The time to decide to re-align your investments is not when approaching the time you’re ready to call it quits to your 9-5 day job. Some careful consideration and adjustment must start years in advance to ensure a smooth transition. Not planning ahead could lead to disaster and prolong your time in the job.
Part of the careful consideration when retiring early is creating a cash position that serves a critical purpose. Having a good-sized stash of liquid assets can provide a cushion to draw on should the markets move to the downside. It’s almost an insurance policy should the markets tank either just as you’re ready to pull the plug or years into your early or regular retirement. During those times – cash can be king!
Temper your risk
What you are trying to avoid or temper is the risk of having several years of poor or downright crappy returns. If that occurs early on in your retirement, it can have devastating results from which you may never be able to recover. This is referred to as Sequence of Returns Risk. There has been lots written on the topic of Sequence of Returns Risk. Rather than duplicate, click this link to a post from Early Retirement Now that I recommend you read if you are not familiar with the term or the risk.
While you are working, you’re saving on a regular basis (your accumulation years). Money is being added to your retirement and investment accounts each payroll or month. Your asset allocation is generally more aggressive early on, meaning you have a greater allocation to riskier equity investments. If there’s a market correction or bear market, that’s usually ok because your next investments will be purchasing more shares at a lower price. When the market eventually rebounds, you’ll profit from the blip. As you’re in it for the long run, temporary downturns, which are inevitable, actually benefit you as a saver.
Dial down risk approaching retirement
However, as you get older or as you near your early retirement goal, you recognize that you’ll need to start withdrawals (decumulation years) in a short period of time. Conventional wisdom has you dial down risk as you approach retirement by adding fixed income or bonds to your assets. Adding fixed income or bonds helps dampen overall volatility of your portfolio. When you’re retired, you don’t appreciate large swings, up or especially down, in your investment portfolio. There is a cost associated with lower volatility and that is generally lower returns.
That makes sense. A riskier portfolio should, over the long run, reward you with larger returns. When you lower the risk in your portfolio, you should expect lower returns.
Add cash for added protection
Beyond your fixed income positions, a cash cushion within your portfolio will help your long-term probability of having a successful retirement. I’m not talking about the 3 to 6 months emergency stash but a larger cash position that can carry you for several years.
Walking into a bear market or correction just when you retire can be a disaster to your portfolio. Your cash position will allow you to pay your expenses while the markets are down. It reduces the need to sell your equities or fixed income positions in a bear market when your investments have a lower value. The cash position allows you to ride out the storm until the market recovers.
Corrections are defined as a 10% market loss and average 4 months in length. It takes, on average, another 4 months to recover. Bear markets are defined as a market loss of 20% or more. The average length of a bear market is roughly 13 months and the recovery period is about 22 months. That’s just about 3 years from top to bottom back to top in the market cycle.
During a bear market and recovery period, having your cash position to pay your expenses is a better solution than selling your equities and fixed income investments when they are undervalued. That’s when you know cash is king!
Slightly lower returns
You may be thinking, having a large position on the sidelines in cash rather than invested will lower your returns. And that’s true. It will lower your portfolio’s total return. But at the same time, it offers some protection to your portfolio during a bear market. The cash doesn’t need to be all sitting in a bank earning next to nothing. You can use money market accounts and ladder in some CDs that routinely mature. You may even put a portion in an ultra-short duration bond fund. While you may be inclined to seek out higher returns be cautious. Seeking out higher returns also puts you at greater risk of not having those liquid assets when you actually need them.
Plan in advance to build up cash
As I wrote in the opening, adjusting your portfolio right before your pull the plug is not the time to start thinking about this and repositioning. It takes some planning and time to raise your cash position.
For Mrs. P2F and I, we felt having about 3 years’ worth of expenses tucked away in cash and cash equivalents was appropriate for us. About 5 years prior to retiring, we began the process of building up our position. To accomplish our goal, we had to stop adding to our investment accounts and let the money market account build up. We also stopped re-investing dividends and capital gain distributions and redirected the payouts to our money market fund.
Honestly, it was difficult! For all of our 30+ years of investing, money was always invested in equity or bond funds. Sure, we had our emergency fund but this was different. It was difficult to see the money market balance growing and not take action by adding to our other investments.
But we had a plan and we stuck with it. By building up the cash, we knew we’d be able to sleep better at night when retired. We know that when (not if) the bear market arrives, we’ll be in a better position to ride out the storm.
How about you? Are you preparing for the next bear market now? Have you built a “cash is king” position to weather the storms? Share your strategy in the comments below.
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