Normal Asset Allocation vs Fund Buffer

[josh4trunks]

Hello everyone,
I have been thinking of a strategy to maintain an amount of "safe funds" available for withdrawl while not being forced to sell during stock lows periods. I think my approach came about because in my situation I look forward to a government pension starting at age 50-63, thought I don't know if these thoughts really are new/different or are even specific to my scenario. I'm 10-15 years out from FI so this really is just a thought experiment.

Parameters
Low Years - You have to make a rule here or base this on gut feelings.
My initial thought is to base the S&P500 on the last 2 year average, I'm sure this is a hotly debated topic and I'd love to know what other people use as indicators.

Low Periods - Assume in most cases stocks only have "low years" for around 4 years in a row. This is tunable; you can make this longer to avoid selling stocks in longer lows, but extending it significantly gives small potential reward for the price in lower returns.

Safe Funds - Assume bonds are "safe" based on them usually not losing more than 10% from previous highs.
You could make things more complicated by supplementing or replacing years of bonds with cash to sell when both stocks and bonds are "low". Then the question is if you replenish this buffer first, or the bond buffer first.

Yearly Withdrawal - Set  based on expected expenses

Strategy
Before FI
Initially have 100% in stocks.
4 years before FI - rebalance 1 year of expenses from stocks to bonds, unless it is a low year
3 years before FI - rebalance 1 year of expenses from stocks to bonds, unless it is a low year
2 years before FI - rebalance 1 year of expenses from stocks to bonds, unless it is a low year
1 years before FI - rebalance 1 year of expenses from stocks to bonds, unless it is a low year

FI and beyond
non-Low Years - rebalance up to 1 year of expenses from stocks to bond, until you have 4 years of expenses as bonds, equivalent to selling stocks
Low Years - rebalance up to 1 year of bonds to stocks, equivalent to selling bonds


Random/Contrary Thoughts

• This strategy does not maintain a specific allocation, it sort of wants to keep as much funds in stocks, with a buffer in bonds.
  
• In the end, with a set withdrawal, this is just another rebalancing strategy. You withdraw some set amount and rebalance funds to equate it to have withdrawn stocks/bonds/cash.
  Really it is a mind game; am I just tricking myself into thinking this is somehow more lean then simple asset allocation of 90-80/10-20?
  
• If you truly knew when it was presently a "low year" it might be better to go all out and sell all bonds for stocks. This strategy does not allow you to be that psychic and only allows you to make changes equal to your yearly withdraw.
  

I wanted to document this for my future self, and look forward to comments =]

[Indexer]

I plan on doing basically the same thing. I'm going for eventually having 5 years of bonds instead of 4, but otherwise it is the same idea. Using a 4% rule you would have 25X expenses. If 5 years of expenses are in bonds that equates to starting with an 80/20 allocation, but as stocks grow faster than bonds over time you could easily end up 90 or 95% stocks.

During withdrawals: My personal view there is to have dividends/income feed into cash. Spend from that first. Spending dividends/income in a taxable account is very important for tax reasons. In an IRA it would be more for psychological reasons. Any spending above that can come from investments. During years where the market is down, either that year, or still down from previous highs, then I will spend down bonds first. Once markets have recovered start building the bonds back up.

If stocks are down for more than 5 years, then and only then, would I be selling stocks for spending. Even by then, in most really bad market scenarios, stocks have at least partially recovered. Using 2000-now as an example, from 2000-2005 you are selling bonds, from 05-06 selling stocks, by 07 use any market gains to shift back into bonds, 08-10 selling bonds again(I'm assuming you didn't build up 5 years of bonds just in 07), selling stocks in 11-12, and by 13 building your bonds back up. In 05-06 and 11-12 you are selling stocks, but those years were significantly better than the years that preceded them so you are never selling from stocks when they are at their lows.

I'm also interested to hear if someone can point out flaws in this line of thought.

[Retire-Canada]

I've had the same thought to get me through the initial decade of FIRE sequence of returns risk.

[Heckler]

And if you get four low years in a row?  Then you only own stocks to live off?

[Retire-Canada]

And if you get four low years in a row?  Then you only own stocks to live off?

No. You have 4yrs to figure out how you want to respond. You might reduce your spending and get a PT job to stretch your bonds out for 5 or 6 years.

Then you might decide to sell your equities as your only source of income or perhaps you'll get a PT job to take the sting out of that. In any case you will avoid drawing down your stocks for the for a significant period. Allowing them to recover.

This addresses the sequence of returns risk and then allows you to pivot to a high equities portfolio to deal with the other major FIRE risk of high inflation.

[josh4trunks]

And if you get four low years in a row?  Then you only own stocks to live off?

I mention my thoughts on this in the "low period" assumption.
You could make it 5 years, as @Indexer said, at 4% this could equate to about 80/20. I was thinking of this a pareto principal type situation. You want to cover most scenarios, but covering every scenario costs you more (in loss of gains from equities) with less chance of being needed.