If you want to withdraw income from your portfolio, how much do you take out and when?
With the stock market up or down at any given time, how can you predict how the market will perform and how much you can take out?
This is where your cash wedge comes in – to help manage market volatility.
What is a cash wedge? How can it help you manage your portfolio?
Read on, including how I’m using cash in our portfolio and a cash wedge approach myself!
The Cash Wedge – A history lesson for any time
You might already know from a popular investing book entitled The Four Pillars of Investing (by William Bernstein), there are some fundamental investing concepts to understand to be a successful investor. I’ve leveraged those concepts for today’s post.
- Pillar 1 – Investing Theory and Risk. Whether you invest in stocks, bonds, real estate or more speculative plays like Bitcoin, you should know that you’re mainly rewarded with returns for your exposure to just one thing— risk. This means the risk you take on, for the potential of higher returns, is related. That said, you should have a plan to weather any stock market or specific investing risk in the near-term if you ever need money from your portfolio in the coming years.
Source: The Four Pillars of Investing
- Pillar 2 – Investing History and Returns. By investing history, what we mean is, from time to time the stock market and investors that invest in it go just bonkers. Yet, we see time and time again from investing history largely “this too shall pass”. So, over time, while any stock market returns might seem hard-pressed in the near-term, we see long-term equity returns trend upwards – if you hold on.
- Pillar 3 – Investing Psychology and Your Returns. Knowing risk and return are related, understanding that stock markets are unpredictable and volatile usually over a period of weeks and usually months, yet largely predictable and stable when we look at multi-year investing history, it therefore makes sense that investing success will probably come down to your long-range behaviour. That includes when you decide to invest and when you decide to drawdown your portfolio.
- Pillar 4 – Be Wary of the Entire Investing Industry. Banks will bank. Businesses will thrive when they make money. I believe the more you understand these basic concepts the better off as a consumer and investor you will be. The financial industry overall is part of a massive marketing machine designed to make money. This means, as a consumer and investor, you must be wary of the entire industry and their incentives. For sure, there are some great companies doing great things, delivering some value-added products and services for consumers, but never discount any of their motives. This makes your decision to invest in any financial product or pay for any financial service of utmost importance to your financial health.
The Cash Wedge – An approach for any time
Now that you understand the framing of where I am coming from, when it comes to holding cash, employing some sort of cash wedge in your asset accumulation years or your asset decumulation years can be a powerful tool when it comes to wealth creation or wealth preservation.
The cash wedge to support asset accumulation
You might not really think about it this way, but any cash set aside for near-term expenses while you are saving for retirement and building your wealth is really a cash wedge. It’s as hedge against known or unknown risks.
We read above that market volatility can be both an investor’s friend and foe.
If you are in your asset accumulation years, you should consider market volatility and any market declines a dear friend.
Lower equity prices can be a great chance to buy your stocks on sale – at lower prices! Think of it this way: would you rather celebrate a sale at the grocery store or higher prices?? I know my answer!
For investors that have some cash set aside, when markets decline, you can rejoice and put that “dry powder” to work. I’ve learned to train my investing brain to invest when my favourite stocks or ETFs decline in value. It is my hope by reading my site you’ve learned to do the same over time.
By keeping cash / your cash wedge in any asset accumulation years, you’ve essentially got money ready to deploy in a liquid, highly accessible way to pounce on any stock market declines. Buying your equities when they go on sale is a GREAT way to fatten your investment portfolio for the future.
The cash wedge to support asset decumulation
For investors building wealth, while tanking markets are favourable for owning more stocks at lower prices, the inverse is true for folks decumulating their portfolios in semi-retirement or retirement. For anyone drawing down their portfolio, a bad set of market returns can be a admirable foe to fight. Any portfolio down in value, without a cash wedge, may also be a double-whammy if you consider inflation:
- You are forced to withdraw from your portfolio when asset values are down, and/or
- You are forced to withdraw from your portfolio when inflation could be higher – eating into any purchasing power.
(#1 is bad enough but when combined with #2 it can be disastrous.)
What we are really talking about here is sequence risk or sequence of returns risk. That’s really a way to say there is a risk that comes from the order in which your investment returns occur in any retirement drawdown. During the accumulation phase, regardless of whether a portfolio experiences poor or strong returns early on, the market value will be the same in the end assuming you stay invested. In your asset decumulation years, timing is everything. If the market is down and you must drawdown your retirement assets the longevity of your portfolio might be in question.
