What caught my eye this week.

Bit of a higgledy-piggledy digest this Saturday, which is right in keeping with a week in the markets that was all over the place.

If you sensibly follow The Accumulator’s advice to watch your paint drying and wash you’re hair a third time before you check out how your portfolio is doing again, you might not know things have gotten a little tasty.

As Merryn Somerset-Webb put it in the Financial Times:

Bonds are supposed to be boring. When they are not, you should pay attention.

That makes this week a good time to do just that. Bond yields are on the up: on Thursday the 10-year US Treasury yield hit 1.6 per cent.

That might not sound like much — and it is very low by historical standards — but it has tripled since the summer, with much of the action happening in the last few days.

It’s also not the direction we are used to bond yields moving in: for the past 40 years they have mostly gone down.

Inevitably share prices are readjusting as the prospect of negative (nominal) interest rates recedes – and as inflation twitches to life, just out of frame.

As yields on the theoretically safest asset in the world rise, more money will want some of that. You might scoff 1.6% won’t butter many panfried parsnips, but remember pension funds and others were buying safe bonds all the way down through zero.

At 2% or more, fixed income managers would be loosening their neckties and doing the graveyard dance from Michael Jackson’s Thriller.

Remember, too, that some high equity valuations have been predicated on very low interest rates persisting indefinitely.

As I wrote a few years ago:

Discounted cash flow models try to estimate the cash due from a company or property. They then compare this to the yield you could get from the lowest risk asset – a government bond.

Plug a historically low risk-free rate into such a model and you can get extreme valuations.

It’s possible to argue that everything from shares to housing is cheap.

That proved a good lens through which to see the future of equity returns over the subsequent years. Most shares – especially growth shares – rose from often already high valuations, unburdened by the gravity of interest rates.

Well, if yields rise a lot, it’s inevitable some of this will reverse.

Extreme growth share valuations will be harder to rationalize.

And income investors will move out of ‘bond proxy’ stocks and back into the real thing.

Market returns could be sluggish as a consequence. Some share prices will probably fall.

Pick your poison

We’ve long warned investors not to expect the unwinding of what they’ve decried as ‘a bond bubble’ to happen without any impact on share prices.

Super-safe government bonds yields are the gravity that permeate all valuations. It is all connected, in the long run.

But what to do about it now? Probably nothing if you’re a passive investor.

Merryn restates the case for shifting from a 60/40 portfolio on the grounds that bond prices could fall even as shares do. You’d possibly get no support from your bond cushion in a market decline, in other words. She suggests holding a bunch of other assets, including more cash.

Well, maybe. If you’re an active investor like me, knock yourself out. Even for passive investors, for years I’ve been suggesting you hold some of your bond allocation in cash as a response to low yields.

Cash – and the treatment of interest income – is a far more attractive to us little guys than to institutions.

But please don’t go crazy. If you own bonds in a well thought out asset allocation, you should probably keep most of them.

Check out the graph in the links below. It shows how a 70/30 portfolio has consistently matched or outpaced returns from the top 25% of – complicated and actively managed – US university endowment portfolios.

Those endowments are invested widely for various reasons (including career risk) but the result is the same.

Some of the best – and the majority of their lesser-performing brethren – could have just owned a couple of index funds, fired most of their staff, and seen better returns, at a lower cost.

What edge do you have that they don’t?

Markets don’t go up without going down. If you’re ten years from retirement, tweaks to de-risk may make sense. But really you should have been adjusting already, not just because yields are climbing off the floor.

Money is still super-cheap and abundant. The adjustments so far are small, and may yet – like the first signs of inflation – be mostly a head fake.

Or the regime of 40 years of declining bond yields may be changing. But please proceed in a calm and orderly fashion towards the exits.

Watch out for missing Monevator emails

Finally a couple of quick housekeeping notes.

The first is I’m going to sign us up to a proper email distribution service.

The one we use is free, creaking, and on deathwatch. Paid-for plans are surprisingly dear but should give us more flexibility in how we email you.

I’m just mentioning this in case you only read us via our email newsletter – rather than on the website, which some people don’t even know exists.

If our emails disappear, it won’t be because we’ve won big on the less-than-1% paying Premium Bonds, after all. (If I won the jackpot on the Premium Bonds, then Monevator’s future would be assured!)

No, it’ll be that something technical has SNAFU-d. You might want to check your spam folder, for example. If that’s empty, please get in touch.

