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Question for Ted on Long Term Fixed Income Holding
Old 01-12-2004, 07:31 AM   #1
 
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Question for Ted on Long Term Fixed Income Holding

Ted,

Since you seem to have similar Investment beliefs as myself, I have a question on the Fixed Income Portion of my Asset Allocation.

My Target Asset Allocation - All Index Funds - is Basically a 60% Stocks and 40% Fixed Income

Large Cap Growth - 15%
Large Cap Value - 10 %
Small Cap Growth - 10 %
Small Cap Value - 10%
International - 10%
REITS - 5%
Fixed Income - 37%
Cash - 3%


Do you have any recommendations for the 37% Fixed Income portion of the Portfolio? - How would you invest it? - This is for the Long Term - And rebalanced Yearly.

Also Feel free to Comment on the Overall Asset Allocation.

Thanks in Advance!
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 05:21 AM   #2
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Re: Question for Ted on Long Term Fixed Income Hol

In line with other posts that I have made, I still think that any long-term bonds that a person holds should be TIPs. If the total amount is less than, say, $15K, then it will probably be most convenient to hold them through Vanguard's Inflation Protected Securities Fund. If you have a brokerage account, it's OK to hold TIPs in that directly, as long as you don't trade them very often.

To address the possibility that the interest rate on TIPs may rise in the future, you may want to put some money in short term TIPs the way that Bob Smith is doing. (See the topic on page 2 of this discussion "Opinions on this Asset Allocation Requested".) You could also temporarily park some of your "bond" money in Vanguard's Short Term Corporate Fund.

Another good thing that Bob is doing is using the Vanguard Total Stock Market Index Fund rather than a bunch of other stock funds. Having a bunch of index funds is not really "bad," and may allow some tax savings if the ones that pay the most dividends are in tax advantaged accounts. But I think that the "ideal" way to invest in stocks is to put the "core" in the total market index, and then supplement that with funds that you think will outperform the overall market, whether through active management or through concentration in a particular market sector. (In that regard there is evidence that small cap value stocks have the best long-term returns.)

I trust that you are satisfied that a 70%stock/30% bond allocation is appropriate for you. I think that a way of slightly improving the risk/return characteristics of your portfolio would be to put at least 10% in a REIT fund (per recent discussions in this forum) and perhaps another 10% to 15% in high yield bond funds. I think that an allocation that would produce similar return with a little less risk would be, say, 60% stocks, 10% REITs, 10% high yield bonds, and 20% TIPs.

If you take this advice and run out of money in 30 years, you can come to my nursing home and push me down the stairs in my wheelchair.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 05:48 AM   #3
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Re: Question for Ted on Long Term Fixed Income Hol

Info only - I will defer to Ted - for the inside skinny. I'm slowly digesting the Vg target retirement package received in the mail - Income(for those in retirement)fund shows 75% fixed at - 50% total index, 25% Inflation protected, and then the remaining 25% at - 5% mony mkt., 20% total stock index.

I believe the current duration for the total bond index is under 4 years.

I don't own the % Ted might suggest but agree with his reasoning - ie Total Bond Index as core, REITS, and High Yield Corporate(for a slighly different reason). The exception being the use of TIP's and Inflation Protected - still pondering.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 05:51 AM   #4
 
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Re: Question for Ted on Long Term Fixed Income Hol

Thanks Ted!

Some good advice here. I'll probably throw another 5% into the REITs making my portfolio 65% Stocks / 35% Fixed.

I just finished Swedroe's Book "What Wallstreet does not want to know" and he had a pretty convincing case against putting your money in a Total Stock Market index. I was leaning this way myself until he broke it down - the Total Stock Market index is weighted very heavily towards Large Cap Growth Stocks, so you are really not as diversified as people think.

Since Vanguard has separate Index funds for each of the four major asset classes, you can achieve much better diversification doing this. More hassle to keep track of I know!

