I’ve got a problem.
I suspect you have a problem, too.
I can’t figure out:
Where Should I Put My Money?
Can you figure it out? Are you struggling with the same question I have with regards to your investments?
As my regular readers know, we recently sold our house and downsized to our cabin. My annual bonus also came in this month, and we’ve had a good year. Both events have generated a fair bit of cash, which has been sitting primarily in our Vanguard Money Market fund until I figure out where to direct the money. I hate sitting on cash, but I really struggle with what to do in the current market environment. My asset allocation is a bit off target (details on that in a minute!), and I can’t figure out what to do with the cash. Good problem to have, I guess, but a problem nonetheless.
Here’s a high level view of our asset allocation, which I’ll get into in more detail later in this article:
As you can see, I’ve got ~10% excess in my “cash & bond” holdings, and I’m slightly underweight in stocks & “alternatives”.
I’ve talked to others recently who are struggling with the same problem, so I thought I’d address it with today’s post. Even if you haven’t had a situation which has generated a surge of cash, you still have your ongoing monthly savings rate which must be invested somewhere. It’s a difficult environment, but everyone needs to decide:Where Should You Put Your Money? Today, I'll tell you what I'm doing. Click To Tweet
A Review Of The Asset Choices
As I think through the options of where to direct our money, there are many possibilities. Below is a quick summary of each of the major categories, and my thoughts on each.
- Equities. The equity market is elevated, and the recent upturn off the concerning start to the year could well be a “dead cat bounce”. I’m only a few years from retirement, what if the “big correction” is coming? I watch the CAPE ratio as a price indicator, and it’s current level of 25+ increases the likelihood that future returns will fall below the long term average. Seems a bit pricey to be throwing much new money into the markets right now.
- Bonds. Yields are unattractive, and there’s a real possibility of interest rate increases over the coming years. We all know that bonds suffer during interest rate increases, so is it worth taking the risk for the small return? This article from Morningstar gives a good overview of current interest rate risk, and potential impact on various bond funds.
- Cash: Fine, I’ll just park everything in a Money Market Fund, or CD. At 0.1%? Really? Even in today’s low inflation world, we’re losing ground every day with that approach on a “real” (inflation adjusted) basis. Not a viable long term strategy.
- Commodities/Alternatives: Commodities appear to be near the low point of a long term cycle. Gold & Silver have been on a tear since the beginning of they year. Maybe it makes some sense to buy precious metals, or am I too late? Purely a speculative timing call, and I’d be giving up dividend growth. Warren Buffet would scold me. Is the world really going to end? REIT’s have an appealing yield, but they’re also subject to downward pressure in the event of an interest rate increase. What about Peer-To-Peer lending, seems there’s been a lot of press around that development of late.
10 Year Returns – The Outlook
Future returns are almost impossible to predict, but I’m a bit bearish on the outlook for US large cap equity stocks. This seems to be a consensus view, as demonstrated in this article, which included the following chart of 10-year return projections by asset class:
International funds have clearly “lagged” the market recently. As a result, they’re relatively inexpensive, and projected by Research Affiliates to outperform other asset classes over the next 10 years. However, that higher return will also be accompanied by high volatility, a concern when you’re in The Red Zone (within 10 years of retirement). Bonds & US Treasuries have a weak outlook, likely influenced by the odds of an interest rate hike in the coming months/years. By the way, I like this Research Affiliate “expected return” site, and have added it to the “Resource” page on my website.
Where I’m Putting The Money
I’ve been an avid personal investor for 30 years, and I’ve never seen an environment that made asset selection more difficult. Regardless, we have to do something. Here’s how I’ve decided to approach the problem, as I face an early retirement within the next few years (note, these are not recommendations for you, as everyone must answer the question for themselves, based on their personal situation, risk profile, etc).
Short Term Money Direction
Pay Off The Cabin. The sale of our primary residence was a downsizing move for retirement. Since we’ve got excess liquidity, the first move we made was to payoff our retirement home’s mortgage with the equity we’ve freed up from our home sale. It’s only a 3.5% yield (mortgage rate), but it’s a lot better than a 0.1% money market fund. Safe, secure, and reduces our expenses in retirement. Plus, we can now claim we’re “Debt Free!!”.
