AA and cash reserves

[audreyh1]

Cash is part of our AA in the portfolio. We don’t consider this a reserve, but part of our fixed income allocation which also contains short-term bond funds and intermediate bond funds. We rebalance between them and the stock allocation.

This is independent of cash used to cover short-term expenses or any cash reserves we choose to hold.

 

[TwoByFour]

The argument against bonds is always inflation. Like most things the devil is in the detail. If you are buying bonds yielding higher than inflation and constantly rolling them over, inflation has a hard time catching you. Rates also go both ways. As rates creep up, going longer on the curve will look like gold when rates begin to go the other way. Like the 13% CD I once owned.

A ladder is only effective against inflation if the maturity is low. A ladder of long-maturity bonds that have a coupon that is less than inflation will take a long time to flush out.

I own bonds, in a ladder, but it is mostly 2 and 3 year bonds. And 5- and 10-year TIPS, but with TIPS it is a non-issue.

 

[TwoByFour]

To me, CDs are effectively "cash" - especially if laddered as that provides additional liquidity. Others treat them as bonds. YMMV.

For the purposes of discussion I think it is less confusing to say what the instrument actually is rather than how you view it. Otherwise we end up discussing apples vs. oranges.

 

[pb4uski]

Whether cash is a drag or not depends on what you have it in. If you have it in a 0.0x% bank savings account or money market fund then it is a drag. If you have it in an online savings account that currently pays 1.9% or something like VMMXX that currently pays 2.2% then the drag is minimal (in my case usually between 3-5% in cash, 5% after I rebalance but lower than 5% on average during the year).

So if fixed income yields 4% and my cash yields 2% then the drag is 0.08%... not much for the peace of mind.

 

[youbet]

Whether cash is a drag or not depends on what you have it in. If you have it in a 0.0x% bank savings account or money market fund then it is a drag. If you have it in an online savings account that currently pays 1.9% or something like VMMXX that currently pays 2.2% then the drag is minimal (in my case usually between 3-5% in cash, 5% after I rebalance but lower than 5% on average during the year).

So if fixed income yields 4% and my cash yields 2% then the drag is 0.08%... not much for the peace of mind.

So you're saying that 0.08% is not much of a drag and that 0.16% is too much of a drag. Is that it? Did I do the math right?

Is there a gradient between these two numbers? You know, like 0.12% is a semi-drag? Or maybe just "Kind of a Drag?"

 

[Dtail]

Cash is part of our AA in the portfolio. We don’t consider this a reserve, but part of our fixed income allocation which also contains short-term bond funds and intermediate bond funds. We rebalance between them and the stock allocation.

This is independent of cash used to cover short-term expenses or any cash reserves we choose to hold.

+1 on the bolded parts.

 

[foxfirev5]

Whether cash is a drag or not depends on what you have it in. If you have it in a 0.0x% bank savings account or money market fund then it is a drag. If you have it in an online savings account that currently pays 1.9% or something like VMMXX that currently pays 2.2% then the drag is minimal (in my case usually between 3-5% in cash, 5% after I rebalance but lower than 5% on average during the year).

So if fixed income yields 4% and my cash yields 2% then the drag is 0.08%... not much for the peace of mind.

If/when FI hits 4% Ill be in fat city. Run the ladder out and let it roll. Furthermore it keeps in eyesight of inflation. At least as far as I can see.

 

[COcheesehead]

A ladder is only effective against inflation if the maturity is low. A ladder of long-maturity bonds that have a coupon that is less than inflation will take a long time to flush out.

I own bonds, in a ladder, but it is mostly 2 and 3 year bonds. And 5- and 10-year TIPS, but with TIPS it is a non-issue.

I agree. My ladders are 5 year, but really mostly in 2-3 year range, which now seems to be a sweet spot.
There are some one off's out there that I buy from time to time like a 2027 muni yielding 7.125% Those are sometimes worth the duration risk.

 

[HI Bill]

This is exactly my concern. It mitigates SOR risk, but when we run the numbers, the cycles that fail are all those that started in the 60s--very illuminating. Trying to figure out a happy medium.

If you were to look at the curves that represent the data, the cycles that fail typically begin 20 years from the start date. In reality, the sequence of returns risk is continuously starting over...you never know when we'll hit a series of down market years. So, if you make it through the first 20 years without encountering a bad run, FIRECALC will say that in 20 years from then, you'll encounter a risk of running out of funds.

The 3-year cash concept is to keep the SOR from depleting your resources prematurely. Play with the Your Portfolio page of Firecalc. Results are typcially better when you have at least 10% in cash/stable investments which will help you weather the storms.

 

[Dtail]

If you were to look at the curves that represent the data, the cycles that fail typically begin 20 years from the start date. In reality, the sequence of returns risk is continuously starting over...you never when we'll hit a series of down market years. So, if you make it through the first 20 years without encountering a bad run, FIRECALC will say that in 20 years from then, you'll encounter a risk of running out of funds.

The 3-year cash concept is to keep the SOR from depleting your resources prematurely. Play with the Your Portfolio page of Firecalc. Results are typcially better when you have at least 10% in cash/stable investments which will help you weather the storms.

So what Firecalc investment definition do you use for your cash allocation?

 

[HI Bill]

So what Firecalc investment definition do you use for your cash allocation?

Since there's no cash option under Mixed portfolio, I use the 1-Month Treasury. Or use Total Market, and change the % box to match your desired equity % (100%-equity % = fixed income).

 

[Dtail]

Since there's no cash option under Mixed portfolio, I use the 1-Month Treasury. Ir use Total Market, and change the % box to match your desired equity % (100%-equity % = fixed income).

Haven't used the mixed portfolio section. Do you feel the extra granularity of this section provides more "accurate" results than the Total Market section?

