Can cash be your friend?

[conwy]

I've been thinking a lot about cash vs investments (e.g index funds, real estate, etc).

Let's assume we agree that investments can lose their liquid (cash) value and thus their purchasing power for long periods (5+ years, if the Great Depression is any indication) and that there is no way to eliminate this possibility. However over a longer period (10+ years) the purchasing power of investment assets is likely to greatly increase via compounding.

Let's also assume that cash can likewise lose its purchasing power over long periods (10+ years) via inflation. However the rate of this loss is typically slow and steady compared to the wild fluctuations investments can undergo. This all assumes we don't experience the unlikely event of a hyperinflation.

So what we're really comparing here is:

1. A store of wealth which might *greatly* lose its purchasing power over 5-10 years but probably greatly increases purchasing power over 10+ years
2. A store of wealth which probably *slightly* loses purchasing power over 5-10 years but definitely greatly loses purchasing power over 10+ years

So we could translate this into two pieces of advice:

1. Hold a portion of investments to fund purchasing 10+ years from now
2. Hold a portion of cash to find purchasing within the next 10 years

Once we have achieved what we consider to be a sufficient investment nest-egg, it seems totally sensible to accumulate a large cash buffer, to cover our living expenses over 10 years, in case our investments experience a protracted period of decline in liquid (cash) value.

Here's an example of an early-retirement portfolio based on these ideas:

Total net worth: $500k
Index funds allocation: $350k
Cash allocation $150k

Assuming living expenses: $15k per year

* Expected yearly income 10 years from now: $15k
This assumes a 4% real return on investments, plus a little supplementation from occasional part-time work and minimal taxation due to being in the lowest tax bracket.

* Expected yearly income over the next 10 years: $15k
The $150k of cash divided by 10 years equals $15k per year.
This assumes a small loss of purchasing power from inflation, which could be offset by occasional part-time work.

In this portfolio, cash is a valuable tool for ensuring a more predictable funding of expenses during early retirement. Rather than fearing inflation, we accept it and incorporate it into our planning. We gracefully deal with the downside of inflation while taking advantage of the upside of investment assets.

This puts pause to the claim that "cash is trash".

Thoughts?

[steveo73]

You are 100% correct. I think this is best summed up in the concept of sequence of returns risk (SORR).

https://earlyretirementnow.com/safe-wit ... te-series/

I'd go so far to say you need some cash/bonds especially at the start of your retirement.

If you honestly have a really low WR (say 3%) then I think you can just go 100% stocks and not worry. The key point is honestly and that is over the course of your lifetime. I think that would be extremely rare.

[prudentelo]

Continuing this logic leads to the Permanent Portfolio.

[AxelHeyst]

I'm somewhat unintentionally taking a run at this approach, at a small scale. I've got cash for 6+ years and intend to generate small income incidentally to turn that in to 10+yrs... So that I can just leave the rest of my (not large) portfolio alone for that entire time and maybe wind up not even touching it until a closer to traditional retirement age. Assuming it's still there then.

[Dream of Freedom]

Here's an example of an early-retirement portfolio based on these ideas:

Total net worth: $500k
Index funds allocation: $350k
Cash allocation $150k

Assuming living expenses: $15k per year

* Expected yearly income 10 years from now: $15k
This assumes a 4% real return on investments, plus a little supplementation from occasional part-time work and minimal taxation due to being in the lowest tax bracket.

* Expected yearly income over the next 10 years: $15k
The $150k of cash divided by 10 years equals $15k per year.
This assumes a small loss of purchasing power from inflation, which could be offset by occasional part-time work.

So a 4% real return for stocks compared to a -3% real return for cash or maybe -1.5% if you offset it with a cd ladder or similar, means a difference of 7% to 5.5%. At $150k that is $10,500 (70% of your yearly expenses) to $8250 (55% of your yearly expenses) per year.

Assuming you keep it all in stocks and the market falls 40% when you withdraw your yearly $15K, it would cost $6000 worth of assets (compared to the highs) for every year it remains down.

[theanimal]

You may be implying this, but you can keep your cash in T-Bills rather than under your mattress so to speak in a checking account. This way you still have the opportunity to get a return outside of a deflationary economy.