Vastly more people get the email than read the site via RSS nowadays. But the several hundred RSS diehards should stay alert, too.

I hope to make the change soon. We don’t want to lose anyone!

Nominated under the influence

Finally, we’ve been nominated for a British Bank Award, run in conjunction with Smart People Money.

Monevator is in the running for Online Influencer of the Year – and it’s not even on account of @TA’s side-project of modelling onesies on Instagram.

You can read about all the nominations at the British Bank Awards website.

There were some new blogs on there to me. You might just find a gem.

When you’re done, you can vote for us if you’d like to, or for one of our worthy competitors. It’s a public vote, so I guess the most influential influencer will win.

Have a great weekend. Hopefully not long now before that won’t sound quite so tired, if like me you’ve been feeling the lockdown blues.

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Living off your investments is the ultimate goal of financial independence (FI) and the trickiest part to get right. This phase is known as decumulation and it’s the part of the journey I’m about to embark on.

My objective is simple:

• Drawdown enough income so that Mrs Accumulator and I can live without needing to work.
• Maintain a decent quality of life.
• Not run out of money before we die.

The key is to allow plenty of margin for error.

Our decumulation plan needs to cope with volatile market conditions, flawed assumptions, and the fifth law of thermodynamics: Grit happens.

What I’ll present – over three detailed articles – is our genuine, all-our-skin-in-the-game plan to meet this challenge.

This is no longer theoretical for me and Mrs A..

It’s the rest of our life.

My plan rests on the best practical research I’ve found over many years, fitted to our personal situation.

It’s resistant to the main threats that bedevil many decumulation strategies:

• A long life – also known as longevity risk.
• Inflation risk.
• Living off volatile assets – sequence of returns risk.

I’ve built in multiple safety features. But I know there are no guarantees.

Decumulation: time to get personal

My plan’s core components will be relevant to other decumulators, FIRE-ees, and near-retirees, regardless of our different circumstances.

Customisation is critical though, so here’s a list of our particulars:

• Time horizon: 45 years
• Chance we both live another 45 years: 8%
• Decumulation method: annual withdrawals based on a sustainable withdrawal rate (SWR) from a portfolio of volatile assets such as equities and bonds.
• Capital preservation required: No
• Legacy required: No
• Back-up sources of income: State Pensions due in approximately 18 years. Small Defined Benefit (DB) pension for Mrs A in the future. Ability to work if required, or as desired.
• Inheritance: No

I’ve decided not to share our personal numbers. This plan scales regardless of wealth or income. I’ve left clues all over the Internet, anyway.

It may be helpful to know that we got here on relatively modest five-figure salaries and plan to live on less than the annual median household income.

That’s quite tight, which is why the plan is bold in some respects.

I’d love to take a ‘safety-first’ retirement approach. To rely more heavily on less volatile instruments such as defined benefit pensions, annuities, and index-linked government bonds.

Sadly, that route is unaffordable for us. But it’s definitely worth investigating if you have greater means.

My final, overriding, set-up point: my job has been fairly all-consuming for more than two decades. I’d like to live a fuller life now.

That entails risk.

That’s life though, so I’ll try to offset the risk via:

• Multiple back-up plans
• Awareness of the failure points
• Conservative assumptions
• Not believing this is fire-and-forget

Living life now means not waiting until we can live off the dividends or fund a conservative 3% SWR.

But a naive 4% SWR is too risky, in my view.

So how can I use more sophisticated decumulation techniques to deploy our wealth more effectively, without turning retirement into a decades-long tightrope act?

The first step is understanding what an acceptable failure rate is.

Failure is negotiable

Standard SWR studies define failure too narrowly.

If the simulated portfolio’s wealth hits zero before the end of its time horizon then it’s a fail.

But we humans can run out of life before we run out of money. If I flatline before my wealth does then… success!

Well, sure. Kinda. Sorta.

The point is that SWR failure rates are less risky when you factor in your own mortality.

If Mrs A and I have a 10% chance of both being alive in 45 years, and our portfolio has a 10% chance of giving up the ghost in that time (at our chosen SWR) then our actual failure rate is:

0.1 x 0.1 x 100 = 1% chance of running out of money and both of us being alive to worry about it.

That’s a 99% success rate! Always look on the bright side of death.

I’m assuming here that the portfolio will more easily support one person than two.

That matters, because there’s a 49% chance that at least one of us will be around in 45 years.

