Retire at the Coffeehouse

Top 12. Jan 29, 2005 12:03 AM

» bob90245 - Chapter 6: Coffeehouse Portfolio

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Having reviewed the annual historical returns of common asset classes, you may have a better appreciation of their risks and rewards. The rewards of stocks are self-evident. They have higher average returns than bonds and cash. The risk is that is that stocks will experience negative returns over the short-term. And withdrawing funds from declining stock funds can deplete those funds sooner than necessary. I mentioned “reverse dollar cost averaging” in chapter 1, but you can read about it again here.

One way to minimize the risk of declining stock funds is to hold a collection of stock funds that move differently from one another. So while one stock fund may be having a bad year, others might be going strong. That’s the great appeal of diversification and the reasoning behind the Coffeehouse Portfolio.

The Coffeehouse Portfolio is composed of six stock asset classes plus fixed income.

Now you may notice that the stock:bond allocation that I’m suggesting is slightly higher than the 50:50 balanced allocation I described in chapter 1. And that’s fine. For your own personal allocation, you may tailor it to your own risk tolerance. For a more complete discussion on asset allocation and risk tolerance, you may read this article I wrote. But for now, I will use the 60:40 stock:bond allocation to make the examples easier to explain.

However, let me get back to the discussion at hand which is diversification of stock funds. This can be demonstrated with the following charts. The first three charts are from www.coffeehouseinvestor.com

This chart first appeared here.

And finally, you must realize that a more diversified stock portfolio will at times perform differently than traditional benchmark indexes such as the S&P 500. So yes, there may be some years when a more diversified stock portfolio underperforms the S&P 500. However, it is likely that a more diversified stock portfolio (like the one that is part of the Coffeehouse portfolio) may outperform the S&P 500 over the long-term.

As evidence, the following chart compares a diversified stock portfolio using historical data from DFA (an institutional fund family) and the S&P 500. The source of the chart can be found at www.fundadvice.com

DFA (Dimensional Fund Advisors) was founded by academics whose research lead to the creation of the “Slice and Dice” strategy.

-- posted by bob90245

Top 13. Jan 29, 2005 12:06 AM

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Top 14. Jan 29, 2005 12:07 AM

» bob90245 - Chapter 7: Sample Year 1

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Let’s review what we’ve learned so far. Based on historical market data, a balanced portfolio (stocks and bonds) is capable of producing an average annual return of 7%. At this rate of return, we can both withdraw an initial 4% and increase withdrawals each year by 3% to keep pace with inflation (assuming an annual inflation rate of 3%). A 4% initial withdrawal rate will require our nest egg to be 25 times our first year’s expenses.

Although stocks have higher historical returns than bonds and cash, they are subject to declines. However, withdrawing funds from declining stock funds will cause those funds to deplete sooner than necessary. This is referred to as “Reverse Dollar Cost Averaging”. One way to mitigate this problem is to have a collection of stock funds which move differently from one another. In this way, we can withdraw from just the gaining funds and leave the lagging funds alone until they recover.

I will demonstrate how this strategy works. The Coffeehouse Portfolio will be used throughout. To keep things simple, taxes will not be a consideration in any of the following examples.

To keep the numbers easy, we will start year 1 with $1,000,000. With a 4% withdrawal rate, we will withdraw $40,000 in the first year. I chose conservative dividend rates for each asset class. You will notice that I split the fixed income component into 30% bonds and 10% cash. The large cash reserve is mainly for peace of mind. It’s nice to know that in case of some emergency a certain amount of cash is immediately available. However, it can be argued that 10% of one’s nest egg is perhaps on the high side to sit in cash. But I’m using 10% just to show as an example. If you prefer, a smaller cash allocation is also O.K.

As I discussed in chapter 4, I believe it is best to use a laddered portfolio of individual bonds or CDs. This strategy will produce a higher overall yield while maintaining a stable value. Since the net asset value of bond funds will fluctuate with interest rates, I recommend them only for a very small part of your overall fixed income portfolio if they’re used at all.

So at the end of the first year, this sample portfolio will produce $23,500 in dividends and interest. During our working years, we would normally reinvest dividends and interest in order to further grow our nest egg. But now during retirement, those dividends will help replace the regular paycheck we used to have while working.

So the $23,500 will go toward our first year’s spending needs. We are more than half way toward our goal of withdrawing $40,000 and we haven’t even sold a single share from our stock portfolio! Let’s look next at an example of gaining and losing stock funds.

I arbitrarily had four gaining stock funds (up 15%) and two declining stock funds (down 10%). This produced total gains of $60,000. (We’ll look at the losses in the next figure.) So from our gains, we only need $16,500 to fund our first year’s withdrawal. We have $43,500 to reinvest.

Out of that $43,500, we will first replenish the lagging stock funds. We will then use the rest to rebalance.

