Author Topic: How much does a 1-year buffer improve the 4% SWR?  (Read 17342 times)

TomTX

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How much does a 1-year buffer improve the 4% SWR?
« on: June 09, 2014, 05:33:22 AM »
So, I've been thinking (dangerous, I know) - and I have started to wonder been wondering how much a cash buffer would help (or hurt) the 'stache during drawdown. The specific concern is starting your retirement immediately before a market crash.

What I was thinking was something along the lines of: 1 year of "cash"* with a use ruleset along the lines of: Anytime the S&P 500 is 30% below it's all-time high, draw from the cash reserve. Whenever the S&P 500 has risen back to that all-time high, replenish the cash up to 1 year of expenses.

There are two obvious variants: whether or not the starting 'stache is 25x or 26x expenses - and does that make a difference in outcomes?

Answering this question is beyond my ability to model, even using the tools like cfiresim.



*Could be a CD ladder, or I-bonds or whatever. Something which notionally can't lose face value - unlike most bonds. For simplicity, call it I-bonds. Yes, it would take ~2.5 years for my wife and I to "refill" the I-bonds due to purchase caps, if we presume a $25k/year spend. Maybe TIPS, though I keep reading about effectively zero yield on TIPS.

warfreak2

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #1 on: June 09, 2014, 08:05:14 AM »
What you're suggesting is essentially a cash portion of your asset allocation (prudent, a fine idea), along with a side order of market timing (questionable, inadvisible). However, your idea is inadvisible even for market timing - you're suggesting holding proportionally more cash when the stock market is low.

If the S&P 500 plunges 30%, don't just withdraw from your cash portion - if you rebalance to maintain the same asset allocation, you'll effectively be buying more stocks while they're on sale!
« Last Edit: June 09, 2014, 03:49:37 PM by warfreak2 »

brooklynguy

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #2 on: June 09, 2014, 03:33:59 PM »
Warfreak, your point about market timing and rebalancing doesn't seem entirely correct because the OP would be doing some "rebalancing" in the right direction by selling equities when the markets are up and not selling when the markets are down.  The approach seems like a variation on what Nords advocated for here:

http://the-military-guide.com/2014/02/20/how-should-i-invest-during-retirement/

aj_yooper

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #3 on: June 09, 2014, 03:59:55 PM »
Building a wall of cash around the stache sounds like a good idea.  Rick Ferri suggests 2 years worth of expenses.  Long enough to handle a big drop.

warfreak2

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #4 on: June 09, 2014, 04:10:18 PM »
It's true that at least you aren't selling when the market is down, but crucially, you aren't buying when the market is down. If you have a $24k cash buffer on $600k of stocks, after a 30% crash you'd use about $7,200 of your cash to buy stocks if you were rebalancing.

I mean, really you'd have to simulate it to get a proper answer, but intuitively I'm not sure it would even be an improvement.

Mustache Police

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #5 on: June 09, 2014, 05:11:45 PM »
The other point is that this approach only gives you a 1 year buffer.  What if there is a 5 year bear market?

And if there is a one year correction You'll have to reload your cash position while the market is rebounding, thus missing out on the rebound.  (you will "sell low" on your stocks to refund your cash position.)

In some instances it will work, and in others it will hurt.



« Last Edit: June 09, 2014, 05:13:53 PM by Mustache Police »

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #6 on: June 09, 2014, 05:48:11 PM »
It's true that at least you aren't selling when the market is down, but crucially, you aren't buying when the market is down. If you have a $24k cash buffer on $600k of stocks, after a 30% crash you'd use about $7,200 of your cash to buy stocks if you were rebalancing.

Let me clarify:

I'm not proposing 96% stocks/4% cash.

Likely it would be more like 75% stocks, 25% bonds, 4% cash.*

Scenario: Market crashes. We rebalance to 78% stocks, 26% bonds, 0 cash.

Scenario: Market rebounds. We rebalance to 75% stocks, 25% bonds, 4% cash

We still have the benefits of rebalancing, but avoid selling stocks when the market is down for a little while.

*Yes, this is 104%, because I was talking about a 4% SWR, plus a 1-year "extra" cash cushion.

Nords

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #7 on: June 09, 2014, 05:51:13 PM »
So, I've been thinking (dangerous, I know) - and I have started to wonder been wondering how much a cash buffer would help (or hurt) the 'stache during drawdown. The specific concern is starting your retirement immediately before a market crash.
Most bear markets are less than two years, so choose your asset allocation to include two years' expenses (4% x 2) in cash.  If your asset allocation includes assets that throw off interest & dividends, then consider the interest & dividends to be part of your cash.

We put the first year of cash in a money market and we ladder the second year of cash in three-year CDs.  During up markets we replenish the cash stash every year.  On down years we start working our way through the CDs until there's an up year.  Here's an excruciatingly-detailed post on the scenarios:
http://the-military-guide.com/2014/02/20/how-should-i-invest-during-retirement/

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #8 on: June 09, 2014, 06:08:29 PM »
The other point is that this approach only gives you a 1 year buffer.  What if there is a 5 year bear market?

Then I am still in a better position than someone without a buffer.

Quote
And if there is a one year correction You'll have to reload your cash position while the market is rebounding, thus missing out on the rebound.  (you will "sell low" on your stocks to refund your cash position.)

