Don't need no stinkin' bonds

[Rich_by_the_Bay]

Portfolio 1:
Stocks 60%
Bonds 30% (total idx or intermediate mostly)
Cash 10% (nothing riskier than very short-term bonds)

Portfolio 2:
Cash 30%
Stocks 70%

Question is whether there is really any disadvantage of Portfolio 2?

True, a lot tied up in low yielding cash but that enables an extra 10% in stocks to offset it. True, bonds have a stabilizing effect on volatility, but then again they have some market price risk, too, whereas cash is the ultimate stabilizer and has virtually no market risk. And portfolio 2 gives you rock solid protection for 7+ years.

So who needs bonds (other than as near-cash)?

 

[Mwsinron]

What about tax friendly bonds if you are in a higher tax bracket? The yield usually produces more than plain old cash accounts.

 

[brewer12345]

You forgetting about the times that high grade bonds are negatively correlated with equities (generally when the commode hits the windmill)?

 

[Rich_by_the_Bay]

You forgetting about the times that high grade bonds are negatively correlated with equities (generally when the commode hits the windmill)?

With 8+ years of cash why not just ride it out?

I assume that negative correlation also means that bonds might down when stocks are up, so over time wouldn't that be a wash?

I guess the theory is to let stocks be your growth engine since they are better at that than bonds. And let cash be your secure, reliable, volatility-reducer, which it does better than bonds. Inquiring minds...

 

[brewer12345]

With 8+ years of cash why not just ride it out?

Generally makes for a bumpier ride.

Besides, if you are depending on your cash stash to carry you, you have the messy decision to make of when t o top the cash stash up again.

 

[FIRE'd@51]

You forgetting about the times that high grade bonds are negatively correlated with equities (generally when the commode hits the windmill)?

Isn't this only true in the "depression" scenario - falling equity prices with disinflation or maybe even deflation? In a rising inflation environment (which IMO is the more likely today), bonds will likely underperform stocks.

 

[Rich_by_the_Bay]

Generally makes for a bumpier ride.

Cash makes for a bumpier ride? Please explain - seems like cash would be the smoothest ride in such a scenario (must be missing your point), or do you mean the emotional effect of sitting by watching your stocks melt away like a snowman?

Yes, deciding when top the cash cache after many years of a bad market is tricky, though I'm not sure how that issue is any better if you are holding bonds rather than cash (and then there are those times when both stocks and bonds (but not cash) are down. Ouch).

 

[brewer12345]

Isn't this only true in the "depression" scenario - falling equity prices with disinflation or maybe even deflation? In a rising inflation environment (which IMO is the more likely today), bonds will likely underperform stocks.

Yep, in a disinflationary environment bonds kick butt (see 2001-2003). But high grade bonds (especially treasuries) also do very well in market crashes, as they tend to be the beneficiaries of a "flight to quality."

As for the near term future, I am pretty sure we will see the Fed cutting rates later this year once the weight of the housing recession drags the general economy down enough. Your crystal ball may show a different outcome.

 

[jIMOh]

Portfolio 1:
Stocks 60%
Bonds 30% (total idx or intermediate mostly)
Cash 10% (nothing riskier than very short-term bonds)

Portfolio 2:
Cash 30%
Stocks 70%

Question is whether there is really any disadvantage of Portfolio 2?

True, a lot tied up in low yielding cash but that enables an extra 10% in stocks to offset it. True, bonds have a stabilizing effect on volatility, but then again they have some market price risk, too, whereas cash is the ultimate stabilizer and has virtually no market risk. And portfolio 2 gives you rock solid protection for 7+ years.

So who needs bonds (other than as near-cash)?

I plan to do something similar. If some of the cash was in something indexed to inflation (like TIPs), I see this working quite well.

As long as equities are up once every 4 years, this should work (withdraw equites only when they go up).

The TIP component would also "index" for inflation... so if I put 40k (one year's income in TIPs) and it's worth 44k a year later, I know to withdraw 44k from equities to replace 40k of income.

 

[brewer12345]

Cash makes for a bumpier ride? Please explain - seems like cash would be the smoothest ride in such a scenario (must be missing your point), or do you mean the emotional effect of sitting by watching your stocks melt away like a snowman?

High quality bonds/treasuries tend to go up in price when t he equity market is taking it on the chin. Cash is cash - it doesn't go up or down in value regardless of what the equity market does. So if the equity market swoons, having bonds instead of cash would be better because the increase in the prce of the bonds would help offset losses in equities. Cash would not give you such an offset.

 

[FIRE'd@51]

High quality bonds/treasuries tend to go up in price when t he equity market is taking it on the chin. Cash is cash - it doesn't go up or down in value regardless of what the equity market does. So if the equity market swoons, having bonds instead of cash would be better because the increase in the prce of the bonds would help offset losses in equities. Cash would not give you such an offset.

