What I Talk About When I Talk About Bonds

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Warning: this will not be a particularly well researched or philosophical post.

I’ve read my fair share on the subject I’m about talk about, but I’m certainly no expert.

The reason I’m writing this post is just to communicate the simple model that I have in my head when I think and talk about bonds.

The model may be right, and it may be wrong, but I would hold it’s important to have a blueprint when you construct something. And each feature of your blueprint must have a well-defined pre-specified function. Otherwise what you’re constructing is liable end up being a pile of rubble with no logic or utility.

P1000558

(You should see the blueprints)

In this clunky metaphor the thing that we are building is a house, and the final construction will require many different parts A roof and windows, finish carpentry and cabinets, sheet rock and framing, sewer pipes and water pipes, Electric boxes and conduits and outlets…. You get the idea. It requires a diverse collection of materials.

And the house, of course, represents an investment portfolio.

But before we can pick out the glamorous parts; the flooring, or curtains, or solar panels, or light fixtures, or skylights, or cabinetry, we must start by digging a hole and laying the foundation. And the foundation of our house (Portfolio) is bonds.

What is a bond?

A bond is simply a loan or an IOU.

An easy example of a bond from every day life is a mortgage. The bondholder is the bank. And the issuer (Or debtor) is the person borrowing money to buy a house.

The bond is a contract representing items that the two sides agree on including a term (The length of the loan), and an interest rate (Or coupon) that will be paid over the life of the loan.

What types of bonds are there?

There are many types of securitized bonds that you can invest in.

There are government-backed bonds (or T-bills, treasury notes, or treasury bonds)

There are government-backed bonds whose interest rates are tied to inflation. (TIPS and I Bonds)

(In general US government backed bonds are felt to represent no risk of default.)

There are company backed bonds (or corporate bonds.)

There are company backed bonds from companies with a very low likelihood of defaulting on their commitments (investment-grade corporate bonds.)

And there are company backed bonds from companies who represent a higher risk to default. (Junk or high-yield bonds)

There are even bonds issued to people with limited assets, no collateral and a high-risk of default from other people, with a middleman taking a high fee off the top of the coupon. (P2P Bonds like lending club and prosper.)

I organized this first grouping of bonds based on credit risk. From the treasuries at the top to the P2P loans at the bottom these different classes of bonds represent successively increasing levels of credit risk.

Credit risk is the risk of losing your money when the bond issuer is unable to pay you back, as in the case of bankruptcy or default.

The more credit risk that is taken on, the higher the bondholders coupon should be.(Otherwise no one would ever lend money to high-risk borrowers.)

But bonds can also be organized by their terms.

Short-term bonds are for three years or less.

Medium term treasuries are from 3 to 10 years.

And long term treasuries are for 10 years or more.

In general the longer the term of the bond the higher the coupon should be (though this is subject to supply and demand in the marketplace.)

Why do long-term bonds pay higher coupons?

Before we answer this we must talk about the interaction of interest rates and bonds.

And before we get there we must talk about what the bond issuer is paying for with his coupon I when he borrows money from the bondholder.

He is paying for the inconvenience of delayed gratification (not spending his money.)

He is paying for the risk of his own default (the aforementioned credit risk)

He is paying for the risk of inflation (inflation risk.)

This is because as time goes on and inflation rises , the buying power of the coupon becomes less and less valuable. (Would you rather spend a quarter in 1960 or 2014?) And obviously the longer the term of the bond the more inflation risk there is as prices tend to go up.

And finally he is paying for interest rate risk.*

Coupons are naturally tied to current interest rates. This is because no one would ever borrow money at a rate less than the current interest rate that they could get from a risk-free asset like a FDIC insured bank account.

Now imagine a rising interest-rate environment. On day one an investor buys a 10 year treasury bond with a coupon of 3% at a current interest rate of 2%.

On day two interest rates rise to 3%.

Investors will now demand an extra percent on the coupon for 10 year treasuries. So on day 2, 10 year treasuries are now bid up to a coupon of 4%.

So how much is our investors 10 year treasury worth on day two?

