Good stocks to invest – Why having a Cash Buffer Does Not Increase the Longevity of Wealth in Financial Independence

Good stocks to invest

I started down this path with the idea that having 2 years worth of cash as a buffer from a bear market is enough.

You see, when you are planning to withdraw your wealth to spend down, you start researching on what are the ingredients of a plan that:

  1. Creates an annual wealth cash flow to pay for your expenses
  2. Is sustainable over long period
  3. Lasts for a long period that you will not earn much
  4. Takes care of different probable market cycles or conditions
  5. Filled with events that are within your control, not within your control, you know and you do not know

In a lot of the articles that I read about, one of the advice that was often given is that, to mitigate the issue of sequence of returns risk is to have a 2-5 years of cash holding.

Negative Sequence of Return Risk and why a Cash Buffer Works

Most of your wealth for retirement, financial independence or financial security are allocated in financial assets that are subjected to market volatility.

Depending on your luck, you might encounter a positive or negative sequence.


good-stocks-to-invest-in

The image above illustrates this. Both portfolio A and B’s compounded returns at the end of 21 years is the same.

The difference is in the sequence of returns within those 21 years.

Portfolio A has more negative years in front while Portfolio B’s negative years is at the back. Both retiree is withdrawing $7000/yr from the portfolio.

Portfolio A got depleted while Portfolio B was able to last for the whole 21 years.

Portfolio A is an example of a negative sequence.

If this draw down happens at the start when you need to withdraw your money, rather than near the end, your wealth cannot recover to its original amount, and therefore your wealth cannot last as long. In contrast, if the bear happens at the end of when you need it, the preceding bull would have grown your wealth much more that, factor in this bear market later, you would still have adequate or even more than you need.

Related: You can read more about Sequence of Return Risk in this article and I list out some possible solutions to combat this

With a cash buffer, it allows you to draw on this cash buffer, leaving the portfolio intact.

For example, like the above example, you can have $14,000 cash buffer or 2 years of your expenses saved up. In the case of Portfolio A, instead of drawing down your portfolio, you can spend from the cash buffer.

In this way the portfolio is untouched and it can do its best to recover to previous level.

This sounds good in theory, but in actual implementation it has its flaws.

Testing which Cash Buffer Approach Yields Better Results

I came across this article by Abraham Okusanya called Cash reserve buffers, withdrawal rates and old wives’ fables for retirement portfolios.

It is a research from the global equities and bonds perspective, its not too long and very research based. And I think the results would help us craft a better plan.

So I wrote this article to collect some of my thoughts.

There are many people who came up with different cash buffer approaches but what this article does is to study 11 different approach.

Abraham sets the following portfolio parameters:

  1.  a control portfolio of 50% global equities and 50% global bonds
  2. a cash buffer portfolio of 40% global equities, 50% global bonds and 10% cash. This cash allocation represents > 2 years worth of annual expense based on a 4% withdrawal rate

There are a few ways to withdraw cash flows from the portfolio:

  1. The baseline approach: Withdraw evenly across all asset class. Rebalance Annually
  2. Withdraw evenly across all asset class. Rebalance once every 2 years.
  3. Withdraw evenly across all asset class. Rebalance based on event that any asset class deviates by > 5% from original allocation
  4. Withdraw evenly across all asset class. Rebalance based on event that any asset class deviates by > 10% from original allocation
  5. Withdraw evenly across all asset class. Do not Rebalance
  6. Withdraw cash, then bonds, then equities. Rebalance once every 2 years
  7. Withdraw cash, then bonds, then equities. No Rebalancing (asset class depletes one at a time). Also known as rising equity glide path (Read Kitces’ article explain this here)
  8. Withdraw equity, then bonds, then cash. No Rebalancing (asset class depletes one at a time). Also known as falling equity glide path
  9. Withdraw cash, then bonds (when cash runs out). Only rebalance when equities are up (sell equities during good year, avoid selling during bad year)
  10. Withdraw best performing asset class each year. No rebalancing
  11. Withdraw the worst performing asset class in previous year. No rebalancing

The success is graded upon:

  1. For different rolling period 25, 30, 35, 40 years, you have > $1 (it means your money at least last that long)
  2. No of years the portfolio lasted in the worst scenarios. The withdrawal methods should lengthen the number of years
  3. How much wealth left at the end of 30 years. Gauge which strategy leaves the most

Here is my interpretation of his results.

