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Why do I need bonds?
Old 02-17-2008, 08:26 PM   #1
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Why do I need bonds?

For the last 1.5 years, I have let Fidelity actively manage about 1/4 of my money. I'm ready to take that back and plan to put most of that in the Fidelity "lazy" portfolio that Paul Farrell detailed on MarketWatch.

He shows equal amounts in index, euro, small cap, and bond funds. When I look at the returns, all I see is that the bonds are dragging the total down.

I'm 46, still w*rking and saving, and have high tolerance for market swings.

Is there a strategic reason for me to own bonds at this stage?
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Old 02-17-2008, 08:39 PM   #2
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When do you intend to retire? If the answer is less than 10 years than I think reducing the volitality of your returns is the strategic reason to own bonds.
If you have 10 years or more year than no.

Good quality bond funds have gained value during the bear market. For instance Vanguard GNMA is up 4% since June, now that isn't a lot but it beats being down 15-20% like many equity funds.


IMO if you have the risk tolerance you say you do you can certainly ignore bonds until 5 or so years before retirement.
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Old 02-17-2008, 08:41 PM   #3
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Because they've returned 10-20% YOY while the S&P returned negative ... ?
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Old 02-17-2008, 08:54 PM   #4
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Because they've returned 10-20% YOY while the S&P returned negative ... ?
I'm not arguing Dan, but I look at the 3,5, and 10-year returns on bond funds versus stocks and there is no comparison; bonds are nowhere near as lucrative. I understand they are good in a bear market with falling interest rates, but they would seem to drag a portfolio down in the long haul. That's the gist of my post; am I missing something?

Retirement is 2016 or whenever my net worth hits the magic number. For instance, another good bull market in the next five years might let me move to a safer AA and head for the farm.
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Old 02-17-2008, 09:00 PM   #5
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Good quality bond funds have gained value during the bear market. For instance Vanguard GNMA is up 4% since June, now that isn't a lot but it beats being down 15-20% like many equity funds.
I look at the scenario above and see a temporary, short-term advantage to owning the bonds. For a buy and hold, non-market timer like me; it seems to not fit my strategy, as you stated. Thanks.
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Old 02-17-2008, 09:12 PM   #6
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You don't have to own bonds if you can live with the stock market's wild ups and downs and if you trust yourself not to panic and sell when the market tumbles hard. But, I am chicken and at age 33 I have about 30-35% of my portfolio in bonds which allowed me to weather the 15-20% drop in the stock maket since last October without selling a thing or losing sleep over it. I know my limits. Are you sure you know yours?
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Old 02-17-2008, 10:08 PM   #7
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Is there a strategic reason for me to own bonds at this stage?
If you buy Bernstein's "efficient frontier" research, bonds reduce portfolio volatility ("risk") while maybe even boosting returns. I believe that.

There's also other ways to deal with volatility-- for example keeping a couple years' expenses in cash. You might even play the odds with long-term CD rates that exceed many bond yields and only have to be broken into once or twice a decade.

Or you could reduce volatility by adding commodities & natural resources or REITs to your portfolio. Conventional wisdom is that those asset classes are still overpriced but getting cheaper in some areas.

Or you could vary your spending if you have a bad down year (no one worries about upward volatility). That'll get you around the issue of having to sell losing stocks into a down market while still allowing you to maintain some sort of safe withdrawal rate.

During your earning years you don't care about bonds because your paycheck will get you through the down markets. Some people worry about losing that paycheck during a recession, so instead of bonds a cash stash might do the job.

But eschewing bonds for MMs or CDs also deprives you of the opportunity for capital gains or more "exciting" (volatile) high-yield debt.

We didn't invest in bonds for our ER portfolio when we were working and we don't do it in ER either. But I have a COLA'd pension to tide over the bumps and we use a two-year cash stash in long-term CDs to ride out volatility...
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Old 02-17-2008, 11:40 PM   #8
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Nords has it correct....

Having bonds have been shown to have superior risk adjusted returns over a 100% portfolio...

Remember... there are some time periods where stock have been down (can't remember the exact number... but) something like 8 or 10 years.... so, if you are only looking at the last 3, 5 or 10 year period, it looks bad...

But if you can.. go back to say... 1972 or 1976 and take a look at the 3, 5 and 10 year returns and you might be asking why people are investing in stocks when BONDS pay so much better... and then look at the early 80s when CD rates hit a high of 17 percent.... my dad got a few at that rate for a 5 year CD... again, it is the time period we are in that makes 100% stock look so good...
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Old 02-18-2008, 12:40 AM   #9
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Bonds are the "sleep at night" element in many folks after retirement portfolio. I have about 25% in various bonds; 75% is equities and the rest in cash or other liquid assets. My mother is about 80 bonds or bond funds and I forced her to get 20% into the market with index funds and MM. She is 86 and is in an Assisted Living center so her expenses are pretty small and consistent. Being a Child of the Depression she does not trust the stock market and her direction to me is " don't lose my money!!" That does not give a lot of options for nearly 100% safe growth.

