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Over the years I’ve studied markets and portfolios. Portfolios are characterized by rate and return.
Portfolios are also characterized by sequence of return.
If you draw a bad sequence you draw a much harder path than if you draw even a mediocre sequence.
I’ve used the FIREcalc calculator and the home page has the following picture
The sequence is for a 750K portfolio with a withdrawal rate of $35K (4.6%) over a 30 year period.
- The red 1973 line heads into the ground and dies in 20 years.
- The blue 1974 line survives with a 50% loss in 30 years.
- The green 1975 line prospers with a 233% gain in 30 years.
Same portfolio, same withdrawal rate, same proposed longevity. The difference is what year the trigger was pulled.
This is a graph of the 1973 to 1975 recession from Wikipedia.
The period involved “Stagflation” which was a period of high inflation and stagnant growth, the double whammy of bad news.
It occurred to me what if you just had enough of a cash like asset around that you could simply re-sequence your portfolio from a 1973 portfolio to a 1975 portfolio?
You would need enough to survive on during this period (I’m guessing 150% to 200% of living expense for 2 years with a contraction to a subsistence budget).
You would want the survival fund in a risk free asset, in other words in an asset with a very different risk than the portfolio in the main.
- Something like the ETF BIL [SPDR Bloomberg Barclays 1-3 month Treasury bill ETF] or VTIP [Vanguard Treasury Inflation Protected ETF].
- You can lose a little money in these but this is insurance you are buying, not return.
- When the market drops x% you want something there guaranteed.
You want a trigger to know when to spend the insurance.
From the above we see a big drop in 2 quarters from +11 to -2.
I don’t know when I would pull the trigger.
My normal funding in general is to get out the money I’m going to spend for a year near the start of the year.
If GDP has dramatically decreased in the course of a year it’s probably time.
In the 1973 recession GDP decreased by 3.6%
The point is, during the course of the recession, to close off the portfolio to withdrawal but still have the ability to re-balance.
Say you own a 60/40 portfolio and you have gains stock gains 5 years in a row.
You re-balance every year into bonds effectively selling your stocks high and buying bonds low.
Your portfolio has gained $220K net re-balanced.
Now you suffer a $300K stock loss. Your stocks are now 432K and you rebalance back to 60/40.
Your new stock balance is $528K.
Risk Management By Rebalancing
| Stock Performance | Stocks | Bonds | Net Worth | |
|---|---|---|---|---|
| Year 0 | 600,000 | 400,000 | 1,000,000 | |
| Year 1 | +70,000 | 670,000 | 400,000 | 1,070,000 |
| Rebalance 60/40: | 642,000 | 428,000 | 1,070,000 | |
| Year 2 | +40,000 | 682,000 | 428,000 | 1,110,000 |
| Rebalance 60/40: | 666,000 | 444,000 | 1,110,000 | |
| Year 3 | +60,000 | 726,000 | 444,000 | 1,170,000 |
| Rebalance 60/40: | 702,000 | 468,000 | 1,170,000 | |
| Year 4 | +20,000 | 722,000 | 468,000 | 1,190,000 |
| Rebalance 60/40: | 714,000 | 476,000 | 1,190,000 | |
| Year 5 | +30,000 | 744,000 | 476,000 | 1,220,000 |
| Rebalance 60/40: | 732,000 | 488,000 | 1,220,000 | |
| Year 6 | -300,000 | 432,000 | 488,000 | 920,000 |
| Rebalance 60/40: | 528,000 | 368,000 | 920,000 |
[Gasem has graciously included his excel spreadsheet where you can input your specific numbers: rebalance example]
You bought stocks low from the proceeds of selling high along the way plus a little bond money.
This is the risk management provided by rebalancing. You are now set for the recovery.
If you are drawing off money from the portfolio to live on it hoses up the risk management.
So by having a little pile of risk free insurance money on the side on the side you avoid hosing up the risk management and effectively sequence the 1973 portfolio into a 1975 portfolio.
The cost of this is 1.5-2x the annual withdrawal rate.
If you save 33x your annual withdrawal rate [aka 3% withdrawal rate], you would need to simply save an extra 1.5 to 2x more in a risk free asset.
If you think about what a bad SORR is, it’s like adding an extra annual withdrawal amount in addition to your regular withdrawal amount.
The extra withdrawal amount can even be greater than the expected withdrawal amount, so by closing off the portfolio and limiting the withdrawal amount, you are controlling the sequence.
If you are close to social security you might consider adding the social security benefits as part of the insurance.
I’m 66 waiting to 70 for social security, but if a 1929 style event happened I would be taking social security earlier and using the risk free asset to make a subsistence income and take me as far into the morass as it could, leaving the portfolio intact while rebalancing as much as is reasonable.
Buy low sell high works.
In other words this technique can be very powerful and flexible if you run all the scenarios:
- Let’s say you have 200K (equivalent to 2 years worth of withdrawal) in insurance and 50K/yr in social security.
