Latest posts by Wanderer (see all)
- Reader Case: Can this 24-year-old from DC Retire Early? - January 18, 2019
- Our 2018 Finances Part 2 - January 14, 2019
- Reader Case: Does FIRE Math Apply to the Elderly? - December 21, 2018
Today we will be concluding our multi-part series on the Yield Shield. Over the past few weeks we wrote about all the parts that make up the Yield Shield, namely:
And throughout it all, people have been emailing me asking “Yeah that’s great, but how do I put it all together to assemble my own Yield Shield?” So today we’re going to be talking about exactly that.
It’s All About Pivoting
Building a Yield Shield isn’t hard. It’s simply a matter of taking your existing low-cost indexed portfolio and pivoting a portion of your assets towards the higher-yielding versions that we talked about. To do this, we have to answer two questions:
Q1: Which assets do we pivot? And for what?
I’ve alluded to this in those previous articles, but generally you want to match up the higher-yielding assets with the ones that are the most similar in nature to avoid swinging your portfolio’s risk/return characteristics too much. For example, if you decided to add more REITs, but you swapped your bonds out for it, you’ve fundamentally changed your portfolio’s equity/fixed income mix, and that’s probably not what you intended. For the higher-yielding assets we’ve discussed, your swaps generally should look like this:
Bonds –> Corporate Bonds, Preferred Shares
Swapping your regular bonds for Corporate Bonds or Preferred Shares doesn’t fundamentally change your equity/fixed income allocation, since Corporate Bonds are still bonds, and Preferred Shares act more like bonds than equities. In fact, if your bond allocation is in a Total Bond Market Index of some sort, it likely already owns Corporate Bonds. By doing this swap, you’re just pushing your bond allocation’s credit rating towards the BBB end, so you’re not doing anything too crazy. Generally, this swap will increase your portfolio volatility, but your yield will go higher.
Domestic Equities –> Dividend Stocks, REITs
Like the above swap, swapping the Domestic Equity Index for Dividend Stocks is not too different, since the Index itself owns Dividend-producing stocks. This will, however, pivot your allocation more towards bigger, established companies in saturated marketplaces like Coca-Cola and Johnson & Johnson, and away from smaller high-growth stocks that will tend to return their value as long-term capital gains. If you’re building your Yield Shield, this is a good trade-off. Similarly, pivoting towards REITs is a bit like owning the building those companies are in rather than the company itself. You’ll get more steady month-to-month income, but you won’t participate as much in those companies’ success.
International Equities –> International Dividend Stocks, REITs
Because a significant portion of our portfolio is in International Equities (US, EAFE, Emerging), I could theoretically find similar International Dividend Stock ETFs and International REITs to swap for yield as well. The reason I haven’t done that is because I don’t like depending too much on international yield. When you stick with bonds and stocks of your home country, you know exactly how much yield you’re going to make. But when that yield comes from other countries, you’re going to get that yield in a foreign currency, and if that foreign currency swings in value relative to your home currency, you may not be getting as much money as you thought. That being said, just because I haven’t done it myself doesn’t mean you can’t (or shouldn’t), so if you’re up for it this is another worthwhile swap to consider.
Q2: How much of each asset should I pivot?
The short answer is: As much as you need. And for a longer example, let’s do an example, shall we?
The Canadian Workshop Portfolio
For our example Yield Shield exercise, let’s start with the Canadian portfolio we used for our Investment Workshop series. If you’ll recall, our Canadian portfolio was this:
Great. Super. Now what’s the yield on this portfolio? To find that, we have to go to each ETF’s prospectus and pull out the current yield on each one. Then we have to calculate a total portfolio yield by multiplying the weighting on each asset by its yield, and then adding it all up, like so.
2.3%. Not bad, but we can do better. Let’s add in our higher yielding assets and their respective yields (shaded in grey).
And now it’s a matter of playing around with the weighting in Excel until you arrive at a weighting that you’re comfortable with that gets you the yield you need. For us, we’ve decided to aggressively pivot into higher-yielding assets because in our early-retirement phase, we need the yield more than we need the capital growth. Right now, we are sitting around here:
So to recap, I’ve decided to pivot the majority (75%) of my fixed income towards higher-yielding fixed-income assets. I’ve also decided to pivot half of my domestic equity towards Dividend Stocks and REITs. International equities I’ve left alone.
