# Avoid sequence of return risk by using cash wedge and increasing equity ratio later



## janus10 (Nov 7, 2013)

I've heard of something similar to this idea postulated. The idea is to create a cash wedge of 5 years of anticipated retirement expenses by laddering GICs or Bonds so that you have cash handy for the first year, and then 1, 2, 3 and 4 year term interest investments.

The other wrinkle is that you actually have a high fixed income ratio upon retirement and gradually move to a higher equity ratio as time goes on.

For example, maybe you start 80-20 FI/EQ and then gradually move to a 40-60 FI/EQ ratio.

I'd imagine you also could adjust for when you're eligible for various government programs to quickly transform to a higher equity ratio.

Anyone adopting (or already adopted) this strategy?


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## gibor365 (Apr 1, 2011)

The best possible rate for 5 y GIC right now is 2.75% at oaken, but even if you making 5 mil ladder, you will get per year just 27,500 that is not enough for living... also CDIC limit is only 100K....so I don;t get how such strategy is useful


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## livewell (Dec 1, 2013)

This is the strategy I am using. Been retired 3+ years now, pre CPP/OAS no DB pensions, I have an asset allocation of 65%/35% equity/FI+cash. With a 5 yr (20 rung) GIC ladder + cash I have ~5 years cash wedge. This is neglecting the dividend income my equity stream returns which reduces the needed cash wedge. The equity portion dividend income gives me ~50-60% of my annual income. So I think my cash wedge is really significantly longer than 5 years, though in a downturn I would expect some dividend cuts would lower my income. 

I have done some 'mathematical' stress testing, based on 30-50% falls in equity and how I would re-balance my asset allocation (Buying more equities, reducing the cash wedge) seems to work for me, but has not yet been through the emotional test (Can I burn income + buy equities with a reduced portfolio.)


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## humble_pie (Jun 7, 2009)

,

i realize that so far i haven't grasped the euclidean beauty of all this geometry. But admittedly, i am kind of a slow bulb.

the only advantage my dim wits have been able to perceive so far is that this sounds like a helluva good plan for the heirs. Assuming that stocks will continue to outperform over half-century time frames.

still, i'm hung up on the 5-year anniversary. At that point in time, theoretically speaking, our senior's cash wedge has been spent. It's gone. All that remains are equities. Doesn't that make our senior even more vulnerable to crash losses?


.


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## james4beach (Nov 15, 2012)

janus, in case you haven't seen this, here is Pfau's 2013 paper describing this concept
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2324930

Here's an article about that paper's findings. There's no 5 year deadline, but a gradual increase in % stocks.
http://www.nytimes.com/2013/09/14/y...retirees-on-its-head.html?smid=tw-share&_r=2&

And a nice article about sequence of return risk
http://www.marketwatch.com/story/how-to-avoid-sequence-of-return-risk-2013-09-28

Pfau says the greatest risk to a retiree is a weak stock market -- a bear market -- in the first few years of retirement. A high fixed income allocation in the early years of retirement mitigates that risk.

~ But remember this! ~

If you haven't already, read Jim Otar's work as it's eye-opening. (He's a University of Toronto engineer by the way). Otar has a PDF book available. To get straight to the critical mathematical points, see his article on the inherent flaws of Monte Carlo simulation based retirement projections: http://www.retirementoptimizer.com/articles/MCArticle.pdf

Otar's work is essential reading because it shows the systemic flaws / shortcomings in the kinds of analysis that Pfau (and everyone else) initially did. I'll sum it up in one sentence: the models used by the MC simulations don't adequately describe real markets, and miss some really big effects like secular market trends.

I don't think those criticisms apply to Pfau's 2013 work, but it's still worth reading and becoming familiar with.


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## james4beach (Nov 15, 2012)

I can't seem to download this Pfau 2013 paper but from what I can see in the summaries of it, they ran historical market data and didn't just rely on idealized Monte Carlo simulation. I think this means that the Pfau 2013 work doesn't suffer from the flaws that Otar raised.

