2. This may sound like another sales pitch, but this book and the accompanying web site (www.assetdedication.com) provide historical data to support the claim. The evidence will speak for itself.
3. This is 100 percent true for U.S. Treasury bonds. It is over 99 percent true for bonds issued by corporations, state or local governments, municipal agencies, and other public entities when they have investment-grade ratings of A or higher. See Chapter 14 for more details and the historical record on bond default rates.
4. Total return consists of the two main components of return, appreciation resulting from a rise in price and yield resulting from dividends. Various definitions of returns will be covered in Chapter 12 on quantitative fundamentals.
5. William F. Sharpe, Gordon J. Alexander, and Jeffery V. Baily, Investments, 5th ed.
(Englewood Cliffs, N.J.: Prentice-Hall, 1995), p. 478. Technically, Sharpe is right if the word exactlymeans to the penny. Because many bonds can be purchased only in $1000, $5000, or $10,000 increments and bond prices fluctuate minute to minute, it is nearly impossible to get an exact match. But precision to within 1 percent of the target income stream and cumulative errors of less than a few hundred dollars over entire 10-year periods are attainable. Examples of this can be found at www.assetdedication.com.
6. Under some circumstances, certificates of deposit (CDs) or collateralized mortgage obligations (CMOs) can be used, but these are more complicated financial instru- ments that are best left to sophisticated investors with very large portfolios. Most investors should stick to the standard types of bonds—government, corporate, or municipal.
7. See Chapter 11 for further explanations of bond types and Appendix 1 for a defini- tion of bond ratings.
8. Phillip Cooley, Daniel Walz, and Carl Hubbard, “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable,” The AAII Journal, February 1998. This study was called the Trinity study (the authors were professors of economics at Trinity University in Texas) and will be described in greater detail in Chapter 10.
Their research was later embellished by the Zunna Corporation (www.zunna.com).
Whereas the Trinity study used predefined asset allocations, Zunna finds optimal asset allocations using a computational technique known as simulated annealing, available in the software Zunna sells, called WATS. Three of Zunna’s major studies, which it provides free of charge on its web site, are
Study 1: “Maximum Sustainable Withdrawal Rates with Varying Historical Suc- cess Rates Using Large Cap Stocks, Corporate Bonds and US T-Bills. Ending Value Goal: Above Zero (Don’t Go Broke).” Data from 1946 to 2000.
Study 2: “Maximum Sustainable Withdrawal Rates with Varying Historical Suc- cess Rates Using Large Cap Stocks, Corporate Bonds and US T-Bills. Ending Value Goal: Equal or Greater than Original Corpus.” Data from 1946 to 2000.
Study 3: “Maximum Sustainable Withdrawal Rates with Varying Historical Suc- cess Rates Using Large Cap Stocks, Corporate Bonds and US T-Bills. Ending Value Goal: Equal or Greater than Inflation-Adjusted Corpus.” Data from 1946 to 2000.
9. Harry M. Markowitz, “Portfolio Selection,” Journal of Finance7, no. 1, March 1952, pp. 77–91.
10. One investment adviser, Bert Whitehead of Cambridge Advisors (www.bertwhite- head.com), uses 15 years because long-term U.S. Treasury bonds have traditionally earned interest in the 5 percent range, and at 5 percent, money doubles every 15 years. Thus, at the end of each year, 2 years are added to the ladder.
Asset Dedication—How It Works 61
11. There are three primary categories of bonds based on source: federal government, corporate, and muni bonds. Corporate bonds are issued by corporations, and munis are issued by state and local government agencies. Munis are free of federal taxes and of state taxes in some states. See Chapter 14 for a table of historical default rates on various bond ratings.
12. Zero-coupon bonds (“strips”) pay no interest, only principal. So strips whose face values match the income stream needed will do the trick quite neatly. There is a catch, however (as always). First, interest-rate yields on strips are sometimes a lit- tle less than on regular bonds, so strips sometimes cost a little more. Second, taxes must be paid on the accrued interest in accounts that are not tax-deferred even though the interest has not actually been paid. That means that if your strips accrue $1000 this year, you will have to pay taxes as if you had received the $1000, even though you did not really receive it. Therefore, money will have to be set aside to pay these taxes. These two factors can make strips (or other zero-coupon bonds) a second-best solution, but do-it-yourselfers may like the idea anyway.
13. Part 3 of the book discusses the challenges faced by anyone who is trying to forecast the market and the probability of getting 10 heads in a row. It is not that mutual fund managers are necessarily inept or fraudulent (some are, no doubt). Their poor performance relative to the index funds is due to the higher costs they face (trans- actions costs, marketing expenses, fees, taxes, and so on), which average roughly 1 to 3 percent more than the costs incurred by index funds. Thus, they need to beat the index funds by more than this to come out on top. They may get lucky in some years and do this, but as a group, they cannot do it consistently.
14. The year-to-year compound annualized rate since 1926 for small-cap stocks is 12.1 percent, but over 5- year periods, the average is a bit higher. The mathematics of annualized versus average annual growth rates is somewhat nonintuitive and will be explained in Chapter 12.
15. The figure of $759,151 is simply the value of $600,000 growing with inflation at 4 percent per year over the entire span of 6 years (the current year plus 5 additional years). If interest rates on bonds were the same then as now, she could in theory buy an equivalent set of bonds for her next 5 years and start the process all over again. The $428,280 in the growth portion of her portfolio would need to earn a total return of about 10 percent per year to reach $759,151 in 6 years.
16. This assumes interest rates on bonds will be the same then as now. She could in theory buy an equivalent set of bonds for her next 5 years and start the process all over again.
17. For the technically inclined, the standard deviation of returns, the most common measure of volatility in academic research, also declines as the horizon gets longer.
18. Inflation is not factored into this 10-year span. If inflation were factored in, it would take an average of 14 years to make the portfolio equivalent in real terms.
19. These conclusions ignore the impact of inflation. They relate only to preserving the corpus of the starting portfolio, not its purchasing power.