Don't need no stinkin' bonds

[Nords]

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.

This is why your financial advisor had to let you go.

You keep analyzing these situations and making logical choices instead of paying someone to hold your hand and tell you what you think...

 

[wabmester]

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.

Rich, you are making selective assumptions about stocks based on historical behavior. Depending on one's assumptions, you can craft a zillion different strategies. If you free yourself from those assumptions, then you would simply diversify your investments.

I don't know what the future returns of stocks will be (but traditional valuation techniques suggest they may be about the same as cash). I don't know what inflation will be. I don't know what the fed will do to short-term rates. So, I diversify.

Let's assume you're right, and that stocks are simply a highly-volatile high-return investment, and you want to dip into "cash" reserves during periods of negative volatility. Why not simply take the MPT approach, and find other highly-volatile high-return investments with low correlation, and then you'll always have something "up" to withdraw from. No cash or bonds required! (Assuming your prediction about future behavior based on past behavior is accurate, of course.)

 

[terminator]

Rich,

Have you looked at the historical yields of very short-term T-bills (which is essentially cash) versus longer T-bills and T-Notes (6 mo., 2 yr, 5yr and 10 yr) and corporate bonds? That went a long way toward helping me decide how to allocate my "cash" stash. There are always other things to consider (inflation, credit quality, risk tolerance, need for liquidity, fund price swings, etc.) but when I look at "cash" versus medium-duration bonds/CDs/etc I find the latter more attractive over the long haul. I think Bernstein is right that long-term bonds aren't worth the risk and very short-term deprive you of yield while the medium duration ones give you most of the higher yield of longer ones without nearly as much risk.

Here's a link to some historical rate data:
http://www.federalreserve.gov/releases/h15/data.htm

 

[jIMOh]

My thoughts would be this:

Ths biggest risk is what happens the first 3-5 years of ER... if you have to draw down starting in 2000-2002, the answer changes significant from starting draw down 1997-2000. The purpose of the cash is to hedge the early risk, it may not be a permanent 7 years cash from year 1- year 40 of retirement. I think 5 years cash is enough except for first 3-5 years, where risk of down year is higher.

I've read articles where using things like Firecalc show "100% success" with 1960-2006 going forward data. But if returns "reverse" (meaning order years 2006-1960), it fails numerous times, because the 2000-2002 period is in beginning, of other negative years come before positive years.

I would do it this way.
Have 7 years cash, of a 65-10-25 portfolio.

assume an income needed of 50k (initial withdraw), so the 25% cash needs to be 7*50=350k. Overall portfolio of $1.4 M. $910k equity/$140k bond/ 350k cash.

The 910/140 portfolio is "85-15" (stocks-bonds). <5% return is needed for the 50k income.

The idea is anytime there is a 50k gain in value, a person takes "50k" and moves to bonds or cash. If gain is 100k (12% return), then take 100k out and move to bonds/cash. If there is a gain the next year, let it ride as needed... Provided there is a positive return somewhere in first 3 years of retirement, this should work. My biggest fear of ER is seeing the "equity piece" shrink to where it cannot rebuild itself... most bear markets recover "some" within 4 years and close to fully in 7 years.

The 7 year "cash" uses TIPs and CD type mixes. The TIPs prevent purchasing power from eroding "too much".

I would assume I would spend the first 2-3 years cash before replacing 1 single year (to let 85-15 piece compound some).

 

[Rich_by_the_Bay]

Rich, you are making selective assumptions about stocks based on historical behavior. Depending on one's assumptions, you can craft a zillion different strategies. If you free yourself from those assumptions, then you would simply diversify your investments.

Your point is well taken: why not just consider bonds to be another noncorrelated asset class and keep it in your mix to draw down from when it looks like the best choice. Fair enough, and that has certainly stood the test of time.

In a way, it is almost a slice and dice decision. Just as you can have your stocks divided up 3 ways or 15 ways, I am looking at bonds (in the current discussion) as a slice I might be able to do without in return for the SPIA-like comfort premium of 7+ years in cash. And without the risk factors which bonds bring but cash doesn't.

 

[brewer12345]

In a way, it is almost a slice and dice decision. Just as you can have your stocks divided up 3 ways or 15 ways, I am looking at bonds (in the current discussion) as a slice I might be able to do without in return for the SPIA-like comfort premium of 7+ years in cash. And without the risk factors which bonds bring but cash doesn't.

Why not have your cake and eat it too? Set up a 7 (or whatever) year ladder of bonds, split 50:50 inflation indexed vs nominal. That way you get a constant stream of cash from maturing bonds plus an average maturity and duration pretty similar to the Lehman Agregate bond index.

 

[Rich_by_the_Bay]

This is why your financial advisor had to let you go.

