5-7 Years Expenses in Cash versus Rebalencing to Fixed AA

[Hydroman]

5-7 Years Expenses in Cash & Balance in Equities

A number of retirees believe one should just put 5-7 years living expenses in cash and/or bonds and the rest in a diversified set of equities (ala Frank Armstrong). The premise is with 5-7 years expenses set aside you should be able to ride out a bear without selling equities during the down times. I do see how this may help you sleep at night during a bear market, but on the other hand you would be missing out the benefits of buying low and selling high during rebalancing. My understanding is you just ride out the market until it returns to its previous high.

I also do not understand if you are supposed to wait until the market returns to exceed its previous high before replenishing your cash reserve or just wait for the next up year even if the market has not returned to the previous high.

Feedback from the the forum will be appreciated, particularly from those who follow this system.

Thanks.

 

[grumpy]

When deciding what to sell to replenish my cash supply for living expenses I do not look at where "the market" is because I do not own "the market" and I am not selling "the market". I am selling a particular fund or shares of a specific company. I make my decision based on the current prices of those particular assets. It is true that the decision is easier when "the market" is at a new high because that usually means many of my assets are also at new highs. Hopefully my portfolio is sufficiently diversified that during a 5 year span I can find an asset that is priced attractively to sell if I need cash.

Grumpy

 

[Hydroman]

When deciding what to sell to replenish my cash supply for living expenses I do not look at where "the market" is because I do not own "the market" and I am not selling "the market". I am selling a particular fund or shares of a specific company. I make my decision based on the current prices of those particular assets. It is true that the decision is easier when "the market" is at a new high because that usually means many of my assets are also at new highs. Hopefully my portfolio is sufficiently diversified that during a 5 year span I can find an asset that is priced attractively to sell if I need cash.

Grumpy

My mistake for not being clear about what I meant by market. I should have referred to my portfolio of equities. That said, I would sell the high flyers as part of rebalancing within my equity portfolio, but would not fund my cash pot from the sale of any specific equity unless my total equity portfolio is up. At least that is the way I understand the system is supposed to work.

 

[mathjak107]

5 to 7 years may be to short of a time span for what you are trying to do. we may still be in a downturn in a 5 -7 year period. i would go with 1-7 in cash, 7-14 in income producing slightly more risky stuff ,and then have my equities.

you would be hard pressed to find a 14 year period that wasnt up,however its easy to find 5-7 year.

thru out the 14 year period i would refill the other buckets when things were up.

 

[mathjak107]

whats nice about this system is market drops dont upset your financial actions at all. rebalancing is based on need not on market performance so much.

if your 1-7 and 7-14 buckets are full from an extended stock run previously then even though stocks may have unbalanced a typical 60/40 mix say to 70/30 this system would call for no rebalancing in the stock bucket.

if a particular area in your stock bucket had a great run up, small cap as an example and you now had 20% instead of 10% of your stock bucket in small cap then you may rebalance within the equities bucket and buy more large cap but you need not buy more bonds or cash instruments

 

[chinaco]

A number of retirees believe one should just put 5-7 years living expenses in cash and/or bonds and the rest in a diversified set of equities (ala Frank Armstrong)...

Ideally in both phases (accumulation and draw-down), you would have a target allocation of stocks and bonds say 60/40. Based on some approach (Time, Trigger, or Combo), one rebalances the portfolio to the target allocations. For example, if stocks drop and the allocation is now 56/44, one would sell bonds and buy stock (this is buy low). Likewise if bonds went up (maybe interest rates dropped) and changed the allocation, the same move. If stock go up and the allocation is 64/36, sell equity and buy bonds (or perhaps short-term securities). This is a mechanism that is intended to capture money from the (hopefully non-correlated) up and down movement of the security classes. Buy low/Sell high based on the relative valuation in the security class and across security classes.

The 5-7 year number is to meet one's income needs. This would imply a particular allocation for the portfolio. It would also mean that only a certain % would be withdrawn each year.

If you intend to spend all of the money in a near/interim time frame, one might consider going to all cash and intermediate bonds to eliminate the equity volatility. That is why you see many models go almost completely to bonds in late life of retirement. Of course, these models assume that most people are not extremely wealthy. If one were extremely wealthy that approach does not make sense.

 

[justin]

I think the "5-7 years in cash/bonds" method is basically equivalent to a non-bucket portfolio consisting of 20-28% cash/bonds and 72-80% equities, given a 4% withdrawal rate. The only difference is the rebalancing rules you follow.

Under the "5-7 years in cash" bucket method, you "replenish" (really rebalance) the cash bucket when you think equities are more fairly priced.

Under the typical 4% safe withdrawal rate method, you rebalance annually to your target allocation. Your rebalancing is a set mechanical process that doesn't require judgment (just do it every year).

Knowing that you have 5-7 years in cash can help you sleep at night, but after a few years of using your cash (and not replenishing the cash bucket) you might not be sleeping as well.

