I think we can consider a few downside scenarios to start.Thank you all for the insights, gives me a lot to digest. Will try to resist the “do something itis” that Sandtrap mentioned which is easy to fall into when not working.At OP level of assets it makes sense to maximize protection from various downside scenarios, but 20% cash is not a good way to do that.
Rogue Economist: I note your view that this was too much cash / not the way you would shelter from downside scenarios. What do you favor for this and what’s your approach?
1.Recession/Depression—Equity markets down, low inflation or even deflation. This is a good time to have cash, but historically these have been relatively short periods (the great depression in the Gold Standard era is probably not a relevant basis of consideration now)
2.Stagflation—Equity markets perform poorly, but inflation is also high. This happened in the 70's and is a bad time to have cash. Also, in this case your equities aren't keeping up with inflation.
3.Negative Real Rates—This was a more recent issue we encountered following 2008. For a long time after the financial crisis and until recently cash, especially FDIC insured cash, paid rates less than inflation. While the equities markets did well overall and kept up with inflation (as they should over the long term) the negative real rate on cash puts a lot of drag on a portfolio that can be an issue if you are looking at a long retirement.
The common thread with all of these is inflation and its risk to cash. So the shelter from these needs to be inflation resistant. A few options for that.
1. Equities. Over the long haul, equities should take into account whatever inflation we have, even extreme inflation that has fortunately not struck the US in a very long time. However, as equities are volatile this is only protection over long periods, and assuming you already have an appropriate equities allocation in the portfolio they cannot add much beyond that.
2.Treasury Inflation-Protected Securities (TIPS) which are US bonds paying interest on a principal that adjusts for inflation. These are very popular with Bogleheads. Volatility is of course low since we are dealing in US government debt, so these can help inflation protect the portion of the portfolio not in equities. However, one issue I have with them, which is not necessarily brought up frequently, is a skepticism that in extreme inflation scenarios there would not be any kind of "soft default" etc. since they represent only a promise of future tax dollars, not real productive capital like equities. For the most part this is probably not a major concern as long as you have sufficient equities in the portfolio.
3.Fixed rate, low interest debt. Interestingly low interest debt can hedge against inflation. Consider this, suppose you move and buy a new house for say $500k. You put 20% down and borrow $400k at 3.5% (a rate which was possible not long ago). Now with 30 year fixed rates, you are borrowing at 3.5%. Inflation is running 2% on average, so your real rate is 1.5% (lets assume no tax benefit from paying the interest, although in 2026 when the tax cuts expire the deduction on paying interest may lower the effective rate a bit further). Your other investments are paying at least a 1.5% real yield, so you come out ahead. But, if any time during the next 30 years you have high inflation, the real value of the fixed rate debt is effectively eroded. Obviously this isn't as simple as buying a different kind of asset and requires favorable interest rates, but its worth considering as a way to hedge against high inflation. And of course, its not really an alternative to cash per se.
4.Gold and Silver. Metals are not especially popular with Bogleheads, but over the long run they do generally act as a good inflation hedge, at least compared to cash. Unlike other investments, you can keep them yourself which provides an additional store of value resilient to all kinds of extreme downside scenarios that only come up every few generations but that tend to be very painful when they do (war, famine, conquest, pestilence, etc). A 5% allocation of metals might be enough to improve the safe withdrawal rate in certain downside scenarios like Stagflation, while also being enough wealth that you would be better off than the vast majority of people in one of those "extreme downside" scenarios. Arguably, for someone who has "won the game" the minor potential hit to total return versus equities seems worth the potential upside in tail risk scenarios.
5.Land. They can't make more of it, and it rarely goes down in value. You might consider either having a larger plot to live on if you move or a nice getaway piece somewhere else. Depending on what you get it can generate some revenue, which helps offset the taxes (timber sales, hunting lease, grazing lease, etc). Downside is of course its difficult to impossible to get small amounts of this value out every year or re-balance in a portfolio due to terrible liquidity which in a sense makes it the opposite of cash. But in 30 years if you are downsizing, consolidating, etc. it will probably have done better than the cash. This probably makes sense only if you would get some other utility or enjoyment out of it as well.
Statistics: Posted by rogue_economist — Fri Jul 19, 2024 12:14 am