You keep analyzing these situations and making logical choices instead of paying someone to hold your hand and tell you what you think...

I'm in a "simple is better" mood these days. These are thought experiments (like Einstein used to do, just stupider) for me but some of them stick. It's incredibly helpful to hear what others smarter than I am think of my naive ideas.

I were forced to commit today, here's where I'd be:

Stocks @ 70% of total portfolio:
S&P 500: 40%
Extended Mkt 30%
Total Intnl 20%
REITs 10%

Cash @ 30% of total portfolio:
ST bonds, MMF
A year or two in TIPS

Probably need to get more sophisticated, eh?


P.S. to Brewer's cross-post: note the TIPs as part of the "cash" - maybe 50:50 is better - thanks.

 

[wabmester]

And without the risk factors which bonds bring but cash doesn't.

Cash has no risk of capital loss (or gain), but it has fairly high inflation risk -- generally higher than nominal bonds, and certainly higher than inflation-indexed bonds.

I'm not an MPT-purist, but the MPT guys generally view cash as a drag. It'll lower both volatility and returns (in theory). Bonds are better both wrt returns and volatility reduction (in theory).

 

[Mwsinron]

"Stocks @ 70% of total portfolio:
S&P 500: 40%
Extended Mkt 30%
Total Intnl 20%"

Almost exactly how I just rebalanced. Except I have a 75/25 split with 5 percent into Emerging Markets

 

[Rich_by_the_Bay]

I'm not an MPT-purist, but the MPT guys generally view cash as a drag. It'll lower both volatility and returns (in theory). Bonds are better both wrt returns and volatility reduction (in theory).

Careful not to bundle the accumulation phase with the draw-down phase. What is a drag in the former may provide a fair amount of reassurance in the latter.

 

[wabmester]

Careful not to bundle the accumulation phase with the draw-down phase. What is a drag in the former may provide a fair amount of reassurance in the latter.

As somebody in the draw-down phase, let me suggest that if your portfolio can throw off ~4% in interest and dividends, then a pool of cash reserves provides no additional benefits.

However, as a market timer, I like a bunch of cash right now.

 

[wabmester]

Why not have your cake and eat it too? Set up a 7 (or whatever) year ladder of bonds, split 50:50 inflation indexed vs nominal.

FWIW, this is basically what I do. But my portfolio throws off enough cash that I almost never need to consume the matured end of the ladder. It goes back in to whatever looks tasty at the time.

 

[donheff]

Why not have your cake and eat it too? Set up a 7 (or whatever) year ladder of bonds, split 50:50 inflation indexed vs nominal. That way you get a constant stream of cash from maturing bonds plus an average maturity and duration pretty similar to the Lehman Aggregate bond index.

Brewer - I am new to bonds, having been in the all equities class for some time. I have recently gotten religion but instead of going to bonds I converted a few years worth of funds to CDs since the returns seem to be high. I assume that situation won't last so I figured I would eventually create a bond ladder of the sort you recommend. Then my "year's worth of expenses" would mature annually and I would decide to roll it back into the ladder or spend it depending on equity performance that year.

The only thing that gives me pause is that others seem to feel that you can do about as well with a bond index. Does the constant flux in the bond indexes effectively reduce volatility and make them about as stable as a ladder? I wouldn't bother with the tinkering needed for a ladder if I could just pull from a bond fund in a bad equity year to the same effect.

 

[saluki9]

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.

Not really. My returns software is only backward looking (Sorry WAB) as soon as I get my forward looking software I will retire to my own pacific island.

I took two hypothetical portfolios from 1926 - 3/31/2007

Portfolio 1 has: 60% S&P 500, 25% long bonds, 10% 5 year notes and 5% one month treasuries

Portfolio 2 has: 70% S&P 500 and 30% one month treasuries.

Both had a -100% weighting to the CPI-U to report "real returns"

The lifetime annualized real return of portfolio one was 7.02% VS 6.15% on two. at 10 years it gets even wider at 5.58% to 4.31%.

As far as diversification portfolio one had a worst one year return of -14.01% Vs -20.10% in portfolio 2. Portfolio 1 also has a lower Sdev of 12.04 VS 13.55

 

[brewer12345]

The only thing that gives me pause is that others seem to feel that you can do about as well with a bond index. Does the constant flux in the bond indexes effectively reduce volatility and make them about as stable as a ladder? I wouldn't bother with the tinkering needed for a ladder if I could just pull from a bond fund in a bad equity year to the same effect.

The total return (cap gain/loss plus interest) of a bond index fund and a bond ladder with about the same average quality, duration and maturity should be very close. So if you get your panties in a wad about not having cash come due at a particular time, then a bond ladder would be appropriate. If you don't care, an index fund or ETF probably makes more sense since it will be more liquid and better diversified than any bond ladder you the retail investor can assemble (due to the nature of the bond market).

