Uncertainty vs Risks….part 2

A few months earlier, I talked about the difference between Uncertainty and Risks (https://humblefi.com/2019/07/14/uncertainty-vs-risks/). If you read that post, it would be a really good foundation to understand this post. So, I encourage you to take a peek at that first.

Genuine Uncertainty vs Risk

The basic thesis of the first post was to differentiate between two things:

  • Genuine Uncertainty
    • Events that come of of nowhere like the 2008 global recession
    • Since we do not know when such events happen, how can one create a risk mitigation plan?
  • Risk
    • Events are known and also the probability of occurrence is also known
    • For example, for a recession, here are some possible events with different risk probabilities.
      • Portfolio loss during recession
        • Probability: 80-100%
        • Risk mitigation Plan
          • Keep some cash aside to avoid selling stocks when they are down.
          • Keep some case to keep investing to dollar-cost-average down
      • Job loss during recession
        • Probability: 20%
        • Risk mitigation Plan
          • Emergency fund to last 6 months without a job
          • Life insurance outside of work….
          • Network with people in other companies
          • Always be ready to interview.

Dealing with Genuine Uncertainty and ordinary risks

The basic question that came to me was: what financial system can I set up to deal with both Genuinely Uncertain events and ordinary risk events? Lets capture all the risk events that I want the system to handle.

  • Inflation Risk
    • Cash funds and many bond funds have yields less than 3% inflation.
    • I.e. we need funds with total return (dividends + capital gains) of greater than 3%…mostly implies equity funds.
  • Falling Interest Rates Risk
    • Negative rates anyone…reduces Cash and bond fund returns a lot.
    • This also implies some sort of equity funds.
  • Rising Interest Rates Risk
    • Reduces stock market returns by making borrowing costly
    • Newer bonds will offer more yield i.e. older bonds lose value
    • This implies some sort of bond funds.
  • Longevity Risk
    • If all assets are in cash and bond funds, inflation can eat into them and we may have more life left when the portfolio is down to zero.
    • Historically, inflation protected assets have been stocks, tips, real estate,….
  • Sequence of Returns Risk
    • Retiring when there is a bear market means that stock assets could be worth less than paid for. I.e. drawing down on portfolio which is down, at the beginning of retirement, has been proved to be bad news for a portfolio.
    • For example, 2008 Bear market was a Genuine Uncertainty event
      • Between down market and up market, it took almost 5-7 years
      • Nobody can predict when such an event can happen
    • Dr. Wade Pfau has done a lot of research here which a normal person can read and understand 🙂
  • Job loss risk
    • Need to sustain household expenses for some time until the next job can be found.
    • This time period can be 1-2 years…from seeing folks around me going through some rough times.
  • Health Scare risk
    • Need to have sufficient cash reserves for a health scare when one cannot work
    • Also, need some income protection as well.

After considering the above risks, some of which I have personally experienced and/or have been around people who experienced it, I can sort them into three buckets based on time:

  • Short term risks mitigation for 1-2 years
    • Temporary job loss, health scare, family emergencies like sick parent, etc
  • Medium term risks mitigation for 5-7 years
    • Serious health scare, long term disability, 2008 type bear market (aka sequence of return risk), etc
  • Long term risks mitigation for 30 years
    • investments to overcome longevity risk, overcome inflation risk, etc

System 1: Passive Income Streams

There are two components of this system that I followed for the past 5+ years.

  • Emergency Fund to cover 6-12 months
    • Held in CASH…high yield accounts….appx 1-2% interest rate
    • After taxes on interest and inflation, this is a negative yielding account
  • Passive Income Streams to cover all the expenses
    • Income from Municipal bonds: state and federal tax free
    • Income from Qualified (stock) dividends

Recessions can turn into bear markets. If the bear markets lasted more than 6-12 months, then I would be forced to sell the stocks and/or bonds from my passive income streams.  In addition, many dividend paying companies reduce their dividend payout in bear markets. I.e. I may have to sell stocks when the their prices are down.

Can I come with a better system? Apparently, smart people have already thought about this problem and produced a better system 🙂

System 2: Bucket Investing Strategy

I have always invested until now with Vanguards Risk Levels approach i.e. invest money in different risk buckets to diversify risk (Risk Analysis). The bucket based investing is a much more exhaustive version of the same….a system that can handle both ordinary risk events (job loss, short term education break, etc) and Genuine Uncertain events like 2008 bear market.

Conceptually (imo), the Bucket Investing Strategy has three parts.