Oversimplified Example: The cash is spent when the market is at -33% instead of selling (say) 1500 shares of stock. When the market rebounds, I sell 1000 shares of stock to replenish the cash. I am ahead by 500 shares of stock.
 

butchmonkey

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #9 on: June 09, 2014, 07:12:29 PM »

The other point is that this approach only gives you a 1 year buffer.  What if there is a 5 year bear market?

Then I am still in a better position than someone without a buffer.

Quote
And if there is a one year correction You'll have to reload your cash position while the market is rebounding, thus missing out on the rebound.  (you will "sell low" on your stocks to refund your cash position.)

Oversimplified Example: The cash is spent when the market is at -33% instead of selling (say) 1500 shares of stock. When the market rebounds, I sell 1000 shares of stock to replenish the cash. I am ahead by 500 shares of stock.

You will not necessarily be in a better position. Don't forget the appreciation that your 4% cash will not benefit from during bull markets. And your increased susceptibility to inflation.

As I said sometimes you will win sometimes you'll lose.

Take a look at the bear market in the 20s, before you come to a conclusion about the duration of bear markets.

Your idea is simply having a bigger emergency fund. No more no less. If it helps you sleep well at night do it. But it's certainly no panacea.

There are no free rides.


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Mississippi Mudstache

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #10 on: June 09, 2014, 08:30:37 PM »
You do realize that you're basically just talking about using a 3.85% SWR instead of 4%, right? Of course it will increase your odds of success, but probably not drastically.

wtjbatman

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #11 on: June 09, 2014, 08:32:56 PM »
Like you pointed out bm, it's basically an emergency fund. One that, IMO, is even more important considering you may no longer have a steady stream of income from a job after you FIRE. If I have an emergency fund now, and it gets used up in an honest to god emergency, I just keep working at my job and replace it. If my emergency fund gets used up in retirement, I have to start drawing on the stash. If there's an emergency AND it's a down year, suddenly I'm drawing more from my stash and it's going to hurt me in the long run. Not exactly ideal.

I definitely plan to have a minimum of a year's expenses available when I pull the trigger on retirement.

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #12 on: June 09, 2014, 08:50:16 PM »
You do realize that you're basically just talking about using a 3.85% SWR instead of 4%, right? Of course it will increase your odds of success, but probably not drastically.

It can be seen that way, but the planned usage isn't the same. The "cash"* reserve is used specifically in down markets. If it makes you feel better, 72% stocks, 24% bonds, 4% "cash"


You will not necessarily be in a better position. Don't forget the appreciation that your 4% cash will not benefit from during bull markets. And your increased susceptibility to inflation.

Sure, and I actually hope that I do miss out on that bull.  Missing out on 4% of a bull run, when I already have 75% in stocks.... is effectively irrelevant. Getting to the absolute highest figure doesn't matter. Avoiding zeroing out is the important thing.

This proposed approach is primarily to blunt what appears to be the main failure mode of the 4% SWR - an immediate drop in the market forcing liquidation of devalued stocks.

*Regarding inflation - I did note that this was planned as "cash" - it's not literally going to be stuffed in the mattress. I-bonds seem the easiest way to neutralize inflation risk for this cash. Other options are TIPS, CD ladders, et cetera.

FIPurpose

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #13 on: June 09, 2014, 09:07:52 PM »
Plus consider the fact that cash kept in CD's (though they have been down for the past 4 or 5 years) have averaged about 4% in the last 10 years. If you take stocks to be at 8% average, that means your theoretical losses would be:

No Cash Portfolio
1*.08 = 8% growth

4% portfolio
.96*.08 + .04*.04 = 7.84% growth

Like you said, the losses are negligible, and if you reasonable boundaries on when to buy and sell, then I can't see it hurting.

butchmonkey

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #14 on: June 09, 2014, 10:33:57 PM »

You do realize that you're basically just talking about using a 3.85% SWR instead of 4%, right? Of course it will increase your odds of success, but probably not drastically.

It can be seen that way, but the planned usage isn't the same. The "cash"* reserve is used specifically in down markets. If it makes you feel better, 72% stocks, 24% bonds, 4% "cash"


You will not necessarily be in a better position. Don't forget the appreciation that your 4% cash will not benefit from during bull markets. And your increased susceptibility to inflation.

Sure, and I actually hope that I do miss out on that bull.  Missing out on 4% of a bull run, when I already have 75% in stocks.... is effectively irrelevant. Getting to the absolute highest figure doesn't matter. Avoiding zeroing out is the important thing.

This proposed approach is primarily to blunt what appears to be the main failure mode of the 4% SWR - an immediate drop in the market forcing liquidation of devalued stocks.

*Regarding inflation - I did note that this was planned as "cash" - it's not literally going to be stuffed in the mattress. I-bonds seem the easiest way to neutralize inflation risk for this cash. Other options are TIPS, CD ladders, et cetera.

Right.

So if your "cash" is in I bonds, Tips and CD ladders, then all you have done is shift a small percentage of your portfolio from equities to fixed income.

Which is fine. Less risk. Less reward. No more and no less.

How you feel about this bucket is of course wholly irrelevant to your entire portfolios performance. Or your likelihood of not running out of money in retirement.

But if it helps you sleep well at night, who am I to object?