The traditional thinking is that if stocks tank, bonds will be doing fine so you will still have money to spend in retirement.
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Old 02-18-2008, 05:27 AM   #10
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If you buy Bernstein's "efficient frontier" research, bonds reduce portfolio volatility ("risk") while maybe even boosting returns. I believe that.
... We didn't invest in bonds for our ER portfolio when we were working and we don't do it in ER either. But I have a COLA'd pension to tide over the bumps and we use a two-year cash stash in long-term CDs to ride out volatility...
Nords, not trying to pick a fight, more curious and trying to learn something.
How do you resolve the 1st statement with the fact that you don't invest in bonds? Especially the 'boosting returns' part of it.
Thanks.
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Old 02-18-2008, 05:32 AM   #11
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I'm not Nords but if you click on the "my profile" link in his sig you'll find an answer to the 'no bonds' question.
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Old 02-18-2008, 05:35 AM   #12
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I'm not arguing Dan, but I look at the 3,5, and 10-year returns on bond funds versus stocks and there is no comparison; bonds are nowhere near as lucrative. I understand they are good in a bear market with falling interest rates, but they would seem to drag a portfolio down in the long haul. That's the gist of my post; am I missing something?

Retirement is 2016 or whenever my net worth hits the magic number. For instance, another good bull market in the next five years might let me move to a safer AA and head for the farm.
Since you can 'take the heat' and you are 8 years away from pulling the rip cord, I would stay fully invested (especially now with the market down) in equities and start to 'ease over' to whatever you want your AA with bonds to be, starting say in 3 to 4 years or so.

Ideally you would want to be at your planned AA by the time you retire. So you may need to go to plan b if you hit your magic number before 2016 and accelerate your move to bonds.

Best of luck to you.
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Old 02-18-2008, 06:19 AM   #13
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If you buy Bernstein's "efficient frontier" research, bonds reduce portfolio volatility ("risk") while maybe even boosting returns. I believe that.

There's also other ways to deal with volatility-- for example keeping a couple years' expenses in cash. You might even play the odds with long-term CD rates that exceed many bond yields and only have to be broken into once or twice a decade.

Or you could reduce volatility by adding commodities & natural resources or REITs to your portfolio. Conventional wisdom is that those asset classes are still overpriced but getting cheaper in some areas.

Or you could vary your spending if you have a bad down year (no one worries about upward volatility). That'll get you around the issue of having to sell losing stocks into a down market while still allowing you to maintain some sort of safe withdrawal rate.

During your earning years you don't care about bonds because your paycheck will get you through the down markets. Some people worry about losing that paycheck during a recession, so instead of bonds a cash stash might do the job.

But eschewing bonds for MMs or CDs also deprives you of the opportunity for capital gains or more "exciting" (volatile) high-yield debt.

We didn't invest in bonds for our ER portfolio when we were working and we don't do it in ER either. But I have a COLA'd pension to tide over the bumps and we use a two-year cash stash in long-term CDs to ride out volatility...

and what happens at the end of 2 years if an extended down market dosnt recover so fast? do you liquidate stocks at a loss?
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Old 02-18-2008, 06:57 AM   #14
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Table 1-1. Historical Returns and Risks of U.S. Stocks and Bonds in the 20th Century
Asset
Annualized Return
Worst Real Three-Year Loss
Treasury Bills
4%
0%
Treasury Bonds
5%
-25%
Large Company Stocks
10%
-60%
Small Company Stocks
12%
-70%


At first glance it sure looks like it makes more sense to hold cash instead of bonds as a way to reduce volatility and shelter you from bad times. Why would you tie your money up in T bonds for only 1% extra return, but more risk of loss of principal? What am I missing?
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Old 02-18-2008, 09:08 AM   #15
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the answere was something i posted in another post so ill just copy it:


although im only using long term treasury bond funds as a trading vehicle right now , going on the 10th time ive bought and sold them this year for someone who wants a truley diversified portfolio long term treasury bonds or funds are really the only way to go right now in my opinion.

the reason is they are the only asset class that will protect a portfolio in a deflation or global recession with enough ooomph. shorter term bonds just cant give that kind of gains to make them worth owning at this point with rates so low. . even at this level of just below 4% they can stiill easily provide capital gains of 20-30% if economic conditions dictate.

remember a truely diversified portfolio doesnt shy away from buying an asset class because one thinks its over valued, or the interest isnt high enough or the economic conditions of the moment show a drop in that class highly likely. 25 years of investing has taught me nothing ever plays out the way it looks. there is always something not even on the radar yet to alter the course of events. . you do it for the protection it can provide to ease the pain of the losses in other areas. yes if rates go the other way you will sustain losses in your bonds but the gains in other areas should far out weight it. isnt true portfolio diversification about taking the good with the bad and never having to say im sorry?


a truley diversified portfolio always is designed to answere the age old question... WHAT IF IM WRONG?
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Old 02-18-2008, 09:14 AM   #16
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I bet that those returns of -60% and -70% include the Great Depression, right? It's a different world from then. No FDIC, 90% margin allowed in stocks, bad government policies actually extended the Depression, etc.