By the way, we had a thread discussing some of these modelling criticisms
http://canadianmoneyforum.com/showthread.php/63346-Jim-Otar-s-method-of-retirement-modeling


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## humble_pie (Jun 7, 2009)

vaguely i remember moneyGal's posts in the linked plus even earlier threads.

returning to the practical basics: retiree believes he's mitigating the risk of a market collapse during his first 5 years of retirement by selling a portion of a 5-year cash wedge each year & supposedly replacing with stocks.

but how can he replace with stocks? he's selling because he has to spend the proceeds to buy the daily bacon & pay for the daily roof, right? the cash wedge is being depleted across 5 years, correct? if markets go south during his 5 years, he'll be left with zero cash & only a basket of crashed equities, no?

on the other hands, if markets climb during his 5 years he'll be in clover. Make that clover plus. He'll be in heaven. It's like he'll have a giant 5-year bull call option with all interest & margin costs prepaid.

it seems to me that under the first scenario - falling markets - he would have done significantly better with a balanced portfolio. Live off income stream plus redeem when necessary.

under the second scenario - rising markets - it seems to me he would do better with a strict cash wedge. 

on the other hand, in the second scenario he could have maintained balanced while adding bullish options. That way he would have been prepared for the first scenario at all times.


.


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## humble_pie (Jun 7, 2009)

livewell said:


> This is the strategy I am using. Been retired 3+ years now, pre CPP/OAS no DB pensions, I have an asset allocation of 65%/35% equity/FI+cash. With a 5 yr (20 rung) GIC ladder + cash I have ~5 years cash wedge. This is neglecting the dividend income my equity stream returns which reduces the needed cash wedge. The equity portion dividend income gives me ~50-60% of my annual income. So I think my cash wedge is really significantly longer than 5 years, though in a downturn I would expect some dividend cuts would lower my income.
> 
> I have done some 'mathematical' stress testing, based on 30-50% falls in equity and how I would re-balance my asset allocation (Buying more equities, reducing the cash wedge) seems to work for me, but has not yet been through the emotional test (Can I burn income + buy equities with a reduced portfolio.)




livewell i returned to look more carefully at your post since you say you are walking the walk. Plus your figs are not altered - one might even say contaminated - by any OAS/CPP/pension income. At least, i imagine no pension income is what you mean when you say no DB pensions.

first, may i mention i'm not looking to pry out any extra information. I just think yours is a good real-life example. I hope this is OK with you.

looking at your stated situation, i can't see that it differs radically from a balanced portfolio.

you mention that the cash wedge is sufficient to carry you for at least 5 years. The projection doesn't include the stream of dividend income from equities, although you indicate that this stream is 50-60% of total annual income. 

of course, receiving the income doesn't equate to spending the income, so is one correct to assume that in a classic cash wedge strategy, the retiree reinvests all dividend income while regularly invading capital in order to spend a portion of the cash wedge on daily living costs?

this would work wonders across a 5-year bull market. Not good across a 5-year bear market though, unless i'm missing something.

on the other hand, a retiree who uses part or all of the dividend income stream to pay for daily living expenses surely cannot be said to be practicing a classic cash wedge strategy. I'm still left thinking that cash wedge works at its best only in bullish market phases. 

then i'm left thinking that classic balanced plus a bullish option strategy on the side will do the exact same income-producing job. Meanwhile it will smooth performance across all kinds of markets & certainly perform better in a bearish scenario. Not to speak of a global crash scenario, where balanced would outshine.


.


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## livewell (Dec 1, 2013)

humble_pie said:


> ...
> of course, receiving the income doesn't equate to spending the income, so is one correct to assume that in a classic cash wedge strategy, the retiree reinvests all dividend income while regularly invading capital in order to spend a portion of the cash wedge on daily living costs?
> 
> this would work wonders across a 5-year bull market. Not good across a 5-year bear market though, unless i'm missing something.
> ...


