How about a 33x3 PP with no cash?

[Roger1]

I am looking to deploy a PP.  Given the fact cash is yielding approximately zero right now, and has essentially no growth potential, why not do a 33x3 PP with no cash instead of a regular 25x4?  Did Harry Browne contemplate a time when a money market account would be yielding only .01%?  Obviously, a 33x3 portfolio would have a bit more volatility, but, right now, the cash position seems like a total waste.  If short term interest rates exceed a reasonable threshold, say maybe 4%, then I can switch to a regular 4x25 PP.  Eliminating the cash position while it is yielding around zero seems like a pretty easy way to boost returns.  Other than the increase in volatility, what is the downside to a 33x3 PP with no cash? 

Thanks!
Roger

[Ad Orientem]

Hi Roger1 and welcome to the forum. Cash is not there for growth it's there to help smooth things out in the event we have a tight money recession. It's also a strategic reserve that is there for those unexpected moments in life when you need some serious cash. You don't wanna get caught in a situation like that and be forced to sell some of the more volatile assets possibly at a disadvantageous time. A straight 3x33% could take a serious beating if the FED ever jacked interest rates sharply.

[k9]

1981 was a bad year for the PP (I think the worse ever), but the drawdown was limited by the cash portion of the PP. A 3x33 PP would have been decimated (something like a 20% loss instead of a 5% one, not including the high inflation of that time).

[kka]

Decimated is not the word I would use.
http://www.peaktotrough.com/hbpp.cgi says PP was down 9.4% in 1981, while cashless PP was down 14.6%.  http://www.portfoliovisualizer.com/View ... calReturns shows PP was down 5.2%, cashless PP down 11.6%.

And in 1981, T-bills returned almost 15% and 2-year treasuries nearly 20% to actually boost returns, but they're not going to do that again anytime soon.

CAGR 1972-2013 was 8.9% vs. 10%.

[mabcpa17]

PP is not just about boosting returns. It's about preserving wealth!

[barrett]

Hey, Roger1. Have you set up your three-asset PP so that you still have plenty of cash for living expenses outside of the PP? What you are doing is against all the standard advice that is on this form, but I am especially interested in it because I did something similar. I have only been invested in the PP for a month or so. My retirement accounts are filled with a Gold ETF, an S&P index fund and LTTs. I have a bit of cash in each account - I have a SEP, Roth & regular IRA - for rebalancing purposes only. Outside my retirement accounts I am holding a bunch of savings bonds as the bulk of my 25% in cash (both EE and I-Bonds). These by themselves are actually not bad investments because they are generating 4% plus for me on my cash holdings. Critics would say, yes, but you will have to pay interest in the savings bond interest if you need to cash some in for rebalancing. But I am covered for that to an extent because I still hold some cash in all three of my IRA PP accounts. I just couldn't bring myself to implement the PP without doing something like this. If you are on this forum enough, you find all kinds of creative ways to get some juice out of the cash position. Right now it's probably the number one or two concern of most people who are new to the PP (essentially waiting until the FED stops pushing short-term rates down).

The other big fear I had to get over is that LTTs are likely headed down but I don't know that for sure. If I waited for LTTs to sink in price and for corresponding yields to climb to, say, 5% or 6%, yeah, I'd feel really smart for "saving" money on that 25% of my PP, but I almost definitely would have lost out on a run up in one or two of the other assets. The PP is supposed to help the investor have peace of mind and the savings bonds are my coping mechanism. Mine might not be the perfect approach but it's better than what I was doing before! Cash will eventually produce yields again at which point you and I can accumulate ST treasuries.

But wait for others who are more knowledgable than I to weigh in. Don't follow only my opinion on this one. There are some smart folks on this forum and a few are bound to pounce and tear my little strategy to shreds!

Good luck!

[goodasgold]

I second the use of I-bonds for the cash portion of the PP. New I-bonds are paying about 1.4%. The purchasing limit is $10,000 per year, but another $5,000 can be added by overpaying your income tax and telling the IRS to convert the refund into an I-bond. I did this in December and am anxious to pay my income tax to quickly obtain the $5,000 bonus.

