The big idea and why it matters: The “waterfall” approach to managing portfolio income isn’t ideal due to the known vulnerability of extended market downturns and potential cash drag. Focusing on aligning portfolio income with lifestyle needs while incorporating Dividend Growth and Alts can create a more robust portfolio and increase portfolio/investor antifragility.
“When you ask people, ‘What’s the opposite of fragile?,’ they tend to say robust, resilient, adaptable, solid, strong. That’s not it. The opposite of fragile is something that gains from disorder. -Nassim Taleb
We’re back to Nassim Taleb for today’s quote, as it helps clarify what we’re trying to accomplish within this topic of portfolio robustness. He’s alluding to his concept of being anti-fragile (the opposite of fragile). Our focus remains on constructing a more robust portfolio, but we can also discuss anti-fragility and how it may help increase expected long-term returns. We’ll think through all that and more today, but let’s get right into it. Here we go!
Of Buckets and waterfalls: surviving, not thriving
One school of thought says to insulate against downturns by “bucketing” assets based on spending needs; to do this, the first step is determining the annual cash flow required from your portfolio. The hardest part is figuring out your lifestyle costs (aka expenses). Then subtract any regular income sources (e.g., pensions, social security) from your total expenses, and the remaining gap must be filled by portfolio income. Let’s call that number your “Cashflow Gap.” Are you with me so far? Good.
The bucketing approach advocates holding a multiple of your Cashflow Gap in cash reserves, a multiple of your Cashflow Gap in fixed income/bonds, and then investing the remainder in longer-term instruments, like stocks, to help generate growth and combat inflation. There is a lot of discretion in doing this, but here is an example with common attributes:
- Bucket 1: Liquidity focus.
- Two years of Cashflow Gap
- Attributes: preservation of capital; potential for interest, but no growth.
- Types of investments: Cash alternatives, like CDs, high-yield savings, or money market funds
- Bucket 2: Income focus.
- 3-5 years of Cashflow Gap
- Attributes: fully liquid, but higher income potential than Bucket 1; limited growth potential.
- Types of investments: High-quality bonds
- Bucket 3: Growth focus.
- Remaining nest egg
- Attributes: higher growth potential that can outpace inflation; typically involves greater volatility and less current income than Buckets 1 & 2
- Types of investments: stocks, private investments
The idea is that the growth of Bucket 3 (stocks) refills Bucket 2 (bonds), which refills Bucket 1 (cash) and provides the income to cover the Cashflow Gap. As we know, stocks can go up or down in any given year, and the shorter-term buckets offer multiple years of insulation against a market downturn before being forced to sell stocks. Using gains from stocks to refill the other buckets is the “waterfall.”
Like the classic ending to Clue: The Movie (“That’s how it could have happened”), the waterfall approach is a possible solution for not depleting one’s nest egg, but I think there’s a better answer If we end up in extended sideways markets with substantial periods of drawdown, it’s possible to deplete Buckets 1 and 2 without having the luxury of appreciated stocks to refill them. And that’s a worst-case scenario I’d like to avoid on behalf of our clients.
Full disclosure: I used to employ strategies like the above, but with a belief in our team to directly execute a particular style of Dividend Growth (h/t to David Bahnsen, of course), coupled with the evolution of Alts, I now approach the portfolio income problem very differently.
Closing the gap
To me, true portfolio robustness comes from the understanding that when I wake up on January 1st of each year, I already know that I can:
- a) live off the income my nest egg provides without ever having to sell anything, AND
- b) that income will grow at a rate faster than inflation.
If you can do those two things, the most common concern (volatility) becomes secondary; the value of your nest egg is effectively separate from your income stream. Whether your stocks are up 20% or down 20% in a given year, you can still live your lifestyle. The second-most common concern, fighting inflation, is also naturally solved for. We can call it “robustness,” but we’re becoming content and calm, which some deem priceless.
It starts with a plan.
The portfolio robustness I speak of involves thoughtful financial planning. It takes work. It requires a process to fully understand one’s situation, Cashflow Gap, and other objectives/risks beyond an investment portfolio. However, focusing only on portfolio income for today, most retirement situations require a spending rate that is realistically in the 4-5% range. A numerical example would be solving for a Cashflow Gap of $160-$200k from a nest egg of about $4 million. Through a thoughtful allocation and portfolio construction process, we can solve for such a need using the following pieces:
- Dividend Growth: current income, growth of income, and long-term appreciation
- Private Alternatives: current income, growth of income, long-term appreciation, and diversification (different risks) vs. public markets
- Other holdings: we may need to seek higher current income via other equity or credit investments; some personalities or situations call for more or less fixed-income holdings; gifting strategies need to be accounted for; account titling, asset location, and taxes are a cross-cutting consideration…but it all is designed to add up to a solution that is reliable and robust.
- Knowing what you own and why you own it: remember Al Gore Rhythm and WYOWYO?
And if you’re not a retiree, foundation, or endowment?
For the accumulators (I didn’t forget about you), achieving robustness still begins with a plan. The resulting framework is designed to help maintain a state of being content in any environment: cash reserves, borrowing needs, insurance coverages, estate implications, and embracing the volatility of markets are all a part of that. Specific to the investment piece, knowing what you own, why you own it, and having faith in the power of dividend reinvestment at lower prices sure doesn’t hurt.
I promised to talk about Antifragility
First, it’s easy for the accumulators to see antifragile characteristics at the portfolio level. Though more difficult to measure, good companies often become better companies by enduring the challenges of volatile markets. But, practically speaking, one’s portfolio benefits from downturns through dividend reinvestment (buying more shares at lower prices) that can have massive compounding benefits over time (for both income and growth).
However, for all investors, including retirees, having a more robust portfolio can have antifragile benefits for the investors themselves, and this can actually help increase long-term returns. How? There’s a domino effect that plays out as follows:
- Going through a downturn and living the reality of maintaining a reliable and growing income stream goes a long way toward alleviating fears about future downturns.
- As portfolio income and trust in that income increase over time, it can reduce the need to hold assets regarded as “safer,” like bonds, which they may have previously held solely for being content.
- Owning companies (stocks) or seeking particular areas of private markets should come with higher expected returns (albeit with potentially more volatility) than lending to public companies (bonds) over the long term.
- In contrast, the Waterfall approach (as only one example) requires holding many years of one’s Cashflow Gap perpetually in cash alternatives and fixed income known to have lower long-term return potential.
Be robust, be antifragile, be better.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
