Managing Cash Contributions

Our signal plans deploy it gradually.

From Chapter 5: “Managing Money in the Plan” of The 3% Signal:

No matter where you run your ... signal plan, you’re likely to contribute more cash periodically to your bond fund. In an individual retirement account, you’ll probably contribute on a monthly basis. In an employer retirement account, cash usually flows in from every paycheck. In a nonretirement brokerage account, you might set up a regular cash transfer schedule from your bank and send extra cash whenever you’re lucky enough to find some.

If the market rises over a long enough period without many setbacks causing [your plan] to buy, your selling proceeds and cash contributions could combine to grow your bond balance until it’s too big relative to your stock balance. You want most of your money to work for you by rising with the stock market over time, so an unduly large bond balance should be avoided. Then again, the stock market occasionally plunges so deeply that what looked like an oversized bond balance can suddenly come in handy for buying the lower lows. You need to strike a balance, so to speak.

The way to strike that balance is with a modified growth target. The Kelly Letter incorporates one every quarter to draw in cash received via its funds’ distributions. The letter never makes contributions. But, as mentioned above, your plans might receive contributions from you in addition to fund distributions.

In this update, I’ll review how the modified growth target works using real-world examples from Kelly Letter subscribers and a new graphic to help you see the relationship of your cash contributions to the quarterly signal line.

Join me now as I walk you through two hypothetical quarters.

Q1

Let’s say you run a 9Sig plan in your retirement account, with $63,000 in the stock fund and $37,000 in the bond fund. For simplicity, we’ll say it began this first quarter at those allocations: a 63/37 stock/bond split.

A 9Sig plan’s quarterly growth target for the stock side is 9%, hence the name. Easy enough to calculate:

$63,000 x 1.09 = $68,670 quarterly balance target

During the quarter, you contributed $10,000 to the bond fund (all contributions go completely into the bond fund, along with all distributions), and directed $700 in distributions from both of your funds into the bond fund.

By “all contributions and distributions go completely into the bond fund,” I do mean all. They don’t get divvied up on the way in. This is as simple as can be: all new money in the plan goes into the bond fund, and is drawn in to the stock fund quarterly using the modified growth target we’re exploring here. Set your stock fund to distribute cash to your account, your bond fund to reinvest distributions, and put all new cash into that bond fund, and you’ll be set.

New cash added during the quarter is the sum of contributions and distributions:

$10,000 contributions + $700 distributions = $10,700 new cash added

We aim to draw your new cash into the stock market on an evergreen schedule. To do this, we add half of the new-cash value to the quarterly balance target to determine your signal line. That’s the balance you’ll adjust your stock fund to by either buying a shortfall below it or selling a surplus above it. Using the numbers above, here’s how to calculate your signal line:

$68,670 + ($10,700 ÷ 2) = $74,020 signal line

If your stock-fund balance ended the quarter at $84,020, you would sell the $10,000 surplus and put the proceeds into your bond fund. If your stock-fund balance ended the quarter at $64,020, you would buy the $10,000 shortfall using funds raised by selling shares of your bond fund.

Let’s say the stock market delivered a quarter for the ages, sending your stock-fund balance up more than 33% to the aforementioned $84,020. You sold the $10,000 surplus and put it into your bond fund by purchasing shares.

After your quarterly orders filled, your plan looked as follows, assuming no change in the price of your bond fund’s shares through this time frame (which would almost never be the case, but we’ll keep the numbers easy for this example):

Hypothetical
9Sig Plan Allocation
After Q1 Orders ($)
– – – – – – – – – – – – – – –
74,020 stock fund
57,700 bond fund

Are you wondering how your bond fund balance grew so much if its price remained unchanged? Let’s run the numbers:

$37,000 starting balance +
$10,000 contributions +
$700 distributions +
$10,000 stock-fund sale proceeds =
_______
$57,700 new-quarter bond fund balance

“But wait a minute,” you object. “I thought we added half of that new money to the growth target to get the signal line. Why is the full amount of new money still in the bond fund?”

Because we added half the value of the new money to determine the signal line, then ran the quarterly order calculation. Despite your substantial new money adding a sizable $5,350 ($10,700 ÷ 2) on the growth target to get the higher signal line, your stock fund did so well in the quarter (up more than 33%) that you still received a sell signal. You followed it, and put the proceeds into the bond fund.

After all this, you entered Q2 at a stock/bond allocation of 56/44.

Q2

Into Q2 you went, at your 56/44 stock/bond allocation. During this quarter, you contributed $12,000 and received $800 in distributions.

First things first: what’s your growth target for the quarter? You’re an old hand at this by now, so you know it will be your quarterly starting balance plus 9% growth:

$74,020 x 1.09 = $80,682 quarterly balance target

Your $12,000 in contributions plus $800 in distributions makes $12,800 in new cash, half of which is $6,400. You know that to determine your signal line, you’ll add that amount to the quarterly balance target.

“But wait a minute,” you protest. “What about the leftover new cash from Q1? Shouldn’t we factor that in somewhere?”

Nope. Each quarter is a fresh start—no baggage, no regrets. You run your calculations quarter by quarter and let bygones be bygones. If only the rest of life worked this way.

Here’s your signal line:

$80,682 + $6,400 = $87,082 signal line

This quarter, stocks took a breather—understandable after their historic 33%+ showing in Q1.

Your stock-fund balance declined 9% to $67,358. That’s $19,724 below its signal line, so you needed to sell enough bond-fund shares to generate that amount of money and move it into your stock fund by buying its shares at the new, lower price. If it went perfectly, and your bond fund’s price still hadn’t budged all year, here’s how your plan looked after your Q2 orders filled:

Hypothetical
9Sig Plan Allocation
After Q2 Orders ($)
– – – – – – – – – – – – – – –
87,082 stock fund
50,776 bond fund

You entered Q3 at a stock/bond allocation of 63/37.

Watch Your Cash Work

Let’s visualize cash management over these two quarters for better understanding. The following shows your growth target over the two quarters, and how it was modified by your new cash at quarterly signal time:

Kelly Letter subscribers use tools to make the quarterly signal easier, including the cash management part explained here.

The first is a calculator that automatically divides the value of new cash in half and adds it to the signal line, then generates the signal. It does it all, with the new-cash part handled in the field shown below with the help bubble engaged to remind you yet again that all new cash goes into the bond fund:

The second is an allocator that skips all this in favor of a “close enough is good enough” approach that matches your portfolio to the letter’s new quarterly stock-fund allocation. The key field is this simple:

Both the calculator and the allocator generate specific signals for your portfolio based on the quarter’s price change.

Salient to today’s article, the calculator manages your quarterly cash following the procedures explained here.

Happy cash management!