A few years of these purchases would build up a respectable amount of I-bonds (guaranteed to match inflation, tax deferred, for 30 beautiful years and free from state and local income tax.)

I don't care for EE savings bonds because their value can be wiped out by a burst of inflation. And I would be skeptical of claims that "this time is different" and that "inflation will never return." If history is any guide, the only response to these claims is: "Hah!" (and this is the polite version.) 

[Libertarian666]

I second the use of I-bonds for the cash portion of the PP. New I-bonds are paying about 1.4%. The purchasing limit is $10,000 per year, but another $5,000 can be added by overpaying your income tax and telling the IRS to convert the refund into an I-bond. I did this in December and am anxious to pay my income tax to quickly obtain the $5,000 bonus.

A few years of these purchases would build up a respectable amount of I-bonds (guaranteed to match inflation, tax deferred, for 30 beautiful years and free from state and local income tax.)

I don't care for EE savings bonds because their value can be wiped out by a burst of inflation. And I would be skeptical of claims that "this time is different" and that "inflation will never return." If history is any guide, the only response to these claims is: "Hah!" (and this is the polite version.) 

Anything issued by the government can be wiped out by a burst of inflation, regardless of their guarantees.

[barrett]

I didn't know about the overpaying your taxes trick! One would really have to love I-Bonds to do that but for some it could be a very clever move. Will definitely keep that one in mind.

Not trying to hijack this into a discussion on EE Bonds, but... I don't particularly like them either but I have some from the early 1990s that for whatever reason are locked into 4% returns, so I will keep those for the foreseeable future.

Ah, just saw Libertarian666's response while I was typing. Yes, the purchasing power can be wiped out by a burst of inflation but can't the same be said for short term treasuries or any other "cash"? Or is it the buy and hold nature of the bonds you don't like for the cash position?

Thanks.

[goodasgold]

Anything issued by the government can be wiped out by a burst of inflation, regardless of their guarantees.
[/quote]

The government will never run out of paper money as long as the printing presses keep churning out those greenbacks. As to their purchasing power under a catastrophic scenario, all bets are off.

I think Harry B. was wise to encourage us to accumulate federal bonds instead of corporate holdings, since corporations, no matter how healthy they appear on the outside, can collapse. (See: Enron and Lehman Bros.) And I don't trust SPIAs. After handing over all your money for the SPIA, what's to guarantee that the insurance company doesn't go down the tubes?

[Kshartle]

Having 25% of your money in cash paying basically zero percent right now is just handing yourself a near certain loss in real terms.

There's nothing wrong with it if you have a very short time horizon for all your money (<10 years).

If you have it because you struggle so much with the fear of temporary loss in your investments, and you check them all daily or weekly and experience emotional highs and lows based on it, or have trouble sleeping at night thinking about the price of stocks, gold or bonds possibly dropping........you might need some counseling.

I realize this is just my opinion...but if you are relatively young and this money is for the future and you are this risk-averse with your investments you should try and figure out why. Your inability to handle even the small amount of volatility in a Stock/LTB/Gold portfolio will hold you back in the long run.

[Libertarian666]

I didn't know about the overpaying your taxes trick! One would really have to love I-Bonds to do that but for some it could be a very clever move. Will definitely keep that one in mind.

Not trying to hijack this into a discussion on EE Bonds, but... I don't particularly like them either but I have some from the early 1990s that for whatever reason are locked into 4% returns, so I will keep those for the foreseeable future.

Ah, just saw Libertarian666's response while I was typing. Yes, the purchasing power can be wiped out by a burst of inflation but can't the same be said for short term treasuries or any other "cash"? Or is it the buy and hold nature of the bonds you don't like for the cash position?

Thanks.

Yes, it applies to anything whose value depends on the value of "US dollars".
Which is why I don't hold any of those things other than as transaction balances.