While there definitely is a "flight to quality" in the circumstances you are describing, isn't this generally more of a short-term phenomanon, as opposed to the secular rises/declines in interest rates (inflation) - much like the "flight to quality" we saw in late Feb, early March of this year? That "flight to quality" has largely reversed itself over recent weeks (Treasury rates have risen). I would think this would have minimal effect on the 70/30 allocation that R-I-T is describing.

 

[Rich_by_the_Bay]

High quality bonds/treasuries tend to go up in price when t he equity market is taking it on the chin. Cash is cash - it doesn't go up or down in value regardless of what the equity market does. So if the equity market swoons, having bonds instead of cash would be better because the increase in the prce of the bonds would help offset losses in equities. Cash would not give you such an offset.

OK, I see what you are saying. From a portfolio net value perspective, bonds bolster you up more effectively than cash in that scenario.

I was thinking more from a SWR, don't-sell-low perspective after FIRE - you just keep on taking your yearly allowance from cash and ignore the misbehavior of your stocks long enough to let them see the error of their ways, then you rebalance somewhere down the line.

 

[brewer12345]

While there definitely is a "flight to quality" in the circumstances you are describing, isn't this generally more of a short-term phenomanon, as opposed to the secular rises/declines in interest rates (inflation) - much like the "flight to quality" we saw in late Feb, early March of this year? That "flight to quality" has largely reversed itself over recent weeks (Treasury rates have risen). I would think this would have minimal effect on the 70/30 allocation that R-I-T is describing.

Maybe. Maybe not.

There is a reason PIMCO became one of the largest fund managers in the US during the 2001-2003 period.

 

[Nords]

Well, I guess I'm not going to surprise anyone with my objective & unbiased perspective on this question.

OK, I see what you are saying. From a portfolio net value perspective, bonds bolster you up more effectively than cash in that scenario.

Sure, bonds offer the prospect of cap gains that cash can't achieve. And most people don't ladder their cash stash in CDs yielding 6.25%, so bonds can beat that when the yield curve cooperates.

But Rich, your point is well made. A higher-equity/cash portfolio is certainly more volatile than one with bonds, and it's also irrelevant if you're not selling. While cash doesn't offer cap gains, it neatly sidesteps that whole "yield-curve convexity backwardation contango" vocabulary.

Besides, if you are depending on your cash stash to carry you, you have the messy decision to make of when t o top the cash stash up again.

The decision to top up the cash should be straightforward-- if the portfolio's up this year, then top off the cash stash. If it's down, don't. There's also variable spending, so a cash stash might stretch a lot longer in a down market than one expected it to.

There is a reason PIMCO became one of the largest fund managers in the US during the 2001-2003 period.

Yeah, for Bill Gross' riveting clear-sighted commentary and omniscient stock-market predictions.

Or maybe it's investor's Pavlovian comfort-food reaction to the conventional wisdom. But that would contradict the EMH, right?

 

[youbet]

Besides, if you are depending on your cash stash to carry you, you have the messy decision to make of when t o top the cash stash up again.

Rich and Brewer,

While I keep a couple years of near-cash on hand, Brewers point of making the decision of when to top the cash stash up again is exactly what keeps me from carrying additional cash and assuming I'll be able to project the future and top off at optimal times.

When I look at history, keeping 7 years cash makes sense. "Gee, look at that dip in equities. I would have used cash then. Gee, look at that peak in equities, Iwould have sold equities to refill the 7 year cash bucket then." And on and on. The problem is that at the end of the graph, where the future lurks waiting for us, we don't know what to do and chances are you'd do a lot of buying and selling at the wrong time. Or at least I would.

I was thinking more from a SWR, don't-sell-low perspective after FIRE - you just keep on taking your yearly allowance from cash and ignore the misbehavior of your stocks long enough to let them see the error of their ways, then you rebalance somewhere down the line.

Rich, if you were RE today and totally living off your portfolio, would you be living off of cash (and thereby reducing your cash percentage hoping to refill later) or would you be liquidating equities to cover expenses now since the market is "up" (although still down in terms on not having recovered to it's all time high). In the small correction we had a few weeks ago, what would you have done?

 

[brewer12345]

Yeah, for Bill Gross' riveting clear-sighted commentary and omniscient stock-market predictions.

Or maybe it's investor's Pavlovian comfort-food reaction to the conventional wisdom. But that would contradict the EMH, right?

I would have said idiot performance chasing behavior in the wake of an equity market collapse, but that's just me.

 

[wabmester]

You guys do understand that the kind of "cash" you're talking about is implemented with bonds, right? They just happen to be very short-term bonds.

If you believe in the message of "diversification," then why would you want to make such a large bet on zero-duration bonds? We just came off a period when "cash" had strongly negative real yields. Who would want that?

If you believe in diversification, then diversify.