The Fixed portion has me baffled a bit. Since you regard the Short Term Corporate almost like cash and the TIPS are paying so little now, would it make sense to park the bulf of the fixed in the Short term Corporate and wait until TIPS started to rise a little? It just seems that TIPS are not paying anything now and I am trying to understand why I would want them at current rates.

Swedroe is against Bond Funds, the reason has to do with why pay an expense for something you can do yourself or something like that. Also he claims the fixed portion of a portfolio is to reduce volatility of a portfolio instead of any kind of growth. - However it seems to me that you should try and maximize this.

Is there a long term bond fund at Vanguard that you recommend?

Actually in 30 years if I do run out of money, I can come to the nursing home and give you ride in your wheelchair and push myself down the stairs. - At age 82 I'll be pretty much ready to check out anyhow! I have seen 82 and it does not look pretty at all!
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 06:28 AM   #5
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Re: Question for Ted on Long Term Fixed Income Hol

I suspect that Swedroe's observation about the total market index being overly weighted towards large cap growth stocks was made a couple of years ago when growth stocks were booming. In line with John Bogle's theory that essentially all classes of stocks "revert to the mean" in their long-term returns, the decline in value of large cap growth stocks has brought their capitalization back to a "normal" proportion of the total stock market.

Data compiled by Ibbotson Associates suggests that the performance of very small cap stocks is a slight exception to Bogle's theory. Part of the higher return from these stocks comes from their being riskier, but there appears to be a slight additional return beyond that. But for most practical purposes, I think that any index fund is likely to produce about the same long-term returns on a risk-adjusted basis. It's just that the total market index offers the advantages of simplicity, low expenses, tax efficiency, and the theoretically optimal ratio of expected return to risk.

The important thing about TIPs is that they are the only type of bond that will provide a positive real rate of return if inflation increases. I can't predict when inflation will really start to "take off," but it is bound to do so eventually because of the Federal Reserve's "loose money" policy.

Bear in mind that the 2.5% interest rate being paid by long-term TIPs is only part of their guaranteed return. For example, if the inflation rate over the next 6 months turns out to be 2.5% per year, the par value of TIPs will be bumped up by 1.25%, and the coupon rate will be applied to that higher par value in determining the interest payment. I think that TIPs are the safest long-term investment possible, and I think that it is remarkable that they pay as high an interest rate as they do, given that it represents only part of the expected return from TIPs.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 07:00 AM   #6
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Re: Question for Ted on Long Term Fixed Income Hol

"revert to the mean" seems to apply only to certain countries - at least that's Berstein's take in his Winter issue of Efficient Frontier.

In the past(Bernstein) small cap (lower right Morningstar box) as growth sucked - BUT small cap value beat all the the other eight boxes over the long term(from 1926?)

I have an emotional block with TIPs - Mark Twain's "Lies, Dam Lies, and Statistics". Do I trust those who are calculating inflation or the free market. History(looking back) seems to suggest that the free market has done a lousy job and TIP's might be the better solution.
SO-Total Bond Index is a default position - for now. Until I see data that makes the rational overcome the emotional doubt.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 07:09 AM   #7
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Re: Question for Ted on Long Term Fixed Income Hol

I believe the argument against TSM is that it is always weighted heavily towards whatever performed best last year. By investing directly in index funds that track the different asset classes, you can rebalance to avoid this overweighting on "hot stocks".

There are also compelling arguments against TIPS, and it is one of the best examples of how bonds are a much more efficient market than stocks. Basically, the market always does expected inflation rate arbitrage that increases treasury yields relative to TIPS.

