Personal Investments • Re: Cash allocation in early retirement

Assuming you’ll have no source of income other than portfolio withdrawals, keep 5 years of expenses in cash equivalents.

That should get you through the vast majority of stock market downturns, so you won’t have to sell stocks at reduced prices.

Alternatively, you could go with 100% stocks and accept the tradeoff of higher long-term returns for having to occasionally sell low.

I expect that lost gains of keeping 5 years in cash (compared to a 100% stock portfolio) will probably outweigh the losses prevented during downturns.

What you expect may be correct, but it means nothing to those of us living through those 5 years. We'll have to deal with actual returns, not what was likely or expected.

I am no longer trying to maximize gains. By definition, voluntary retirement means you ALREADY HAVE ENOUGH. There is no longer any need for MORE.

The goal is safety at this point. I no longer care about "lost gains", only minimizing the impact of losses.

I assume by "safety" we mean reducing the risk that we will run out of money, correct?

Let's all take a field trip over to cFIREsim.com. This is a backtesting site.

We'll leave all the defaults alone except as described. The defaults assume a 30 year retirement starting with $1,000,000, taking out a SFW of 4% ($40,000).

So we will only make the following changes:

Simulation 1: Put in 100% Equities. Run the Simulation.
Success Rate: 95.2% (Failed 6 of 125 cycles).

Simulation 2: Put in 80% Equities, 20% Cash. Run the Simulation. (Note: If you are spending $40,000 a year, (which is what we are using here with the SFR of 4%, then 5 years of cash will be 20% of the $1,000,000 or $200,000. To allow for the expected increases from inflation, you could make it a bit higher, but for our purposes, we'll just use 20% for now.)
Success Rate: 90.4% (Failed 12 of 125 cycles).

Simulation 3: Put in 60% Equities, 20% Cash, and 20% Bonds. Run the Simulation.
Success Rate: 88% (Failed 15 of 125 cycles).

Running these again with a 5% withdrawal rate. Success Rates:
1. 79.2%
2. 71.2%
3. 60.8%

And with a 3.5% withdrawal rate. Success Rates:
1. 100%
2. 96.8%
3. 95.2%

You can run different withdrawal rates. As a general rule, you'll see that the lower your withdrawal rate, the less asset allocation matters to success.
And as a general matter, the higher your withdrawal rate, the more it matters. Why is this relevant? Because we all aim to have low withdrawal rats, or at least we should. But sometimes factors outside our control result in higher withdrawals than we would like. For example, medical expenses, or assisted living facility costs.

At 6%, the success rates are:
1. 65.60%
2. 50.40%
3. 44.80%

At 10%--which is crazy high, the success rates are:

1. 10.40% (Note: This is pretty incredible if you think about this considering you are starting with only $1,000,000 and taking out $100,000 adjusted for inflation every year for 30 years.)
2. 0%
3. 0%

Some observations, as to how this has played out in the past:
1. People fear market downturns, and the impact they have on equity, but the biggest risk of equities is that you sell at the bottom of the market- and crucially, this risk does not show up in the backtesting simulations because they assume you "stay the course" with the chosen asset allocation. If you stay the course, you can expect that your portfolio will recover.
2. Inflation is a much bigger risk than a lot of people give it credit for. And probably a bigger risk than market downturns for people using reasonable withdrawal rates. This is because inflation is almost always with us. It is there even in good times, and in bad times it can be worse. Also, the impact on cash is one way--it uniformly reduces its value. And this reduction is irreversible as a practical matter, because deflation is extremely unlikely. So cash is the riskiest asset over any appreciable time horizon, because inflation continually chisels away at its value--often slowly and sometimes quickly.
3. Stocks are volatile but provide the highest returns, and are the best hedge over the longer term against inflation.
4. If your withdrawal rate is low enough, your asset allocation makes less difference. But that said, a 100% cash allocation will generally drop like a rock.

Nobody knows what will happen in the future. But at least over the last 100+ years, the perceptions of risk regarding equities has not been consistent with how they have actually performed, at least in the portfolios of people who "stay the course" and don't panic and sell near the bottom.

There are not guaranties. Again, nobody knows what will happen in the future. Don't think that a 100% equities porfolio is "safe" - it is not. But historically a 80% equities, 20% cash, or 60% equities, 20% cash, 20% bonds portfolio has been even less safe.[/b]

Statistics: Posted by Finridge — Thu May 16, 2024 11:22 pm

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