I have not interpreted a cash wedge as one that depletes doing the first 5 years, as you say that seems a bit silly. If that is a 'classic cash wedge' then I am not doing that. For me the idea is the cash wedge is to be used/depleted during extended bear markets. The whole premise as I understand it is to avoid selling equities when they have fallen significantly. During a bull market I plan to top the cash wedge up (By basically rebalancing my portfolio back to 65%/35%)


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## humble_pie (Jun 7, 2009)

livewell said:


> I have not interpreted a cash wedge as one that depletes doing the first 5 years, as you say that seems a bit silly. If that is a 'classic cash wedge' then I am not doing that. For me the idea is the cash wedge is to be used/depleted during extended bear markets. The whole premise as I understand it is to avoid selling equities when they have fallen significantly. During a bull market I plan to top the cash wedge up (By basically rebalancing my portfolio back to 65%/35%)



i'd thought your strategy as you originally posted it upthread looked exceptionally sensible. I think everything you've mentioned in the above post looks exceptionally sensible. Especially the part about tapping into the cash wedge - one could also say tapping into short-term fixed income product - during extended bear markets.

i intend to try exactly this myself. There is a certain mild aspect of long-term market cycle prediction involved here, as otherwise how does an investor determine when he's in a bear market or a bull market.

another governing factor will be portfolio size. A large portfolio can have a normal amount of cash, yet the same will be sufficient to sustain a retiree for 5 years ...

still, my understanding of classic cash wedge is quite different from all of the above. My understanding of CCW is that it involves strictly spending the cash - & nothing but the cash - across the first five years of retirement, regardless of market conditions. This is an approach that appears fraught to me, at least under some scenarios.


.


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## james4beach (Nov 15, 2012)

Again I'll point you all to Pfau's paper which describes this concept janus raises... along with detailed simulations based on it
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2324930

But the study doesn't use a 5 year fixed time frame, so I'm not sure that's a good idea. The study says:



> Generally, depending on the underlying assumptions, the optimal starting equity exposures are around 20% to 40% and they finish at around 40% to 80%.
> ...
> 
> The highest success rate on the chart, signified by the standalone box around the result, *shows that an initial allocation of only 30% in equities at retirement, rising to 80% by the end of retirement, actually provided the highest success*. More generally, any allocations that begin at 20% to 40% in equities and finish at 60% to 80% provided the highest success rates, which is notable given that they have less equity exposure during the years when the portfolio size effect is greatest. In addition, these outcomes are typically superior to static asset allocations that simply maintain the same average equity exposure throughout retirement.


What this result means is that as you finish your working years and enter retirement, you boost your fixed income way up, to something like 70% fixed income (bonds and GICs). Basically you retire with very minimal stock exposure. Then, in your ongoing rebalancing, you gradually raise your equity allocation.

I have repeatedly suggested to my parents that they begin retirement with a high fixed income allocation similar to this.


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## janus10 (Nov 7, 2013)

gibor365 said:


> The best possible rate for 5 y GIC right now is 2.75% at oaken, but even if you making 5 mil ladder, you will get per year just 27,500 that is not enough for living... also CDIC limit is only 100K....so I don;t get how such strategy is useful


As you and HP incorrectly and understandably assumed, but livewell articulated beautifully, the cash wedge is your buffer to be depleted in a bear market so you don't have to sell in a down market, and replenished in a bull market. I've recommended this book multiple times, and I'll do so again (could be available in your local library) - "Your Retirement Income Blueprint" by Daryl Diamond. 

The idea is not to simply build up a cash wedge and immediately deplete it upon retirement. I also made the mistake of thinking that was the purpose - until I read Daryl's book. You could liken it to an emergency cash fund while working - you hope to never use it, but if you do, it is there. And, when you get back on your feet, top it up again so that you can ride out a lengthy bear market.

The other concept that I really wanted to focus discussion on is the Rising Equity versus Declining Equity. I think james has found some articles - but I haven't read the entire thread of posts yet!

We already have more than enough to implement a 5 year cash wedge. It would be relatively easy to move from 40/60 to 70/30 or some other fixed income/equity ratio as it stands right now. But, I've not committed a single dollar to a GIC or any other term instrument - it's all in cash (RRSPs, TFSAs, margin and savings/chequing accounts). If the right opportunity comes up, then I'll utilize the cash to trade.


