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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|
[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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