 

[FIRE'd@51]

I'm not sure that the "cash bucket" has to be all that large in terms of percentage of assets. The cash (and it's interest) only has to supplement the dividends and interest generated by the longer-term piece of the portfolio (mainly equities). I look at my "cash bucket" as being a self-amortizing piece of the portfolio.

For example, take a $1 million portfolio with a 40K annual draw (4% WR)

If you assume a 5% nominal return on the "cash-bucket" and 3% inflation, you would "only" need to have about 130K in cash (13%) to provide an inflation-adjusted 20K per year for the next 7 years. The rest of the portfolio would only have to provide an inflation-adjusted cash flow (dividends and interest) of 2.3% to produce the other 20K, so it could be very heavily invested in equities (perhaps even 100% if you choose to go the route of a broadly diversified portfolio of dividend payers).

As time marches on, dividends will likely grow faster than inflation, so your subsequent "cash bucket" requirement will likely become smaller in today's dollars, and, hopefully, as a percentage of the portfolio.

 

[Hydroman]

whats nice about this system is market drops dont upset your financial actions at all. rebalancing is based on need not on market performance so much.

if your 1-7 and 7-14 buckets are full from an extended stock run previously then even though stocks may have unbalanced a typical 60/40 mix say to 70/30 this system would call for no rebalancing in the stock bucket.

if a particular area in your stock bucket had a great run up, small cap as an example and you now had 20% instead of 10% of your stock bucket in small cap then you may rebalance within the equities bucket and buy more large cap but you need not buy more bonds or cash instruments

Assuming annual expenses equating to 4% of your total portfolio, with 14 years expenses invested in MMA's and Bonds, means a 44/56 mix of cash & FI to equities. Also by letting the equities run you risk watching your equities run up and then fall down thus missing the opportunity to capture some of the profits that would be captured by rebalancing.

 

[Hydroman]

whats nice about this system is market drops dont upset your financial actions at all. rebalancing is based on need not on market performance so much.

if your 1-7 and 7-14 buckets are full from an extended stock run previously then even though stocks may have unbalanced a typical 60/40 mix say to 70/30 this system would call for no rebalancing in the stock bucket.

if a particular area in your stock bucket had a great run up, small cap as an example and you now had 20% instead of 10% of your stock bucket in small cap then you may rebalance within the equities bucket and buy more large cap but you need not buy more bonds or cash instruments

Assuming annual expenses equating to 4% of your total portfolio, with 14 years expenses invested in MMA's and Bonds, means a 44/56 mix of equities to cash/FI. Also by letting the equities run you risk watching your equities run up and then fall down thus missing the opportunity to capture some of the profits that would be achieved by regular rebalancing the overall equities to cash/FI mix. I can see waiting for the overall equity portfolio to recover from some down years before replenishing the cash but I would not want to let the equity portfolio run up without taking at least enough profits to maintain the original cash/FI position.

 

[mathjak107]

see the point you are missing is, retirement is a different mentality then when your in the accumulation stage. now its not about getting every last percentage of gain, its now not about growing richer , its about not growing poorer and maintaining an output from your mix that generates the income you need ..... its okay to let the stock portion run . you will be periodically filling the buckets over time so you will be taking profits.

a 14 year time frame gives you a 99.5% chance of never loosing money as well as the mix generating a 7-8% average return . all that gives you the numbers you need to sustain a 4% withdrawl rate

all you need at this point of your life is for the portfolio to generate the numbers you need. you no longer need to worry about eeking out an extra point or 2 by trying to out guess the markets movements and when to take profits.

 

[audreyh1]

If you have say a 40% allocation to cash and high-quality short-term fixed income investments, you have 10 years of expenses covered right there. If equities were to go down severely enough that rebalancing causes your cash/fixed income to drop below say 7 years of expenses, you might want to hold off going all the way.

I tend to think of that 5-7 year rule as a low bound on my cash/fixed income allocation. I won't rebalance so much that it reduces my cash/fixed income below that amount, but otherwise I rebalance normally (not too often - at least a year between and longer if there is not much divergence between allocations).

Audrey

 

[Milkman]

What are your thoughts about letting portfolio dividends replenish your cash? On one hand, keeping 5-7 years of expenses in cash is a significant amount of money that would be earning money market returns rather than potentially significant total market returns. Let us assume that a balanced portfolio throws off 2.5% dividends and interest. That would go a long way to funding a 4% annual withdrawal, and significantly reduce the amount of cash necessary to fund 5-7 years of expenses.

Milkman

 

[cute fuzzy bunny]

Get rid of the big buck expenses, predominately debt. Then you no longer have a problem of large expenses to pay, requiring the big cash buffer that saps your returns.

Chances are you could get by on dividends alone in a tough stretch, making the share price and volatility irrelevant.

 

[mathjak107]

while dividends would work , in the bucket system they would normally be left alone to grow being reinvested in the stock bucket. you may end up over time with a stock bucket short of the amounts it should have in it since dividends can be 1/3 of the entire return of an index like the s&p..

but each person has to have a plan that works for them. its all a means to an end. the ability to draw about 4% for ever.