Author Topic: Sequence of returns and asset allocation near RE point  (Read 2774 times)

englyn

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Sequence of returns and asset allocation near RE point
« on: February 22, 2018, 10:02:58 PM »
Given that a significant purpose of holding cash/bonds is to reduce volatility and thus sequence of returns risk, but they deliver lower gains overall, does that support a long term strategy of the below?

Main accumulation phase: shovel money into total stock market index funds
Secondary accumulation phase: When desired amount of stock allocation has been reached, shovel money into bonds/cash etc
Initial RE phase: Withdraw money from cash/bonds. If during this period a crash occurs, won't have to sell shares at a loss. If it does not, spending from cash while the shares increase in value improves later long term outcomes.
Main RE phase: You've passed the major sequence of returns risk period. Shares should support withdrawal rate from now on.


englyn

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Re: Sequence of returns and asset allocation near RE point
« Reply #1 on: February 22, 2018, 10:11:36 PM »
Example using made-up numbers: say you need 500k to ER. Your max SWR indicates you should have 40% in bonds/cash & 60% in shares (pretending for the sake of simplicity that these are the only options). That supports 200k in bonds/cash.

Main accumulation phase: put money in shares until value of shares = $300k
Secondary accumulation phase: put money in bonds until value of bonds = $200k (I know the value of shares has now gone up which affects this detail somewhat. Stay with the example for simplicity's sake).
FIRE. Celebrate.
Initial RE phase: spend your bonds until depleted
Subsequent RE phase: withdrawal from shares

Seems to me this staged approach would get the maximum value out of the volatility-reducing power of cash/bonds while also getting the max value out of the wealth-increasing power of shares?


terran

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Re: Sequence of returns and asset allocation near RE point
« Reply #2 on: February 22, 2018, 10:15:02 PM »
Interesting thought. Seems like another way of looking at a rising equity glidepath. You might find this post (and really the whole series) an interesting read: https://earlyretirementnow.com/2017/09/20/the-ultimate-guide-to-safe-withdrawal-rates-part-20-more-thoughts-on-equity-glidepaths/

My current thinking (which could very well change as more market history becomes available and more research is done) is to keep a high equity allocation until we have decided on an "irreversible" retirement date (put in notice, booked a trip, committed to a move, etc) then immediately switch to 60/40 stocks/bonds and at retirement start a rising equity glidepath by spending from bonds and reallocating over the next 10-12 years until 100% stock.

englyn

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Re: Sequence of returns and asset allocation near RE point
« Reply #3 on: February 22, 2018, 10:55:58 PM »
Niiiice, thanks for that.

Quote
(when the Shiller CAPE is high) Most glidepaths pretty consistently beat the static equity weights. The consistently best performers are the 60 to 100% glidepaths and the active glidepaths perform slightly better than the passive ones. The failure rates are less than half those in the static allocation simulations!

I am considering extending the idea to pre-FIRE as well (climb-path?), whereas you're looking at taking a step-change at your decision date. Interesting! I wonder what the relative benefits are? It'd depend when you made the decision I think. Your strategy may be better suited to a RE date based on external factors and mine a little more on optimising RE date based on having enough assets.

Not that I'm overly attached to my idea yet, having only thought of it today, having just discovered that the optimal SWR for Australia may involve a much smaller stock allocation than I'd previously thought.

terran

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Re: Sequence of returns and asset allocation near RE point
« Reply #4 on: February 22, 2018, 11:41:20 PM »
My basic thinking is that paid employment is much like a bond in that it keeps you from having to withdraw in a down market (unless you lose your job of course). As long as you're flexible in when you start drawing down then on average you should do better with more stocks. But, as soon as you've committed to a particular date you've entered sequence of return danger zone since you can no longer choose not to draw down.

I'd actually say you might have it backwards? My step version should (on average) get me to any given FIRE number faster, then I can make the decision to FIRE based on having enough assets and immediately switch to sequence of returns survival mode. Your climb-path (I think it's actually referred to as a glidepath in both directions in the literature) on the other hand should (on average) take longer to reach a particular FIRE number, but it's "safer" in the sense that you're prepared for sequence risk further out. So if the market takes a dive the day before I make my final decision and adjustment then I could be working several years longer, while if it dives right before you commit to a FIRE date you're probably fine to still FIRE.