[Gosso]

I am looking to deploy a PP.  Given the fact cash is yielding approximately zero right now, and has essentially no growth potential, why not do a 33x3 PP with no cash instead of a regular 25x4?  Did Harry Browne contemplate a time when a money market account would be yielding only .01%?  Obviously, a 33x3 portfolio would have a bit more volatility, but, right now, the cash position seems like a total waste.  If short term interest rates exceed a reasonable threshold, say maybe 4%, then I can switch to a regular 4x25 PP.  Eliminating the cash position while it is yielding around zero seems like a pretty easy way to boost returns.  Other than the increase in volatility, what is the downside to a 33x3 PP with no cash? 

Thanks!
Roger

Roger,

One alternative is to combine the long and short treasuries (barbell) into intermediate treasuries (bullet).  As long as the average duration is the same for the barbell and bullet then there will be little difference in the performance of the PP.  So it would look like this:

25% Stocks
25% Gold
50% Intermediate Treasuries

You would want something with an average duration between 5-10 years.  iShares offers IEF which is in the middle with a duration of 7.5 years (I believe others have recommended TLH which has a duration of 10 years).  I think this version of the PP cuts down on the cognitive dissonance that some PPers seem to have in regards to cash and long treasuries.  You could also build your own treasury ladder from 1-15 years, where a bond would mature each year and then use the proceeds to buy a new 15 year bond.  However, this can get a bit messy in terms of rebalancing (adding new funds), and expensive if there are transaction fees.

Having said that many people like the convenience of having cash easily accessible, so the barbell would work better for them.

[Ad Orientem]

Decimated is not the word I would use.
http://www.peaktotrough.com/hbpp.cgi says PP was down 9.4% in 1981, while cashless PP was down 14.6%.  http://www.portfoliovisualizer.com/View ... calReturns shows PP was down 5.2%, cashless PP down 11.6%.

And in 1981, T-bills returned almost 15% and 2-year treasuries nearly 20% to actually boost returns, but they're not going to do that again anytime soon.

CAGR 1972-2013 was 8.9% vs. 10%.

Are you sure about those numbers for T Bills? I think the 15% applied to LTTs. And if you were getting 20% you were likely dipping into the junk bond market. Interest rates were high back then, but not that high. And decimation is actually a very appropriate term for a loss of more than 10%.

[barrett]

I don't have T-Bill data but I remember getting 16% or 17% in a money market fund for a brief time in 1981 or so. Interest rates were just incredibly high at the time.

[barrett]

Thanks for the chart, Buckaroo Banzai. If rates ever get that high again, there won't be so much angst about holding 25% in cash!

[D1984]

Decimated is not the word I would use.
http://www.peaktotrough.com/hbpp.cgi says PP was down 9.4% in 1981, while cashless PP was down 14.6%.  http://www.portfoliovisualizer.com/View ... calReturns shows PP was down 5.2%, cashless PP down 11.6%.

And in 1981, T-bills returned almost 15% and 2-year treasuries nearly 20% to actually boost returns, but they're not going to do that again anytime soon.

CAGR 1972-2013 was 8.9% vs. 10%.

Are you sure about those numbers for T Bills? I think the 15% applied to LTTs. And if you were getting 20% you were likely dipping into the junk bond market. Interest rates were high back then, but not that high. And decimation is actually a very appropriate term for a loss of more than 10%.

Looks like TennPaGa beat me to it but the 3-month T-bill rate did peak at a little over 17% in May of 1981 (it started the year at around 14%); 6-month bills hit just shy of 16% around the same time frame (they actually may have hit 17% yields but I don't have data that granular for them like I do for the 3-mo and 1-yr) and one-year Treasuries reached about a peak of 17.25% in late August and early September of 1981 before going down into the 13 to 14% yield range by the end of the year. Note that some of that 20% return on 1-3 yr T-notes was probably from the yield drop toward the end of the year as well and not just from the coupon.

You are right that 30-year Treasuries only reached about 15%; they actually yielded less than the shorter-term maturities (the yield curve was inverted over several months in 1981)...although that only applied to coupon-bearing Treasuries; the 20 and 30-year yield zero coupon yield curves never inverted at all during this time period according to the Kamakura Book Of Yields (I don't think true Treasury  STRIPS were available until 1985 or so but if they had have existed in 1981--although TIGRS and other privately STRIPped Treasury bonds did exist--can you imagine buying a 30-year zero at 17%....the investment of a lifetime over the next three decades but nobody would have wanted them then due to inflation fears and bonds having been in a thirty-year long bear market by then).

