pages (see Investing Tools drop-menu above, or click this link):

Investing Tools> Safe Withdrawal Rate

This page introduces our technical analysis and methodology to determinine your own, personal SWR. Our innovation: we capture each individual’s beliefs about his own future returns and inflation to find the expected value of his SWR, irrespective of market history. Ultimately, your personal beliefs about how future returns and inflation evolve is all that matters for your planning purposes.

I grant that low long-term interest rates could continue for months, or even well into next year. But just as easily, long-term rate increases can emerge with unexpected suddenness. Between early October 1979 and late February 1980, for example, the yield on the 10-year note rose almost four percentage points.

He generally warned us that

The United States, and most of the rest of the developed world, is in need of a tectonic shift in fiscal policy. Incremental change will not be adequate.

Do you believe the curent regime has any political courage, let alone sufficient to change course?

Today, Bloomberg News makes a very strong and creatively presented case for deflation. We now have some serious validation….but no joy.

www.defeatthedebt.com

“There is the strong possibility that policy makers in the US and UK will not time the transition from the current quantitative easing to a more tightened monetary policy. That is not because they are no competent. It is because the task is very tricky and there is no play book outlining the steps. This is not Tom Landry (former Dallas Cowboy coach) pacing the field with a play for every situation already planned and practiced well in advance.

The odds favor they will either be too late or too early. Getting it “just right.” The Goldilocks play, would be more than fortunate. In fact, there may be no right play to call. They may be forced to choose between a slower economy and/or inflation/deflation. And as this week’s Outside the Box authors note, there is also the possibility of yet another asset bubble, making the choices even more risky.”

See full text here

Of course, we have written about this looming disaster, and proposed some specific ways investors can prepare for it. See, for example:

http://www.rocketcap.com/portfolios-for-deflation-inflation-and-good-luck/

(Please keep in mind all information and ideas presented on this web site are subject to our Terms of Use. We also remind you that nothing written here can be a recommendation for any particular person to invest. Please consult your own financial or investment advisor before you make any investments.)

Can the Fed Control the Money Supply?

The problem is this: Given the enormous amount of money Bernanke’s Fed has “printed” to restart the credit markets, there now is a substantial danger the Fed will not successfully retrieve that money. Bernanke needs to use all the Fed’s tools to raise interest rates sufficiently for banks to place money on deposit with the Fed, and out of the economy. The Fed must start, at a crucial time we’ll label TIME, a control policy of raising rates fast enough and high enough to attract money. This is a tricky balancing act. When the Fed pays interest, the amount and timing must not be so high or fast as to slow the economy into recession again and deflation, or be so low and slow as to enable inflationary expectations to squirt loose. There are thus three huge unknowns in this problem and all of them are beyond investor influence: TIME, interest rate level, and speed of change in interest rates. Perfection happens when Ben gets it exactly right, and the economy washes the excess money supply back with minimal impact on prices. But being wrong will launch deflation or inflation.

Under these conditions, how best to invest? We take a scenario approach. There are three main future economic conditions (Deflation, Perfection, Inflation) and four main investable asset classes to choose from. We need to pick the amount to invest from each class, depending on our beliefs about the future.

Main Investable Asset Classes

The main asset classes are roughly described this way, considering the variations within each class. First, cash. This ranges from cash in mattress, to money market funds and extremely short term T-Bills. Second, Fixed Income comprises all forms of bonds and ETFs/Mutual Funds based on bonds, both corporate and municipal, and various Treasury offerings, most particularly Treasury Inflation Protected Securities (TIPS). Third are corporate equities and ETFs/Mutual Funds based on them. Finally, we have hard assets. These consist of commodities (metals, precious metals, food products, animal products,…) and real estate (land, buildings, and Real Estate Investment Trusts (REITs)). REITs enable liquidity in real estate purchases, since one trades shares of corporations whose assets are interests in real property. Note that more esoteric asset classes, such as hedge funds and derivatives all can be fit into these categories, if you are willing to sit on top of the bag to close the zipper.

