Trump Trade War Investment Mitigation Strategies

No trademark long-winded Grumpus Maximus preamble for this article. However, since this is part three in a series about the Trump Trade War’s potential impact on your bottom line; I suggest you read parts one and two prior to reading this. You’ll need the context from the previous two articles for this post to make sense. In the second article, specifically, I explained Risk, Risk Tolerance, and Risk Capacity. I also laid out my investment philosophy. As you’ll see in the next few articles, I refer to Risk and my investment philosophy continuously.

Assuming everyone is up to speed, I suppose it’s time to talk Trump Trade War Investment Mitigation Strategies (T-TWIMS), right? Hang on while I run out and register the trademark on T-TWIMS … OK, I’m back! I’ll assume that’s a “yes” since you’re still reading. Well then, what’s your investing timeline or time horizon? In other words, when will you need the money?

Don’t groan. You knew that question was coming based on everything I discussed in my previous two articles. Since everyone obviously has a different answer, I’ll simply walk through some investment strategies based on different time frames in the next few articles. I’ll tackle the easier time frames first, and then move on to the harder time frames.

A 10+Year T-TWIMS

If you’re investing for ten or more years, you have the easiest investment mitigation strategy because all you need to do is …. buy as much Bitcoin as possible.

Just kidding!

In reality, 10+years is the easiest time frame for executing a T-TWIMS because you don’t need to do anything. At least … you don’t need to do anything differently. That assumes you’ve been saving and investing responsibly up to this point. If that’s not the case, go back and read part two of this series. In fact, you should probably just go back to the beginning of my Planning section and start from there. On the other hand, if you’re already investing responsibly, simply keep on investing as aggressively as your Risk Tolerance allows. Why?

Well, statistically speaking, there’s an extremely high chance that an investing time frame of 10+years would see an investor through multiple market cycles. Since I don’t know your exact timeline, I can’t predict how many market cycles. However, you can, with a little bit of research. Regardless, even at a minimum of a 10-year investment horizon, it’s highly likely (statistically speaking) that we’ll be through the next downturn and then some.

My 10+Year T-TWIMS

Therefore, if I were investing for myself on a 10+year timeline, I wouldn’t try and time the market. Nor would I horde cash while waiting for the big drop. I say that because I know my psyche and my propensity to procrastinate. I’d just keep delaying and miss the dip altogether — which is what I did through the 2008-09 crash. As a result of that experience, this time I’d just keep plugging away while buying at my planned routine intervals and riding the market down and back up.

Now, if the market saw a significant dip like 25% to 50% I might try and come up with some additional cash to buy more index funds since they’d all be on sale at that point. I’ve actually done that several times during the last few market corrections, but that’s only because of my personal finance self-education effort over the past four years. Prior to that, I’d get scared just like everyone else, sit big crashes out, and miss out on all the cheap deals.

Portfolio Balance

Now prudence, or at least modern portfolio theory, would recommend a well-diversified portfolio for anyone investing through a downturn. In my opinion though, whether or not that’s truly needed for a 10+year investment horizon has more to do with one’s Risk Tolerance than it does with maximizing returns. The way I see it, Risk Capacity for a 10+year timeline is still great. Furthermore, since I subscribe to the Jim Collins‘ theory that Risk is merely volatility on a long enough timeline, my ideal portfolio for a 10+year timeline is 100% in U.S. stock market index funds. I’d seek maximum returns while stomaching maximum volatility based on the assumption that I’m not going to sell when the market tanks. Gulp!

Have I put my money where my blogging is? Yes! I did just that in both of my kids’ 529 plans. I recently noticed that the target date fund in Grumpus Minimus #1’s (GM#1’s) 529 transitioned from 100% stock market index funds to a 90/10 mix of stock to bonds when he turned seven. That’s despite the fact that GM#1 is at least 11-years away from college. That wasn’t aggressive enough for me, so I traded his 529 monies out of that (supposedly aggressive) target date fund, and into a self-managed portfolio composed 100% of an S&P 500 ETF. While I was there, I also did the same for GM#2’s account.

Betting With Other People’s Money

Will the value of my kids’ accounts drop during the next Bear Market? Undoubtedly! Yet, since they won’t need the money to pay for college during the next Bear Market and recovery cycle; I’m letting that money ride the volatility roller coaster. I do that knowing that statistically, the odds are greatly in my favor to grow their money exponentially. I will obviously re-adjust the allocation in those 529s the closer they get to university, but until then … let ‘er rip.

Who says I don’t put skin in the game? Or at least my kids’ skin in the game? If that bet doesn’t pay off, those two can take out millions of dollars in loans for college just like all their peers!