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## OnlyMyOpinion (Sep 1, 2013)

Daryl's blog gives a brief summary (in 3 parts): http://www.boomersblueprint.com/blog/2014/06/the-cash-wedge-an-income-delivery-process-%e2%80%93-part-1/


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## janus10 (Nov 7, 2013)

livewell said:


> This is the strategy I am using. Been retired 3+ years now, pre CPP/OAS no DB pensions, I have an asset allocation of 65%/35% equity/FI+cash. With a 5 yr (20 rung) GIC ladder + cash I have ~5 years cash wedge. This is neglecting the dividend income my equity stream returns which reduces the needed cash wedge. The equity portion dividend income gives me ~50-60% of my annual income. So I think my cash wedge is really significantly longer than 5 years, though in a downturn I would expect some dividend cuts would lower my income.
> 
> I have done some 'mathematical' stress testing, based on 30-50% falls in equity and how I would re-balance my asset allocation (Buying more equities, reducing the cash wedge) seems to work for me, but has not yet been through the emotional test (Can I burn income + buy equities with a reduced portfolio.)


I'll have to make a mental note to follow your posts as you sound like you are relatively close to where I'd like to be in <5 years. I don't think I'll have as much dividend income contributing to my overall income, however. 

20 rungs on the ladder?! Does that mean you have something coming due every 3 months? Would that mean that you would not have an easy time taking advantage of a market correction to buy the dip because there wouldn't be any free capital to deploy? Or, did your stress testing for the significant correction involve reducing the cash wedge by cashing out early?

Missing out on that kind of opportunity would be a concern of mine. That's why I would want to have additional cash beyond the cash wedge.


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## OnlyMyOpinion (Sep 1, 2013)

janus10 said:


> ...Would that mean that you would not have an easy time taking advantage of a market correction to buy the dip because there wouldn't be any free capital to deploy? ... Missing out on that kind of opportunity would be a concern of mine. That's why I would want to have additional cash beyond the cash wedge.


In its 'pure' form, maturing GIC's in a cash wedge are intended to pay for your ongoing retirement expenses, not to fund new equity purchases.
It sounds like Livewell may work with a permutation of the cash wedge though. We do also. We have a 'cash wedge' consisting of 5 yrs + of maturing strip bonds that we move to our chq acc to pay for expenses (2nd year into retirement). Our equity slice is 'for the future' and its dividend income is still DRIP'd.


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## livewell (Dec 1, 2013)

janus10 said:


> 20 rungs on the ladder?! Does that mean you have something coming due every 3 months? Would that mean that you would not have an easy time taking advantage of a market correction to buy the dip because there wouldn't be any free capital to deploy? Or, did your stress testing for the significant correction involve reducing the cash wedge by cashing out early?
> 
> Missing out on that kind of opportunity would be a concern of mine. That's why I would want to have additional cash beyond the cash wedge.


 Yes every 3 months I roll over a 5 yr GIC (The latest was at a spectacular 1.95%!?) Not having cash available for buying opportunities is not really a problem, I keep a years spending money in an HISA, and in all my investment accounts the dividends pile up together with un-spent cash. I would actually like to have a higher FI/cash ratio, but I struggle to buy bonds, and other FI and with current FI climate (The brokerage HISA at 0.8% vs 5yr GIC at ~2%) its almost reached the point where it is not that relevant. The harder part is whether in a market correction I will have the emotional fortitude to buy more stocks whilst also depleting the cash wedge. I played around with what-ifs where stock portfolio fell 30 and 50% and fell over 1 and 2 yrs, and could I maintain and re-balance to a 65/35 allocation. Mathematically it is easy to do and buy the dips, the reality when markets are going down and you don't know where or when the bottom will be reached will be harder.

the problem I am having today, is when and how to re-balance. So far in last 3 years since retirement my equity/FI ratio has not really drifted much despite the regular drawdown, But now my equity is starting to push close to 70% and I have planned to re-balance at +/- 5% (But not more than once every 12-18 months). So I will probably sell some stocks soon, but do I sell the dogs (a strong temptation but then you are selling low which is likely bad) selling the winners seems risky. I do own a couple of positions in XIC, and XIU that I bought a longtime ago, so I will probably avoid the stock decision and just sell these.