(I'm just a male-looking, female, simian, primate. )

Butch. Monkey. No more. No less.


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warfreak2

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #15 on: June 10, 2014, 04:52:41 AM »
No Cash Portfolio
1*.08 = 8% growth

4% portfolio
.96*.08 + .04*.04 = 7.84% growth
This is a loss of 0.15%/year, or 0.22%-0.25%/year if stocks grow at their historical average of 10%-11%.

Quote
Like you said, the losses are negligible
Well, sure, if "negligible" is taken to mean "about the same as Vanguard's fees, which still total about 5.3% over a 30 year period".

I mean, neither of our arguments really establish whether the strategy is safer/better or not, but my point is that it's not clear at all. Someone has to do a simulation.

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #16 on: June 10, 2014, 05:15:13 AM »

Right.

So if your "cash" is in I bonds, Tips and CD ladders, then all you have done is shift a small percentage of your portfolio from equities to fixed income.

Which is fine. Less risk. Less reward. No more and no less.

How you feel about this bucket is of course wholly irrelevant to your entire portfolios performance. Or your likelihood of not running out of money in retirement.

But if it helps you sleep well at night, who am I to object?

Sort of. It's "fixed income" - but a particular subset, which will not be significantly hurt by rising interest rates. The value of normal bonds are slaughtered in a rapidly rising interest rate environment. TIPS self-adjust upwards with inflation, I-bonds self-adjust upwards with inflation, PLUS you can cash them out with minimal penalty after the 1st year. CDs can be cashed out with minimal penalty, and you can buy the current higher-rate CDs.

Because of this difference in behavior, I don't think plunking it in cfiresim (or whatever) as simply "bonds" accurately simulates the effects.

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #17 on: June 10, 2014, 05:18:37 AM »

Well, sure, if "negligible" is taken to mean "about the same as Vanguard's fees, which still total about 5.3% over a 30 year period".

I mean, neither of our arguments really establish whether the strategy is safer/better or not, but my point is that it's not clear at all. Someone has to do a simulation.

Absolutely, it needs to be simulated - I've been hoping enough discussion would "hook" someone more skilled with simulators. It's beyond my skill level. cfiresim comes close, I think (you can put in a 'cash' portion and an interest rate) - but I don't see how to put in the spending/refill parameters. I consider those to be pretty important.

clifp

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #18 on: June 10, 2014, 06:06:23 AM »
I think it is mostly just making a larger buffer.

However, if the intent is exactly what you say it is. If the market drops 30% I want to buy more, than I'll suggest an alternative approach which will earn you a bit more income.

Write a long term put at 30% below the market.  SPY is at 195 so 30% below would be 136.  You could sell a SPY 135 all the way out until Jan 2016 for around $250, but the $13,500 into a 18 month CD earn 1-1.5%, plus the 1.9% you get from the option premium. If the market crashes the money is in the bank ready to be used to buy cheap stocks.  If the market doesn't crash write another put and buy another 1 year CD.

Even if you are uncomfortable for writing options (plenty of reasons to be), conceptually you should be willing to do this.. Other wise it seems like it is just having a larger cash buffer.

Rural

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #19 on: June 10, 2014, 08:54:21 AM »
This approach allowed my parents to retire at the height of the last crash without worry. They lived on laddered CDs.

FIPurpose

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #20 on: June 10, 2014, 10:11:29 AM »
I do not claim to be an expert at the cFireism calc but here are some simulations I ran:

Default Values 75/25 ratio and 4% withdrawl: 92.92% success.

Unfortunately, it wasn't readily apparent how to have stops and puts on historical data from cFireism so I couldn't test that:

72/24/4 portfolio assuming a 4% gain on Cash: 91.15% success.

I would also be interested in seeing simulations on how only buying Cash at certain points would affect the success rate, but I don't have enough skill to do that.

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #21 on: June 10, 2014, 09:53:08 PM »
I think it is mostly just making a larger buffer.

However, if the intent is exactly what you say it is. If the market drops 30% I want to buy more, than I'll suggest an alternative approach which will earn you a bit more income.

Write a long term put at 30% below the market.  SPY is at 195 so 30% below would be 136.  You could sell a SPY 135 all the way out until Jan 2016 for around $250, but the $13,500 into a 18 month CD earn 1-1.5%, plus the 1.9% you get from the option premium. If the market crashes the money is in the bank ready to be used to buy cheap stocks.  If the market doesn't crash write another put and buy another 1 year CD.

Even if you are uncomfortable for writing options (plenty of reasons to be), conceptually you should be willing to do this.. Other wise it seems like it is just having a larger cash buffer.

I'm not sure I understand what you're saying.
If you're writing put options, wouldn't you lose a ton more money on a market crash?
That would increase volatility/risk which is the opposite of what we want.

bacchi

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #22 on: June 10, 2014, 11:09:59 PM »

I'm not sure I understand what you're saying.
If you're writing put options, wouldn't you lose a ton more money on a market crash?
That would increase volatility/risk which is the opposite of what we want.

Picking up nickels in front of a steam roller. :)

Nords

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #23 on: June 10, 2014, 11:32:18 PM »
I think it is mostly just making a larger buffer.

However, if the intent is exactly what you say it is. If the market drops 30% I want to buy more, than I'll suggest an alternative approach which will earn you a bit more income.