@Tyler9000 has a good post on cash on his site: https://portfoliocharts.com/2017/05/12/ ... -investor/

Portfolio Charts wrote:
.....
There are three important takeaways from that chart and the previous heat maps:

1.Cash is a dynamic asset and the return is not at all fixed
2.Cash correlates quite well to inflation
3.Cash does pretty well even in times of rising interest rates

That last point is especially important with today’s extremely low rates and a general worry that they have nowhere to go but up. In contrast to longer-maturity bonds that are particularly harmed by rising interest rates, cash actually benefits by continuously rolling over expiring bills into new higher yielding options. Cash is a fine asset in all investing environments.

[conwy]

So a 4% real return for stocks compared to a -3% real return for cash or maybe -1.5% if you offset it with a cd ladder or similar, means a difference of 7% to 5.5%. At $150k that is $10,500 (70% of your yearly expenses) to $8250 (55% of your yearly expenses) per year.

Assuming you keep it all in stocks and the market falls 40% when you withdraw your yearly $15K, it would cost $6000 worth of assets (compared to the highs) for every year it remains down.

It seems (but please feel free to correct me) your argument is that the longer-term expected return on $150k, invested in stocks, is higher than the expected loss from selling $15k worth of stocks per year over a 10-year period during which a 40% market fall occurs.

In rebuttal, my question would be: what if the market falls further than 40%?

Assuming your living expenses remain at $15k per year, selling stocks during such a drastic market decline could ruin even your 10+ year return.

So what the cash buys you is a buffer of time for your stocks to recover from any market decline drastic enough to impact your return 10+ years from now, assuming the stock market does recover over those 10 years.

Though I guess we could argue about whether 10 years is enough or whether longer might be needed. Maybe it's a question of probabilities.

[Dream of Freedom]

True, but a decline that much higher would only be caused by economic failure to a point that it would be unlikely there would be much left to buy with your cash either.

It is also a little unfair to dismiss the low possibility of hyperinflation while entertaining this. A 40% decline is rare. More is even rarer.

[conwy]

True, but a decline that much higher would only be caused by economic failure to a point that it would be unlikely there would be much left to buy with your cash either.

I'm not so sure about that. Any market cap weighted portfolio these days is dominated by a small number of very large companies. It's conceivable that most of those companies could go bust while all the other companies continued to operate. In fact it's conceivable that all the listed companies could go bust while a vast number of very small companies that never even listed continue to operate. This would be a drastically different economy, of course, but there would still be an economy and cash would likely still be useful in that economy.

I like to think of risk management in terms of searching for possible leaks and then plugging them as early and thoroughly as possible. If there's a way my strategy can fail, I want to cover it, even if that failure mode currently seems unlikely to eventuate.

So for me, holding a large amount of cash can cover cases/situations in which cash is useful while stocks experience a massive decline. I think that's a worthwhile strategy.

It is also a little unfair to dismiss the low possibility of hyperinflation while entertaining this. A 40% decline is rare. More is even rarer.

I agree hyperinflation is a possibility, which is partly why I like to be globally diversified in my stock holdings and am considering holding cash in several currencies (probably should make a thread on this).

Of course there's always the possibility of hyperinflation across all major currencies, but how would we protect against that?

I guess my question to you would be: given hyperinflation is a possibility (though unlikely) how would you suggest protecting against it?

[jacob]

Let's assume we agree that investments can lose their liquid (cash) value and thus their purchasing power for long periods (5+ years, if the Great Depression is any indication) and that there is no way to eliminate this possibility.

Let's for a moment proceed to not assume that. Negative or near zero real interest rates coincides with the revival of the FIRE movement and so many who have gotten into the saving&investing game in the past decade have never experienced positive real rates on cash. However, that is not the historical norm. Cash can and throughout the fiat currency era has had positive&nontrivial real interest rates. For example, investing in CDs replaced gold as the "The Thing" back in the 1980s (can't possibly lose money) before it in turn was replaced with dotcom stocks, then physical RE, and now [global] index funds has become "The Thing"---when global cash rates are near zero, the Fed model does wondrous things (think Dow36000). Currently there seems to be a bit of a battle for the hearts and minds^H^H^H^Hmoney between government fiat and crypto currencies which equity does not necessarily have to win.