If our investor wants to sell his treasury to another investor he will have to lower the price below the amount of the bond itself. This is in order to compensate the buyer for the coupon payments that he will not be recieving from the current issue of bonds for the next 10 years. So our investor will have to sell his 10 year treasury for about 90% of its original value. In other words, his treasury lost 10% of its value in one day. (In general if you multiply the term of the bond times the instantaneous change in interest rates you will get the percentage of value lost. (so a 10 year duration bond times one percentage point of interest equals 10% value lost.)

So the value of bonds, are inversely proportional to interest rates and this effect is stronger the longer the term of the bond.

Which (again) is why long-term bonds generally pay higher coupons than short-term bonds. The long-term bondholder is taking on inconvenience,  interest-rate risk and inflation risk in addition to credit risk.

Why include bonds in your portfolio?

The long-term expected returns of stocks are almost always higher than the long-term expected returns of bonds. This means that every time we increase the amount of bonds in our portfolio we are expecting less growth of our portfolio.  So whats the point of investing in bonds at all?

Which brings us back to our original metaphor.

Like a House rests on foundation, everything else in your portfolio rests on your bonds.

While stocks are zigzagging up-and-down on an overall skyward trajectory, Bonds are boringly marching upward slowly by the rate of their coupons.

And the shorter the duration and the lower the credit risk of the bond the less upward and more stable the slow march is. Screenshot 2014-07-22 23.04.14

Blue= Short Term Treasuries, Green = Medium Term Total Bond Market, Yellow = S&P500

So the less your portfolio can afford to lose (or you the investor can stomach losing) the more bonds of less credit risk and shorter duration you should have in your portfolio.

So retirees who are constantly withdrawing funds will want a big foundation and a house somewhat like a bunker.

While a young and ambitious investor at the start of his career might want a less bulky foundation in order to erect a faster rising skyscraper.

the-leaning-tower-of-pisa

Clearly built by young accumulator

And you will note that the one factor not mentioned in this calculation is the current interest rate.  In low interest rate environments your bonds will make less (while your equities may well make more…)  But the take home is….

The main determinant of your percentage of bonds should be your risk tolerance. 

Compared to stocks, your bonds will contribute less to your wealth, but they will also decrease the volatility of your portfolio (and volatility eats away at returns.) And the higher your percentage of bonds the higher the rebalancing bonus will be when the market inevitably crashes.

What type of bonds should you hold in your portfolio?

In general the sweet spot in terms of returns and efficiency for most portfolios is medium-term bonds.

My personal philosophy is to hold predominantly short-term treasuries and short term investment-grade bond funds in my portfolio in order to avoid interest rate risk, inflation risk, and credit risk.

Of course avoiding all these risks means I am forgoing some returns.

But when the yield on long-term TIPS gets above 2 1/2 to 3% my investment policy statement calls on me to shift my bond allocation almost entirely to long term TIPS so I can lock in a real 3% return from my bond bucket for up to 30 years. (But that’s a story for another day.)

And I have no argument with holding all of your your bonds as medium-term treasuries.  There is nothing wrong with that, and it may very well be smarter than my strategy.
(This increase in interest rate/inflation risk has been adequately compensated by the market in the past.)  I wouldn’t even argue holding long term equities as your bonds in portfolios with high equity allocations (>90% equities.)

But I what I would not recommend is including real estate investment trusts, high-yield (junk) bonds, or P2P loans in your bond bucket. And the reason is that these assets all have equity like risk when the stock market drops which kind of defeats the purpose of having bonds in your portfolio in the first place.

* Yes I am ignoring term risk, liquidity risk, credit downgrade risk etc….

What is your bond percentage, bond allocation, and critique of my bond philosophy?  (I’m 25%, short term treasury/tips/short term investment grade depending on the interest rate.)

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21 Responses to “What I Talk About When I Talk About Bonds”

  1. Grant July 23, 2014 at 1:58 pm #

    Alexi, I like your analogy, and agree with not owning high risk bonds. I don’t think it makes sense to have risky assets in the safe side of your portfolio. I’m curious about your reasons for owning only short term government bonds, given that, as you acknowledge, the interest rate and inflation risk has been adequately compensated for in the past. I.e. for most portfolio allocations, bonds with an average term of 4-5 years have been the most efficient.