Write a long term put at 30% below the market.  SPY is at 195 so 30% below would be 136.  You could sell a SPY 135 all the way out until Jan 2016 for around $250, but the $13,500 into a 18 month CD earn 1-1.5%, plus the 1.9% you get from the option premium. If the market crashes the money is in the bank ready to be used to buy cheap stocks.  If the market doesn't crash write another put and buy another 1 year CD.

Even if you are uncomfortable for writing options (plenty of reasons to be), conceptually you should be willing to do this.. Other wise it seems like it is just having a larger cash buffer.

I'm not sure I understand what you're saying.
If you're writing put options, wouldn't you lose a ton more money on a market crash?
That would increase volatility/risk which is the opposite of what we want.
In this example you're agreeing to boldly step up and buy like a boss at 135 (while Warren Buffett cheers you on), which implies that the market dropped over 30% (from 195 to 135).  Presumably you'd be able to sell those shares at a profit someday, although they might go quite a bit lower than 135 before they recovered.  The way to lose money on the shares would be to buy at 135 and then sell them at a lower price, which would imply panicking or running out of cash before the market recovers.

The "risk" is that you're contracting to buy shares after the market has dropped 30%.  Technically volatility is a component of the price of an option, but the strike price of this option is so far out of the money that its trading price wouldn't be very volatile.  (And by the time you get exercised, volatility has pretty much smacked every equity investor.)  Instead the option has actually reduced volatility by letting the investor put their money in CDs (no volatility there) and boost their return a little (the premium from selling the put) while still owning a chance to participate in the market. 

The mechanics of getting exercised are problematic but straightforward.  The brokerage that let you sell the option is probably insisting that you have to clear all of your exercised options (if they're exercised) within three trading days.  That means they would require you to have a margin account from which to supply the cash for the purchase, and if you tap those funds then you'll pay interest on them.  The bank or credit union that holds the CD (which you're planning to use if your put option is exercised) will drag their feet for a week or two before you can get your hands on the cold hard cash (after paying the early-redemption penalty).  Then you'd have to EFT or wire the cash to the brokerage account to settle your margin debt (or keep paying the interest).  So although you earn some money from selling the put you'd probably pay far more than those earnings by being charged margin interest, redeeming the CD (at a penalty), moving the money to the brokerage (wire fee), and executing the trade (trading fee + commission).

Every investor who's safeguarding "dry powder" should be willing to sell naked puts.  It's a powerful way to commit to your decision.  Otherwise when the market drops 30% we'd all curl up in a fetal ball around our dry powder and insist that the market was going to drop a lot more and that we don't want to do anything with our cash because we might need it to buy MREs, seed corn, and ammunition.
« Last Edit: June 10, 2014, 11:34:59 PM by Nords »

clifp

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #24 on: June 10, 2014, 11:50:19 PM »
I think it is mostly just making a larger buffer.

However, if the intent is exactly what you say it is. If the market drops 30% I want to buy more, than I'll suggest an alternative approach which will earn you a bit more income.

Write a long term put at 30% below the market.  SPY is at 195 so 30% below would be 136.  You could sell a SPY 135 all the way out until Jan 2016 for around $250, but the $13,500 into a 18 month CD earn 1-1.5%, plus the 1.9% you get from the option premium. If the market crashes the money is in the bank ready to be used to buy cheap stocks.  If the market doesn't crash write another put and buy another 1 year CD.

Even if you are uncomfortable for writing options (plenty of reasons to be), conceptually you should be willing to do this.. Other wise it seems like it is just having a larger cash buffer.

I'm not sure I understand what you're saying.
If you're writing put options, wouldn't you lose a ton more money on a market crash?
That would increase volatility/risk which is the opposite of what we want.

No you'd lose the same less the small premium you collect for writing the option which would decrease volatility.

The OP is basically proposing this.
You have a 1 million dollar portfolio with some mix of stocks/bonds let say 50/50.  Plus you have a $40K on the side to invest when ever the market drops below 30%
The market drops 30% you have a stock portfolio worth $350K and $500K bonds (assume fixed income remains the same).  You now take the $40K in your money market and  buy stock. The market continues to drop another 20% leaving you at 250K stock the 40K in new money would drop another $10,500 or so.

Mine proposal is basically the same. You have 50/50 portfolio but instead you of having 40K in a money market or CD waiting to buy when the market is down 30, you write $40K worth of SPY options out 1-2 years. Same thing happens market falls 50%.  The person who you sold the puts to exercise them you give him the 40K and get more stock. 

The only difference is with my option is you proposal is you end up with roughly an extra $750 regardless of if the market goes up/down or moves sideways.

clifp

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #25 on: June 11, 2014, 01:37:32 AM »

Every investor who's safeguarding "dry powder" should be willing to sell naked puts.  It's a powerful way to commit to your decision.  Otherwise when the market drops 30% we'd all curl up in a fetal ball around our dry powder and insist that the market was going to drop a lot more and that we don't want to do anything with our cash because we might need it to buy MREs, seed corn, and ammunition.

Yes Nords made my point quite well.  Although these aren't really naked puts but rather cash secured ones. 
I should also point out with VIX trading at a very low level, this isn't a trade I'd personally make.   A 2% premium for an 18 month contract implies that we would ony  see a 30% correction twice over the next 150 (or maybe 100 years) when in fact it has crashed a lot more often than that.