 

[HI Bill]

Haven't used the mixed portfolio section. Do you feel the extra granularity of this section provides more "accurate" results than the Total Market section?

I would choose the one that most closely allows you to model your exact AA. Depending on how your AA varies from the defaults, it can make little/no difference, to a lot of difference.

 

[popntx]

I'm struggling with the concept of maintaining a large "cash cushion" in order to mitigate SOR risk. If the idea is to have enough cash (3 years worth in this case) that you choose to use instead of choosing to use equities in a down market, isn't this the same as market timing? How does one know when the market is down and when it has recovered?

I agree that a larger fixed income position lowers the volatility of the overall portfolio, and in that sense I suppose it can lower SOR risk. But isn't the idea to choose an asset allocation that you can live with, and stick with it regardless of when the market is "up" or "down"?

 

[HI Bill]

I'm struggling with the concept of maintaining a large "cash cushion" in order to mitigate SOR risk. If the idea is to have enough cash (3 years worth in this case) that you choose to use instead of choosing to use equities in a down market, isn't this the same as market timing? How does one know when the market is down and when it has recovered?

I agree that a larger fixed income position lowers the volatility of the overall portfolio, and in that sense I suppose it can lower SOR risk. But isn't the idea to choose an asset allocation that you can live with, and stick with it regardless of when the market is "up" or "down"?

Yes, the idea is to choose an asset allocation that you can live with and stick to. Given the potential for both bonds and equities to depreciate, having some of your assets in cash at all times only makes sense. I would suggest that if the asset (equity) you want to sell is worth less than you paid for it, and the sale would result in capital losses, that's not the time to sell it. In that case, you're better off tapping the cash reserves. In my world, I'll likely base the determination on the peak value of the assets (e.g., I don't want to sell equities right now to live off of, as they've already encountered a 10% drop). The idea is not to sell low and make temporary losses permanent.

When you start the spending phase of your life, the 'when' of each distribution involves involuntary or voluntary market timing. Some folks just withdraw the year's amount on January 2; some do it quarterly, some monthly, and some randomly, at times they perceive market peaks. Since you are unlikely to consistently make the right market timing guess, I'd suggest that a monthly draw, with occasional deferrals for obviously down markets is the best strategy; quarterly withdrawals are easier, though, and can coincide with making quarterly tax payments, if required.

Hope this helps/makes sense.

 

[RobLJ]

My allocation calls for 5% cash (+35% bonds; 60% stocks), but as the S&P PE has soared I've been willing over the last 18 or so months to let cash build (to 16%!), by taking some of the incremental stock gains and even some bond gains (foreign, real estate income, and bank loan funds). The MM yields are within spitting distance of conservative bond funds, which has been the kicker.
This will allow me to shovel more into stock funds painlessly, although I'm waiting for another 5% drop or the end of January when I usually rebalance. I do think the environment now is a little unusual (given stock pricing and the small differential between bonds and cash), although I wouldn't be shocked if stocks run back up for a while--if so I may not have to do anything in January.

 

[TwoByFour]

Given the potential for both bonds and equities to depreciate, having some of your assets in cash at all times only makes sense.

Bonds don't have to depreciate. And cash always depreciates at the rate of inflation. The question is really liquidity - how much do you need, and then make sure your portfolio has that amount of it. Liquidity comes at a cost, so you have to balance it with other things, like return.

 

[audreyh1]

Bonds don't have to depreciate. And cash always depreciates at the rate of inflation. The question is really liquidity - how much do you need, and then make sure your portfolio has that amount of it. Liquidity comes at a cost, so you have to balance it with other things, like return.

Bonds depreciate at the rate of inflation too. No different from cash.

The only thing is that bonds usually (but not always) pay a higher interest rate, and, with the exception of US Govt used bonds, are subject to credit risk.

 

[HI Bill]

Bonds don't have to depreciate. And cash always depreciates at the rate of inflation. The question is really liquidity - how much do you need, and then make sure your portfolio has that amount of it. Liquidity comes at a cost, so you have to balance it with other things, like return.

Imagine this year, only three times worse. And the markets take 5 years to recover (middle-of-the-road scenario). Your cash assets only lose value due to inflation, which is a much lower reduction than your equities experience. You have saved yourself from SOR risk. The cost was insignificant compared to having losses in bonds or equities (maybe 1% per year). I consider this the cost of safety. JMHO.

 

[TwoByFour]

Bonds depreciate at the rate of inflation too. No different from cash.

Not TIPS.

But I took his meaning to be NAV, not total return. It is certainly possible to get a total return on bonds (non-TIPS) that keep up with inflation.

 

[TwoByFour]

Imagine this year, only three times worse. And the markets take 5 years to recover (middle-of-the-road scenario). Your cash assets only lose value due to inflation, which is a much lower reduction than your equities experience. You have saved yourself from SOR risk. The cost was insignificant compared to having losses in bonds or equities (maybe 1% per year). I consider this the cost of safety. JMHO.

When you say "this year", I take it you mean equity performance. My post was only a comment on the FI part of one's portfolio. My point is that you don't have to load up on cash in your FI to have safety and liquidity. Use bond (or CD) ladders of short term bonds (or CDs) and/or TIPS. Doing so you should not need more than 1-year worth of cash, IMO.

 

[COcheesehead]

Imagine this year, only three times worse. And the markets take 5 years to recover (middle-of-the-road scenario). Your cash assets only lose value due to inflation, which is a much lower reduction than your equities experience. You have saved yourself from SOR risk. The cost was insignificant compared to having losses in bonds or equities (maybe 1% per year). I consider this the cost of safety. JMHO.

If I am rolling bonds, in a short term 3-5 year ladder to deal with SOR, I am not taking a hit because my yield overall is almost always going to be higher than cash.