In asset decumulation, the sequence of investment returns is a major concern for those individuals who have just retired. Consider this: if the initial returns are positive, it’s clear sailing ahead for the retiree: capital can grow and gains can be taken as withdrawals as planned. But an investor who experiences a series of negative early returns in retirement must confront at least two issues if not three:
- capital must be sold for income needs,
- the smaller capital account that remains will compound less, and depending on inflation,
- you have less aforementioned purchasing power.
Let’s look at an example using two different worst-case 10-year market scenarios.
Under both scenarios, the returns are identical, except in reverse order.
Take notice of the negative returns in years 1 and 2 at the start of retirement in Scenario B.
|Scenario A Returns||Scenario B Returns|
Under scenario B, even though the average returns are the same as Scenario A over time, the portfolio for Scenario B lasts 5 years less.
Check out this great, detailed post on managing sequence of returns risk in retirement including a case study.
However, it’s not all doom and gloom. If you develop a cash wedge for your retirement needs you can better navigate market volatility, in a very simple way. This cash wedge won’t cost much although there could be some opportunity costs. Yet the cash wedge will help you preserve some wealth during any market downturn, and help you stick to the long-term plan you’ve been building all along.
The Cash Wedge – Building it now or later
Whether you decide to build your cash wedge now (to help you in your asset accumulation years), or later, as you enter semi-retirement or retirement, I believe it’s an important approach to consider to navigate uncertain market waters that will always persist.
Whether you are saving for retirement or in retirement, consider adding a cash wedge approach to your portfolio arsenal.
In your asset accumulation years, it could simply be a few thousand bucks (or more!) in a high-interest savings account. It’s basically your emergency fund. 🙂
In your asset decumulation years, a typical construction could be:
- Year 1 – a year (or so) of expenses in cash and/or in a combination of cash and a money market fund that is highly accessible. This is the bucket where you draw your retirement income from.
- Years 2 and 3 – this is a portion of your retirement portfolio that is allocated into short-term investments, such as a 1- or 2-year Guaranteed Investment Certificate (GIC), some bonds or some fixed-income funds. On maturity when using GICs in this example, these investments are used to replenish your cash wedge (Year 1).
- Years 4+ – the rest of your portfolio is left to grow, as a diversified equity portfolio, providing growth for future years. Hopefully by years 4 or even 5, the equity markets have rebounded a bit.
I’ve included a good visual for you below:
You can download this simple 1-pager for your reference too!
What is my cash wedge approach? What is my cash wedge?
I’m likely to keep about (or just slightly more?) than 1-years’ worth of expenses in cash as I enter semi-retirement in a few years. Semi-retirement means I will still work just not full-time.
Many readers have asked me after reading this post when to start building their cash wedge. Well, as you can appreciate in this post I believe you should have a cash wedge as an investor – ideally – at all times!
However, owning your cash wedge becomes critical at the time of retirement.
So, if you’re planning to retire or semi-retire in the coming 2-3 years, you should consider building your cash wedge now.
I am for a few years ahead.
In fact, when I consider full-on retirement, I’m very likely to own GICs or some cash ETFs at least in my porfolio for Year-2 and Year-3 when I’m no longer working at all…
The Cash Wedge – Managing market volatility summary
As a prudent investor at any age, thankfully, there’s an option to manage market volatility in your asset building years or asset drawdown years: use the cash wedge.
The beauty of the cash wedge is that unlike other strategies, it is easy to implement, it costs next to nothing, it avoids any deep thought or any flawed decision-making about market timing, you certainly don’t need to pay fees to a financial advisor for it, and most importantly a cash wedge helps you with your other investment goals.
So much to love!
This is a good reminder to all of us that the perfect portfolio only exists in hindsight. Every retiree is going to face some sort of unique market conditions, spending needs, tax and withdrawal circumstances that are special to them. Therefore, the best way to hedge any sequence of returns risk is to have a flexible financial plan that allows for the occasional course correction. Consider this flexible spending approach to help you adjust to the realities of what the stock market and/or life could toss your way!
Your approach should likely consider holding enough cash (or some fixed-income) in the form of a cash wedge to see you through a prolonged bear market so you avoid becoming a seller of equities at the worst possible time.
Thanks for your readership and I look forward to your comments about the cash wedge!
Here are some overlooked retirement income planning considerations.