Nothing wrong with with holding more cash, but realistically for most people the fetal ball position is very common when the market crash 30%.  Perhaps a more realistic approach is to as part of your written investment policy is to change your AA when the market gets relatively cheap. 

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #26 on: June 11, 2014, 05:20:02 AM »

The OP is basically proposing this.
You have a 1 million dollar portfolio with some mix of stocks/bonds let say 50/50.  Plus you have a $40K on the side to invest when ever the market drops below 30%
The market drops 30% you have a stock portfolio worth $350K and $500K bonds (assume fixed income remains the same).  You now take the $40K in your money market and  buy stock. The market continues to drop another 20% leaving you at 250K stock the 40K in new money would drop another $10,500 or so.

Similar, but I was not proposing to buy stock with the cash reserve. I was proposing to avoid selling stocks with the cash reserve by using it for living expenses during severe market corrections, and then selling stocks to refill the reserve only when the market has recovered.

This is different than how cfiresim treats cash - it always assumes you rebalance to the same cash percentage.

Some may dismiss this as "market timing"  - but I'm not trying to predict where the market will be. This proposal only recognizes that the market has crashed compared to historical prices.  It is a method of having a reserve to weather unexpected market drops - one which the value is uncoupled from the stock market, and most other asset classes. It won't vary much with stock market crashes, bond market crashes (due to interest rate rise), commodity crashes or inflation.

Would it all be used in a long bear market? Absolutely. I'm not claiming this is "the" answer - I think it is interesting and worth investigating further, but I don't have the tools to simulate it properly.
« Last Edit: June 11, 2014, 05:29:10 AM by TomTX »

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #27 on: June 11, 2014, 01:58:21 PM »
I think a fixed income low bond mix is ok until about 5-10 years until your retirement. At that time it is really best for capital preservation instead of growth. Especially 1-2 years before retirement. I think an ultra safe mix of 70/30 bonds equity would be ideal leading into retirement. As you progress through retirement people tend to get more thrifty and hunker down on their expenses and at that point you can start taking some more risk on again if you have an excess of savings every year and get back towards the 50/50 mix.

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #28 on: June 11, 2014, 03:58:17 PM »
I think a fixed income low bond mix is ok until about 5-10 years until your retirement. At that time it is really best for capital preservation instead of growth. Especially 1-2 years before retirement. I think an ultra safe mix of 70/30 bonds equity would be ideal leading into retirement. As you progress through retirement people tend to get more thrifty and hunker down on their expenses and at that point you can start taking some more risk on again if you have an excess of savings every year and get back towards the 50/50 mix.

That's a bit off topic.

arebelspy

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #29 on: June 11, 2014, 07:49:21 PM »
Similar, but I was not proposing to buy stock with the cash reserve.

That's too bad.  I like buying low via rebalancing when equities crash.
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clifp

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #30 on: June 12, 2014, 01:55:36 AM »

The OP is basically proposing this.
You have a 1 million dollar portfolio with some mix of stocks/bonds let say 50/50.  Plus you have a $40K on the side to invest when ever the market drops below 30%
The market drops 30% you have a stock portfolio worth $350K and $500K bonds (assume fixed income remains the same).  You now take the $40K in your money market and  buy stock. The market continues to drop another 20% leaving you at 250K stock the 40K in new money would drop another $10,500 or so.

Similar, but I was not proposing to buy stock with the cash reserve. I was proposing to avoid selling stocks with the cash reserve by using it for living expenses during severe market corrections, and then selling stocks to refill the reserve only when the market has recovered.

This is different than how cfiresim treats cash - it always assumes you rebalance to the same cash percentage.

Some may dismiss this as "market timing"  - but I'm not trying to predict where the market will be. This proposal only recognizes that the market has crashed compared to historical prices.  It is a method of having a reserve to weather unexpected market drops - one which the value is uncoupled from the stock market, and most other asset classes. It won't vary much with stock market crashes, bond market crashes (due to interest rate rise), commodity crashes or inflation.

Would it all be used in a long bear market? Absolutely. I'm not claiming this is "the" answer - I think it is interesting and worth investigating further, but I don't have the tools to simulate it properly.

That sounds like Ray Lucia's bucket system..

Still why are are you selling stocks for living expense during a market crash, you are selling bonds not only to fund your daily living but also to buy more stocks.

Now if you want have a good amount of your fixed income in cash (as opposed to bonds) I think that is just fine.  Generally bonds go up when stocks go down, in which case you are selling bonds both to fund your expenses and to buy more stocks. But it is true that sometimes both and stocks go down.  In those situations then yes CD make a lot of sense. Personally, I have hated bonds for the last 4 or 5 years, so anytime PenFed has a CD deal like the 5% 10 years CD a few years ago I transfer bond money into it.

My intention is to use the CD to fund additional expense beyond interest and dividends in a future bear market.

But I think the typical rebalancing of most simulators do a pretty good job of simulating this.

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #31 on: June 12, 2014, 05:36:04 AM »

Well, sure, if "negligible" is taken to mean "about the same as Vanguard's fees, which still total about 5.3% over a 30 year period".

I mean, neither of our arguments really establish whether the strategy is safer/better or not, but my point is that it's not clear at all. Someone has to do a simulation.