FWIW, I agree that outsized CD rates will have a finite lifespan. Deposit competition is already showing signs of flagging, and in the long run that would tend to reduce CD spreads over treasuries.

 

[Rich_by_the_Bay]

Not really. My returns software is only backward looking (Sorry WAB) as soon as I get my forward looking software I will retire to my own pacific island.

Thanks, Saluki.

That's a bigger difference that I would have estimated. Firecalc only lets you go down to 5 yr treasures, at which point there is little differene in total survivability between 70/0/30 and 60/40/5 allocations.

Do you think that adding half TIPs to the "cash" piece (realizing you may not be able to model it that way historically) might dampen the differences between the two (think early 1980s)?

 

[saluki9]

Rich, you can model it (by removing part of the inflation impact) and thereby simulating short term TIPS and it does close the gap.

 

[Rich_by_the_Bay]

Rich, you can model it (by removing part of the inflation impact) and thereby simulating short term TIPS and it does close the gap.

In other words, the two portfolios are roughly comparable re: total returns if the 30% cash piece in portfolio 2 is divided 50:50 between cash and TIPs. 60/40/5 = 70/0/(15 cash/15 TIPS)

Score one for Brewer.

 

[brewer12345]

Rich, you can model it (by removing part of the inflation impact) and thereby simulating short term TIPS and it does close the gap.

Except that this is a simulation, not actually based on historical data. So we should be appropriately skeptical.

 

[saluki9]

Except that this is a simulation, not actually based on historical data. So we should be appropriately skeptical.

Yeah, the TIPS part is simulated (from a synthesis of 5 and 1 year notes and CPI-U), everything else is historical data.

 

[wabmester]

Except that this is a simulation, not actually based on historical data. So we should be appropriately skeptical.

How skeptical do you have to be? The historical real return on cash is around 1%, and TIPS today will give you 2%+.

 

[FIRE'd@51]

The period that seems to cause the failures in FireCalc was for those who retired around 1966. Long bonds didn't help at all in the high inflation of the 1970's and early 80's. From 1966-1982 the real return on stocks (0%) was 200 basis points above that on long Treasuries (-2.2%), and that on cash (+0.2%) was higher than either stocks or long-term Treasuries. Inflation averaged 6.4%. A 70/30 stock/cash portfolio had a real return +0.4%. The interest rates on "cash" were able to adjust upward quickly enough to the rising inflation to avoid total devastation.

I'm not saying this proves anything, but I think it is instructive to focus on the period that caused the most FireCalc failures, and try to build a portfolio that will withstand that stress test and still perform adequately in other periods.

BTW, since 1982, the real return on cash has been 2%. From 1926-1982, it was zero. Today you can earn more on 3-month T-bills than on 30-year Treasuries. Yes, I know the inverted yield curve is predicting a drop in short rates. But when that happens, my guess is that it will be good for equities, unless it is accompanied by rising inflation, in which case, long Treasuries at 4.6% won't be much help.

 

[wabmester]

Oy, how many ways can we torture the data? Yes, bonds sucked for a couple years in the late 70's. Yes, bonds and cash were great in the early 80's. Yes, stocks returned 10% historically.

What does this tell us about the future? Nada, I'm afraid. The future will be different. Crank the yield up on your portfolio to 4% or so, hedge inflation, and you should be fine. Unless we get another Japan 1990.

Some real yields for you over the last 30 years:

 

[chinaco]

Rich,

Good description of why Low Correlation helps the portfolio
Here is a article from the CPA Journal : "The Power of Low-Correlation Investing" http://www.nysscpa.org/cpajournal/2003/1103/features/f114203.htm



Here is another article from the CPA Journal : "Reducing Investment Risk by Capturing Volatility". It describes why bonds are superior to cash for return/growth, yet still reduce volitility through diversification. http://www.nysscpa.org/cpajournal/2002/0502/dept/d057002.htm

 

[Rich_by_the_Bay]

Good description of why Low Correlation helps the portfolio

Yes, thanks; it's pretty much axiomatic around here that diversification among asset classes with low correlation is the way to go. The question in this thread is whether a higher stock, lower bond, higher cash/ST bond/TIPS allocation (e.g. 70/0/30) is advantageous when compared to the conventional 60/35/5 allocation. Either way, within your stock allocation you maintain a reasonable degree of diversification as well.

That's a little harder to get a handle on. Data are minimal. Experts: Armstrong likes 7y in near-cash and the rest in stocks. Lucia likes up to 28% each in cash and bonds as a starting point. Devil's in the details.