    My portfolio is 40% bonds (I’m 61, but plan to keep working, my hobby, for a few years yet), 2/3 of which are government bonds with an average term of 5 years and 1/3 short term corporate bonds.

    • Miles Dividend M.D. July 23, 2014 at 2:29 pm #

      I’ll admit its a little irrational.

      But my reason is that I want simple inflation protection from the bond side of my portfolio.

      I am willing to give up 1% or 2% yield to know that I am insulated from market volatility, credit risk and interest rate risk.

      If you look at 2008 you can see that total market lost some value during the crisis.

      On the other hand short term treasuries ticked up with the “flight to safety. ”

      In high interest rate environments, I am more than willing to pick up yield from long term TIPS, because there is limited interest rate risk, and no inflation risk.

      My equity allocation is quite aggressive with a strong value/size tilt with a healthy emerging markets exposure. So I am happy to keep it boring on the bond side.

      Again, you’ll get no argument from me from owning the vanguard total bond market in your bond basket and calling it good. More money is always smart.

      AZ

  2. Grant July 23, 2014 at 9:01 pm #

    I think either short or intermediate term bonds are fine, the more important thing is to pick either strategy and stay the course.
    In 2008 total bond didn’t go up as much as short or intermediate treasuries, I think due to corporate bonds in total bond. Credit risk doesn’t mix well with equity risk which is why I prefer to keep government and corporate bonds separately. Should the next financial crisis be an inflationary crisis short term bonds should do even better than total bond did in 2008.

    I know TIPS are supposed to have limited interest rate risk, but last year, in Canada, where I live, (here TIPS are called real return bonds), the only real return bond fund available is long term fund, duration 16 years, which went down 15%. I don’t own any real return bonds as I don’t really want that degree of volatility in my bond portfolio.

    • Miles Dividend M.D. July 23, 2014 at 11:25 pm #

      Grant,

      Good point about the effect of corporate bonds (and mortgage backed securities) on the total bond market during 2008.

      In terms of TIPS, they have well defined range of yields and almost never get above 3.5-4%. So if you buy them at higher yields interest rate risk is actually pretty small.

      Say you buy a 30 year TIPS at a yield of 2.5% and interest rates rise and the yields go to 3%. Your value will drop a bit on the secondary market, of course, but it’s sort of irrelevant. You are guaranteed a real 2.5% yield from a risk free asset for 30 years! and you can reinvest your coupon at an even higher yield. And if the yield drops significantly? You can sell your position at a premium and reinvest in short term treasuries and investment grade corporates.

      Swedroe writes about this strategy in his bond book, which I recommend highly recommend.

      And it goes without saying, I’m not holding a significant position in TIPS in the current environment.

      AZ

  3. Robert July 24, 2014 at 4:19 pm #

    Alexi, much of what you say is pretty basic, and I agree with 90% of it. However, I want to quibble over some of the points you make or how you make them. And I want to disagree more strongly about asset allocation and the role of bonds for most investors.

    I’ve read a lot about asset allocation yet question the standard pitch about the efficient frontier and its underlying efficient market hypothesis. But even assuming the market is efficient as far as you and I are concerned, and that we can’t market time (though I’m not convinced on that point, at least on a risk-adjusted basis), I think there are still problems with using a metaphor like a house to argue for bonds. One’s job/income is arguably a better analog of a house foundation in the investment realm. Without it, one can’t build the house at all! But let’s skip quibbles about metaphors and talk about bonds.

    You neglect to mention the tax advantages of stocks vs. bonds (ability to time income; capital gains/qualified dividends at favorable tax rates), for those with money to invest outside tax-deferred accounts.

    Your graph of stocks vs. bonds is highly misleading. You show the last 20 years of a 35 year secular bull market in bonds that is near its theoretical limits. There have been several stock market cycles during that period. For long-term investors (those looking at retirement investments, for instance), a longer duration chart that extends into the last bond bear market (e.g., 1970s) would give a more balanced perspective on how stable a foundation bonds are or are not, relative to stocks.