You should probably start after WW2. IOW, 1945 or 1947 to present.
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Old 02-18-2008, 09:24 AM   #17
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Using bonds and a general diversified portfolio reduces risk in a number of ways. One risk that is diminished [overall] portfolio volatility.

If you are diligent with regular rebalancing, you also get a built-in buy low sell high technique that moves upward with the benefit of reduced risk.

One other point. While many look at stats that show the market peaks and long-term growth of equity being more than the equivalent balanced portfolio... I believe few actually attain those results because they make poor decisions in terms of timing and security selection... which factors into each person's final growth results.

To sum it up. I am a mere mortal not a genius. Therefore I am not very good at picking individual securities and/or at timing said sells/purchases. Therefore being highly diversified (using low cost funds) and a simple rebalancing strategy is best for me. I would recommend it to everyone who is a mere mortal.
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Old 02-18-2008, 09:37 AM   #18
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right now our guard should be up because assets that normally are totally opposite are moving together... that tells you these arent the normal of times ahead.

long term bonds and tips are opposite, one is a bet on low inflation , the other high. right now they both are making highs. commodities and bonds are making friends. both traveling up together. these oddities dont last long as they only do this until the actual trend forms. but its telling you commodities and bonds should be the bets as one will emerge the winner of the 2 and since you dont know which buy both
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Old 02-18-2008, 10:27 AM   #19
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Nords, not trying to pick a fight, more curious and trying to learn something.
How do you resolve the 1st statement with the fact that you don't invest in bonds? Especially the 'boosting returns' part of it.
Thanks.
No offense, I'm saying that Bernstein is one of the few who has both the math and the history to back up his assertions. (Even Sharpe is apologizing for his Nobel Prize these days.) I just agree with his claim that bonds reduce a portfolio's volatility while offering the chance to boost returns through capital gains.

IMO the only advantage of a bond is its historical inverse correlation with the stock market. (OK, another advantage is the priority claim it offers shareholders in case of the comany's bankruptcy.) Bonds lower portfolio volatility to make people sleep better at night. OBTW you might make money on them, although results over the last few years have been a bit rocky. Over the last century bond returns have been pathetic. Despite the shareholder's bankruptcy risk I'd much rather have a dividend-paying stock.

But you can also achieve inverse correlation through commodities, real estate, natural resources, and leveraged beever cheese futures. They just don't happen to have the same history & liquidity as most bond markets, although (except for beever cheese) that's changing.

The military has done my bond investing for me. My COLA pension gives me $3102/month from the equivalent of Treasuries or I bonds, which is why we can afford to hold an ER portfolio of 92% equities. The other 8%, held in cash, is how we sidestep the volatility.

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and what happens at the end of 2 years if an extended down market dosnt recover so fast? do you liquidate stocks at a loss?
Strawman argumentation. You claim to know better-- maybe you're the one trying to pick a fight?

We do the same thing we do after an extended up market. We sell off whatever's needed to rebalance and then if we need more money we sell off whatever sucks the least. If that's a loss then that's what we do, but not every stock loses money in a bear market (particularly the international stocks). Our ETF/stock portfolio isn't designed to conserve principal and, if our track record is any indicator, it's certainly liquidated stocks at a loss once or twice before.

Unless you're trading like a hypercaffeinated bunny or woefully undiversified, most stocks retain enough of their pre-bear gains during a bear market that they'd be sold at a profit anyway. In 2004 we bought Dow Jones Select Dividend ETF (DVY) shares for $55. I think the worst we saw last month was $59/share, and that doesn't count four years of dividends. It's not rocket science and it's not a roller coaster, either.

But I'm not just talking a piddly little bear market like Sep 2001-Oct 2002 either, I'm talking about 1973-1974 or 1979's "death of stocks" gloom. Keep in mind that by the second or third year of an extended bear we'd also probably cut spending-- we'd defer the second cruise vacation, hold off on the replacement vehicles, and maybe not upgrade the kitchen for a few more years. (Or maybe we'd do that anyway, because the Craigslist desperate-seller bargains would be too epically tempting to pass up.) After three years we'd go full defense and cut non-essential spending in the "entertainment" and "dining out" categories. Maybe I'd be spending a lot more time gardening, reading library books, taking long neighborhood walks, and surfing. I'd also be going nuts with excitement trying to rebalance our portfolio among all the single-digit-P/E blue-light-special fire sales out there. So, yeah, I'd probably be liquidating buttloads of stocks at a loss.

Historically, two years handles the typical bear market and escapes all but the worst of them. One of the reasons we keep a year's worth of those two year's expenses in small long-term CDs is that it boosts the yield without much of a risk of having to break into it. Currently that's three-year PenFed 6-6.25% CDs until 2009 & 2010.
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Old 02-18-2008, 11:15 AM   #20
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Unless you're trading like a hypercaffeinated bunny
How did you know I just poured my 5th cup?

My stuffed beaver just told me to buy some of those there tech stocks.

Do note that we're nearing the tail end of a nice 30+ year bull market in bonds. Might not be so good from here. But they sure do offer some predictable income...
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