Again I jest. However, these 529 moves check most of the boxes from my investment philosophy. A portfolio of 100% U.S. stock index funds (Vanguard to be precise) at 11+ years is simple and cheap. While I don’t have a target amount in mind, I want maximum returns based on the lifespan of the investment. I also want that grown amount to be there when I need it. So, I go aggressive early, ride the market for maximum returns as long as feasible, and then mellow out with bonds the closer we get to their college entrance. Of course, I’ll need to take the market cycle into account. That will help determine when I should start to transition heavily into bonds.

The Two-Year T-TWIMS: Cash Purchase

My suggested two-year T-TWIMS is almost as easy as my 10+year, but in this case, it actually matters what you intend to spend the money on. For instance, if you plan to use the invested money for a large cash purchase (such as a house), then on a two-year timeline “Cash is King”. In fact, Actuary on Fire (AoF) recently published a post which ran the mathematical simulations. As a result, AoF demonstrated that 100% cash is not only the safest but also the most efficient investment mechanism over a 2-to-5 year horizon! As AoF states:

So I’m (somewhat reluctantly) concluding that if you are saving to meet a specific target over 2-5 years and you absolutely have to meet this target then 100% cash is the way to go.

Grumpus’s Cash Plan

Anyone who’s read my Why I Trust My Plan … For Now post understands this is exactly what I’m doing with the money I’m accumulating for the purchase of the Grumpus Familias retirement home. For those who didn’t read that post yet, just understand that my early retirement calculations don’t work with a mortgage. Or, to put it in terms of my investment philosophy, since I absolutely need the house money on a 2-to-3 year time frame, my Risk Capacity is zero.

Since I can’t afford the Risk that the stock market might be down in two-years based on Trump’s economic policies; all of the money we’re saving for the retirement house is going into a CD ladder. I’ve built it using a mix of CDs from my credit union, and an online bank’s high-interest savings account. By building a CD ladder the money at least partially paces inflation, but I’m not looking to those CDs to generate a significant compounding return. I just need to know it will 100% be there when I need it.

The Two-Year T-TWIMS: Investment Portfolio

Now, let’s say a person is looking to retire in two-years, rather than spend their entire invested amount on a cash purchase. In that case, the two-year T-TWIMS looks different than the “Cash is King” model I outlined above. That’s because the Risk is different. In this case, the Risk is called Sequence of Returns Risk (SRR). SRR is the mathematical probability that if a market crash occurs early within the withdrawal cycle from an investment portfolio (e.g. a person starts retirement withdrawals from their portfolio just as the market crashes), then the underlying portfolio will suffer irreparable damage.

The Risk is that a person might run out of money in the out-years due to the damage caused in the early years. Ironically, if the start of withdrawals is offset by only a few years from the worst of the market crash (say 1 to 3 years after retirement), then SRR is not nearly as troublesome. Since SRR is a complicated issue to understand, I’ve linked to an article from TheBalance.com that explains it much better than I do.

Independent Performers

The best way to overcome SRR is to own investments within your portfolio that perform independently from stocks. Examples of this might include bonds, real estate, and precious metals. Theoretically speaking, each of those alternatives possesses the potential to perform differently than stocks during a stock market crash. In reality, though, a lot of their independence depends on what caused the stock market crash in the first place. For example, real estate certainly didn’t perform independently of the stock market in 2008 and 2009, since it caused the stock market crash. The other downside is that many of those offsetting investments don’t possess the same return potential as stocks.

As already addressed above, since I prefer simplicity and tend to avoid investments I don’t understand, I plan to stick with bonds and/or cash to offset the danger of SRR when I retire. Fortunately, for both you and me, numerous and better bloggers have already written about how to overcome SRR with a mix of stocks, bonds, and/or cash. Thus, in an attempt to speed this article to its conclusion, I plan to reference their work heavily in the next several sections.

The Safe Withdrawal Rate (SWR)

The idea of a Safe Withdrawal Rate (SWR) came about specifically to address the problem of SRR. It essentially proposes that when tested against all historical performances of the U.S. stock market, an investment portfolio intended for a specific length of time with a specific mix of stocks and bonds has a maximum withdrawal rate that it can successfully sustain. Since this SWR takes Sequence of Returns Risk (SRR) into account, then an investor needn’t worry about SRR as long as they stick to withdrawing in line with their portfolio’s SWR. While the actual SWR for any given portfolio depends on the mix of stocks-to-bonds, and the intended length of time the money needs to last; the general rule of thumb used by financial planners over the past two decades is the 4% SWR.