Investment Grade Bond Funds: Looking over my options for the “cash” while deciding on longer term allocations, I decided to take advantage of the slightly higher yield in investment grade bonds. The majority of my cash position now sits in Vanguard’s Intermediate-Term Bond Index Fund (VBIIX), earning 2.11% while I search for better options. There is slight interest rate risk, but it’s a tradeoff I’m willing to make at this point in time. I’m viewing this as a short term holding situation, not a long term strategic allocation.
Muni-Bonds: In addition to VBIIX above, I’ve also directed some of my short term cash holdings into Vanguard’s Intermediate-Term Tax-Exempt Fund (VMITX). It’s yield is slightly lower at 1.32%, but the earnings are tax free. Both the Investment grade and muni-bond funds have some interest rate risk, but given that Vanguard’s Money Market Fund is only yielding 0.16%, and I view the risk of significant interest rate hikes as minimal, they’re better options in my situation of needing a place to park short term cash.
Cabin Upgrades: For several years now, I’ve been forecasting what our “Starting Cash Position” will be for retirement. I want to insure we have several years of expenses safely parked in cash as part of our bucket strategy, and I knew there would be some major moves to our cash position between “Now” and “Retirement”. As part of that “starting cash” projection, I’ve built a section in my retirement planning spreadsheet which lays out the changes between our current cash position, and our projected retirement postion (green = additions of cash, red = subtractions of cash):
Since we’ve been planning for it for several years in our financial plan, I have no hesitation in relaxing and “enjoying the process” of upgrading our cabin. We’ve had several hundred renters through the cabin while renting it out the past 3 years, and it is now our permanent home. Time for an upgrade. My wife is enjoying the process of working with an interior designer on all of the changes, and we’ve reserved the money for the project. It’s time to enjoy the fruits of our labor, within reason. The current estimate for our cabin upgrades (kitchen and exterior work) are lining up well with our budgeted amount, so we can spend on the project without worrying about whether or not we can afford the work.
Longer Term Investment Direction
After the above moves are made, we still have an inbalance in our asset allocation. To address this, a deeper look at our current asset allocation vs. target is required:
As I mentioned in my “5 Moves I’ve Made” article, I am disciplined about tracking our current asset allocation vs. our “target” asset allocation. As you can see, we currently have too much cash, and too little of essentially everything else.
My Strategy To Adjust Asset Allocation
Given the current high valuations of equities, and potential interest rate risk for bonds, I’ve decided to take a gradual, but accelerated, approach to rebalancing our portfolio. Using the figures from above, for shortfalls by asset type, I’ve set up monthly automated transfers within our Vanguard accounts to gradually move funds from our cash allocation into the funds which comprise our strategic asset allocation. This will allow some level of dollar cost averaging into our targeted allocation, and avoid moving too much money at the “wrong” time.
Within this “accelerated reallocation” (which will take ~12-18 months at current monthly transfer amounts), I’ve also established the goal of Maintaining Diversification. I know that wide diversification is the most logical approach for someone within 2 years of retirement. While I may not like the current valuations or returns, it’s best to not try to time the market with big asset allocation shifts. Long term, I need exposure to equities to insure my portfolio keeps up with inflation and can fund my wife and I if we live to 95. I also need the stability of bonds and cash to smooth out the ride. “Alternative” investments are a reasonable diversification play, given the uncertainty around everything else, so I’ve got them in the mix. I’ll retain enough in cash in a Reserve Fund to cover 2-3 years of living expenses. Anything above that level, and I’m moving the cash out and across the board, into the diversified portfolio with Vanguard.