Absolutely, it needs to be simulated - I've been hoping enough discussion would "hook" someone more skilled with simulators. It's beyond my skill level. cfiresim comes close, I think (you can put in a 'cash' portion and an interest rate) - but I don't see how to put in the spending/refill parameters. I consider those to be pretty important.

I will say that a long time ago I considered putting in the option to simulation the "cash bucket refill" strategy, but I ultimately put it off (in fact, I'm pretty sure it's listed somewhere in cFIREsim's forums on a "to-do" list still).  I put it off because of research indicating that 2+ years of expenses in cash puts a significant amount of portfolio drag.  This effect is amplified when you're talking about extra-long retirements.  I believe that you're better off with a simple stock/bond split, and annual rebalancing.

However, if there is enough interest, I can certainly add it to the "soon" list. I'm actually about to finish a rather large UI change on the site, and then I can get back to more interesting stuff like this.

So, from a user perspective, how would you see this playing out on a simulator?  You check a box stating that you want to withdraw cash during major downturns, rather than sell stocks... then you give it a % threshhold for what a "downturn" is? Like, a market drop of 10% constitutes a cash withdrawal?

Also, do you think that I-bonds should be on the list of cFIREsim allocation's?  These are specifically tied to inflation, so I suppose I already have the inflation portion coded in there.

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #32 on: June 12, 2014, 09:39:38 AM »


Similar, but I was not proposing to buy stock with the cash reserve. I was proposing to avoid selling stocks with the cash reserve by using it for living expenses during severe market corrections, and then selling stocks to refill the reserve only when the market has recovered.



But what you are proposing is to buy cash with stock and bond funds during severe market corrections.

In general, such a strategy has proven suboptimal in the past.


« Last Edit: June 12, 2014, 02:15:15 PM by milesdividendmd »

rmendpara

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #33 on: June 12, 2014, 09:46:55 AM »
So, I've been thinking (dangerous, I know) - and I have started to wonder been wondering how much a cash buffer would help (or hurt) the 'stache during drawdown. The specific concern is starting your retirement immediately before a market crash.

What I was thinking was something along the lines of: 1 year of "cash"* with a use ruleset along the lines of: Anytime the S&P 500 is 30% below it's all-time high, draw from the cash reserve. Whenever the S&P 500 has risen back to that all-time high, replenish the cash up to 1 year of expenses.

There are two obvious variants: whether or not the starting 'stache is 25x or 26x expenses - and does that make a difference in outcomes?

Answering this question is beyond my ability to model, even using the tools like cfiresim.



*Could be a CD ladder, or I-bonds or whatever. Something which notionally can't lose face value - unlike most bonds. For simplicity, call it I-bonds. Yes, it would take ~2.5 years for my wife and I to "refill" the I-bonds due to purchase caps, if we presume a $25k/year spend. Maybe TIPS, though I keep reading about effectively zero yield on TIPS.

Minimal, if any.

Basically, take the (1) long term blended return on cash equivalents (CDs, i-bonds, whatever) and subtract that from the (2) long-term blended return on what you would invest it in otherwise PLUS the avoided losses:

 (3) (cash amount used during downturn) x (% drop in portfolio you would have held) = $ saved

So (2) - (1) + (3) will be your gain. A lot of it depends on how you "fluff" the numbers. Since there's no way to backtest an "uncertain" scenario under imprecise guidelines, maybe try testing it on what would have happened if you did that during 2003-2012? Of course, this is just one market scenario of many possibilities...

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #34 on: June 14, 2014, 03:12:14 PM »
Similar, but I was not proposing to buy stock with the cash reserve.

That's too bad.  I like buying low via rebalancing when equities crash.

That's what the bonds are for.

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #35 on: June 14, 2014, 03:16:05 PM »
So, I've been thinking (dangerous, I know) - and I have started to wonder been wondering how much a cash buffer would help (or hurt) the 'stache during drawdown. The specific concern is starting your retirement immediately before a market crash.

What I was thinking was something along the lines of: 1 year of "cash"* with a use ruleset along the lines of: Anytime the S&P 500 is 30% below it's all-time high, draw from the cash reserve. Whenever the S&P 500 has risen back to that all-time high, replenish the cash up to 1 year of expenses.

There are two obvious variants: whether or not the starting 'stache is 25x or 26x expenses - and does that make a difference in outcomes?

Answering this question is beyond my ability to model, even using the tools like cfiresim.



*Could be a CD ladder, or I-bonds or whatever. Something which notionally can't lose face value - unlike most bonds. For simplicity, call it I-bonds. Yes, it would take ~2.5 years for my wife and I to "refill" the I-bonds due to purchase caps, if we presume a $25k/year spend. Maybe TIPS, though I keep reading about effectively zero yield on TIPS.

Minimal, if any.

Basically, take the (1) long term blended return on cash equivalents (CDs, i-bonds, whatever) and subtract that from the (2) long-term blended return on what you would invest it in otherwise PLUS the avoided losses:

 (3) (cash amount used during downturn) x (% drop in portfolio you would have held) = $ saved

So (2) - (1) + (3) will be your gain. A lot of it depends on how you "fluff" the numbers. Since there's no way to backtest an "uncertain" scenario under imprecise guidelines, maybe try testing it on what would have happened if you did that during 2003-2012? Of course, this is just one market scenario of many possibilities...