A Financial Planner named William Bengin first established the idea of a 4% Safe Withdrawal Rate in 1994 when he published an article in “The Journal of Financial Planning“. The press quickly, and erroneously started to call it the “4% Rule”. Much has been written about SWRs in general, and the 4% Rule specifically, in the intervening years. This includes by such Personal Finance luminaries as Michael Kitces, and Wade Pfau. In my humble opinion though, no one has written more quantitatively or qualitatively about how to overcome SRR using an SWR than Big ERN (Karston) at Early Retirement Now. He’s currently written 26 articles for his Safe Withdrawal Rate Series.

SWR Findings

That isn’t to say ERN’s SWR series is easy reading, because it’s not. In fact, it’s statistically dense. As an alternative, I recommend the first half of Wade Pfau’s book entitled “How Much Money Can I spend in Retirement?” which makes for slightly easier reading. And of course, there is always Jim Collins’ explanation on the basics of the 4% SWR at his website — which is where I originally learned about it.

In any case, both ERN and Pfau’s analysis concludes that in today’s historically low-interest rate environment, the most efficient stocks-to-bonds ratio is roughly 80/20, which yields an approximate SWR of 3.5%. This especially looks true (mathematically speaking) for those planning a retirement of longer than 30 years. So, if your retirement nest egg is now big enough to support your annual spending through withdrawals of no more than 3.5% annually, and you are no more than two years away from retiring; you should transition to that mix now.

Nuance #1: The 2-to-3 Year Cash Bridge

Of course, not everyone trusts the idea of an SWR completely. Thus, there are numerous nuanced strategies that combine the idea of an SWR along with some other tactic to hedge against SRR. The first nuanced strategy for avoiding SRR is utilizing an SWR with a Cash Bridge.

The Cash Bridge is a concept that many Personal Finance and Early Retirement bloggers either practice and/or preach. In it, retirees keep somewhere between 1-to-3 years of cash on hand in a money market/savings account in case the market crashes. That way, they don’t have to sell stocks when the market nosedives in order to generate cash. If/when they utilize their bridge, they then refill the cash once their portfolios recover. There are varying ways to employ this mitigation tactic, but FI bloggers Fritz Gilbert at RetirementManifesto.com and Darrow Kirkpatrick from CanIRetireYet.com capture it best in my opinion.

Testing The Cash Bridge

Does it work? As it so happens, Big ERN put the Cash Bridge tactic through his historical simulations for one of his articles. He tested several different employment methods in the run-up to the 2000 Dot.com crash — which was historically the worst crash and recovery for the S&P 500. Unfortunately, ERN’s findings were less than conclusive either way. In some cases, a Cash Bridge helped, and in some cases, it didn’t. There were a lot of caveats. I summarize below:

• The Cash Bridge worked in 3 out of 4 scenarios.
• However, the Cash Bridge is no silver bullet; even a 3-year cash bridge wouldn’t have mitigated the irrecoverable effects of SRR for someone who retired in December 1999, only months before the market crashed.
  • Assuming the December 1999 cohort of retirees did nothing else to mitigate SRR, a three-year Cash Bridge with an SWR of 3.5% will only delay the inevitable decline of the portfolio a few more years into the future.
• Thus, timing still matters! Especially when:
  • Retiring — don’t do it within a year of markets crashing (see above)
  • Building a cash bridge — It’s OK to build a cash bridge as large as three year’s worth of spending but do it no more than two years before a crash.
    • The opportunity cost of pulling that money out of the market becomes too great at 3+years
  • Don’t replenish your cash bridge too quickly — and don’t do it all at once — ease into it after the recovery starts.
• In three-out-of-four retirement scenarios, the cash bridge outperformed a 100% equity portfolio — so it does work.

Cash Bridge Verdict

If I understood ERN’s research correctly, the Cash Bridge tactic in combination with a 3.5% SWR to avoid SRR works on a two-year timeline as long as:

1) A person can offset their retirement from a historically bad crash by at least one year (in either direction before or after)

and 

2) They build up their cash bridge nor more than two years in advance of the crash

Of course, for someone like me who just poo-pooed (a technical term used by economists) the idea of market timing in my previous article, ERN’s findings seem a bit like a cruel joke. If a person could successfully predict a market crash two years in advance in order to build up a cash bridge; then they could certainly time their retirement around the predicted market crash! At that point, forget about SWRs; a person could just market time by selling high and buying low. Thus, while taking a percentage of your portfolio as cash into retirement to mitigate the worst effects of SRR may be prudent; since we can’t predict the Trump Trade War induced crash’s exact timing, the Cash Bridge tactic may not be the preferred method to mitigate the Trade War’s effects on your portfolio.

Nuance #2: Equity Glidepaths

Is there a better tactic that a person can combine with SWR to avoid SRR? Fortunately, big ERN is relentless in his testing of the SWR strategies. In this case, I refer specifically to his two articles on “Equity Glidepaths”. An Equity Glidepath is simply a fancy term for smoothly changing the percentage of stocks and bonds within a portfolio over time. A portfolio can either go from a high percentage of stocks to a high percentage of bonds, or vice versa. If you think about it, this is exactly what life-cycle or target-date funds do as an investor approaches retirement.

