January 11, 2021: Smart Cash Management: Can I Just Withdraw From My Bond Portfolio?

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Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday February 1, 2021.

Please note: As of March 1, 2020, we officially phased out our old rebalance calendar for both SAA and TAA. They are now always rebalanced on the first trading day of a month.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Smart Cash Management: Can I Just Withdraw From My Bond Portfolio?

We always pay attention to cash management as we believe most investors and savers have been ill served by banks or brokerages for their cash. Many people simply ignore and dismiss this ‘unsexy’ part without knowing that some companies rely on cash to make most profit (see, for example, July 8, 2019: Surprise! Brokerages Make Most From Your Cash, Not Commissions).

In this newsletter, we look at one of the simplest ways to handle cash and concludes that in many scenarios, it works well enough.

Handling short term ‘safe’ investments

Roughly, one can divide investments into two parts: long term stock-type risk investments and short term bond-type ‘safe’ investments. Notice ‘safe’ is just simply a relative word: it does not imply bond or fixed income investments to be safe, but just relative to stocks, they are safer.

For these short term investments, we have stated some rules of thumb on how to allocate them (see previous newsletter, for example):

Immediate cash needed within a few months such as up to 3 or 4 months to pay living and other expenses. This portion should be placed in a money market fund or a saving/checking account.
Ultra short term capital needed within a year or so. This portion should be invested in an ultra short term fixed income portfolio or just simply in a money market fund. We will discuss and reveal some ultra short term fixed income portfolios in a future newsletter.
Short term investments (for capital needed up to 7 to 10 years): this portion should be in a fixed income bond portfolio such as the one on our Fixed Income page.

Put simply, we can divide ‘safe’ investments to immediate cash, ultra short-term investments and short-term investments. Portfolios like MPIQ ETF Fixed Income are for ‘long-term’ ‘safe’ investments, usually for capital needed beyond a year or longer.

But in practice, quite some investors just simply sell some of their holdings in these portfolios for monthly spending and when ever they have new deposits, they are immediately invested into both stock and bond portions (portfolios) based on its allocation.

In this case, basically, all you need is a long term stock and bond portfolio (depending on the breakdown outlined in the previous newsletter) and then you withdraw and deposit directly to this portfolio every month.

How effective is this approach? Do we need a more elaborate division as outlined above? The answer is that it depends. For many people who have a relatively stable and consistent monthly spending, this simplified approach works just fine. The key lies in the word ‘consistent’: basically, if you use this approach month-in and month-out for normal spendings for more than five years, this should work well. On the other hand, occasionally large or abnormal sum for special spending (such as buying a car or a house downpayment) require more target approach.

Consistent monthly withdrawal

To answer the above question, let’s look at a typical fixed income portfolio that we have advocated: Schwab Total Return Bond that rotates among a selected list of excellent total return bond mutual funds. We look at the following:

Withdrawing monthly from this portfolio for just a year (i.e. 12 withdrawals in a year)
Withdrawing monthly for 2 years at least.

We take a simple approach: we look at the average monthly returns for every calendar year from 2001 to 2020 (20 years). The result is as follows:

What the above chart tells us is that, for example, if an investor only withdraws a constant amount for 12 months from this portfolio in 2008, it would incur -0.128% loss monthly. Apparently, this is inferior to immediate cash approach (meaning she or he should have 12-month cash before hand for the spending).

On the other hand, we notice that if this investor can extend the withdrawal for more years, the gains from other years would hopefully offset the losses in a few of years.

The following shows that if we extend the withdrawal to 2 years (or 24 months), we now see that we can out perform cash withdrawal

However, if we examine how the monthly withdrawal turns out for Vanguard Total Bond Index Fund VBMFX, we have the following chart:

Observations:

One, two, three and even four-year monthly withdrawal schedules can still result in average monthly loss. This is especially true for years in late 80s and 90s.
When we extend to 5-year (60-month) schedule, average monthly withdrawal will become positive.

So, to be safe, we might want to extend our consistent withdrawal to 5 years or beyond to make sure we will be able to get much better returns than cash. This is not a very strict constraint: many people can manage to utilize this approach year-in and year-out for their normal monthly spending (that are mostly stable) so long they make sure they just keep sticking to the same bond portfolio for a long time (no less than 5 years, say).

To summarize, the above studies validates the practice some investors have adopted to directly withdraw their monthly spending from a bond portfolio. This will eliminate low returns from cash and cash equivalent from banks or brokerages (such as savings or money market funds). For non-regular spendings such as a one time big purchase, however, it’s still better and safer to allocate the money to an ultra-short bond portfolio, CDs or target (defined) maturity bond fund (such as those we discussed in August 24, 2020: Target Maturity Bond ETFs For Short Term Cash).

Regardless, the results here are very encouraging: one can probably just forgo those short term cash investments for regular recurring spending need and simply rely on a good fixed income bond fund or portfolio that have intermediate-term maturity.

Market overview

Well the whole world was shocked to see the chaos and riot in the US Capitol hill last week. It’s hard to imagine this actually happened in the US. Regardless, the event indeed reveals the deep divide in the society (and the economy). Coupled with the serious Covid pandemic, the resilience of financial markets is quite a wonder, to say the least.

The recent rise of 10-Year Treasury yield is concerning (see the chart below). Furthermore, the Wall Street Journal reported that now there is a world wide chip shortage has now slowed global auto production. Whether the inflation is finally propped up by world wide ultra-loose monetary policies remains a question. However, this is definitely an area to watch out as rising inflation can pressure interest rates to rise. This will likely create a big problem for stocks and bonds whose elevated levels are mostly attributed to ultra-low interest rates.

We again call for the following practice:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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