I'm also not necessarily saying I'll make the adjustment, put in my notice and FIRE two weeks later. I'm just thinking I'll keep a high stock allocation until I've decided I have enough that I can set a "real" date and no longer feel that I want to risk that date possibly having to move further out thanks to a market correction.

We're probably not actually talking about too terribly different things, I just don't think I would switch to all bonds as soon as I had hit 60% of my number in stocks. Maybe get it close to 80-90% then ratchet back down to 60% for the final year or two? Of course if you're saving fast enough that final year or two might be all you need to save the final 40%. It's also possible I'll be willing to either get closer or further from my number while still mostly stocks depending on how antsy I'm feeling about FIREing by the time I'm closer than I am now. I guess what I'm saying is that once the risk of having to work through a downturn outweighs the greater return then it's probably time to ratchet back. At this point I'm expecting to work through a few downturns before it's time anyway, so I may as well ride it out. 

sol

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Re: Sequence of returns and asset allocation near RE point
« Reply #5 on: February 22, 2018, 11:54:56 PM »
Given that a significant purpose of holding cash/bonds is to reduce volatility and thus sequence of returns risk, but they deliver lower gains overall, does that support a long term strategy of the below?

Sure, this is just the classic rising equity glidepath theory.  Basically, you put your stock buying time and your stock selling time as far apart as possible, by only buying and selling bonds around your retirement date.  Stocks give higher returns with higher volatility, but over longer periods of time that volatility is significantly reduced.  US stocks have never lost money over a 15 year period, so you can almost guarantee that you're protected from losses if you can last that long on bonds in between.

The 4% rule generally doesn't fail because of stagnant stock markets.  Most of the failure cases are due to significant drawdowns shortly after retirement, and many other planned retirements are delayed by significant drawdowns right before retirement.  You protect yourself from some sequence of return risk by increasing your bond allocation around these vulnerable years.  If you do this, you're trading away the expected value of future returns to mitigate short term risks out at the probability tails.  It's mathematically suboptimal for the population of retirees as a whole, but it also protects individual retirees from finding themselves in that worst case scenario.  In that sense, it's kind of like buying insurance.  And most of us like insurance!

Scandium

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Re: Sequence of returns and asset allocation near RE point
« Reply #6 on: February 23, 2018, 08:55:32 AM »
Example using made-up numbers: say you need 500k to ER. Your max SWR indicates you should have 40% in bonds/cash & 60% in shares (pretending for the sake of simplicity that these are the only options). That supports 200k in bonds/cash.

Main accumulation phase: put money in shares until value of shares = $300k
Secondary accumulation phase: put money in bonds until value of bonds = $200k (I know the value of shares has now gone up which affects this detail somewhat. Stay with the example for simplicity's sake).
FIRE. Celebrate.
Initial RE phase: spend your bonds until depleted
Subsequent RE phase: withdrawal from shares

Seems to me this staged approach would get the maximum value out of the volatility-reducing power of cash/bonds while also getting the max value out of the wealth-increasing power of shares?



Why not just buy stocks until you're at $500k then rebalance $200k into bonds?

2Birds1Stone

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Re: Sequence of returns and asset allocation near RE point
« Reply #7 on: February 23, 2018, 11:39:48 AM »
There was a good thread on this over on Bogleheads yesterday.

It's called a bond tent. The theory being that you suffer from portfolio size risk the years right before retirement as well as the first decade of retirement.

Bumping up bonds prior to retiring and then drawing from them after the sequence of returns risk in the first decade after RE subsides, is a common way of setting up a portfolio.

2Birds1Stone

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sol

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Re: Sequence of returns and asset allocation near RE point
« Reply #9 on: February 23, 2018, 11:49:10 AM »
Just as a counterpoint, bonds look to be unusually sensitive to interest rate risk right now, which would seriously undermine this strategy.  If they're not stable, they're no good for this purpose.

You can mitigate this by buying shorter term bonds and just holding then to maturity, since then today's price doesn't matter.  But it means you're stuck with the lower rate on the shorter duration, and you're still forced to sell other non-bond assets until bond maturity because they don't technically pay anything until maturity if you're not selling them, so you have cash flow problems.

In short, stocks are expensive right now because they're the best option right now.  I think bond tenters may be increasing their risk exposure, not controlling it.  It's a weird time to be an investor.

anisotropy

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Re: Sequence of returns and asset allocation near RE point
« Reply #10 on: February 23, 2018, 03:21:55 PM »
There was a good thread on this over on Bogleheads yesterday.

