My First Dip Into Principal: Market Timing or Cash Management?

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This isn’t one of those full-disclosure "reality" blogs where I document every lurid detail of our financial life. I’m a pretty private person by nature and it’s been a long, drawn out process just for me to talk about our finances as much as I do. I got to this point because it became clear that I couldn’t help people with my story, if I was afraid to tell it in public….

So this week I’m going to lift the veil a bit on our personal finances to reveal some decisions I made for our portfolio recently, because I want to share, to some extent, the actual experience of being an early retiree. Here then is a snapshot of one significant investment decision in our early retired life, now that we are a year and a half out from financial independence….

This will also be a reminder that I’m not a financial adviser, just an engineer who became financially independent. I’m figuring this out as I go along. Specifically, I might be a "real world" accumulation expert, given that I did build a substantial portfolio and retire at age 50, but I’m not a distribution expert. I’m at the very beginning of my understanding of how to best structure a retirement portfolio for lifetime income.

So here was the problem at the end of this summer: When I early retired in the spring of 2011, I set aside about 2 years of living expenses in cash. We’d eaten into about half of that cash, and would probably need more sometime in the next 6-12 months. What should I do?

At the time I retired I knew little about the the process of living off a nest egg. I was familiar with the hallowed 4% rule (now under serious attack) and had a vague sense that we’d take a “total return” approach, consuming our investment income each year plus selling some holdings to meet our living expenses.

In the time since, I’ve learned quite a bit about the distribution problem, writing posts such as A Floor with an Upside: The Best Strategy for Lifetime Income? and Why an Annuity Could Be in Your Future…

I’ve gradually changed my militant anti-annuity stance to accept that simple fixed income annuities will likely play a role in assuring our retirement income. I even got quotes from ImmediateAnnuities and Vanguard for Joint Life annuities — one inflation-adjusted, one not — for a couple like us in their early 50’s.

And, if I was willing to believe that serious inflation wouldn’t be an issue over the next few decades, we could lock in a very comfortable lifetime income with an annuity right now. Unfortunately, I’m not willing to make that leap of faith. And the payout on the inflation-adjusted annuity, about 2% lower, wouldn’t be enough for a comfortable retirement.

With annuity rates based on bond rates, and those at all time lows, things are unlikely to improve until interest rates have normalized. When will that be? Ask the Fed.

Even if rates were more favorable, after just a few months of researching the annuity marketplace, I doubt I’d be comfortable enough yet to pull the trigger on a 6-digit transaction that would irrevocably hand over control of our financial future. I expect that time to come, but it isn’t now.

In that case, what should I do about our need for cash?

The default option, for now, is to manage our investment portfolio for retirement income. And, though I’ve staked out some research and future articles on systematic withdrawal strategies, I’m still a newcomer to that territory.

So what exactly did I do?

Simple: I sold stuff. Over the last two months I gradually cashed out some positions, and moved others into bonds. The total changes involved about 5% of our portfolio. I sold small amounts of a real estate fund and a natural resources fund, and moved some international and domestic broad market index holdings into my favored all-weather investment vehicle: Vanguard Wellesley Income (a low-cost balanced fund with an emphasis on dividend-paying stocks). The net effect was to add a year or two to our cash and liquid holdings plus shift our overall allocation away from stocks to bonds, by a few percent.

Why did I do this now? Well, there were three factors:

  1. As noted, we would probably need cash sometime in 2013.
  2. Learning more about retirement income and the perils of distribution portfolios has made me even more careful about protecting against losses early in my retirement.
  3. The market has been near multi-year highs, plus we are approaching the end of the well-known election-year market cycle.

Hey, some will object, that last point sounds like market timing!

I don’t care. I view these recent sales of mine no differently than I do the many purchases I made during my accumulation years. During my working career, I had a substantial pipeline of cash coming in to be invested. And, naturally, I always pointed that cash at the investments that seemed to be doing worst — buying at their lows. Yes, I also kept an eye on my asset allocation. But, to be honest, that ruled my decisions far less than a simple understanding of whether stocks or bonds were currently out of favor.

Now, as I tap my holdings for retirement income, I’m doing exactly the same as I did during the accumulation years, but the equation is reversed. Instead of buying at lows – adding to assets that have done the worst, I’m selling at highs — pulling from the assets that have done the best.

Hey, some will object: you should have an investing plan, buckets or something, and stick with it.

Plans are great. You should make them. But I’ll tell you — and this is coming from one of the world’s most obsessive planners — that, despite all the strategic planning you do, real world financial life is full of tactical decisions. That’s what this was.

No matter how much planning you do, pay attention to reality.

Long-term strategies sometimes don’t work for the simple reason that they are long-term. Everything in the world around them, including you, changes. Sure, you do your best to plan and implement some core principles, but then the world proceeds on its way, regardless of your plans. You gain experience, and change your opinions. This happens all the time.

So, after planning, I try to focus on the few key behaviors that have done well for me over the years. Behaviors represent wisdom that adapts to different situations. Here are the important ones for me:

  1. Don’t act rashly: move in small steps
  2. Don’t react out of fear or greed
  3. Don’t follow the herd

In this recent scenario, I sold positions using about 6 separate small transactions over a period of about two months. Rather than trying to make a killing, or reacting to a sudden fall in the market, I was simply selling asset classes that had done well, and locking in another few years of retirement living expenses. And rather than following the herd to bid stock prices higher right now, I pocketed some gains.

Until I have a more comprehensive plan for retirement income in place, if such a plan is even possible, I’m content with this approach….

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