In conclusion, almost any financial instrument that wins the Keynesian beauty contest and becomes "The Thing" can be your friend.

[WFJ]

I can only share my strategy. When working and earning an income, I'm usually nearly 100% equity, all US, front load contributions each year as much as possible (as aggressive to US equities as possible without leverage or buying ARKK/tech garbage). When not working, or nearing another ERE date (December is current estimate of end date), I'm anywhere from 50/50 to almost 0/100 with hedging (sell calls, sell futures) as I want to have 100% flexibility in what, where, when, how I use my capital and live life. The last 12 years (thanks to Yellen and Powell) there have not been a liquidity crunch where there are no buyers for assets at any price, but this is not constant feature of markets over long time periods.

One astonishing feature of the MMM/ERE community is the delusion that a 40% or 50% drawdown has the same probability of a Permian extinction asteroid hitting the Yucatan peninsula again. There is a 100% probability that any market can experience a greater than 50% peak to trough real value drawdown in any 50-year period. The probability a market experiences a 90% peak to trough drawdown is nearly 100% in any 100-year period.

My first exposure to a bubble in an asset was the Arabian horse bubble in the late 70's early 80's where someone offered my father 3x what our home was worth if he could get the backyard zoned for stables. He didn't want to do that to the neighbors (traffic and horses stink), months later Arabian horses were being "liquidated" as the cost to maintain the asset was much higher than the value of the "asset". Anyone who assumes "This can't happen to (insert asset class)" is delusional. I also remember going through bags of quarters as a child picking out pre-1960 quarters, the price of silver is down 80% from the peak in 1980. Plan accordingly.

[Toska2]

I am poorer than most on this forum (by choice :p). While I agree, I run a slightly "cash poor" variation from op. There's a variety of reason; youth, health and most importantly, agency.
Agency at work until I find a better transition to agency at play. I tried a couple years ago but I ended up too "simple". Having my days revolve around hiking and mtn biking had no depth.

[Dream of Freedom]

It is interesting to see how

A 40% decline is rare. More is even rarer.

becomes...

One astonishing feature of the MMM/ERE community is the delusion that a 40% or 50% drawdown has the same probability of a Permian extinction asteroid hitting the Yucatan peninsula again.

Straw man much?

[Mister Imperceptible]

1.Cash is a dynamic asset and the return is not at all fixed
2.Cash correlates quite well to inflation
3.Cash does pretty well even in times of rising interest rates

That last point is especially important with today’s extremely low rates and a general worry that they have nowhere to go but up. In contrast to longer-maturity bonds that are particularly harmed by rising interest rates, cash actually benefits by continuously rolling over expiring bills into new higher yielding options. Cash is a fine asset in all investing environments.

I think when one looks at 1970s and 1980s data in particular it shows that cash as an asset pays an attractive yield when the yields are priced to indicate that the sovereign bank’s credibility is in doubt and therefore the yields on offer are close to the rate of inflation.

Compare with today and the future and ask if you expect the yields on currency offer to compensate you for the loss of purchasing power in that currency.

This is the difference between cash strategically held as a long term positive expectation bet and cash strategically held for tactical deployment.

[conwy]

However, that is not the historical norm. Cash can and throughout the fiat currency era has had positive&nontrivial real interest rates. For example, investing in CDs replaced gold as the "The Thing" back in the 1980s (can't possibly lose money) before it in turn was replaced with dotcom stocks, then physical RE, and now [global] index funds has become "The Thing"---when global cash rates are near zero, the Fed model does wondrous things (think Dow36000).

I'm old enough to remember catching the tail end of that era in Australia (which I guess lags the US). I can definitely recall a time when the consensus was that one should put one's excess money into high interest savings accounts paying as much as 5-6%.

This all makes me think that a lot of the stories told about the stock market, even where backed up by over a century of historical data, have some significant "this-century" biases. Especially, it seems like the long periods of poor returns (e.g. the crash of the 1920s) are glossed over, as if future similar periods would have equally predictable end-points, when in fact, there's no way to prove such a thing (as many footnotes quietly admit, historical returns do not predict future returns).

Currently there seems to be a bit of a battle for the hearts and minds^H^H^H^Hmoney between government fiat and crypto currencies which equity does not necessarily have to win.