Well, if it were in cfiresim - I would try a bunch of scenarios (Cash spend @ a drop of 10%, 15%, 20%, 30%, 40%, 50%, cash refill at various points as well.)

Again, this is intended to be largely independent of stock/bond rebalancing. Stock/bond rebalancing would still happen on its regular schedule.

arebelspy

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #36 on: June 14, 2014, 05:21:35 PM »
Similar, but I was not proposing to buy stock with the cash reserve.

That's too bad.  I like buying low via rebalancing when equities crash.

That's what the bonds are for.

Right, and typically the bonds would also be used for your expenses.

What we're saying is that instead of having 25 years expenses in stocks/bonds and 1 year in cash, as in your scenario, it's better to put all 26 of those years in stocks/bonds.

When stocks drop, you don't sell them (similar to your scenario, where you don't want to sell stocks low), but you sell bonds to both rebalance and pay your expenses.

In neither case do you sell stocks low, but having more bonds allows a higher return than random cash, and allows more rebalancing when stocks are low.   By not having that cash drag on the portfolio, I think you'll come out ahead over your scenario.
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Dr. Doom

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #37 on: June 14, 2014, 05:48:09 PM »
Similar, but I was not proposing to buy stock with the cash reserve. I was proposing to avoid selling stocks with the cash reserve by using it for living expenses during severe market corrections, and then selling stocks to refill the reserve only when the market has recovered.
..
Some may dismiss this as "market timing"  - but I'm not trying to predict where the market will be. This proposal only recognizes that the market has crashed compared to historical prices. 

If you're interested, I took a amateurish crack at manually simulating holding a 2-year cash buffer _over_ your 30x annual spending asset totals.  Traced scenarios through the great depression, the 70's bear market, and the crashes of 2000 and 2008.

You definitely don't dip as far down at trough, and I've made a personal decision to follow this strategy.  It's not exactly what you're proposing but the main bits are there.

Yes, no doubt holding cash is a slight drag on you when the markets are rising.  But there's some real protection on the other side, when ETFs are locked in a death spiral.

Also, I like sleeping.


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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #38 on: June 14, 2014, 07:16:12 PM »
Dr. Doom, thank you for your extended comments on the topic. 

Roland of Gilead

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #39 on: June 14, 2014, 07:50:02 PM »
We will be at 75% stocks 25% cash (laddered CD's, I bonds) during early retirement.  The 25% cash essentially represents  6 or 7 years living expenses during periods of low inflation.

I see no point in buying bonds in this market.  Upside is almost nothing compared to cash (early redemption CD's and I-bonds are essentially cash).

If a number of years down the road a 10 year starts paying 4% or more, then might consider bonds.

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #40 on: June 14, 2014, 08:15:49 PM »
Dr. Doom, thank you for your extended comments on the topic.

Sure thing, I hope some of the content was useful to others.
And in turn, a big thanks to Nords -- I read the post he mentioned two months ago and decided to do some additional investigation to see how the strategy would have fared during some of the rougher periods in US market history.  I'm really close to the RE part of FIRE and addressing these concerns felt particularly urgent. 

TomTX

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #41 on: June 14, 2014, 08:35:37 PM »
Thanks, Dr. Doom - lots of work you put in.

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #42 on: June 14, 2014, 10:29:31 PM »
And in turn, a big thanks to Nords -- I read the post he mentioned two months ago and decided to do some additional investigation to see how the strategy would have fared during some of the rougher periods in US market history.  I'm really close to the RE part of FIRE and addressing these concerns felt particularly urgent.
You're welcome!  It's a popular question on the blog.

Workinghard

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #43 on: June 15, 2014, 03:14:46 AM »
So it looks like my dh will be retiring at ~28 times our annual living expenses (excluding SS since that will be on hold for 5 years). I'll be retiring at the 30 times annual expense with 2 years cash reserve. Again not including SS. That's assuming the market does not tank between now and then in which case my dh will be retiring when we have less. We really will be able to do it (retire) won't we?

Similar, but I was not proposing to buy stock with the cash reserve. I was proposing to avoid selling stocks with the cash reserve by using it for living expenses during severe market corrections, and then selling stocks to refill the reserve only when the market has recovered.
..
Some may dismiss this as "market timing"  - but I'm not trying to predict where the market will be. This proposal only recognizes that the market has crashed compared to historical prices. 

If you're interested, I took a amateurish crack at manually simulating holding a 2-year cash buffer _over_ your 30x annual spending asset totals.  Traced scenarios through the great depression, the 70's bear market, and the crashes of 2000 and 2008.

You definitely don't dip as far down at trough, and I've made a personal decision to follow this strategy.  It's not exactly what you're proposing but the main bits are there.

Yes, no doubt holding cash is a slight drag on you when the markets are rising.  But there's some real protection on the other side, when ETFs are locked in a death spiral.

Also, I like sleeping.

arebelspy

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #44 on: June 15, 2014, 08:22:37 AM »
So it looks like my dh will be retiring at ~28 times our annual living expenses (excluding SS since that will be on hold for 5 years). I'll be retiring at the 30 times annual expense with 2 years cash reserve. Again not including SS. That's assuming the market does not tank between now and then in which case my dh will be retiring when we have less. We really will be able to do it (retire) won't we?