It's called a bond tent. The theory being that you suffer from portfolio size risk the years right before retirement as well as the first decade of retirement.

Bumping up bonds prior to retiring and then drawing from them after the sequence of returns risk in the first decade after RE subsides, is a common way of setting up a portfolio.

That's interesting. Do you actively buy more bonds once you start drawing it down by selling stocks?

Eric

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Re: Sequence of returns and asset allocation near RE point
« Reply #11 on: February 23, 2018, 06:24:59 PM »
There was a good thread on this over on Bogleheads yesterday.

It's called a bond tent. The theory being that you suffer from portfolio size risk the years right before retirement as well as the first decade of retirement.

Bumping up bonds prior to retiring and then drawing from them after the sequence of returns risk in the first decade after RE subsides, is a common way of setting up a portfolio.

That's interesting. Do you actively buy more bonds once you start drawing it down by selling stocks?

The goal is to start retirement with the greatest amount of bonds you would ever hold, and then decrease from there.

TheAnonOne

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Re: Sequence of returns and asset allocation near RE point
« Reply #12 on: February 25, 2018, 08:08:33 AM »
My one gripe with this is that you need to switch OUT of buying stocks before hitting 4%

Otherwise you are basically "FIREable" and keep working anyway for this cash-stache.

You could be describing the rising-equity path like above but you could also just be describing a complicated way of using the 1% - 2% -or- 3% rule

BTDretire

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Re: Sequence of returns and asset allocation near RE point
« Reply #13 on: February 25, 2018, 08:36:16 AM »
Just as a counterpoint, bonds look to be unusually sensitive to interest rate risk right now, which would seriously undermine this strategy.  If they're not stable, they're no good for this purpose.

You can mitigate this by buying shorter term bonds and just holding then to maturity, since then today's price doesn't matter.  But it means you're stuck with the lower rate on the shorter duration, and you're still forced to sell other non-bond assets until bond maturity because they don't technically pay anything until maturity if you're not selling them, so you have cash flow problems.

In short, stocks are expensive right now because they're the best option right now.  I think bond tenters may be increasing their risk exposure, not controlling it.  It's a weird time to be an investor.
Sol, That's my situation now, the expected norm for me would be to diversify into bonds. (62 years old)
But, in this rising rate environment, the price of any bonds I would purchase would be dropping in
value over the next few years. And as you say, low return on short term bonds.
  I have choose a different route which may not suit others, I have bought REIT preferred stocks.
 They pay 6% to 8% and I try to purchase below par price, so their is a tiny bit of room for appreciation,
and if they are called, I'll get full par price. Yes, there can be some downward price pressure because of
rising interest rates, but there are other factors that negate that, to some extent.
 I have about 13% in 6 REIT preferreds, held in a tax deferred account.

englyn

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Re: Sequence of returns and asset allocation near RE point
« Reply #14 on: February 26, 2018, 08:42:59 PM »
This forum is the best :D

2Birds1Stone

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Re: Sequence of returns and asset allocation near RE point
« Reply #15 on: February 27, 2018, 03:54:14 AM »
This forum is the best :D

Only because Pornhub hasn't launched theirs yet.

Leisured

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Re: Sequence of returns and asset allocation near RE point
« Reply #16 on: March 01, 2018, 07:23:37 PM »
Good thread. In retirement, it should be possible to take withdrawals purely as dividends, so there is no need to sell shares. In normal years, companies do a little better with each passing year, and slightly increase dividends each year. The 'bond tent' is a good idea, to avoid selling shares, but the 'tent' need not be large if dividends pay a moderate income even in a bad year. I live in Australia, and we have a government age pension scheme which is meant as a safety net, so that is only a small portion of retirement income for me. I also have superannuation, which makes up about half my retirement income. My total retirement income comes from superannuation, a small age pension, rents from property, and dividends.

A person approaching FIRE is likely to want to travel after retirement, in which case the travel expenses are anticipated and paid for from short term cash deposits.

Very rich people can afford to live entirely off dividends, because dividend income for them is still large even in a bad year.

