Cash Drag

[jsnikeris]

I just came across this concept:

https://www.betterment.com/resources/in ... cash-drag/

Is it just me, or does this analysis completely ignore the value of having cash available to purchase assets at a discount during an economic downturn?

[stuper1]

Somebody please correct me if I'm wrong, but it's my understanding that PP rebalancing almost always (or maybe always always) happens by hitting a 35% band, not by hitting a 15% band.  Is this true?  Has anybody had to rebalance because an asset went down so bad that it hit the 15% band?

If my understanding is correct, then that seems to indicate (although not prove completely) that one of the three volatile assets is always "up" in relation to the cost at which you bought it.  If that's the case, then I don't really understand this "dry powder" argument about cash.  If the other two assets go down hard, I can always sell the asset that is up (it only takes a few days to clear), and then buy the assets that are down.

What am I missing with this thinking?

Having said all that, I'm not arguing against holding cash.  I'm just saying that the value of cash is not so much to be able to buy discount assets during an economic downturn as just to deleverage the volatility of your overall portfolio so that you don't make rash decisions.  Us PPers hold cash, and we also hold long-term bonds (barbell strategy).  The people behind the link that you posted probably don't hold long-term bonds either.  They just hold intermediate bonds (bullet strategy).  Of course, they probably also hold a separate emergency fund in cash.  A lot of us think of the cash in our PP as our emergency fund.

[mukramesh]

I don't remember who posted it, but somebody in this forum said something I found very insightful regarding the value of cash. Cash doesn't just help reduce portfolio volatility, but it really helps with life volatility (their phrase, not mine).

Consider the financial crash in 2008. Someone investing in the stock market, in addition to having lost a large chunk of their life savings, would have a high chance of losing their job. A job loss coupled with a bad economy means that in order to pay for living expenses, an individual might have to resort to selling their investments. Since investments were down, they sold at a loss and reduced their ability to ride the subsequent upswing in the market.

Having a large cash allocation (some refer to this as an emergency fund) means that even in a scenario like above, one would not be forced to sell assets at depressed prices. They can keep their money in the market and ride the eventual rebound. The PP accounts for this life volatility by having a 25% cash allocation.

This is the difference between backtesting and real-life investing.

[Pointedstick]

Exactly. There's also the fact that people with cashless portfolios often (hopefully…) maintain large emergency funds or high checking account balances. So they really do have a lot of cash, but they just don't count it in their portfolio. I like how the PP integrates them, explicitly transforming cash into a productive asset not because of its high return (though it can be when interest rates are high) but because it serves a valuable role in that is allows the other assets to do their job better by reducing your need to sell them at inopportune times, thereby minimizing taxes on gains or having to take losses.

[madbean]

If my understanding is correct, then that seems to indicate (although not prove completely) that one of the three volatile assets is always "up" in relation to the cost at which you bought it.  If that's the case, then I don't really understand this "dry powder" argument about cash.  If the other two assets go down hard, I can always sell the asset that is up (it only takes a few days to clear), and then buy the assets that are down.

I'm old enough to have seen 18% CD's. I wasn't making enough money to buy a single one at the time but that's where my parents put all their money. If somebody had been in the PP at the time I'm sure they would have been using cash to buy other assets. Whether you call that "dry powder" or not, I don't know. And whether we'll ever see anything like that again in our lifetime I don't know either.

[Mark Leavy]

I just came across this concept:

https://www.betterment.com/resources/in ... cash-drag/

Is it just me, or does this analysis completely ignore the value of having cash available to purchase assets at a discount during an economic downturn?

This is just betterment lashing out at Schwab for competing with them in the tax optimization game.
Schwab offers a service similar to betterment, but does it for free.  The caveat is that Schwab requires you to maintain a portion of your portfolio in cash.

Betterment can't compete against "free", so they are writing a FUD piece to confuse the market.
http://en.wikipedia.org/wiki/Fear,_unce ... _and_doubt

For the record, I don't use either service.

[AnotherSwede]

Somebody please correct me if I'm wrong, but it's my understanding that PP rebalancing almost always (or maybe always always) happens by hitting a 35% band, not by hitting a 15% band.  Is this true?  Has anybody had to rebalance because an asset went down so bad that it hit the 15% band?

