Hello again everyone, it's Molson Montgomery with another post.
Today I'm looking at how cash wedges can help protect against down markets. Back in the 1980s, the consensus was that with your CPP and old age security, as well as your lifetime savings, you should be able to live off the interest that a bank's savings account will give you for the rest of your life without touching the principle. This is called the 4% Rule. Fast forward to today, however, and the interest rates banks give on their savings accounts are abysmal. To obtain a 4% rate of return your money can no longer sit inside of a savings account. It needs to be placed in a diverse portfolio of equity and fixed income investments. Ultimately what that means, is that no matter what portfolio you choose, no matter how safe you think it is, when we move into a bear market, you will begin losing money. Well, the issue with that, is in retirement we can't lose our money, it’s all we have. So, how do you create a system that will allow you to keep your money safe and protect against down markets such as 2008 and the first half of 2022? Most people try to put their money into more fixed income, but 2022 has shown that no investment is truly safe. At one point bond portfolios were down 10% to 20% depending on geographic location. If you are a retiree drawing out money to live during a bear market, your portfolio is going to get disproportionately smaller and will never recover from those losses. So, what do we do?
Let’s look at how a cash wedge works.
A cash wedge is a fairly simple concept. Basically, what a financial advisor will do, is take the entirety of your portfolio, create a financial plan around it, and then help you decide on how much income you need on an annual basis to live from your money. This can be a tricky question. made harder because many people forget to factor in CPP or Old Age Security. Once you've decided on the amount of money you need to live, the financial advisor will take two years of income from your lump sum amount of money and place it into what's called a money market fund. This money market fund is the equivalent of a cash account. That financial advisor will then take the remainder of your money and invest it within a market portfolio of equity and fixed income investments. The market portfolio is focused on obtaining a greater rate of return with your money.
What happens when the market falls off a cliff like in 2008 and and the first half of 2022?
Once the market begins to fall and impacts your fixed income and equity portfolio, the financial advisor will stop drawing money out of the market portfolio and begin drawing money out of the money market fund instead.
Why would the Financial Advisor do that?
Well, the first thing that we note is that most bear markets have a break-even point. The cycle from the top of the market, to when it began to fall and to when we break even again is usually 388 days. What we're trying to achieve is to allow the money that's in the equity/fixed income market to freefall, reset itself and then come back up and out of the bear market without drawing money from it.
Historic data shows that once a bear market has hit the break-even point we will have another 3.8 years of a bull market on average. During the 3.8-year average bull market, there are two things that you can do. You can a) let it ride and try to make as much money as possible within your portfolio, however, you will be exposed to another potential market correction without the cash wedge or b) you can begin drawing money out monthly and move it back toward the money market fund over the next 3 to 4 years to replenish your cash wedge. In doing that, your lifestyle income as well as the cash wedge replenishment will come from your portfolio's growth.
For more information on how a cash wedge works, please reach out and we will get you in touch with a top financial advisor in your area.
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