One person won’t be able to live half as cheaply as two, but the portfolio will definitely last longer if it isn’t financing my chocolate habit.

The upshot is I’m comfortable picking a higher SWR – based on a 10% failure rate – when it’s twinned with a reasonable life expectancy for both of us.

Remember, we only stand an 8% chance of both being around in 45 years, so I’m still choosing an optimistic life expectancy. There’s a 2% chance we’re both here in 50 years time.

Also, SWR sims don’t account for humans noticing when the bank balance is draining at an alarming rate.

In real life people put the spending brakes on years before their portfolio sparks out. (More on this later.)

• We’ve written before on life expectancy for couples.
• Try running your numbers on a life expectancy calculator.

Next!

Decumulation diversification

SWR research is generally based on single-country portfolios split fifty-fifty between equities and conventional government bonds.

In a nutshell, US-based historical studies may be too optimistic. But non-US studies don’t account for the contemporary advantages of global diversification.

Research into asset-class diversification generally shows a modest uptick in SWR.

As a UK investor I’m not going to bank on history repeating the stellar US asset returns of the past century.

But I’m happy that a diversified global portfolio could replicate historical developed world returns. Those were scarred by two world wars, after all.

Here’s my de-accumulation asset allocation:

Growth – 60%

• 20% World equities
• 15% World multi-factor (Size, Value, Quality, Momentum)
• 10% UK equities
• 10% Emerging Market equities
• 5% REITS

(Note: there’s approximately 2% more UK exposure in the World funds.)

Defensive – 40%

• 15% UK gilts (long, intermediate, and short durations)
• 15% World index-linked government bonds (Hedged to £, short duration)
• 5% cash (currently it’s 10%)
• 5% gold (I don’t own this yet)

Most of my holdings are in cheap index trackers, though I will use active funds when I don’t have a good passive investing alternative.

I won’t use high-yield funds because I think that a total return strategy beats an income investing strategy.

Decumulation portfolio rationale

Here’s a short (ish) explanation of my decumulation portfolio choices. Happy to debate any of it in the comments after.

Growth

The expected returns of our equity holdings should provide the real returns we need to sustain our income over the decades. A strong equity allocation along with our State Pensions is our best protection against longevity risk.

It’s that or troughing out on deep-fried Mars Bars and cigarettes for the next 30 years. YOLO!

Adding a multi-factor holding to my equity split increases diversification at the price of higher fees, mitigated by the hope of slightly higher returns. This is debatable, optional, and may well be a slim hope.

Threats

The volatility of equity returns exposes us to sequence of returns risk. That is the chance that a poor run of market conditions sends our portfolio into a death spiral we can’t escape.

Another threat is high inflation whittling away the value of our defensive assets over the long-term.

Defence

Our defensive assets reduce our sequence of returns risk – as well as the stress of watching our main income source collapse during a market crash.

Conventional government bonds are likely to outperform other assets during a steep market decline.

Short duration bonds and cash guard against rising interest rates but they are much less effective than longer bonds when equities bomb.

(Cash sometimes outperforms bonds, especially in inflationary scenarios. It’s also easier to get change from a tenner than a 10-year gilt at Tesco.)

Index-linked government bonds are best against runaway inflation. Equities do badly in these scenarios. Equity inflation protection asserts itself in the medium to long-term, but linkers can pay your bills today.

We’ll hold linkers and conventional bonds in a 50:50 ratio.

Structural problems with the UK’s index-linked gilt market explain why I use developed world linkers.

For conventional bonds, choose a global government bond fund or total global bond market fund if you prefer. Just make sure it’s hedged to the £ (to eliminate currency risk) and that it’s overwhelmingly concentrated in high-quality bonds.

Match your bond fund’s duration to your time horizon to reduce interest rate risk.

Gold is a wild card that can perform when nothing else works. It’s typically uncorrelated to other assets and, in recent years, has spiked when people think the financial system is circling the drain.

I see gold as a one-shot wonder. It’s a shotgun blast in the face of some crisis occurring during the first 10-15 years of decumulation.

That early period is when we’re most exposed to sequence of returns risk. After that gold will be discarded like an empty weapon because its long-term returns are poor.

Triple threat

Does the age of negative interest rates, QE, and government bazookas mean we’re in for secular stagnation, rampant inflation, or stagflation on steroids?

Your guess is as good as the next clairvoyant. I’ll hedge my bets with that mix of equities, linkers, and gold.