50/50 Equity/Bond Portfolio

good-stocks-to-invest-in

The withdrawal rate is fixed at 4%, and so is the starting amount of 100,000 pounds and equity/bond allocation.

We can observe that the longer you need the money the % probability of success, or you have at least $1 at the end of each period is reduced.

The first thing is that when the order of withdrawal is rather fixed, whether you re-balance annually, once every 2 years, or when the allocation is 5% or 10% out of alignment, it does not make much difference.

In the worst case, portfolio last 15-16 years.  The 10th percentile or the lowest 10% last between 20-22 years.

Another important point, is found on the right section of the comparison.

Instead of the even withdrawal schemes, those withdrawal schemes that withdraw predominately bonds first perform much better. This includes withdrawing last year’s worst asset class, which typically is bonds since the asset class that does comparatively worse are usually bonds.

This is also a rising equity glide path, which is to systematically increase the equity allocation. Micheal Kitces wrote an article explaining why this is better, if you want your wealth to last longer.

The crux is:

  1. avoid large draw down 5 years before the retirement date and 5 years after
  2. slowly increase the equity allocation
  3. equity over time produces higher average returns, thus allows the wealth to grow and sustain a longer period
  4. more equity tends to be more volatile, but the key thing is to avoid the negative sequence of return risk which goes back to why we do #1

In those withdrawal schemes, by not re-balancing, and withdrawing the worse or even asset class (typically bonds), it allows the equity allocation to naturally increase.

The worse performing are the withdrawing equity first and last year’s best performing years (both short equities). The results are drastically worse.

However, quantitatively, the worst number of years the wealth lasted and the 10th percentile is not that far off from those even withdrawal. It is just 2 years less.

With 10% cash allocation

Now what about if we allocate a cash buffer to it.

good-stocks-to-invest-in

If we compare this to the previous table, the success rate for 35 years is less (average 71% vs 76%). So is the success rate for 40 years (56% vs 70%).

You will also have less balance at the end of 30 years.

The worst and 10th percentile is pretty similar to the previous table.

Why is this so?

The key difference is that you take 10% of equity and move it to cash. It is a drastic reduction in overall wealth growth rate.

For Cognitive Purpose

Abraham mentioned that for some of us, we really wish to have that peace of mind of a cash holding, replace the bonds with cash instead of equities.

The success rate is better if not comparable to the 50/50 equity and bond allocation.

In this way we will not kill the growth rate.

Some of My Conclusions After Reading the Article

From this article, I draw the following conclusion:

  1. Rebalancing helps to buy low sell high, but when it comes to wealth withdrawal the concept changes to the objective whether the money would last, and whether you can fund your annual expenses. From the looks of it, different frequency does not matter that much
  2. If holding a cash holding is suppose to length how long your wealth would last, the case studies show that it does not help at the expense of equity. If you wish to have a cash allocation replace the bonds not equity
  3. To make the money last, overall its how much equity you have in your allocation
  4. This will increase the spending volatility (due to increase in equity allocation) and you need a way to resolve this

Research is Based on a Passive Equity and Bond Approach

This research might invite the inevitable question that, if I see a bear market soon, should I still remain in 100% equity or high equity allocation?

You need to be aware that the researchers needed to make certain assumptions, and one of these assumptions is that the wealth is deployed into passive index funds or exchange traded funds (ETF).

This way, it makes the simulation possible and some systematic results can be achieved.

The conclusion of the results show that you need a high enough overall rate of return.

If your approach is an active based wealth building such as active individual stock investing, then you need to ensure that you can deploy a 70% stock, 30% cash allocation, provided you can achieve an overall equity portfolio like rate of return.

If your better than equity portfolio return entails having cash for opportunities, then by all means have the cash lying somewhere.

How this factors into my Original Plan

Each of us would have our own plans.

This can be financial independence, financial security or total retirement.

My original permutations is as follows:

  1. Prefer to be semi-retired rather than full retirement. Preferably work for income with shorter hours
  2. Withdraw Cash Flows based on A Variable Withdrawal Decision System on a 5% Withdrawal Rate
  3. Only increase cash flow for annual expenses when things get more expensive (not always increasing by 2-3%)
  4. Follow an Action Script to control how much variable spending I can spend in the year
  5. Build up more than the $500,000 required to generate $24,000/yr at 5% withdrawal rate for a 100% equity portfolio. Adding $200,000 to the target allows us to reduce the overall withdrawal rate and make the plan more conservative
  6. Setup a Equity/Bond or Cash allocation based on rising equity glide path. For the first few years prior to the definite date, and the few years after that, have a bond or cash allocation to avoid the negative sequence of return risk at the start of when you need it. Over the years, slowly increase the equity allocation through allocating more bonds or cash to equity to make the wealth last long
  7. Spend the stronger asset class first. If bonds are stronger, spend that one. Re-balance the portfolio to an ideal allocation (if its rising glide path, the targeted equity allocation should increase)

This plan is not bad, in that for some time, I do know that having too much cash on the portfolio is a drag on the return. However, there are justification to have a heavier cash holding, based on trying to avoid the negative sequence of return risk.