Yes.  But the two years cash reserve has nothing to do with why, and likely will hold your returns back and/or lead to a slightly higher failure rate.  But if it lets you sleep at night, that's all that matters.

Dr. Doom's piece was good in that he recognized in his final conclusion that he had the means to do that, so it was fine.

You should be okay doing that, so go nuts.

I personally still wouldn't recommend it though.  Rebalancing from bonds to buy stocks and pay your expenses during a crash is more efficient, IMO.

Either way, you're looking pretty darn good.  Congratulations on your success. :)
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Workinghard

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #45 on: June 15, 2014, 11:46:03 AM »
Success?  I don't even feel close to that yet. Haha. Maybe in a few years. And keep in mind, we're farnpast the age of ER since my dh will be 65. My age of retirement is yet to be determined, but I will probably cut down OT once he quits. A 10 yr work hiatus definitely delayed things.

So it looks like my dh will be retiring at ~28 times our annual living expenses (excluding SS since that will be on hold for 5 years). I'll be retiring at the 30 times annual expense with 2 years cash reserve. Again not including SS. That's assuming the market does not tank between now and then in which case my dh will be retiring when we have less. We really will be able to do it (retire) won't we?

Yes.  But the two years cash reserve has nothing to do with why, and likely will hold your returns back and/or lead to a slightly higher failure rate.  But if it lets you sleep at night, that's all that matters.

Dr. Doom's piece was good in that he recognized in his final conclusion that he had the means to do that, so it was fine.

You should be okay doing that, so go nuts.

I personally still wouldn't recommend it though.  Rebalancing from bonds to buy stocks and pay your expenses during a crash is more efficient, IMO.

Either way, you're looking pretty darn good.  Congratulations on your success. :)

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #46 on: June 15, 2014, 12:16:56 PM »
So it looks like my dh will be retiring at ~28 times our annual living expenses (excluding SS since that will be on hold for 5 years). I'll be retiring at the 30 times annual expense with 2 years cash reserve. Again not including SS. That's assuming the market does not tank between now and then in which case my dh will be retiring when we have less. We really will be able to do it (retire) won't we?
You're good to go. 

We retired in June 2002 at 25x with white knuckles on the purse strings.  As it turned out, we were way too conservative on our spending and could have loosened up considerably.  You're already over-capitalized for the retirement calculators, and you have the flexibility to adjust your spending if necessary.  Retirement calculators don't do a very good job of simulating variable spending or a two-year cash stash.

arebelspy

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #47 on: June 15, 2014, 03:35:34 PM »

Success?  I don't even feel close to that yet. Haha. Maybe in a few years. And keep in mind, we're farnpast the age of ER since my dh will be 65. My age of retirement is yet to be determined, but I will probably cut down OT once he quits. A 10 yr work hiatus definitely delayed things.

So it looks like my dh will be retiring at ~28 times our annual living expenses (excluding SS since that will be on hold for 5 years). I'll be retiring at the 30 times annual expense with 2 years cash reserve. Again not including SS. That's assuming the market does not tank between now and then in which case my dh will be retiring when we have less. We really will be able to do it (retire) won't we?

Yes.  But the two years cash reserve has nothing to do with why, and likely will hold your returns back and/or lead to a slightly higher failure rate.  But if it lets you sleep at night, that's all that matters.

Dr. Doom's piece was good in that he recognized in his final conclusion that he had the means to do that, so it was fine.

You should be okay doing that, so go nuts.

I personally still wouldn't recommend it though.  Rebalancing from bonds to buy stocks and pay your expenses during a crash is more efficient, IMO.

Either way, you're looking pretty darn good.  Congratulations on your success. :)

Are you eligible for SS?  If so, run cFIREsim with those numbers as well. Medicare should also help.  I think you're good to go.
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Workinghard

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #48 on: June 15, 2014, 06:27:52 PM »
Nords, arebelspy,
We definitely have to wait until my dh is eligible for Medicare. He was 63 this spring, so it's not that far off. My goal is 75k a year savings between now and then. Initially he was going to work until 66, but I told him if he wanted to quit (or go PRN) at 65 that was okay too.  We just need the Medicare coverage. He'll wait unto 70 for SS since he's 6 years older and his is more than mine.

We'll put our house on the market next spring and go to apartment living. I can't wait. I'm so done with yard, home, pool maintenance and cleaning. It was fine when we had all the kids (foster and bio) but not now. He's not as frugal as me but is willing to make lifestyle changes such as one vehicle when we both retire. And I've managed to hold him back on buying a newer car until he retires--assuming his 14 y/o makes it that long. :)

One he retires, that will be it for him. Kinda scary but if I work for another year or two after that, I'll feel better. I do know after he retires, before RMDs start, we need to convert 401ks/iRAs to Roths.

Workinghard

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Re: How much does a 1-year buffer improve the 4% SWR?
« Reply #49 on: June 15, 2014, 06:51:04 PM »
Oh, cFIREsim shows a 100% success rate and their numbers correlate with Vanguards. When my dh retires, I'll evaluate things again. It's only as good as the assumptions and mine might be off thus the reason I'm trying to build a safety net by not factoring in things like SS. Too bad I don't have a military pension. :p