 

StacheInAsia

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Re: Sequence of returns and asset allocation near RE point
« Reply #17 on: May 19, 2018, 06:08:08 AM »
This thread touches on a point that has been bothering me for a while in trying to finalize my IPS/AA. I have read various discussions of sequence of returns risk and equity glidepaths on this forum and on Kitces' blog/earlyretirementnow. One thing I keep wondering, which I haven't seen directly addressed, is how this applies to lower SWRs (or whether it does at all). 

If a SWR/asset allocation has 100% historical success rate, does that mean the SORR is effectively zero (barring World War III/complete economic collapse/etc)? I remember seeing in a thread someone mentioning that JL Collins had said a SWR of ~2.4% would reduce SORR to zero, but why wouldn't that be the case at 3% if it has never failed historically?

My own SWR is likely to be sub-3% (2.4% at my current lifestyle/stash size), so I have been struggling for some time to figure out how to account for SORR in my own IPS/AA (besides the general flexibility of cutting expenses in a downturn). Mainly as it applies to how much to allocate to bonds. I was considering doing more homework on the equity glidepath but not sure if it would be relevant to my situation at all.
 
« Last Edit: May 19, 2018, 09:07:07 AM by StacheInAsia »

DreamFIRE

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Re: Sequence of returns and asset allocation near RE point
« Reply #18 on: May 19, 2018, 08:30:40 AM »
My own SWR is likely to be sub-3% (2.4% at my current lifestyle/stash size), so I have been struggling for some time to figure out how to account for SORR in my own IPS/AA (besides the general flexibility of cutting expenses in a downturn). Mainly as it applies to how much to allocate to bonds. I was considering doing more homework on the equity glidepath but not sure if it would be relevant to my situation at all.

The current high stock valuations play into the fear that 4% won't be enough or to squeeze their gains for all they can, so people look for something to give them an edge, like the rising  equity glide path.  The difference in the SWR using the rising equity glide path isn't huge, but it could make a difference on the margins.  The 2.4% you've reached is below any of the SWR percentages I've seen shown to be successful for a 30 year retirement, so you should be safe either way:

http://www.aaii.com/journal/article/increasing-retirement-withdrawal-rates-through-asset-allocation
 
Quote
[Please no comments/facepunches about working too long or OMY syndrome. I've already been discussing my overall situation in a different thread. TL;DR I didn't hit 4% and slowly keep grinding away.]

You just said were at 2.4% with your current stash, then you ended your post saying you haven't even hit 4%.  I didn't read the other thread, but that looks like a contradiction.
« Last Edit: May 19, 2018, 08:32:32 AM by DreamFIRE »

StacheInAsia

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Re: Sequence of returns and asset allocation near RE point
« Reply #19 on: May 19, 2018, 09:05:27 AM »
Quote
The current high stock valuations play into the fear that 4% won't be enough or to squeeze their gains for all they can, so people look for something to give them an edge, like the rising  equity glide path.  The difference in the SWR using the rising equity glide path isn't huge, but it could make a difference on the margins.  The 2.4% you've reached is below any of the SWR percentages I've seen shown to be successful for a 30 year retirement, so you should be safe either way:

http://www.aaii.com/journal/article/increasing-retirement-withdrawal-rates-through-asset-allocation

Thanks, I hadn't seen the summary presented in this article before, just different information in various places. This is very helpful.

Quote
You just said were at 2.4% with your current stash, then you ended your post saying you haven't even hit 4%.  I didn't read the other thread, but that looks like a contradiction.

I realize I didn't word that very clearly, I'll just edit it out to avoid any confusion.
« Last Edit: May 19, 2018, 09:07:52 AM by StacheInAsia »

mintleaf

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Re: Sequence of returns and asset allocation near RE point
« Reply #20 on: May 20, 2018, 08:12:26 AM »
The goal is to start retirement with the greatest amount of bonds you would ever hold, and then decrease from there.

I've seen this approach described before, but I've never been able to wrap my head around why you'd want to decrease the bond holding over time. Surely the same conditions hold true later in retirement as well, right? You have consistent short term spending needs, no outside income, and you'd like the option to avoid selling stocks during a dip. Wouldn't a bond buffer be useful regardless of how far along you are?

maizeman

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Re: Sequence of returns and asset allocation near RE point
« Reply #21 on: May 20, 2018, 08:29:09 AM »
ShacheInAsia,

There is always going to be some SORR, but what you're seeing from the simulations is that the risk at a 2.4% withdrawal rate is too small for us to have observed it in the historical data we've collected to date.