 

[FIRE'd@51]

While I keep a couple years of near-cash on hand, Brewers point of making the decision of when to top the cash stash up again is exactly what keeps me from carrying additional cash and assuming I'll be able to project the future and top off at optimal times.

Why would the "top-off" have to be done at optimal times? I interpreted R-I-T as saying you would top off when the equity market was above it's starting point, which has a pretty good probability of happening over a 7-year period. The point is to avoid selling stocks when the market is down (if possible). The "top-off" is simply a rebalance, not a market-timing call.

 

[Nords]

You guys do understand that the kind of "cash" you're talking about is implemented with bonds, right? They just happen to be very short-term bonds.
If you believe in the message of "diversification," then why would you want to make such a large bet on zero-duration bonds? We just came off a period when "cash" had strongly negative real yields. Who would want that?
If you believe in diversification, then diversify.

For our next episode of "ER'd Vocabulary People", brought to you by Dave Barry's "Mister Language Person", we'll attempt to answer the question: "What is the definition of 'net worth'?" And then stay tuned for our encore presentation of these classic late-night specials: "What are these 'buckets', anyway?" followed by "Should I keep my mortgage, or should I pay it off?"

 

[FIRE'd@51]

If you believe in the message of "diversification," then why would you want to make such a large bet on zero-duration bonds? We just came off a period when "cash" had strongly negative real yields. Who would want that?

The reason for "zero-duration bonds" is to minimize interest rate (inflation) risk from that part of the portfolio. If short rates fall (as they did a few years ago) just spend "principal". The opportunity cost of spending cash when rates are 1% is very small.

 

[youbet]

The decision to top up the cash should be straightforward-- if the portfolio's up this year, then top off the cash stash. If it's down, don't.

Easy for you to say......

"if the portfolio is up" means up relative to what? The previous year? The previous all time high? If you're up vs. last year but way down compared to earlier years' highs, how about that?

I know I'm not as sophisticated an analyst as you guys (understatement!) but the decision on when to sell to replinish a large cash postion just doesn't seem all that straight forward......

 

[brewer12345]

For our next episode of "ER'd Vocabulary People", brought to you by Dave Barry's "Mister Language Person", we'll attempt to answer the question: "What is the definition of 'net worth'?" And then stay tuned for our encore presentation of these classic late-night specials: "What are these 'buckets', anyway?" followed by "Should I keep my mortgage, or should I pay it off?"

And for those of you with the adult access switch enabled, "Piglet sodomizers walk among us!"

 

[wabmester]

The opportunity cost of spending cash when rates are 1% is very small.

What about the opportunity costs of having 30% of your portfolio in cash during a multi-year period when cash has a negative real yield?

Many here look to historical data for predicting future returns (as silly as that might be). If that's your conceptual framework, then you should understand that cash has historically returned less than longer duration bonds. So, I guess I just don't see the rationale.

 

[Nords]

I know I'm not as sophisticated an analyst as you guys (understatement!) but the decision on when to sell to replinish a large cash postion just doesn't seem all that straight forward......

Youse guys are making this way too hard. If I didn't know better I'd think that I was back amongst my fellow nukes.

Pick a date. There's only 365 or 366 of them, so let's call it "1 January" to keep this example moving along. Compare the size of the portfolio on that date to its size a year ago (again, 365 or 366 days, the actual choice being left to the user). If the current portfolio is bigger than a year ago, then sell off (1) the excess or (2) a year's spending cash, whichever is smaller. If that's not complicated enough then implement ESRBob's 95% rule or find some other rationale that helps you sleep at night. If you're up vs last year but still down from earlier years, then refer to option (2) or the aforementioned alternate methods.

If the portfolio sets a record high then assess your comfort level. If you're sleeping at night do nothing. If you're finding yourself discussing your options with strangers you've met over the Internet then sell half of the increase over last year's all-time high and take a nap.

I suspect we can make this more complicated, but I'm reluctant to encourage that behavior... especially if it involves a discussion over whether or not to convert to a Roth IRA!

 

[Rich_by_the_Bay]

Rich, if you were RE today and totally living off your portfolio, would you be living off of cash (and thereby reducing your cash percentage hoping to refill later) or would you be liquidating equities to cover expenses now since the market is "up" (although still down in terms on not having recovered to it's all time high). In the small correction we had a few weeks ago, what would you have done?

I'd look at it every year or so, and if it's up, prune it back. Not something I'd particularly try to time, nor would I worry about it other than infrequently. Maybe cheat a little here and there during a run-up is about as close as I'd get to timing.

I suppose that if things went well, at some point I'd say that this is enough cash to last me til I die, and let the big dogs run. Some fun money, kid money, whatever. That would be a nice closure to the plan.

Wab, the opportunity cost of having money in cash v. bonds - more than offset long term by having 70% in stocks versus 60% with a traditional allocation, no? The boringness of cash (and lack of capital risk) makes me feel more comfortable going higher in equities than I would otherwise.