You can think of non-TIPS treasuries as having a real return plus an expected inflation adjustment. In addition, they carry a slight yield premium for the risk that inflation might be different than what is expected. I believe the data shows that treasuries have always out performed TIPS in real terms.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 08:11 AM   #8
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Re: Question for Ted on Long Term Fixed Income Hol

Just one more thought on multiple stock indices vs TSM. For someone in the distribution phase of investment like most of we early retirees, it seems diversification of indices should help avoid selling an asset class when it is down. Frank Armstrong points out in one of his papers that if you are figuring out where to make withdrawals for living expenses, the diversified portfolio allows you to choose from the classes that have done well vs. those that may have fallen. Withdrawing from a TSM forces a pro-rated withdrawal from all asset classes.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 08:17 AM   #9
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Re: Question for Ted on Long Term Fixed Income Hol

If there are "compelling" arguments against TIPs, I have yet to hear any, but I'm thankful for people who think so because if they all went out and bought TIPs, the interest rate would drop to a point where it was unattractive.

The market interest rate on long term bonds other than TIPs certainly does contain a premium based on "the market's" expectation of inflation. If I invest in TIPs and inflation surprises me and turns out to be less severe than the "market expectation," then I end up making somewhat less return than I would by investing in other types of long-term bonds, but I'll still have a positive real return and will be just fine financially.

On the other hand, if I am right and "the market" is underestimating future inflation, people who have invested in long-term bonds other than TIPs are going to get creamed both in the near term and in the long term. And when that starts happening, I am sure that there will be a clamor for politicians to "do something," and at least some will start advocating totally stupid responses like price controls the way that even Republicans who should have known better did back in the 1970s.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 08:20 AM   #10
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Re: Question for Ted on Long Term Fixed Income Hol

Quote:
I believe the data shows that treasuries have always out performed TIPS in real terms.
I just searched for where I read this, and I couldn't find the source -- so assume I'm lying for now. I'll keep digging.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 08:26 AM   #11
 
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Re: Question for Ted on Long Term Fixed Income Hol

OK Ted,

I think you sold me on the 20% Tips. I want to buy these In my IRA account, does this mean that I should buy through Vanguard rather than direct?

What long term bond fund did you recommend for the 10% portion.

Thanks,
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 08:28 AM   #12
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Re: Question for Ted on Long Term Fixed Income Hol

Wabmester,

That might be true, but TIPs have only been available for about ten years, during which time inflation was declining. It's what will happen in the future that is important.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 08:46 AM   #13
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Re: Question for Ted on Long Term Fixed Income Hol

Ted, it's true that TIPS are relatively new, but other countries also offer inflation protected securities with a longer history. What I thought I read (but can no longer find) was that expected inflation during the term of a given bond was consistently overestimated by the market, thus providing a premium over the guaranteed inflation adjustment of TIPS.

However, I'm not sure I believe that anymore since my search did find a chart of the real yield on treasuries, and the market clearly underestimated inflation in the 70's:

http://www.martincapital.com/chart-pgs/CH_mmnry.HTM
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 09:05 AM   #14
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Re: Question for Ted on Long Term Fixed Income Hol

Yep - I was 'young' in the 70's - enough to remember some pain from bonds - And REITs - some mortgage types that went bankrupt.

I certainly hope to view a possible TIP investment with a rational mind.

I'm still inclined to get back to 80% balanced index and let the the non-emotional computers in Valley Forge do the asset class rebalancing. The other 20% is mine - all mine from bond classes to individual stocks. The default position is target retirement series and just 'go fishing'.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-13-2004, 09:21 AM   #15
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Re: Question for Ted on Long Term Fixed Income Hol

Just to add to the confusion, I should say that the chart on real treasury yields doesn't necessarily invalidate my original point. What I need to find is data that shows the expected inflation over the life of a bond vs actual inflation.