    Jeremy Siegel (Stocks for the Long Run, Chap. 2) makes the argument for stocks as the better inflation hedge and long-term investment for most investors with reasonable time horizons (say, 10+ years). He argues that a reasonable portfolio for many investors would be 100% stocks (“moderate” and “risk-taking” investors with 30 year horizons, which is most of us). The problem he points to in most EFF curves you see is that they don’t take into account holding time horizon. When that is done, stocks become more favorable and bonds contribute little. He also makes the point that bonds are only helpful when negatively correlated with stocks, but that since the gold standard disappeared, that has mostly not been the case except during short-term flights to safety during financial crises (not an issue for long-term investors).


    Let’s play a game with the following simple rules: (1) You decide how much money you want to play with. (3) You may add or remove money from the game after any turn, actively or by passive “rebalancing”. (3) A turn consists of my flipping a coin and then my adding or removing money from your pile according to the outcome: If heads, I will add 20.5% to your money pile; tails, I will remove 5%. I have an enormous money pile so there is virtually no risk that I won’t pay you when “heads” turns up. (4) Many players may play simultaneously, with all results determined by the same coin toss.
     
    Thus, for example, a game could consist of the following 5 turns: HHTTH. That would result in two sequential 20.5% increases followed by two sequential 5% losses followed by a 20.5% gain, for a net gain of 58% (average 9.57% compounded rate of return). With an honest coin, i.e., 50% heads and 50% tails, the overall average compound growth rate is 7%.
     
    Given the above rates of return and honest coin tosses, the long term return from a sequence of many coin tosses will be positive. Any money removed from the game will diminish overall returns. Any strategy for removing money and then putting it back in presumes an ability to predict results of future coin tosses from past coin tosses; if the process is truly random, this is not possible, and such strategies will underperform.
     
    A rational player will stay fully invested at all times except if he needs money for other purposes, either now or within the probable duration of any string of negative coin tosses. In that case, he should remove only the amount of money he will need. Any additional money removed will only diminish overall returns.
     
    Is the following behavior rational? (a) Keeping 40% (or 25% in your case) of your money set aside so that your overall net worth doesn’t fluctuate as much? (b) “Rebalancing your portfolio” by removing money from the game after sequential wins or adding money to the game after sequential losses? (c) “Sleeping better” because your net worth doesn’t fluctuate as much that of someone 100% in the game at all times, even though you are earning lower returns than they are?
     
    I argue that diluting your equity investments with bonds/cash is unwise unless (a) your spending vs. time horizon demand it; (b) you are actively market-timing and have evidence-based methods for doing so (not easy, but Shiller’s P/E is arguably one method for long-term investors); (c) you know you are unable to resist the urge to act irrationally.

    You did strongly emphasize that risk tolerance should drive one’s equity exposure. That is directly related to “c”. If one believes himself unable to resist irrational behavior after a market downturn, he might do better to increase bond allocation. But I wonder how many such people could stomach these fluctuations if they knew the cold hard math instead of relying on misleading MPT curves and beliefs that bonds are an important component of a portfolio–in fact, the very foundation?

    I wasted much of today creating a spreadsheet just to play around with some of these things for illustrative purposes. I’ll send it to you offline.

    • Robert July 24, 2014 at 4:27 pm #

      Oh…and I meant to also say, rebalancing isn’t a good approach either. If you plan to use bond money to invest in equities after a stock market decline, then you are saying that the bond money isn’t money you need for living expenses. In that case, it would have been better to have it invested in equities all along. If it is money you do need for expenses, then you can park it in short-term bonds matched to the time horizon of your needs.

    • Robert July 24, 2014 at 4:29 pm #

      And, one final comment! I’m no expert either, and while I’m comfortable challenging conventional thinking, there is risk in doing so–not least that one might be wrong! So I welcome criticism of this argument against bonds. Fire away!

    • Robert July 24, 2014 at 4:51 pm #

      Well…still one more comment. I disagree with some of the author’s illogical conclusions, but the data in this article bolster my point above about the incompleteness of your graph of bond vs. equity performance. http://finance.yahoo.com/blogs/the-exchange/what-would-the-bursting-of-the-bond-bubble-look-like-165833587.html
      Where he goes off the rails is in arguing the use of bonds as short-term holding tanks for money to “keep your powder dry.” That is only true if you believe you can market-time. Otherwise, the money is better invested in equities. (Unless, of course, you need it for other expenses, which is a good reason to hold short-term bonds or cash).