Looking around at historical data from other countries, there have been scenarios where a 2.4% withdrawal rate has failed, but that outcome requires something like having all of your money investing in domestic stocks and government bonds in France right before the Germans invaded and occupied the country at the start of world war II (so that'd fall into your World War III/complete economic collapse bucket).

Quote
[Please no comments/facepunches about working too long or OMY syndrome. I've already been discussing my overall situation in a different thread. TL;DR I didn't hit 4% and slowly keep grinding away.]

You just said were at 2.4% with your current stash, then you ended your post saying you haven't even hit 4%.  I didn't read the other thread, but that looks like a contradiction.

My reading of that was SiA does current have high enough net worth to support a 2.4% WR but didn't get there by working extra years. So presumably some sort of sudden windfall: startup went public and stock options became worth a lot of money, already had a bunch of cryptocurrency before the price spiked last year, received a sudden inheritance, something like that.

sol

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Re: Sequence of returns and asset allocation near RE point
« Reply #22 on: May 20, 2018, 09:52:32 AM »
The goal is to start retirement with the greatest amount of bonds you would ever hold, and then decrease from there.

I've seen this approach described before, but I've never been able to wrap my head around why you'd want to decrease the bond holding over time. Surely the same conditions hold true later in retirement as well, right? You have consistent short term spending needs, no outside income, and you'd like the option to avoid selling stocks during a dip. Wouldn't a bond buffer be useful regardless of how far along you are?

Mintleaf, the idea behind the rising glide path appears to be mitigating the short-term risk of portfolio failure due to a massive economic downturn immediately after you retire.  The historical data suggest that if you avoid that scenario in the first four or five years, you're (historically) guaranteed to survive 30 years at that SWR.  That is, there are no historical sequences in which a massive economic downturn in year 15 or 25 bankrupts your portfolio within a 30 year window, because the initial growth up front more than makes up for the later losses.

With this reasoning in mind, the equity percentage can increase as you age because you will have far more money than you need for the remainder of your ever-shortening life.  That makes the additional risk essentially meaningless (assuming you don't increase your spending more than inflation) and you can swing for the fences by choosing the mathematically optimal allocation (i.e. all stocks).  In the best case scenario, you die with tens of millions of dollars.  In the worst case scenario, you still die in the black.

In practice, people who find themselves in this situation seem to just become lavish spenders in their old age and thus need to maintain some healthy bond percentage in order to mitigate that downside risk.

mintleaf

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Re: Sequence of returns and asset allocation near RE point
« Reply #23 on: May 20, 2018, 12:43:25 PM »
Thanks sol, that makes sense. It's basically about optimizing for your one human lifetime, as opposed to creating a system with a truly perpetual time horizon, like an endowment.

StacheInAsia

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Re: Sequence of returns and asset allocation near RE point
« Reply #24 on: May 21, 2018, 08:44:14 AM »
ShacheInAsia,

There is always going to be some SORR, but what you're seeing from the simulations is that the risk at a 2.4% withdrawal rate is too small for us to have observed it in the historical data we've collected to date.

Looking around at historical data from other countries, there have been scenarios where a 2.4% withdrawal rate has failed, but that outcome requires something like having all of your money investing in domestic stocks and government bonds in France right before the Germans invaded and occupied the country at the start of world war II (so that'd fall into your World War III/complete economic collapse bucket).

Quote
[Please no comments/facepunches about working too long or OMY syndrome. I've already been discussing my overall situation in a different thread. TL;DR I didn't hit 4% and slowly keep grinding away.]

You just said were at 2.4% with your current stash, then you ended your post saying you haven't even hit 4%.  I didn't read the other thread, but that looks like a contradiction.

My reading of that was SiA does current have high enough net worth to support a 2.4% WR but didn't get there by working extra years. So presumably some sort of sudden windfall: startup went public and stock options became worth a lot of money, already had a bunch of cryptocurrency before the price spiked last year, received a sudden inheritance, something like that.

Your reading was correct. Last year I sold my apartment in a HCOL city, and wasn't counting it as part of my stash before that.

Point taken about the SORR. In my own case I don't think it makes sense to do a kind of equity glidepath as long as I'm diversified, but I will probably spend down a couple years' bond expenses after I leave work anyway. Thanks.
« Last Edit: May 21, 2018, 08:53:30 AM by StacheInAsia »