- If you split your 200K into 8 that’s 75K per year for 8 years.
- Into 10 it’s 70K (pretty much gets you through all of the great depression event with an intact rebalanced portfolio).
I would fill this account counting down to the end of my work life.
- Early in accumulation you need all the compounding you can get.
- At the end [of the accumulation period] buy the insurance.
If you’re the lucky one and chose a good year to retire with a good SORR you have an extra year or two in the bank plus all the extra interest you have for choosing right.
If you chose wrong, you get to “not die poor.”
I would probably fund this as a one-shot deal.
Decreasing time to death, annual withdrawal amount, portfolio size and portfolio risk also affect SORR so this is sequencing insurance and not a method to try and overcome those methods of SORR management
Thank you Gasem for another informative guest post demonstrating another option readers have to prolong their retirement portfolio and avoid running out of cash.
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Another great Gasem post. I plan to ride out SORR issues this way too. Having a cash “bucket” hopefully will get me through a bad sequence. I think this also points out that oversaving greater than 25X will also work. I find it curious that people who say they are 100% equities fail to included their cash bucket.
Thanks for stopping by hatton1md. Yeah I love reading any Gasem post, whether it is on my site or anyone else’s blog. I actually have 2 more of his that will post in the next 2 months that I’m sure you will enjoy as well. Have a great day!
Thanks Hatton1md. Nice to see your instinct and mine coincide
Thank you Gasem and XRV! This one is awesome. There are plans and then there are PLANZ!!!
Gasem, I am sure you missed your calling as an asset manager. You would have been rather scary good.
Correct me if I’m missing something but all of the more senior docs have back ups to our back ups to our other back ups….
Also cash may offer almost no return when you don’t need it but infinite returns when you do need it….just saying.
I am most certainly re-reading this one again.
Thanks DMB. Yeah I really liked this post as well. Gasem has an incredible mind and you are right he could have killed it in finance (I have told him to start a blog as well because it is such a unique perspective) but until that day I am happy to be the beneficiary of some of his ideas (there are 2 more already created and on the schedule so please continue to see more examples of his inner mind
Thanks Dr MB Every asset has a reward and a risk. When the market is up reward dominates, when the market is down risk dominates cash substitutes for risk to some extent when things go south.
I love the concept of re-framing it the way you describe, Gasem: setting aside a few years of living expenses is sufficient to buffer against SORR by bridging (catapulting? golden parachuting?) you from the crap years to the safe years.
Thanks for another fine contribution to the canon, my friend.
Thanks CD for stopping by and commenting. I too like the reframing concept that allows you to bridge a poor SORR and make it as it you timed it for a good one.
CD thanks for stopping by. I love the idea of playing one risk, market risk off another risk, risk free asset over a couple years. We tend to project out for decades but miss the dynamic granularity which can be applied to change outcomes.
Thanks Gasem for your analytic approach to dealing with SORR. Intuitively I know this needs to be addressed but so far I’ve used a less rigorous method. Basically I keep “enough” in a short term muni bond bucket to hopefully buffer the risk. My intent is the same as the cash bucket although at a mildly increased risk. I like your use of ETFs and actually having a trigger. Since I haven’t actually used the bucket yet for it’s intended purpose I appreciate your thoughts on an appropriate action trigger. Also thanks to XRV for hosting the Gasem analysis. I… Read more »
Appreciate the comment GasFIRE and yes I am very lucky that Gasem even considered my platform for his high level analysis posts. I have 2 more in the books (1/mo) left (I’m hoping that he is kind enough (hint hint Gasem) to create some more posts that I would be happy to put on the schedule indefinitely).
Have a great weekend!
Thanks GasFIRE, my approach is a little different than the bucket approach in that it’s a one shot insurance policy. As you progress in retirement the “SORR load” on the portfolio decreases over time with the most dangerous period at the beginning. If you’re on track 10 years into retirement SORR will affect you but likely won’t kill you. You get best protection by having a lot of money and a low WR but if you RE that limits accumulation. Basically this is a 2 more year accumulation approach relying on re-sequencing your withdrawal. In the standard scheme it would… Read more »
nice post gasem!
have you looked at the bond tent strategy? It was proposed by wade pfau. It increasing bonds in the first 5 years and then decreases them to the baseline.
I’d love to see you contrast this with your risk free bucket
regards,
psy-FI MD
I’ve taken a lot of risk off the table, in no small part thanks to reading and dialoguing with Gasem. Limiting down side overshadows upside potential as your number is reached. Appreciate the thoughtful analysis,
CD
Gasem has influenced a lot of my decisions as well. He has a much higher level of thought than I have so nice to pick up tidbits
That’s a lot of cash to sit on. Why not just sell off the bonds to fund your living expenses for a few years? That will mess up the asset allocation a bit, but you avoid locking in your equity losses. You can rebalance once the market recovers.