[Kshartle]

In one of Browne's early, pre-PP books I remember reading where he describes how an inverted yield curve is a very good indicator of falling interest rates on the horizon and a very good time to hold longer maturities vs. shorter-term, regardless of the higher rates on the short term.

[Ad Orientem]

Indeed I stand corrected. There is a wealth of historic data on rates from here.

http://bonds.about.com/gi/o.htm?zi=1/XJ ... 5/data.htm

[sophie]

If you have a good size emergency fund and nerves of steel to sit on your hands during market dips, a cashless 33x3 PP might work well for the accumulation period.  During the drawdown period, i.e. after retirement, the cash portion becomes crucially important. 

Two problems:  when to convert from "accumulation" to "drawdown" modes - you obviously don't want to sell volatile assets if they're in the toilet, so you will end up market timing to some extent.  And, how do you know when to switch modes?  At retirement obviously, but other things could happen too e.g. sudden disability.

[dragoncar]

If you have a good size emergency fund and nerves of steel to sit on your hands during market dips, a cashless 33x3 PP might work well for the accumulation period.  During the drawdown period, i.e. after retirement, the cash portion becomes crucially important. 

Two problems:  when to convert from "accumulation" to "drawdown" modes - you obviously don't want to sell volatile assets if they're in the toilet, so you will end up market timing to some extent.  And, how do you know when to switch modes?  At retirement obviously, but other things could happen too e.g. sudden disability.

This seems to help solve the issue of "retiring too soon in a bull market."  For example, with a standard Boglehead 70/30 and a retirement target of $1 million, a huge bull market might push me up to the $1 million mark.  Then I retire -- hurray!  But of course I retire at the peak, meaning my first few years of retirement are stock market losers.

On the other hand, with a 33x3 PP, a bull run for the PP is likely to push me over my $1 million mark.  That is when I sell assets high and move into cash.

Of course, there are pathological cases where the above doesn't apply.  But even if you pass your retirement target during a bear market purely from savings, you're still in good shape.

[gap]

Reply to the original question:

This  has been my approach:

1. Decide what you need for living and to handle emergenicies(let’s say 6-8months worth of living expenses)
2. Only what is remaining is eligible for investing
3. Decide on your criteria for optimality ,e.g. Sharpe ratio, Sortino ratio  or Return/(-Maxdd) or something else
4. Based on your criteria figure out the best allocation using Portfolio Optimization, if you believe the future will look like the past – Otherwise use the 4 x 25 PP. For the last 9 years for which I had data the 4 x 25 has a better Sharpe ratio and lower MaxDD than the 3 x 33.3 PP
5. If you don’t like even the low risk of the  4 x 25 PP, increase the amount of Risk Free cash further. This will reduce both Return and Volatility but keeps the Sharpe Ratio the same.
Think  of the PP investment the the same way one thinks of one’s house – I can’t worry about the daily, monthly or even yearly variation of its potential selling price.
Over long periods the 4 x 25 PP has done well and has been quite steady. This may or may not be true of the future. No method is perfect and no amount of historical justification will satisfy everyone, but history is all we have, to learn and to prepare for the future.
I found the above approach useful to me and certainly gives me plenty of good sleep

So, if you think, based on your criteria, that the 3 x 33.3 is more optimal, I would advocate using it but I would still do step1,2 and 3 above first. The optimal portfolio depends on the market not on you or me. One's total portfolio is a combination of what one's needs are and the optimal portfolio(of course this optimal is not easily found)

[dragoncar]

Reply to the original question:

This  has been my approach:

1. Decide what you need for living and to handle emergenicies(let’s say 6-8months worth of living expenses)
2. Only what is remaining is eligible for investing
3. Decide on your criteria for optimality ,e.g. Sharpe ratio, Sortino ratio  or Return/(-Maxdd) or something else
4. Based on your criteria figure out the best allocation using Portfolio Optimization, if you believe the future will look like the past – Otherwise use the 4 x 25 PP. For the last 9 years for which I had data the 4 x 25 has a better Sharpe ratio and lower MaxDD than the 3 x 33.3 PP
5. If you don’t like even the low risk of the  4 x 25 PP, increase the amount of Risk Free cash further. This will reduce both Return and Volatility but keeps the Sharpe Ratio the same.
Think  of the PP investment the the same way one thinks of one’s house – I can’t worry about the daily, monthly or even yearly variation of its potential selling price.
Over long periods the 4 x 25 PP has done well and has been quite steady. This may or may not be true of the future. No method is perfect and no amount of historical justification will satisfy everyone, but history is all we have, to learn and to prepare for the future.
I found the above approach useful to me and certainly gives me plenty of good sleep

So, if you think, based on your criteria, that the 3 x 33.3 is more optimal, I would advocate using it but I would still do step1,2 and 3 above first. The optimal portfolio depends on the market not on you or me. One's total portfolio is a combination of what one's needs are and the optimal portfolio(of course this optimal is not easily found)

Wait, why does decreasing cash reduce the sharpe ratio but increasing cash leaves it the same?

[gap]

Forget, for the time being what is contained in the optimal portfolio and only remember that it contains risky assets, by which I mean assets that have some volatility. I have used SHY as my cash-like asset for the fourth asset ; however this also has some volatility  albeit a very low amount.

I should have made it clear when I talk about increasing cash I mean something with near zero volatility. Tbills might fit the bill. Real cash does. (Again I am not talking about risk since real cash entails inflation risk)

Now the Return/St Dev  of your chosen portfolio lies along the line joining points (std dev=0,ret= current bank return(close to 0 but it does not matter whether it is something else) and the point (std dev =st dev of the optimal portfolio, return of optimal portfolio). If you have zero cash in your total portfolio you have chosen the optimal portfolio. At the other extreme you could choose an all cash portfolio where your volatility(st dev) is zero

The point I am trying to make is that determining the optimal portfolio(given a time horizon)  can be considered independently and you can then choose your portfolio to be anywhere on that line. The ratio or slope of  the line is the same anywhere on that line. The point you choose should be based on your need and ability to handle a certain volatility; this point will give you the best possible return volatility ratio if the optimal market portfolio is chosen correctly.

So let us do a simple example if the optimal point has Std dev =10% and the return is 8% the Sharpe ratio(for a Risk free rate of 0) would be 8/10 =0.8. Incidentally getting a ratio of near 1 is very good. Now if you feel the volatility, as measured by Std dev,  is too much you can reduce it by adding say 50% more in cash with zero std dev. In this case std dev of your total portfolio (i.e.  a 50% cash and 50% optimal portfolio,which could very well be the 4 x 25 PP for the future) would be 5% and the return would be 4%. Note the Sharpe ratio would be the same - 0.8.

In this approach a professional or someone who has studied the markets can help determine the optimal portfolio. Given the uncertainties and un-knowabilities of the future, and past behavior of portfolios, many consider this to be close to the 4 x 25 PP. Independently you can determine your needs and degree of volatility that you can handle. This ratio between cash and the optimal portfolio will obviously differ for different people. A financial planner or advisor can work with you to help determine where you want to be on the line. This point could change as your needs change. Even the optimal point might change but the latter is very hard to predict and that I believe accounts for the wisdom and reality  of the 4 x PP.
Sorry to eb so long-winded about this but I hope this clarifies what I am trying to say

[Jay-UMN]

FWIW, my PP variant is somewhere in between 25x4 and 33x3. As the portfolio gets larger it may very well get closer to 25x4 but as it sits right now, I only add money to the PP once per year my actual cash allocation gets rather large, regardless of what my PP shows. When I rebalance I usually do 30/30/30 and 10% cash, but that is because I am adding to the PP once or twice a year. I don't count the excess cash from paychecks during the interim between contributions to the PP as cash wihtin the portfolio.