The first sample year ended with our portfolio on a positive note. In the next chapter, we will walk through another sample year with a different scenario.

-- posted by bob90245

Top 15. Jan 29, 2005 12:09 AM

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Top 16. Jan 29, 2005 12:10 AM

» bob90245 - Chapter 8: Sample Year 2

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As in sample year 1, we start drawing off the dividends. However, to keep pace with inflation, our annual spending needs have increased by 3%. So instead of withdrawing $40,000, we will instead withdraw $41,200.

Instead of mostly gaining funds, I’ve reverse roles. Now there are 4 losing funds (down 10%) and 2 gaining funds (up 15%).

Still, there was enough from the gaining stock funds to satisfy our second year’s spending needs. Plus there was a bit left over to redirect to the lagging funds.

Unfortunately, it looks like we’ll end sample year 2 less than where we started.

We haven’t covered all the scenarios one may encounter during retirement. But we have covered much of the basics. To give a more complete picture of the “Retire at the Coffeehouse” strategy, what better way than to use actual returns? This is exactly what we will cover in the remaining chapters.

-- posted by bob90245

Top 17. Jan 29, 2005 12:12 AM

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Top 18. Jan 29, 2005 12:13 AM

» bob90245 - Chapter 9: Year 2000

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In the following chapters, we will use actual fund returns from the Coffeehouse Portfolio. We will see the withdrawal strategy in action. I will walk you through the details every step of the way.

So how did the Coffeehouse Portfolio perform during the last 5 years? Well, it’s relatively easy to find out. Vanguard provides fund returns on their website. The following table shows how each of the stock funds performed. However, for fixed income, I will substitute the bond fund with the same constant returns used in the examples shown in the previous two chapters.

We will start with a $1,000,000 nest egg and withdraw $40,000 in the first year. This is our initial 4% withdrawal rate. And then we will increase the withdrawals to keep pace with inflation. To keep the numbers relatively simple, I’ll just use 3% each year instead of the actual inflation rate.

Alright. We are ready to begin. And to make things more realistic, let’s pretend our employer gave us a retirement party on our last day of work on New Years Eve 1999. Feels good, right? You bet! So to celebrate the New Year and the first day of our retirement, we withdraw $40,000 and put it into our checking account that earns no interest (to simplify my examples). We will use the $40,000 to pay our expenses for the next 12 months.

Twelve months go by and our checking account is empty. Time to withdraw for year 2001. First, let’s gather the dividends and interest that have accumulated during the year.

Next, we’ll take profits from the gaining stock funds. The profits were more than sufficient to meet our Year 2001 spending needs.

The remaining profits are then used to replenish the lagging funds.

However, it looks like the value of those lagging funds will be less than what they started the year with.

We’re done with the first year of retirement. We’ve spent our first withdrawal of $40,000. We have our second year’s withdrawal of $41,200 in the bank. So we’re prepared for another 12 months. In the next chapter, we’ll do it all again for Year 2001.

-- posted by bob90245

Top 19. Jan 29, 2005 12:15 AM

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Top 20. Jan 29, 2005 12:17 AM

» bob90245 - Chapter 10: Year 2001

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So year 2001 has come and gone. Here’s how the Coffeehouse Portfolio fared:

Last year, we withdrew $41,200. And to keep pace with a 3% inflation rate, we will need to withdraw $42,436. First, we will gather the dividends.

Next, we take profits from the gaining funds. The profits were more than sufficient to meet our Year 2002 spending needs.

The remaining profits are then used to replenish one of the lagging funds.

Once again, it looks like the value of those lagging funds will be less than what they started the year with.

Investors who routinely rebalance once a year may be tempted to do so now. Rebalancing certainly makes sense in the accumulation phase before retirement. However, now that we are in retirement, rebalancing at this point would entail selling some from our fixed income accounts. I would consider this action only for highly risk-tolerant investors. For this reason, I will leave the portfolio as is, even if it is a little lighter on stocks at 58:42.

Let me spend a little more time explaining my philosophy so that you understand why I prefer to preserve fixed income whenever possible. A portfolio in retirement needs to achieve multiple objectives. On the one hand, we need a stable source of immediate income in the form of dividends and interest -- the bulk of which comes from our bond (or CD) ladder and cash. The fixed income portion also will provide a ballast against the more volatile growth-oriented part of the portfolio. This ballast can be a psychological anchor during bear markets so the investor will have the courage to stay the course until the next bull market. The other objective is growth (provided by our stock funds) so that our annual withdrawals can increase a little each year to keep pace with inflation. End of philosophical ramble.

O.K. We’re done with the second year of retirement. We’ve spent our second withdrawal of $41,200. And we have our third year’s withdrawal of $42,436 in the bank. So we’re prepared for another 12 months. In the next chapter, we’ll do it all again for Year 2002.

-- posted by bob90245