Bonds in portfolio

[donheff]

I currently have very little exposure to bonds in my portfolio. Whenever I ran Monte Carlo calculators I never could find any that showed greater survivability with the bond mix and all showed the potential for a larger estate with equities. I read Scott Burns' column this morning where he was giving good advice about using a self managed bond ladder vs funds with a 1% manager fee. He veered off at the end to argue that annuitizing part of the portfolio was good for survival. That issue is for other threads but a TIAA-CREF chart he posted showed HUGE survivability advantages for an aggressive stock based portfolio (annuity or not). I understand that bonds reduce year to year volatility but if survivability is better without them why does (almost) everyone recommend a 60/40 split?

 

[ladelfina]

I know what you mean, donheff..
A couple of recent discussions that might be pertinent are here:

I like my bonds these days
http://early-retirement.org/forums/index.php?topic=8886.0
and
Retiree Asset Allocation
http://early-retirement.org/forums/index.php?topic=9118.0

With a search you might find something even more appropriate/specific to your particular questions.

 

[donheff]

I know what you mean, donheff..
A couple of recent discussions that might be pertinent are here:

I like my bonds these days
http://early-retirement.org/forums/index.php?topic=8886.0

Thanks L. I missed that entire thread when I was on vacation. I can see the role for CDs, or short term bonds as a cushion for immediate cash for withdrawals during a downturn. It is the long term aspects I don't get.

 

[ladelfina]

I came across this group of links about asset classes:
http://abnormalreturns.wordpress.com/tag/asset-allocation/page/2/

the first of which had this interesting thing to state:

As the chart below reveals, the sharply negative correlation that defined equities and fixed-income in recent years is giving way to something less. To be sure, stocks and bonds still post slightly negative correlation, and so the diversification factor remains potent for owning both asset classes. But if the trend in recent years keeps up, investors may want to re-examine diversification expectations for the classic stock/bond mix. (Note: 1.0 indicates perfect correlation, 0 is no correlation, and -1.0 is perfect negative correlation).

A commenter retorts thusly:

Robust Markowitz optimization is part of a new field of optimizations called inverse conic optimizations. In this type of optimzation you recognize that your covariance matrix (correlations adjusted for variability) and your expected returns have errors so you introduce a certain error term in your optimization. This stops the model from maximizing your estimation error and instead looks at each correlation as a distribution of possible correlations.

It'd take a far more practiced and incisive mind than mine to make any sense out of this. 

ANyway I guess if there's to be more correlation in the future, then bonds will be as good as stocks. OTOH, stocks will be as good as bonds!   

 

[brewer12345]

If you do a search on "Moishe Milevsky" you will find a collection of articles he has written, many of which involve a discussion of annuities and survivability, etc. He is one of the few top flight minds in the world of academic finance that spend a lot oftime on the subject.

 

[saluki9]

Donheff

Your questions cover a lot of territory. As to why people hold bonds if they will reach greater wealth with an all stock portfolio?

1. Most people are not machines who care only about the end result. Most humans care about the value of their portfolio at many points before retirement. That is why people use bonds to limit their volatility.

2. The calculations you are referring to are all based on past performance of equities. Much of the gains that equities have seen in the last 30-40 years have been based on P/E multiple expansion. This is a phenomenon which can't go on forever. In addition, dividends which have historically provided the majority of equity returns are still near all time lows also not spelling good times for equity returns.

As to whether bonds are better than bond funds. I believe that if you have $100K or more to allocate to FI you are better off doing it with individual bonds. If lower volatility is your goal then you will get the most bang from Treasury securities. I still favor funds for high yield bonds though.

 

[justin]

As to whether bonds are better than bond funds. I believe that if you have $100K or more to allocate to FI you are better off doing it with individual bonds. If lower volatility is your goal then you will get the most bang from Treasury securities. I still favor funds for high yield bonds though.

When you can get vanguard admiral class bond funds for ~0.1% expense ratios in a variety of bond types and durations, why would individual bonds be a better choice? With $100000 invested, you will pay $100 in expenses. I don't mean to attack your statement, but I've heard this statement many times (you're better off investing in individual bonds). Can you explain the rationale behind it?

If it is just a matter of the $100, for me as a do-it-yourself investor with minimal bond experience, I'd be willing to pay that amount each year to avoid managing a separate bond portfolio/brokerage/treasurydirect account and/or following individual corporate issues and corp credit ratings. I guess the bond vs. bond fund choice would be more obvious if one were to pay, say, 1-2% expense ratio for the fund, but at 0.1%, it seems like a bargain for outsourcing your bond investing.

 

[ladelfina]

This link to a book by Milevsky (Wealth Logic) was interesting:
http://www.captus.com/Information/Wealth-flyer.htm

I read the sample chapter on dollar-cost-averaging.. right on!

I'm curious to read the last chapter: "Jewish High Holidays: A Time to Invest?" 

Otherwise, it looks like he has written on a lot of the topics that come up frequently on the board.

Brewer, have you read, and if so, can you recommend, this book?
Anyone else?

 

[brewer12345]

I haven't read the book, but I have read several of his academic papers. Smart guy.

 

[donheff]

I haven't read the book, but I have read several of his academic papers. Smart guy.

Thanks for the reference Brewer. He is Exec Director of the Individual Finance and Insurance Decisions (IFID) Centre at the Fields Institute, York University, Toronto. The Center's website has a boatload of academic papers with interesting titles. Looks like some light reading for those RE afternoons.

 

[wabmester]

why does (almost) everyone recommend a 60/40 split?

I believe most people around here recommend something closer to a 75/25 split, because that's been the sweet spot for historical survival.

Bonds do lower volatility (which gets more important the older you get), and the low correlation with stocks have actually increased returns vs a 100% stock portfolio. But the potential downside to bonds is inflation. Bonds have an embedded estimate of inflation as part of their rate, and sometimes that estimate is wrong.

TIPS take away the risk of the embedded inflation estimate being wrong, which is why I like at least 50% TIPS in my bond allocation.

 

[saluki9]

Smart guy.

Understatement of the year


Justin

Point taken (partially) however I like being able to control the specifics of the portfolio. Also, some people who are uncomfortable with fluctuations like knowing they can hold their bonds to maturity.

 

[mathjak107]

As we get closer to retirement and hopefully closer to our financial goals most of us shift gears.We go from the get every last ounce of gains and lets get richer to shifting to not growing poorer and balancing the returns we now need to our risk level.and not take any more risk than we need to.I was always 80-100% in stock since 1987.As of last year im about 60/40.I dont need more than 7-8% at this point to meet my goals so we cut the swings drastically.