During backtesting I've had. Using the yearly figures since -72, LTT hit 14% 1979, Gold 14% in 1989 and 1996, Equity 14% in 2002.
But all these four times the cash% is 25 or less, so your point may be valid.

I'm sure if you're evaluating the portfolio monthly it would happen more often.

[Gosso]

Keep in mind that rebalancing into cash also causes you to occasionally sell early, so overall it is a wash.  Rebalancing primarily keeps your risks in check.

[Tortoise]

Good points so far.

I think cash also has certain returns that are often overlooked when looking at raw balance statements. For example, last month I realized that it was probably pointless for me to continue carrying my comprehensive and collision coverage on my auto insurance policy since I have a sizable cash emergency fund and could thus easily purchase a replacement vehicle if needed. In other words, my cash allows me to "self-insure" that risk. As a result, I chose to redirect those monthly insurance premium payments into my own pocket. That's a guaranteed return on my cash. Granted, it's not huge, but it's something.

By similar reasoning, having a cash allocation allows you to avoid purchasing items on credit (auto loans, credit card debt, etc.), which means you avoid having to pay interest. Again, that's a guaranteed return on your cash.

So even in a zero interest rate environment, your cash still provides financial returns in the sense that you can avoid certain insurance premiums and interest payments that you would otherwise have to pay if you didn't have that cash.

[Tortoise]

Somebody please correct me if I'm wrong, but it's my understanding that PP rebalancing almost always (or maybe always always) happens by hitting a 35% band, not by hitting a 15% band.  Is this true?  Has anybody had to rebalance because an asset went down so bad that it hit the 15% band?

I think this topic has come up before, and from what I recall, most PP rebalance events have historically been triggered by rising, not falling, assets (i.e., the 35% band, not the 15% band).

There's actually a fairly straightforward explanation for that. If we start at exactly 4x25% and the other three assets remain constant, an asset has to go up in price by a factor of 1.62 to trigger the 35% rebalance band. By constrast, an asset has to go down in price by a larger factor of 1.89 to trigger the 15% rebalance band. So in general, the latter should occur less often.

[Pointedstick]

Good points so far.

I think cash also has certain returns that are often overlooked when looking at raw balance statements. For example, last month I realized that it was probably pointless for me to continue carrying my comprehensive and collision coverage on my auto insurance policy since I have a sizable cash emergency fund and could thus easily purchase a replacement vehicle if needed. In other words, my cash allows me to "self-insure" that risk. As a result, I chose to redirect those monthly insurance premium payments into my own pocket. That's a guaranteed return on my cash. Granted, it's not huge, but it's something.

I've done the exact same thing. It's made me a big fan of "self-insuring."

[MachineGhost]

There's actually a fairly straightforward explanation for that. If we start at exactly 4x25% and the other three assets remain constant, an asset has to go up in price by a factor of 1.62 to trigger the 35% rebalance band. By constrast, an asset has to go down in price by a larger factor of 1.89 to trigger the 15% rebalance band. So in general, the latter should occur less often.

That implies the rebalancing bands are not symmetrical in terms of risk to reward.  Another flaw that needs to be fixed?

[Tyler]

Somebody please correct me if I'm wrong, but it's my understanding that PP rebalancing almost always (or maybe always always) happens by hitting a 35% band, not by hitting a 15% band.  Is this true?  Has anybody had to rebalance because an asset went down so bad that it hit the 15% band?

Throw cash withdrawals into the picture, and the answer is "absolutely".  Life sometimes requires liquidity. 

[ochotona]

I have now about 18% of my portfolio in those Schwab "cash-drag" portfolios, and I like that it has that much cash at this point in the market; and 5% IAU, to boot.

[Kbg]

There's actually a fairly straightforward explanation for that. If we start at exactly 4x25% and the other three assets remain constant, an asset has to go up in price by a factor of 1.62 to trigger the 35% rebalance band. By constrast, an asset has to go down in price by a larger factor of 1.89 to trigger the 15% rebalance band. So in general, the latter should occur less often.

That implies the rebalancing bands are not symmetrical in terms of risk to reward.  Another flaw that needs to be fixed?

For my 3x ETF PP VP I rebalance at .5x and 1.5x the target weight. I'm not sure if it is a "flaw" per se or there was any thought behind 15/35% other than +/- 10%, but I decided to go symmetrical. If the theory is no predicting, why weight differently? The one logical thing for having a bigger hurdle for the downside rebalance is things tend to go down harder/faster/more than they tend to go up...so maybe that was why???