Model Portfolios

Let’s look at a straightforward way to invest for each scenario. Consider this table, which shows the amount of your investable assets to invest in each class, given the scenario.

These amounts were intuitively chosen. By applying the Markowitz portfolio optimation algorithm, one can create an optimal portfolio for all three cases based on one’s own specific ROI and risk assumptions.

Perfection

Under the Perfection scenario, the economy percolates along without undue influence of the money supply, and is what we call “normal”. Our nominal portfolio for Perfection consists of equal amounts of equity and fixed income, with lesser equal amounts of cash and real assets. Again, we note the specific assets in each class are chosen by the individual investor.

Inflation

With inflation, one wants to hold hard assets and inflation protected securities. The two most often named are gold and TIPS. Commodities generally gain in price with overall inflation. Stocks vary with inflation. Empirically, the equities evidence is mixed. Some firms win due to having price increases masked by inflation, while others lose since their purhases also rise with inflation. Surprisingly, cash tends to track inflation. So, compared to Perfection, the model portfolio has more cash and fixed income, with an increased dose of TIPS, less equities, and much more Real Assets.

Deflation

Under deflation, cash is king, and the model portfolio shows this bias compared to the Perfection condition.

Combination

Of course, these scenarios are mutually exclusive, and we can build only one portfolio of all our assets. To build the final portfolio, we have to assign a probability to each scenario, and then combine the asset classes according to the scenario weights.

Bernanke Article in WSJ, 7-21-09

He concludes by saying:

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

The only problem with all this is what he failed to address: how to get the timing right. All his tools are good ones, but the entire challenge is to start using them at best time. He can err by starting too soon, and slow growth, or too late, and enable inflation to squirt loose.

How can he get it right?

No answer. So in self-defense, take anti-inflation positions, while their prices are relatively low.

See Original Research Paper

Here are important conlusions, In Our Humble Opinion:

1–”Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth.”

2–”The most extensive research on tax multipliers is found in a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president’s Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3.”

3–”The combination of an extremely overleveraged economy, ineffectual monetary policy and misdirected fiscal policy initiatives suggests that the U.S. economy faces a long difficult struggle. While depleted inventories and the buildup of pent-up demand may produce intermittent spurts of growth, these brief episodes are not likely to be sustained. In several years, real GDP may be no higher than its current levels. However, since the population will continue to grow, per capita GDP will decline; thus, the standard of living will diminish as unemployment rises. These conditions will produce a deflationary environment similar to the Japanese condition.

4–”In the normal recessions since 1950, the low in inflation was, on average, 29 months after a complete economic recovery was underway, and bond yields moved in a similar fashion. If this recession were normal, then the low in inflation would be in late 2011, at which time investors would begin to consider shortening the maturity of their Treasury portfolios. However, because of our highly-indebted circumstances and the movement of private sector resources to the public sector, the trough in inflation will be moved out, meaning that the low in Treasury bond yields is a distant event. The path there will be bumpy, as it was in the U.S. from 1929 to 1941 and in Japan from 1989 to 2008. Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield level may be similar to that of the Japanese.”

We find (2) above especially surreal, since Dr. Romer fully understands what president Obama is doing and that his actions deny reality as revealed by her own empirical research!

Securities for the Economy’s New World Order

The idea was to collect securities that have a focused exposure to some of the identifiable factors driving the economy in the New World of Obama. We applied our Portfolio Diversification X-Ray to study the diversification among these securites and to consider their historical ROIs and volatilities.

Figure 1 shows  the latest PDX.

Table 1

NWO Collection, 45 days Ending 19 JUN 09

There are some useful observations. First, examining the figure reveals the Jim Cramer portfolio for inflation stocks has done extremely well. Congratulations to Cramer!

Next, consider this comparison.

Compare PDXs: 4-30-09 vs 6-19-09

We can see how this NWO collection has doubled ROI while holding volatility roughly constant and increasing the number of uncorrelated securities. We will leave you to choose the best components of this NWO collection, based on your own risk appetite.

Ben Bernanke Speaks: How Fed Will Unwind Massive Balance Sheet Growth