Yep, I'm seeing this too with current crypto celebrities, e.g. Peter Thiel touting Bitcoin as a rival to the S&P 500.

In conclusion, almost any financial instrument that wins the Keynesian beauty contest and becomes "The Thing" can be your friend.

Fascinating link, thanks. I really need to crack open Keynes and try to really understand the modern economy for what it is.

[conwy]

I am poorer than most on this forum (by choice :p). While I agree, I run a slightly "cash poor" variation from op. There's a variety of reason; youth, health and most importantly, agency.
Agency at work until I find a better transition to agency at play. I tried a couple years ago but I ended up too "simple". Having my days revolve around hiking and mtn biking had no depth.

I'm going through a similar reflection on my life and agency. For me, materially frugal, time rich living opens the door to a fresh, new kind of agency - mental, physical and social. I find hiking to contain endless depth, once I get beyond some early (mostly anxiety-induced) resistance. This kind of psychological rewiring seems a necessary part of early retirement for some. Maybe books have (or should) be written on the topic.

[conwy]

I can only share my strategy. When working and earning an income, I'm usually nearly 100% equity, all US, front load contributions each year as much as possible (as aggressive to US equities as possible without leverage or buying ARKK/tech garbage). When not working, or nearing another ERE date (December is current estimate of end date), I'm anywhere from 50/50 to almost 0/100 with hedging (sell calls, sell futures) as I want to have 100% flexibility in what, where, when, how I use my capital and live life. The last 12 years (thanks to Yellen and Powell) there have not been a liquidity crunch where there are no buyers for assets at any price, but this is not constant feature of markets over long time periods.

Interesting, but not sure I understand - when you say "50/50" or "0/100", are you saying you sell 50% to 100% of your stocks and hold cash during a non-working mini-retirement, then build it back up by working after it's depleted?

This seems kind of scary but maybe you found a way to make it work for you? I imagine there could be some tax efficiencies.

I'm thinking of planning my life in 3-month intervals - each 3 months living off the investment income of the prior 3 months, supplementing it with occasional 3-month periods of work for periods where I realise a net loss in my portfolio.

One astonishing feature of the MMM/ERE community is the delusion that a 40% or 50% drawdown has the same probability of a Permian extinction asteroid hitting the Yucatan peninsula again. There is a 100% probability that any market can experience a greater than 50% peak to trough real value drawdown in any 50-year period. The probability a market experiences a 90% peak to trough drawdown is nearly 100% in any 100-year period.

Indeed.

Also I find it odd that the financial independence community so often frames big market drawdowns as just a psychological game. But in fact, no matter how psychologically "prepared" you are, you still need some cash after all, to pay for rent and/or groceries! So your minimum yearly expenditure will force you to sell stocks from a 100% stock portfolio. This isn't psychology, it's math and physics.

Cash isn't a mere psychological safety buffer for someone with weak conviction, it's likely a physical necessity for anyone who wants to be able to pay their bills during a massive drawdown, and whose stock holdings aren't in the multiple millions of dollars.

[steveo73]

Also I find it odd that the financial independence community so often frames big market drawdowns as just a psychological game.
....
So your minimum yearly expenditure will force you to sell stocks from a 100% stock portfolio. This isn't psychology, it's math and physics.

To me the FI community is 100% correct (I'm not sure the FI community actually says that - that is your impression). The only issue is selling stocks in a downturn but if you are prepared for that and it works (the psychological game) then you are good.

100% stock portfolios can work and probably work well if you have the aptitude for that.

I'd love to be 100% stocks but I'd only do it with a bigger portfolio. I'd only buy commodities or crypto etc with a bigger portfolio as well. These are though personal preferences.

[frommi]

Also I find it odd that the financial independence community so often frames big market drawdowns as just a psychological game. But in fact, no matter how psychologically "prepared" you are, you still need some cash after all, to pay for rent and/or groceries! So your minimum yearly expenditure will force you to sell stocks from a 100% stock portfolio. This isn't psychology, it's math and physics.

Just live of dividends/interest alone, problem solved. No need for cash. cash just drags down your long term expected return.

[conwy]

Just live of dividends/interest alone, problem solved. No need for cash. cash just drags down your long term expected return.

Dividends can be cut.

Cash doesn't drag anything down if you already have as much stocks as you want.