I have a fairly high risk tolerance (Hence my 65/35% allocation) but it is a funny feeling when you are living off your portfolio and are drawing an income from it, it is very different to accumulation mode.


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## james4beach (Nov 15, 2012)

I see that a few of us interpreted the notion of a "cash wedge" differently.



> the cash wedge is your buffer to be depleted in a bear market so you don't have to sell in a down market, and replenished in a bull market


I like this idea. A buffer, or emergency fund as you put it. During a bear market you draw down from the cash instead of liquidating securities.


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## OnlyMyOpinion (Sep 1, 2013)

_The idea is not to simply build up a cash wedge and immediately deplete it upon retirement. _
Hmm, not how I interpret it. From the link I provided above: 
_"2. Within the fixed-income portion of the portfolio, create a cash position equal to the income needed for the first 12 months. You will draw your income from this cash position. This is the source for your income because cash does not fluctuate. Also acquire a one-year and a two-year GIC or bond in order to create the source of income for years two and three. As they mature, simply move the proceeds to the cash account to replenish it and continue your income withdrawals. At the outset, this provides three years of guaranteed income. It could also be set up for two or four years, depending on your situation and your preferences"
4. If the equity selections provide investment returns that will allow you to take profits and replenish the Cash Wedge, it may make sense to renew the GICs or bonds. The objective is to maintain a multiple of income payments within the Cash Wedge by taking profits where and when appropriate from the other investments within the portfolio. You want to maintain it but not have too much money in this form.
5. Any profits realized that do not need to be used to restore the Cash Wedge can be used to acquire additional units or positions in the investments that are flat or negative.."_


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## gaspr (Mar 24, 2014)

Michael Kitces has written a blog entry on this topic

https://www.kitces.com/blog/researc...s-dont-work-unless-youre-a-good-market-timer/


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## OnlyMyOpinion (Sep 1, 2013)

gaspr said:


> Michael Kitces has written a blog entry on this topic
> https://www.kitces.com/blog/researc...s-dont-work-unless-youre-a-good-market-timer/


Thanks, very interesting reading. 
Fortunately we're not concerned about the sustainability of our retirement income, so we can tilt for the psychological benefit even if total expected returns are less optimal. I can see risks if your nest egg is insufficient or you are overly conservative with your cash though.


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## janus10 (Nov 7, 2013)

Apologies to HP, OMO et al. I mixed my own strategy for the cash wedge up with the authors intention.

I ran into the same difficulty that HP alluded to, namely how would I, knowing my tendencies, continually earmark additional capital to replenish the 5th year expense requirements.

So I plan on approaching it differently. With a lot more cash than the next 12 months of expenses so that I can always be ready to buy after a correction and still not be forced, except in lengthy downturns, to liquidate equity positions.


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## humble_pie (Jun 7, 2009)

janus10 said:


> As you and HP incorrectly ...assumed ...



lol i didn't think i'd assumed anything, either correctly or incorrectly .each:

i did struggle as best i could through 60% of the plannerspeak in an effort to understand the mystical perfection of a cash wedge that might ease my retirement.

but alas one can see in this thread that the term *cash wedge* is meaningless. it means something competely different to each individual investor on here.

sorry to fail so badly at this euclidean perfection but how is cashwedgebufferplannerspeak really any different from good old-fashioned proper financial management. Sell Hi. Don't Sell Lo. Never Ever Sell Lo. Keep Plenty Cash for Emergencies. KISS.


.


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## canew90 (Jul 13, 2016)

Is the post suggesting that one accumulate what might be 5 years of income in retirement? I've been retired for 10 years and it sounds Dumb to me. I can't think of a situation where I'd want that amount of money tied up in fixed assets generating next to no income during retirement. I've invested to generate income and now my dividends are almost 2 and a half times our annual expenditures. That's how one creates a cash wedge, by ensuring their income exceeds their expenses.