Doing this has allowed me to raise me 2.3% portfolio yield almost a full percentage point to 3.0%.
The American Workshop Portfolio
Now let’s do this again for our American portfolio as featured in our Investment Workshop. To recap, here is our American portfolio.
So what is our portfolio yield? Like before, we need to go to each ETF’s prospectus and grab the most recent yield numbers. Here they are.
So our American portfolio is also yielding around 2.6%. Super. Well, let’s see what happens when we add in the higher-yielding assets we’ve been discussing.
Phew. There are some real juicy swaps to be made here, right? Specifically, the 5.5% yielding Preferred Index vs the 3% yielding Total Bond Market index. Plus the 4.4% yielding REITs vs the 1.8% yielding US equities. In finance terms, this is what we would call a “spread.” And a fairly attractive one at that.
Now, while the above Canadian portfolio is basically the portfolio I’m invested in now, this US one is purely hypothetical. This is what I, personally, would do if I were an early retiree in the US, but this should not be misconstrued as financial advice. I don’t know your personal financial situation, and you should, as always, do your own research!
But as an example for you to work off of, here’s my hypothetical US Yield Shield portfolio.
The US portfolio could potentially yield even higher than my current Canadian one, owing to the fact that my restriction on only swapping out domestic equities means a LOT more room to maneuver on the US portfolio than the Canadian portfolio. Personally, I have a bit of mistrust in pivoting my international equity towards yield because of foreign exchange risk, but if you’re more comfortable with that than I am, you could potentially increase your yield even more!
The Yield Shield and Your Cash Cushion
So why is this all important? Because all of this affects your Cash Cushion.
Recall that the first two lines of defense when guarding against an unexpected market crash in early retirement are:
- The Yield Shield
- The Cash Cushion
The Cash Cushion is the amount of cash you hold to finance short-term expenses. But its’ second job is to provide a way to prevent you from selling assets during a market downturn. Remember that even when markets fall, your Yield Shield still does its job of giving you income. So in reality, your cash cushion only needs to cover the gap between your expenses and your yield. If your expenses were $40k, and your portfolio of $1M was yielding 2.5%, your yearly gap would be:
$40k – $1M x 2.5% = $15k
In other words, you would need to keep a Cash Cushion of $15k for each year of Cushion you wanted. To keep 3 years of Cushion, you’d need $45k. To keep 5 years, $75k.
But if you increase your yield by using the Yield Shield techniques I’ve outlined above, you can get away with way way less in your Cash Cushion. Let’s take the American portfolio, now yielding 3.4%. With a 3.4% yield on a $1M portfolio, and with living expenses of $40k, your yearly gap would be:
$40k – $1M x 3.4% = $6k
Now, you only need $6k of Cash Cushion to cover one years, so a 3 year Cushion would be only $18k, and a 5 year Cushion would be $30k.
This is the power of the Yield Shield. The higher your Yield Shield, the less money you need to keep outside your portfolio. And theoretically, once your Yield Shield covers 100% of your living expenses, you don’t need to keep a Cash Cushion at ALL.
Lowering Your Yield Shield
That being said, don’t think that a Yield Shield is meant to be permanent. It’s not. Creating a Yield Shield distorts your portfolio from a pure indexing strategy, which I (and many FI bloggers) believe to be the only investing strategy that consistently works long-term. The purpose of a Yield Shield is to guard against the sequence-of-return risks that threatens every early retiree.
A pure indexer would get screwed if they retired during a financial meltdown. But someone who implemented a Yield Shield during would have come out unscathed.
But remember this: You don’t need to do this during the accumulation phase. You only need to raise the Yield Shield after you retire. Also, this is meant to be temporary. It increases portfolio volatility, and increases investment fees (since many of these smaller funds that track REITs and such have higher MERs), so these aren’t investments that you should stay in long term.
I’m not planning to either. As our retirement continues to cruise out of the Sequence-of-Returns Danger Zone (3-5 years), we plan on selling off these higher-yielding assets and returning back to pure Indexing. And when we do, the readers of Millennial-Revolution.com will be the first to know!
And with that, we’re done. Questions? Comments? Let us have it below.
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