    • Grant July 25, 2014 at 2:47 pm #

      Robert, I agree with you from a mathematical point of view, but the behavioural aspects of investing are very important. Most people, despite what they say in good times, do not stick with an all equity portfolio when the market crashes. And it’s even more difficult once you no longer have earned income. There was a recent review on Seekingalpha.com that looked at all equity portfolios over the last 114 years. With a 4% withdrawal rate, there were seven starting dates where the portfolio failed to last 35 years, and the one starting in 2000 is not looking good. On the other hand there was not one starting date where a 60/40 stock/bond portfolio did make it to 35 years. So unless you have a large enough portfolio to live off stock dividends alone (and considering dividends dropped by 50% in the depression, today that means a a1% withdraw a rate) you are taking some risk in retirement going all equities. Following the 1929 crash it took 15 years for the market to recover on a real basis with dividends reinvested.

      • G-dog August 3, 2014 at 9:42 am #

        Grant, is there a typo in this statement:
        “On the other hand there was not one starting date where a 60/40 stock/bond portfolio did [not?] make it to 35 years. So unless you have a large enough portfolio to live off stock dividends alone (and considering dividends dropped by 50% in the depression, today that means a a1% withdraw a rate) you are taking some risk in retirement going all equities”

        Otherwise I am having trouble reconciling the 2nd sentence. Disclaimer: I could be having a bad day…

        • Grant August 3, 2014 at 11:15 am #

          Sorry, Alexi, my mistake. All the 60/40 portfolios lasted 35 years.

    • G-dog August 3, 2014 at 9:50 am #

      Robert, maybe I should know this but… In the game scenario, what is the data or rationale behind the +20.5% vs -5% numbers.

      • Robert August 3, 2014 at 3:58 pm #

        -5% was arbitrary. 20.5% was chosen to produce geometric average return (assuming honest coin and a lot of tosses) of 7%. That was chosen because of historical real returns of US equities but any number could have been used. The point was not related to historical returns but to simple mathematical/probability arguments against some of the stuff that is written about asset allocation.

  4. Miles Dividend M.D. July 24, 2014 at 8:44 pm #

    Robert,

    This is an interesting clash of assumptions.

    I’ll give you some individual nitpicky counterarguments and then I will give you what I think is the crux of the disagreement here.

    1. Bonds have historically held a real return as well. And tips give a nearly risk free real return. It is not simply “keeping your powder dry” to own bonds. And the longer the term the higher the risk and the higher the expected returns. The return is less than equities, but then so is the risk when compared to stocks (particularly when we are talking about treasuries.)

    2. Rebalancing is a good strategy because it allows you to bank gains at high valuations and invest at low valuations. There is a “rebalancing bonus” that reflects this truth.

    3. Saying that bonds are not negatively correlated with stocks except during “flights to safety” is the ultimate argument for holding bonds. That’s exactly when you want negative correlation. During a secular Bull market in equities, I’m more than happy to have my bonds display a positive correlation to equities.

    4. And the final point I would make is that I believe our different financial situations dictates some of your bullishness (and my bearishness) on holding all stocks. As I recall you have a guaranteed pension and SSI which will cover your basic needs. So you are looking for inflation protection, and capital growth from your portfolio. In other words you are already holding a meaningful percentage of your portfolio in fixed income like assets. Bonds are already baked into the cake. But what if you had no pension and no SSI? Would you still hold 100% equities? Could you handle a great depression like 80% draw down where your safe 4% withdrawl rate now makes of 20% of your portfolio? I know I couldn’t.

    But the elephant in the room is the question, “what is risk?” and I think that’s worthy of a blog post in and of itself so let me sign off and write it!

    Alexi,

    PS I’m curious to know your take on the Meb Faber video I posted. It should have been pretty against the grain for you given your bias towards american stock market structural supremacy. (I mean bias in a non perjorative manner, as in I have an equal bias against american stock market exceptionalism.)