[mathjak107]

think of cash as owning call options on assets at lower prices.

[barrett]

think of cash as owning call options on assets at lower prices.

Interesting perspective. I kinda like it.

Me too!

[LC475]

For my 3x ETF PP VP I rebalance at .5x and 1.5x the target weight. I'm not sure if it is a "flaw" per se or there was any thought behind 15/35% other than +/- 10%, but I decided to go symmetrical. If the theory is no predicting, why weight differently?

Umm... I hate to break your bubble, but.... you are doing the exact same thing as the PP.  Your rebalance bands are 12.5% (.5X25) and 37.5% (1.5X25).  That is, +/- 12.5%.

Look, your bands and the PP bands are symmetrical... from a certain point of view.  In the PP, if an asset is either +40% of the target weight or -40%, that's when the rebalance happens.  15 is 60% of 25 (that is, 25 has to go down 40% to reach 15) and 35 is 140% of 25 (25 has to go up 40% to reach 35).  For you bands, it's just 50% instead of 40%.  Plus or minus 40% seems like a nice, reasonable figure -- a big range, allows for a lot of volatility between the marks.

The issue that I've thought of before (I was going to start a thread on it back when I was new, but never did) is that the 10-point gap or 40% gap however you look at it between 15 and 25 is bigger, proportionally, than the 10 point gap between 25 and 35.

35/25 = 1.4
25/15 = 1.66

So in that sense, 15 and 25 are actually quite a bit further apart from each other than 25 and 35.

To equalize it, if you're a fan of the 35% upper and want to keep it the same, you'd change it to:

35/25 = 1.4
25/17.857... = 1.4

So the new rebalancing bands are 35% and 17.86%.
If instead you loved the 15% band, you'd make it 41-2/3% and 15%.

That's all looking at the asset in isolation, as if the 25s and 35s and 15s were solid quantities, like 25 dollars becoming 35 dollars or 15 dollars.  But, of course, that's not what's happening in the PP.  The 25s and 35s and 15s are percentages of a whole, just part of the larger portfolio.  And so as the asset price fluctuates, not only the numerator changes, the denominator also changes.

So if one wanted to make the bands proportionally even and equal with respect to rises and falls in the asset price (not to the percentage of the portfolio represented by the asset,  which is what the above bands do) then you'd make your bands 35% and 17.06%.  That way, you buy if your asset goes down about 62% with respect to the rest of the portfolio, and you sell if it has gone up by about 62% with respect to the rest of the portfolio.  Or 38.65% and 15%.  With that one, you'd be waiting until the asset went either up or down by about 89% with respect to the rest of the portfolio.

So, mathematically, them's the facts and there they be.  However, irrational numbers just look so much more complicated on the page than rational ones.  Or in speech.  Can you imagine explaining to a friend, or Harry Browne saying on his radio show: "It's a very simple plan: 25% each, and then you rebalance whenever one of them hits either 35% or 17.0648% of the total portfolio."  Doesn't have quite the same ring, does it?  Also not very easy to remember.  Even rounding to 17%; 17 just doesn't have the pizzang.  And if you're rounding anyway, why not round to 15?

[MachineGhost]

So, mathematically, them's the facts and there they be.  However, irrational numbers just look so much more complicated on the page than rational ones.  Or in speech.  Can you imagine explaining to a friend, or Harry Browne saying on his radio show: "It's a very simple plan: 25% each, and then you rebalance whenever one of them hits either 35% or 17.0648% of the total portfolio."  Doesn't have quite the same ring, does it?  Also not very easy to remember.  Even rounding to 17%; 17 just doesn't have the pizzang.  And if you're rounding anyway, why not round to 15?

Gesundheit!  This is the next logical tweak for the Risk Parity PP.  I come up with 17.857142857142857142857142857143% though! 

[LC475]

I come up with 17.857142857142857142857142857143% though! 

So did I:

To equalize it, if you're a fan of the 35% upper and want to keep it the same, you'd change it to:

35/25 = 1.4
25/17.857... = 1.4

So the new rebalancing bands are 35% and 17.86%.

...but that's only the first iteration of the calculation.  It's 17.06...  in the end.

But maybe you're just making a joke about rounding!  If so,