For example, if you bought a 30-year bond in 1970, it may have had a negative real yield for the first 10 years and then a monster real yield for the next 20. Which would tend to support the argument that the expected inflation over the life of the bond was higher than the actual inflation (which is what a TIPS would give you).
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Old 01-13-2004, 09:50 AM   #16
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Here are some links on bonds and TIPS in a portfolio:

Larry Swedroe and Rick Ferri argue about fixed income allocations

"Tips as an Asset Class" - from Ibbotson Associates

As for the correct AA in the subasset classes of stocks and bonds, I don't believe there to be one correct AA. Obviously, we can't know now what will be the best allocation going forward. And optimal AA are usually different for each person and retiree, as we all have different risks (inflation, job security, etc.) to hedge. For example, some of us may have COLA'd pensions, fixed pensions, or no pensions. Some of us may have stock options or other investments that need to be diversified.

TIPS are a great inflation hedge, as there are one of the only "real" assets (other than commodities and such). Plus, TIPS are very cheap to buy, either from the Treasury directly (or through a cheap broker) or in fund. Even if Treasuries of similar maturities will outperform TIPS or not (which would certainly be good to know now), TIPS should be better diversifiers of equities than regular treasuries. I believe the first Ibbotson paper addresses this.

I think you just have to pick an AA that you can live with. If you don't think you'll be able to do only the TSM funds for equities, then slicing and dicing may be better for you. I came to the conclusion that it will be psychologically easier for me to slice and dice than just use TSM. You may be trading off one risk (portfolio varaince) for another (small and value risks).

Here's another link I found of interest to those concerned about longevity risks (but that's probably for another conversation).

"Merging Asset Allocation and Longevity Insurance: An Optimal Perspective on Payout Annuities" – from Ibbotson Associates

- Alec
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-14-2004, 03:45 AM   #17
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Re: Question for Ted on Long Term Fixed Income Hol

Quote:
OK Ted,

I think you sold me on the 20% Tips. *I want to buy these In my IRA account, does this mean that I should buy through Vanguard rather than direct?

What long term bond fund did you recommend for the 10% portion.

Thanks,
You could hold TIPs in an IRA account by establishing a brokerage account within the IRA, or you could invest in an inflation protected bond fund. One thing about a fund is that the fund manager determines the average maturity of the holdings. In the case of Vanguard's inflation-protected fund, that is about 11 years now. That is OK, but I would personally prefer to have the average maturity up above 20 years, since I hope to live that long and would like some of my guaranteed real rate of return locked in.

I'm not sure what you mean about mt recommendation of a long-term bond fund, since right now I am avoiding long term bonds other than TIPs. When I did have a substantial holding of long term bonds (prior to January of last year) it was in Vanguard's long term corporate fund. I may be accused of "market timing" in getting out of long term bonds, but one of the reasons why I got a degree in economics was to be able to anticipate future financial risks better than the average person, and I see real economic problems in the future that are likely to cause increased inflation that will hurt long term bond holders. I am hopeful that stock prices will keep ahead of it, but don't expect them to do so by the 7% per year average that they have done over the past 75 years.
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-14-2004, 04:49 AM   #18
 
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Re: Question for Ted on Long Term Fixed Income Hol

Ted,

Quote:
I think that an allocation that would produce similar return with a little less risk would be, say, 60% stocks, 10% REITs, 10% high yield bonds, and 20% TIPs.
I guess what I was asking was what high yield bond fund would you recommend for this allocation.

Thanks
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-14-2004, 04:55 AM   #19
 
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Re: Question for Ted on Long Term Fixed Income Hol

ats5g,

BTW *- Very good links you provided!

Thanks
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Re: Question for Ted on Long Term Fixed Income Hol
Old 01-14-2004, 07:54 AM   #20
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Re: Question for Ted on Long Term Fixed Income Hol

Here is a list of some no-load high yield bond funds in approximate order of increasing risk/expected return. Vanguard, TIAA-CREF, T. Rowe Price, Fidelity High Income, Fidelity Capital & Income. This order also reflects expense ratios that increase from about 0.25% to 0.8%.

The first 3 have been sufficiently "conservative" that it would be OK to put all 10% in one of them. The last 2 are considerably riskier and perhaps not more than 5% of a person's assets should go into either one, especially if they have a large amount in stocks.
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