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## OnlyMyOpinion (Sep 1, 2013)

Canew, I agree, your method does not require a cash wedge, especially if you are generating 2x the income you need from dividends - lots of buffer there. 
But in the instance where you don't have enough total capital saved to generate all of the income you require; where you need to sell off some of your holdings each year to provide cash; and when your portfolio has substanial equities - you don't want to have to be selling in a down market early into your retirement to cover your expenses. The plan does have its critics though.


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## Spudd (Oct 11, 2011)

OnlyMyOpinion said:


> Canew, I agree, your method does not require a cash wedge, especially if you are generating 2x the income you need from dividends - lots of buffer there.
> But in the instance where you don't have enough total capital saved to generate all of the income you require; where you need to sell off some of your holdings each year to provide cash; and when your portfolio has substanial equities - you don't want to have to be selling in a down market early into your retirement to cover your expenses. The plan does have its critics though.


In my opinion, if you have a balanced portfolio - i.e. the classic couch potato of can/us/intl/bonds - there will always be something that is not doing as badly as the others that can be sold off to buy groceries. Rebalance by selling the asset class that's the highest out of line (e.g. if you plan to be 40% bonds but you're 45% bonds instead, sell bonds that month).


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## GreatLaker (Mar 23, 2014)

Spudd said:


> In my opinion, if you have a balanced portfolio - i.e. the classic couch potato of can/us/intl/bonds - there will always be something that is not doing as badly as the others that can be sold off to buy groceries. Rebalance by selling the asset class that's the highest out of line (e.g. if you plan to be 40% bonds but you're 45% bonds instead, sell bonds that month).


This article documents a methodical way to do that. It uses ETFs, but the same technique could be used with stocks for equity and bonds / GICs for fixed income.
http://www.moneysense.ca/save/retirement/a-better-way-to-generate-retirement-income/

(Moneysense has a paywall, but usually allows a couple of free articles each month)


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## humble_pie (Jun 7, 2009)

isn't it all a bit like underwear or toothpaste though

everybody has some but the brand differs vastly from person to person

my universal takeaway from all the contrasting & conflicting links that have been posted here remains the same. Don't Sell Lo. Never Ever Sell Lo. Keep Cash on Hand instead.

on some days one might want to add Sell the Children.

.


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## canew90 (Jul 13, 2016)

Spudd said:


> In my opinion, if you have a balanced portfolio - i.e. the classic couch potato of can/us/intl/bonds - there will always be something that is not doing as badly as the others that can be sold off to buy groceries. Rebalance by selling the asset class that's the highest out of line (e.g. if you plan to be 40% bonds but you're 45% bonds instead, sell bonds that month).


Each to their own, but I know I would not have the income from my investments if I had followed that advice. Now that I look back and have the income I do, it's easy for me to make such claims.


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## james4beach (Nov 15, 2012)

Spudd said:


> In my opinion, if you have a balanced portfolio - i.e. the classic couch potato of can/us/intl/bonds - there will always be something that is not doing as badly as the others


Except there are only two asset classes in there: stocks and bonds. I think your general idea is sound, but I prefer adding gold and cash as additional asset classes, so that you have a mix of 4 asset classes as per the permanent portfolio.


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## My Own Advisor (Sep 24, 2012)

james4beach said:


> janus, in case you haven't seen this, here is Pfau's 2013 paper describing this concept
> http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2324930
> 
> Here's an article about that paper's findings. There's no 5 year deadline, but a gradual increase in % stocks.
> ...


Great links James. 

This is where I believe the cash wedge is critical - you can insulate yourself from blindly adopting retirement rules of thumb like the 4% rule - which should be closer to 3% anyhow - given we are no longer in an environment whereby bond yields are double-digits let alone returns are in the double-digits - such as professed in _The Wealthy Barber._

Like cannew, I've decided to be more of an income investor going forward. You cannot count on capital gains (never have) for long-term returns. You can expect them, say 3-4% real returns over the coming decade, but you cannot count on them. I prefer to rely on a health dose of dividends and capital gains whereby the former, is tangible cash.


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## james4beach (Nov 15, 2012)

I agree with you about SWR being closer to 3%. From my earlier research I got a SWR figure of 3.3% - but yes, not to be adopted blindly


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