  • Bucket 1: Cash Bucket for 1-3 yrs
    • Short term risks mitigation only
    • Goal is liquidity and not return i.e. expected return is 0%
    • 1-3 years of total expenses in this bucket.
    • I have used high yield savings account from Ally Bank, SmartyPig, Capital One 360, etc for this bucket.
    • This is the “Salary bucket”…expenses should not exceed the inflow into this bucket from Buckets 2 and 3.
  • Bucket 2: Bond bucket for 5-7 yrs
    • Medium term risks mitigation only
    • Goal is liquidity and not return.
    • But since Bucket 1 is protecting us for 2 years, we can go up the risk-reward ladder for some more yield but with some more risk.
    • Expected return for this bucket is 2.5%….still does not beat inflation.
    • I have used Muni bonds whose tax equivalent yield is a bit more i.e. barely beats inflation.
    • Income from this bucket flows into “Salary bucket” i.e. Bucket 1.
  • Bucket 3: Equity bucket for as long as it takes 🙂
    • Long term risks mitigation only
    • Since this is an equity bucket, assume 4% return per year.
      • NOTE 4% is conservative w.r.t. the long term equity return of 8%.
    • Since buckets 1 and 2 can provide funds for years 1-7, the goal of this bucket 3 is to keep up with long term inflation by investing in equity alternatives like
      • Dividend growth stocks
      • Capital growth stocks
      • Current income stocks like REITs.
    • Income from this bucket flows into “Salary bucket” i.e. Bucket 1.

Examples for Bucket Sizing

When I am ready to retire (still at least 10+ years away), I would like to have all three buckets set up completely to generate passive income that can deal with all the above discussed risks. Lets take one example design and study two implementations based on that design.

  • Bucket 1:
    • 3 years of full expenses
    • Cash at 0% return
  • Bucket 2:
    • 7 years of full expenses
    • Bonds at 2.5% return
  • Bucket 3:
    • Equity funds at 4% return
    • Since this is an equity bucket, question comes: How much money here?
    • This depends on how much income is needed to be generated from this bucket.

Lets take a couple of examples to understand this.

Case Study 1: $4000 per month passive income

In this case study, the passive income requirement in retirement is $4K pm OR $48K per year. Assume gross for now. So, the bucket portfolio should somehow generate $4K pm in dividends.

  • Bucket 1:
    • 3 years of expenses in cash => 3 * $48K => $144K
    • Since we assumed 0% return for bucket 1, we need Buckets 2 and 3 to generate $48K per year in income.
  • Bucket 2:
    • 7 years of expenses in bonds => 7 * $48K => $336K
    • Since we assumed 2.5% return (I am using MUNIs for this), this bucket will generate $336K * .025 => $8400 pa => $700 pm.
    • So, Bucket 3 will have to generate the remaining ($48K – $8400) => $39,600…appx $40K.
  • Bucket 3:
    • The main requirement for Bucket 3 is to generate $40K.
    • Since this bucket has an assumed return of 4%, the amount needed in this bucket is: $40K / .04 => $1 million 🙂
    • This bucket will have the following types of equity funds
      • Dividend stocks
      • Growth stocks
      • Value stocks
      • REITs
      • etc

Case Study 2: $6000 per month passive income

In this case study, the passive income requirement in retirement is $6K pm OR $72K per year. Assume gross for now. So, the bucket portfolio should somehow generate $6K pm in dividends.

  • Bucket 1:
    • 3 years of expenses in cash => 3 * $72K => $216K
    • Since we assumed 0% return for bucket 1, we need Buckets 2 and 3 to generate $72K per year in income.
  • Bucket 2:
    • 7 years of expenses in bonds => 7 * $72K => $504K
    • Since we assumed 2.5% return (I am using MUNIs for this), this bucket will generate $504K * .025 => $12600 pa => $1050 pm.
    • So, Bucket 3 will have to generate the remaining ($72K – $12600) => $59,400 …appx $60K.
  • Bucket 3:
    • The main requirement for Bucket 3 is to generate $60K of income pa.
    • Since this bucket has an assumed return of 4%, the amount needed in this bucket is: $60K / .04 => $1.5 million 🙂
    • This bucket will have the following types of equity funds
      • Dividend stocks
      • Growth stocks
      • Value stocks
      • REITs
      • etc

Steps to take today

To support generating passive income for ever from the first day of retirement, we have designed the three bucket system above.

  • Bucket 1 is the salary bucket.
    • Income flows into this Bucket 1 from buckets 2 and 3 like a regular pay check.
  • Buckets 2 and 3
    • The pay check, from Buckets 2 and 3, is supposed to overcome all the risks we talked about before: ordinary risks and genuine uncertainties.

Assuming that, what should we do today? From now on, all goals will be targeted to build the buckets to their appropriate sizes. For the two examples listed above,

  • $48K passive income pa
    • Bucket 1: $144K
    • Bucket 2: $336K
    • Bucket 3: $1 million
  • $72K passive income pa
    • Bucket 1: $216K
    • Bucket 2: $504K
    • Bucket 3: $1.5 million

Using the above template, please calculate your own bucket sizes for the amount of  passive income you desire per year in retirement. Hope that helps!

One thought on “Uncertainty vs Risks….part 2

  1. Pingback: 2020 Goals and Quarterly Updates | Humble FI

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s