A Retiree's Volatility 'Bucket'
Some retirees and other investors fast-approaching retirement set aside one to two years of living expenses if possible in a cash "bucket". This is to act as a volatility buffer to try to avoid having to sell growth assets at depressed prices to provide enough retirement income during a market downturn.
Critically, a cash bucket should give investors greater peace of mind during difficult investment conditions. In turn, this should help them concentrate on their long-term goals without being distracted by market "noise" and without disturbing their portfolio's carefully-constructed, target asset allocation.
The recent increased volatility and falls on world stock markets are likely to encourage more investors to think about whether a cash volatility bucket is appropriate for their circumstances. (See How to navigate through market volatility, Smart Investing February 8.)
Often, investors begin to progressively create a cash bucket or buffer in their last few years before their intended retirement. One approach is to direct a proportion of your super contributions from your final years in the workforce into cash to establish the buffer.
The size of the buffer and how it is built-up will depend on such personal circumstances as the size of an individual's retirement savings, age, investment timeframe and professional advice received.
There is obviously a price to be paid in potentially forfeited returns by having a low-earning cash buffer rather than in growth assets – particularly given that interest rates are extremely low.
A key issue is how to top-up the cash bucket or volatility buffer if necessary during retirement.
Some advisers may suggest using a proportion of income from an investor's main diversified portfolio to replenish the cash buffer from time to time. Proceeds from regular rebalancing of an investor's main diversified portfolio can provide another source of top-up money.
It would be difficult to underestimate the potential positive effect that a cash bucket may have on investors' behaviour during times of higher volatility and uncertainty on investment markets.
With the comfort of having one or two years' living expenses set aside in a cash bucket, investors should be less likely to get caught up with whatever the prevailing sentiment of the investment "herd" is.
Investment researcher Morningstar published an article several years ago on its US website emphasising the "psychological support" that a volatility buffer can give investors.
Morningstar observed from studying managed fund inflows and outflows that investors "levy big costs on themselves from year to year" by investing after prices have risen only to sell after prices have fallen. This is herd-chasing behaviour.
"Employing a bucket approach is designed to help retirees avoid those bad timing decisions that can erode long-term returns," Morningstar added.
Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.