  5. Robert July 25, 2014 at 10:37 am #

    Alexi, I’ll respond to each of your points below, with the numbers corresponding to yours:

    1. Look at the Yahoo link in my post above. Note that bonds had a negative real return of -37.1% from 1950-1981. I think we are likely entering a period more like 1950-1981 than 1981-2010. There is a nominal return, and it is more than keeping your powder dry, but I was responding to the Yahoo author who used those words. “Keeping your powder dry” is an expression of interest in market-timing rather than one of risk-tolerance and investment time horizon based asset allocation.

    2. If you look at the coin toss game I sent you, it becomes clear that rebalancing is a form of market-timing and an expression of belief that the market is inefficient and not following a random walk. (I don’t necessarily disagree with that, but it certainly is hard to make reliable predictions). If you believe it is following a random walk, then you should always invest in the investment that offers a higher average rate of return (unless you need the money soon).

    3. I disagree! In his technical book, Expected Returns, Antti Ilmanen strongly makes the point that there is a risk premium associated with investments that crater when “bad stuff” happens. As investors, we are in the business of harvesting premia. Investors with long time horizons can harvest the premia associated with those investments that tank during bad times. So…contrary to your argument, IF you have a long time horizon, you should rejoice when your stocks tank because that behavior is what gives them a higher premia than bonds. (I know…I don’t rejoice then either!). It is NOT an argument for having bonds. I’m saying that only makes sense if you don’t have a long time horizon and thus can’t survive the decrease in value during bad times. (Having said all that, I must say that I was ignorant about this a year ago, before I read Ilmanen’s excellent book, which I heartily recommend, with its solid roots in academic research, not opinion). BUT…as to the correlation comment, again, please refer to the linked article. My point is that the correlation changed in part because we came off the gold standard. If something like that “changed the game”, then you can’t expect the same correlations today as historically.

    4. You make a good point. Retirees with a pension (I’m too young for SS yet) do have a stable income source. Others could achieve the same with an annuity purchase if they wanted it. But if I didn’t have a pension or buy an annuity, would I invest 100% in equities? If I was in your shoes, probably. If I was a retiree or expecting to retire within a few years, I probably would not. Remember, I’m not disputing the utility of bonds (or cash) when you need the money for expenses over a relatively short time horizon, and by that I mean I’d probably start slowly shifting into bonds within around 10 years of retirement. Maybe you have that time horizon, but from what you’ve said, it sounds like you intend to keep working at least part-time after an early retirement. As long as you are earning enough to pay expenses (which I would expect you to do in that scenario), why would you want ANY money in bonds now? You are simply diluting your equity returns. With a time horizon well beyond 10 years for needing the money (unless I’m misreading your intentions), a 100% equity portfolio is likely to have higher returns.

    I’ll save comments on risk until your next post. As to the Meb Faber video, can you please refresh my memory? I don’t recall seeing it. What post is it in? (I generally read your posts in an RSS reader and some of the embedded images and stuff don’t come through; if I realize something’s missing I’ll generally go to your webpage, but if it isn’t obvious, I may miss it).

  6. Miles Dividend M.D. July 26, 2014 at 3:32 pm #

    I disagree that rebalancing is a form of market timing. Rebalancing is maintaining a stable risk profile as asset values change.

    The rebalancing benefit is just a happy side effect of rebalancing.

    By my definition for it to be market timing, asset allocation would have to be actively altered in different market conditions. But this is semantics…

    I ran monte carlo simultations for stock/bond portfolios over a 30 year time horizon for stock/bond portfolios from 100% to 80/20.

    The lowest failure rate was for allocations between 88-92% stocks. And if you extend the time horizon out to 50 years the ideal stock allocation shifts up to about 94%.

    So past 94%, stocks actually do not seem to decrease risk even over very long time horizons.

    (But I would have guessed 75% stocks to be the sweet spot, so this is news to me too.)

    Finally if your point about harvesting risk premia was universally true than as a new retiree you would hope for a massive stock market crash (which would be a very unwise thing to hope for given sequence of returns risk.)

    As a young investor however a stock market crash is a fortuitous thing, (If you want to have your parents move in with you!)