Riffing on that idea, and some work done by Michael Kitces, ERN decided to test the effect of a Rising Equity Glidepath on SWR’s and SRR. In other words, he started with a lower than normal percentage of stocks and a higher percentage of bonds at a simulated retirement point. He then added more stocks while decreasing bonds each year throughout the first decade of retirement. He did this to see if the Rising Equity Glidepath provided a higher SWR, or increased the chance of overcoming the effects of SRR early in the retirement.

Rising Equity Glidepath Results

ERN’s results? Again, I summarize below, mostly from the second article (although I suggest you read both):

• A Rising Equity Glidepath helps during a market crash and the immediate recovery.
• A Rising Equity Glidepath’s positive effect is relatively small.
  • “Expect an increase in the sustainable withdrawal amounts by about 5% or a slight to moderate decrease in the failure probability of any given SWR.”
• A Rising Equity Glidepath only works when the CAPE-SCHILLER ratio is high at the start of retirement. ERN found that if the CAPE ratio is below 20, glidepaths are of no use.
  • CAPE-SCHILLER is a method of determining if stocks are overvalued. Investopedia points out that “as of June 2018, the CAPE ratio stood at 33.78, compared with its long-term average of 16.80“.
  • In the case of a CAPE ratio of less than 20 at retirement, ERN recommends an aggressive static equity allocation as close to 100% as your Risk Tolerance can stomach — since 100% equity historically has the best long-term performance.
  • Remember, ERN is a FIRE blogger, so he typically simulates 60-year retirements!
• Be disciplined and execute your glidepath transition from bonds-to-stocks rapidly. ERN recommends transitioning to the maximum equity weight (100%) over the length of one complete bear plus bull market cycle.
  • He used 10-year transition periods starting at retirement for most simulations.
• A glidepath from 60% stocks to 100% stocks was optimal in most scenarios. That translates to adding 4% more stocks into your ratio each year, no matter what!
  • The outlier was a 40% to 100% glidepath for a 30-year retirement. That translates to 6% more stock per year, no matter what!
• Understand the risk. If a market crash doesn’t occur in year 1 or 2 of retirement, then a Rising Equity Glidepath doesn’t provide maximum returns or a maximum SWR. However, it won’t sink your portfolio’s long-term success either. It’s simply an insurance policy against the worst happening.

Grumpus’s Dilemma

So … I just happen to be 25 months away from my preferred retirement date which means I’m particularly interested in the best 2-year T-TWIMS. Based on my Risk Tolerance, my retirement portfolio’s already at an 85/15 stock-to-bond ratio. I’m content to let that ratio ride for now in the hopes that the Trump Trade War induced recession hits in the next 12 months.

If the recession and an accompanying stock market crash does hit in the next year, it would (hopefully) put the worst effects on my portfolio outside of my golden “one-year on either side of retirement window” that Big ERN identified as so crucial. Thus, as I approached retirement, I could simply slip into an 80/20 mix, use a 3.5% SWR, and call it a day. However, if a recession doesn’t hit, and the stock market hasn’t gone into a full-blown bear retreat in the next 13 months, then I’ll be stuck with a tough decision.

Remember, my entire thesis about Trump’s Trade War, and his economic policies are that they seem designed to make the next downturn worse than it otherwise might be. Thus, I’m not confident a 3.5% SWR using an 80/20 stock-to-bond ratio would be enough if I retire within 12 months of this impending crash. Which means I would probably look to using one of the two nuanced tactics I described above.

Grumpus’s Two-Year T-TWIMS Verdict

Prior to penning this article, I was leaning towards the Cash Bridge strategy. That preference was based mostly on the respect I hold for Darrow Kirkpatrick from CanIRetireYet.com. Darrow retired early and has already navigated his way through several stock market crashes using a Cash Bridge.

However, now that I’ve researched this issue further, I think I prefer the Rising Equity Glidepath. I believe it fits my investor psyche better. I’m not sure I could stomach selling two-to-three years’ worth of expenses from my portfolio just to convert it cash and have it sit there. Plus, given the “timing the market issue” that ERN noted when building up the Cash Bridge; simply shifting to a 60/40 stock-to-bond ratio a year from retirement seems both the easier and safer move. At least, it does for me.

On that bombshell, I’m going to cut this article off. In the next part of the T-TWIMS series, I plan to address what I see as the hardest time frames to plan against given the uncertainty caused by the Trade War. That’s the 2-to-5 and 5-to-10 year timelines. Until then, let me know what you think of the article, the series, or the blog in the comment section below!

— GM