In times past, I’d probably have been 50:50 split across bonds:equities on the eve of decumulation. Now I won’t go below 60% equities. I believe I can tolerate the extra risk.

If I couldn’t handle this large (ish) equity allocation, I’d need a bigger portfolio to sustain the same income. I believe high equity valuations and low to negative bond yields heighten the risk of anaemic returns over the next 10 to 15 years.

A diversified portfolio in itself is only worth a small SWR raise, so I’ll also use a dynamic asset allocation strategy to try to squeeze a bit more juice out of my pot. This means my equity allocation could hit 100% if the market stays down for years.

Before I check out

In my next post I’ll explain how I plan to employ dynamic allocation – and dynamic withdrawals – to finesse my plans. Subscribe to make sure you see it.

Take it steady,

The Accumulator (though not for much longer)

What caught my eye this week.

I sold a six-figure shareholding last week for a phenomenal capital gain – over 1,000%.

For historical reasons the shares were held outside of an ISA. This means I’ve got a big capital gains tax bill coming, despite years of defusing.

The sheer size and hence risk of this single position – and the awkwardness of trading it outside an ISA – meant something had to be done. Rumours that Rishi Sunak might raise capital gains tax rates tipped me over the edge.

Like most taxpayers I remind myself I support an accessible health service and a welfare safety net. My sister is a nurse.

Thank you NHS.

But not to the tune of a mooted 45%!

To stash or not to stash the cash

The lessons of this investment – and of getting rid of it – will be fodder for a future post. As will be my specific findings from what happened next.

Which was deciding what to do with it.

Remember, I’m running a big interest-only mortgage, which through one lens is borrowing to invest. So somewhat risky.

Euphoria abounds in the stock market today – and elsewhere. Bitcoin just breached $56,000. Bulletin boards are blowing up hedge funds. Growth stocks seem unstoppable.

Even with nominal yields on government bonds sneakily rising, real yields remain very low and confidently predicting an imminent bust is folly. But it hardly seems imprudent to take some money off the table.

The trouble is where to put it?

I knew, of course, that rates were very low. I sort of assumed if I dug around I’d eek out something decent across multiple savings accounts.

But no, not to the extent it’s worth the hassle.

Long story short, Premium Bonds seem about as good a place as any for the maximum I can put in them.

I will keep a further chunk in cash, despite inflation eroding its value. I’ve felt too light on cash ever since I bought my flat, and I love Jamie Dimon’s description ¹ of having a fortress balance sheet. It’s time to rebuild my walls.

Otherwise, I’m thinking I might actually throw a few pennies at that big interest-only mortgage that half of you hate so much!

I’d presumed I’d run my mortgage full tilt for a decade, at least. But it is looking like some of my expected investment gains have probably been front-loaded.

What’s more, my bank’s rates have already floated off the floor. I have two years left of my very low five-year fixed rate to run. Given the odd way I got this mortgage, the end of this term could be a non-trivial event.

It’s still tempting to stash the cash rather than lock it away forever by paying down some of my mortgage. Even at a cost of lower returns from savings. The set aside cash could cover several years of monthly mortgage payments in a pinch. Sunk into the mortgage, it only reduces monthly payments by less than £100.

Also it’s entirely possible I’ll never be able to get a mortgage of this size again. Not without buckling down and ramping up my earnings, and even that hasn’t helped in the past. (I’m self-employed, one way or another.)

On the other hand, repaying debt charged at 2% looks sweet in a world that barely pays you for lending it cash and expects every share to go to the moon.

Lucky bastard

I’m aware this problem is plucked from the box marked Nice Problems To Have. Despite vast State support, many people and businesses have been hit hard by the pandemic – including several unlisted companies I’ve invested in.

How they’d love to have the headache of where to stash thousands of pounds in cash.

All I can say is I planted the seed of this windfall many years ago, when times were good and most people were spending freely. Now my investment has matured and blossomed. We all have to manage our own finances as best we can, whatever is going on in the world.

Luck won’t always go my way. That’s why I – like you – save and invest for the future. I fully expect to be hit by future tax rises, too, to pay for furlough and other breaks I didn’t get a penny of (but nonetheless supported).

But that’s more article fodder, I guess. Another dividend from reshuffling my assets!

Where would you stash the cash – or would you just save it for the mother-of-all post-lockdown parties? Let us know in the comments below.

Otherwise have a great weekend.

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1. Possibly pinched from Warren Buffett.[↩]