Asset Allocation Targets: A word on how I established my asset allocation targets. Rather than speculate on what’s “hot” vs. “not”, I’ve been spending my time thinking about how much risk I want to face in The Red Zone (+/- 5 years of retirement). I’ve read a lot of articles, and I’m fairly knowledgable about the topic. I’ve built a spreadsheet with the targeted asset allocations that I’m comfortable with, based on my research and personal opinion on the topic. I’m not going with the simple rules of thumb (“110 – Your Age = Equity %”), as I do think things are a bit overheated. Also, I’m intrigued with the work that Michael Kitces and Wade Pfau have done on optimizing withdrawal rates through asset allocation (which argues you’re best to reduce equity exposure at retirement, then increase later in life). Through the exercise, I’ve established the above targets. You could argue if they’re the best, but it’s what I’m comfortable with at this time. Many articles I’ve read claim that the exact %’s aren’t important, but rather the focus of maintaining a diversified allocation across a broad range of funds, keeping the “bucket strategy” in mind (the closer to the date you’ll need the money, the lower risk the asset class).
What I’m Buying
Ok, so now the big question on where I’m putting my money that I’m moving out of cash, and into more strategic investments. Below are the funds I’m directing our cash into, using the monthly transfer strategy outlined above. I’ve broken out the funds by tax status for the more “sophisticated” reader who appreciates why that matters (beyond the scope of this article). All funds are Vanguard.
In addition, for my ongoing monthly contributions to my company’s 401(k) plan, I’m investing in the following funds, at the percentages shown on the right. Funds are a combination of Before Tax, After Tax, and Roth:
“Commodities / Alternatives” Class
Finally, to address my “Commodities/Alternatives” shortfall, I’ve taken a 3 pronged approach.
First, I directed some of the excess cash into my TDAmeritrade account, which is the place I prefer to “play” with the higher risk stuff. For an example of how I gain exposure to alternative investment classes, read my article titled “An Option Trading Strategy To Improve Your Returns”, where I give details on how I’m currently trading options. In addition, I have holdings within my TDAmeritrade account in various “alternative” asset classes, from Agriculture (DBA) to Precious Metals (SLV, DGL, GDXJ, NG), Emerging Markets (FRN, DSUM), Energy (KOL, DUK, MMP), and Interest Rates (TBT).
Second, after reading this article by Mr. Money Mustache, I opened a new position in PeerStreet, an interesting Peer-To-Peer Real Estate investment site. I may write a future article on this “experiment”. Part of my willingness to try PeerStreet was due to the success I’ve had with a Prosper peer-to-peer consumer loan account since 2012. To date, it’s earned 5% (net, after any write-offs) as shown below:
I continue to transfer a small fixed amount monthly into my Prosper account, and consider it among my ‘alternative’ asset class holdings. In the same vein of trying different types of accounts, I also have some money in NetSpend, which I wrote about in the article “Earn 5% on a savings account”. Finally, I also used a bit our excess cash to buy a few precious metal coins.
I’ll continue to monitor my asset allocation (next check-up will be at year-end, as I update our net worth and all related personal finance spreadsheets), and make adjustments for the following year at that time. I’ve done it for years, and I’ll likely continue doing it for years to come. I enjoy it. At some point (e.g., 75+ years old, depending on my mental acuity?), I’ve decided I’ll likely turn over the management of our investments to Vanguard’s Personal Advisory Service for them to manage in return for a 0.30% expense. A good deal, and an option for you to consider if you’re overwhelmed by this topic, or by this article! I’ve also instructed my wife in my “Love Letter” to turn things over to this service in the event of my untimely demise.
Figuring out how to manage your assets to a reasonable asset allocation during challenging market environments is one of the more advanced elements of personal finance and retirement planning. I’ve studied it for years, developed a strategy that works for my wife and I, and figured out a mechanism to make adjustments back to my targeted allocation when things get a bit out of balance.
Hopefully, by doing all of these steps, I’ll sleep well at night in all but the most extreme market situation.
More importantly, I hope my transparency in sharing my strategy will help you as you develop your strategy, and the approach above will help you to answer the question for yourself:
Where Should You Put Your Money?
Answer that question, and you’re well on your way to Achieving A Great Retirement!