Using Vanguard LS60 et al in drawdown

jamesmorgan

Probably a dumb question, but with a cash buffer how do you know when to use cash or sell shares? Isn't that continually trying to time the market? Say, for example, stocks have fallen for 6 months and I need more income. Do I assume it is the start of a bear market and sell shares, or do I feel market has bottomed and use cash? What do I do if it falls for another 6 months? Then, let's say shares rise for 6 months. Is this a sign of the start of a bull market so should I hold onto shares and use cash? It sounds a sensible strategy but I'm struggling to see how you would automate the decision on which to use.

Looking at the FTSE all-share index, very broadly bear markets seem to last 1-3 years and bull markets 4-7 years

Linton

You use a cash buffer purely to pay out during a slump in equity prices. The buffer is replenished during the times when prices are rising using some of the gains from the equity holdings. If you decide in advance the size of the cash buffer and have a graph of the equity holdings assuming a steady return and drawdown a comparison with actuals should make it pretty clear when the time is right to use or replenish the buffer.

jamesmorgan

OK, Linton, I think I understand what you are saying, but it may be useful to put some specific figures on as an example just to make sure.

Let's assume you have a starting fund of £400K. You decide to keep 10% of the total fund as a cash buffer and want to remove £20K as income each year.


Year 1 Shares: £360K Cash: £40K

Year 1 performance, shares decline to £320K. Take £20K income and rebalance.

Year 2 Shares: £306K (-£14K) Cash: £34K (-£6K)

Year 2 performance, shares decline further to £286K. Take £20K income and rebalance.

Year 3 Shares: £270K (-£16K) Cash: £30K (-£4K)

Year 3 performance, shares recover to £320K. Take £20K income and rebalance.

Year 4 Shares: £297K (-£23K) Cash: £33K (+£3K)


Is this the type of approach you mean? If so, I can see that the cash buffer does act as kind of damping, but in the grand scheme of things its effect is quite marginal.

dunstonh

Probably a dumb question, but with a cash buffer how do you know when to use cash or sell shares?

Judgement calls and experience.

Isn't that continually trying to time the market? Say, for example, stocks have fallen for 6 months and I need more income. Do I assume it is the start of a bear market and sell shares, or do I feel market has bottomed and use cash?

You would generally keep more than 6 months cash in the cash account. Its not long enough. Most crashes are recovered within 18 months. So, when you do your yearly review you look at the scenario and if its still in a growth period, you sell to top up the cash account. If there has been a drop, you wait until you have to and maybe do less than you would normally do.

You would usually use income funds and have the income paid into the cash account. So, you really shouldn't find yourself in a situation with only 6 months worth in there.

In your example in post #14, you have looked at total return. Remember the dividends going into the cash account. Plus, you would not sell investments in year 2 to top up the cash account as long as there is enough cash to meet the withdrawals. If there wasnt, you would not sell £20k (or bring back to your desired float). You would sell less and wait for some recovery before refloating back to the higher level.

You cannot be rigid. You need to be flexible and make judgement calls. Having 18-24 months as cash gives you that flexibility.

Your example also highlights one of the reasons why putting an income bias into your investments can make sense. i.e. x% for UK, fill with UK equity income, y% for Asia, fill with Asian income. z% for emerging markets, fill with dividend-focused EM funds.

The more income you generate, the less units you need to sell. You may even be only drawing a sustainable amount fully met from yield and require very little in the cash float.

Linton

The buffer approach is really intended to cover large scale crashes, rather than the normal ups and downs of the market. If there was a 45% drop in share prices the return on the smaller capital may not be sufficient to cover your fixed drawdown so your capital would drop even further. If you were able to take money from a buffer it would give a better chance for the capital to replenish.

bostonerimus

_pete_ wrote: »

I will be entering some kind of SIPP drawdown phase within the next 5 years. I'm in the process of tidying up my 13 or so funds and putting them into Vanguard LS60 and HSBC Global Strategy Balanced, as I've decided that I want to simplify things and rely on a 'passive' approach.

I will keep 1 years worth of my SIPP in cash, which will be separate from my emergency fund held outside of the SIPP

I'm aware of the need to vary my drawdown rate according to inflation/performance etc.

However I'm wondering whether the reliance on multi-asset funds might not be the best idea during a major market downturn. Specifically would it be a good idea to invest in one global equity tracker and one global bond tracker (as well as the multi-asset funds) so that I could just draw down from the bond fund if equities took a nosedive. Or does the automatic rebalancing of the multi-asset funds address my concerns without the need for a separate bond fund?

I appreciate that bonds may well do down in value at the same time as equities, but I'm just trying to minimise the hit from a situation where I need to sell funds when they are falling to pay my living expenses.

I like that you are simplifying. It allows you to easily see what's up and down and manage your money appropriately.

There's lots of good advice on US sites where DC drawdown has been the default for quite a few years and there's been a lot of research. You do need to be careful translating from the US to the UK and it is true that the tax efficiency in the US because of lower trading in passive funds over active ones doesn't apply in the UK, but recent surveys have shown that on average it isn't enough to over come fees and bad decisions if we avoid selection bias. Of course if you believe UK active funds are better than others and can pick a winner go for it.

A total return approach to drawdown uses dividends, interest and hopefully capital gains to produce income. You will use the cash and short term bond buffer to provide income if things have fallen significantly over an extended period. Many people keep one years cash in the bank; take dividends and interest quarterly and every 6 months top up the cash account from investments. If stocks are down they'll transfer from the short term bond /cash buffer in their investment account until stocks have risen again. I'd probably keep at least 2 years of spending in that buffer.

bostonerimus

TARDIS wrote: »

I recognised this from the JL Collins stuff too - would you be kind enough to explain why it's so awful though for us "Newbies" swayed by fancy looking US blogs please?
Many thanks.

There are many personal finance blogs. A better source of inforrnation and debate is at
http://www.bogleheads.org

Joey_Soap

Linton wrote: »

The buffer approach is really intended to cover large scale crashes, rather than the normal ups and downs of the market. If there was a 45% drop in share prices the return on the smaller capital may not be sufficient to cover your fixed drawdown so your capital would drop even further. If you were able to take money from a buffer it would give a better chance for the capital to replenish.

Exactly. My suggestion of a 2 to 3 year cash buffer (preferably 3) would have covered all market events in my lifetime so far without recourse to having to draw down from a severely depleted pot of capital at just the wrong time.

_pete_

Thank you to everyone who has taken the time to share their thoughts.

It sounds like a reasonable approach for me would be to invest in Vanguard LS60 and the HSBC Global Strategy Balanced funds, keeping 2 years in cash (in addition to my emergency fund).

One more question: My funds are all 'acc' at the moment. Do I necessarily need to swap them for the 'inc' versions, or does it not matter if I'm doing the cash/fund rebalancing approach described by other posters?

Thank you again.

OldMusicGuy

You don't need to swap for Inc versions, just sell some units if you need to rebalance.

I'll add, my approach is similar to yours. I have a large DC pot with about 25% in cash, the rest invested for the long term mainly in passive tracker funds (I have one active fund).