  7. Grant July 26, 2014 at 4:39 pm #

    Alexi, the Monte Carlo results are very interesting. I had thought the sweet spot is about 70/30 stocks/bonds. So does that mean we should be at around 90% stocks in retirement (assuming we can tolerate the volatility), as Monte Carlo accounts for sequence if returns risk?

    Of course, Monte Carlo uses past data and the future may not resemble the past. You may have seen this interesting article by Bill Bernstein that looks at stock and bond returns during the last two centuries. He suggests that the higher stock returns that occurred in the 20th century were due to inflation caused by coming off the gold standard and that the coming century may be more like the 19th century.

    http://www.efficientfrontier.com/ef/402/2cent.htm

    What do you plan to do with your asset allocation as you approach and during retirement?

    • Miles Dividend M.D. July 26, 2014 at 11:44 pm #

      Grant,

      Thanks for posting that article. Great stuff.

      I love Bernstein. But I don’t really trust anybodies 10 year predicted return let alone a 100 year predicted return.

      Despite this, the point made is a crucial one. Today’s assumptions are tomorrow’s fallacies. Nothing is written in stone.

      I think this leaves us with a simple message. Past volatility predicts future volatility, and volatility increases the risk of rapid loss, across all time periods.

      In terms of my asset allocation in retirement, I don’t consider myself a risk taker, but I am quite bullish on my options.

      Best case scenario: around the time of my retirement there is a 3+ yield on Tips. If this is the case I will probably put 60%+ of my nest egg in 30 year TIPS. This would give me 30 years of 3% safe withdrawals, and I could then swing for the fences with the remaining allocation of my portfolio. (Simple ETF momentum approach? SCV/EM value a la the Larry portfolio?)

      I may also consider a SPIA to put a floor on my retirement income.

      One thing I am fairly sure of: I will not be >75% equities. (I lack the intestinal fortitude for that sort of thing, and I really can’t deal with that much fat tail risk.)

      What are your thoughts on retirement allocation?

  8. Grant July 27, 2014 at 5:23 pm #

    I plan to buy an annuity to cover the basics and stick with my current 60/40 stock/bond allocation for the rest, although may reduce stocks somewhat. Long TIPS, if yielding enough, are a good idea, although in Canada the TIPS market is quite small, so I’m not sure how practical that is here. I really like the idea of the Larry portfolio (just finished reading his latest book, The Black Swan), but it’s not possible to fully implement it in Canada as we do not have a Canadian equity small value fund. Needing some home bias, I have 1/3 of my equities in the Canadian market despite Canada being only 5% of the global market.
    What do you think about the strategy of cutting back on risk (reducing equities to 30-40%) when you reach your “number”, whether you are retired or not? Or alternatively, reducing risk if you are ahead of schedule, but not there yet, in reaching your “number”.

    • Miles Dividend M.D. July 28, 2014 at 9:20 am #

      Grant,

      Can you not access American ETFs and mutual funds in nonretirement accounts in Canada?

      If you can, I really like RZV (Guggenheim small-cap value) as a stand-in for the dimensional fund advisers small-cap value index. It’s very small, and very value/ey.

      In terms of the adjusting allocation as you get closer to your goal question, i’m a big believer in getting out of the game once the game is won.

      The other thing I would say, is that shrinking your spending ends up being the most valuable single investment strategy that there is. It increases your compounding power, and decreases your needs in retirement.

      I like the idea of creating your own annuity with tips.

      Have you seen this thread?

      http://www.bogleheads.org/forum/viewtopic.php?t=71927

      One thing I like about the strategy, is that since your bases are covered you can actually be incredibly aggressive with the remainder of your allocation.

      Whether that means all in with small-cap value/emerging markets value, or pursuing a simple momentum strategy, once your bases are covered you can be very aggressive about wealth accumulation.

      • Grant July 29, 2014 at 3:15 pm #

        We can buy American ETFs (but not mutual funds) for both retirement and taxable accounts. I have some VBR, before I knew about Guggenheim, but being in a taxable account there would be tax to pay if I changed it. Canadian tax deferred retirement accounts are much less generous than American ones, so that space is filled with bonds and REITs. An interesting thread on a TIPS ladder, something to think about.

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