The enlightenment that I have for this article is that I got mixed up with the implementation of the rising equity glide path and re-balancing of portfolio.

By spending on the asset class that performed the strongest, it sounded rational but if equity outperforms cash and bonds most of the time, I will have a greater bond or cash allocation than equity over time.

And this contrast to the rising equity glide path idea.

The testing with global equities and bonds show that the frequency of re-balancing or even the existence of re-balancing will improve how long your wealth will last. I am incline to withdraw from the bonds or cash portion and let the equity allocation grow.

Finally, since my original target was $500,000 and I manage to expand my wealth to likely $900,000, it is as if the portfolio went through a bull run, before the possibility that the bear run will reduce it closer to $600,000. I would have lived through a favorable bull then bear regime.

If I implement this together with the rising equity glide path, things should look pretty good.

A modification of the plan will be:

  1. Prefer to be semi-retired rather than full retirement. Preferably work for income with shorter hours
  2. Withdraw Cash Flows based on A Variable Withdrawal Decision System on a 5% Withdrawal Rate
  3. Only increase cash flow for annual expenses when things get more expensive (not always increasing by 2-3%)
  4. Follow an Action Script to control how much variable spending I can spend in the year
  5. Build up more than the $500,000 required to generate $24,000/yr at 5% withdrawal rate for a 100% equity portfolio. Adding $400,000 to the target allows us to reduce the overall withdrawal rate and make the plan more conservative
  6. Setup a Equity/Bond or Cash allocation based on rising equity glide path. For the first few years prior to the definite date, and the few years after that, have a bond or cash allocation to avoid the negative sequence of return risk at the start of when you need it. Over the years, slowly increase the equity allocation through allocating more bonds or cash to equity to make the wealth last long

Summary

Abraham’s article is not the only article that have went through this experiment and came up with the same result:

In the end, the reality is that while cash reserve strategies appear psychologically appealing, their actual benefits as an enhancement for retirement income sustainability appear to be a mirage upon closer inspection. The buffer zone approach appears to do little to effectively “time” the market, and/or to the extent it does, the benefits are overwhelmed by the adverse consequences of a large allocation of cash in the portfolio that drags down long-term returns. Notably, though, separate research has shown that shifting equity exposure in light of market volatility (and based on fundamental valuation principles) can in fact enhance both returns, risk-adjusted returns, and the sustainability of retirement income – and without the unfavorable impact of an unduly large cash position. – Research Reveals Cash Reserve Strategies Don’t Work… Unless You’re A Good Market Timer?

Ed Rempel came up with a thorough article recommending a higher equity allocation. Here is his commentary on cash allocation:

Many financial planners recommend holding cash equal to 2 years’ withdrawals to draw on when your investments are down. The idea is that after a significant down year, you can live off the cash and not touch your investments, to give them some time to recover.

This sounds logical, but was not supported by the 146-year study. For example, assuming 100% in equities and a cash holding, here are the success rates for a 30-year retirement:

good-stocks-to-invest-in

In every case, holding cash either had no effect or increased the risk of running out of money. I could not find a single example of a retiring year or withdrawal amount when holding any amount of cash provided a higher success rate than holding no cash.

The study showed that holding cash does not protect you. In fact, it often increases your risk of running out of money. – How to Reliably Maximize Your Retirement Income – Is the “4% Rule” Safe?

Despite these case study, there will still be retirees who believe in the virtues of having cash allocation. This is because there are certainty there. My job here is show the evidence of what might work better.

It is up to you to implement your own wealth withdrawal plan.

I shared my research, what I read and distilled about the retirement, wealth withdrawal aspects of financial independence here > Planning Your Retirement Right Now

It is a bit jumbled up and I would clean up one of these days. But if you wish how I came to this current plan, it is a good linked article to read up.

 

Good stocks to invest

Start trading now on the best platform on the market.



Source link