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Why Hold Bonds?
Old 01-09-2007, 03:16 PM   #1
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Why Hold Bonds?

OK, I exagerate.

However, based on historical results, it is undeniable that over the long-term, a 100% stock portfolio will provide the largest returns. It is widely accepted that this is also the most likely outcome for long-term future market performance.

Some bonds are required in the portfolio during the withdrawal phase (and during the run-up to the start of the withdrawal phase) to ensure that the portfolio is not excessively drawn down if a market downturn occurs. This is most critical if a market crash occurs immediately after retirement.

However, statistically speaking, the most likely outcome of a conservative SWR (say 3.5% to 4.5%) is a portfolio that grows significantly faster than inflation. In this case, the withdrawal rate will drop with time. One possibility in this situation is to adjust your withdrawals upward and enjoy a higher standard of living. However, this will not appeal to many FIRE’d who have moderate needs/taste. It seems to me that an alternative action in this event is to decrease your bond exposure, since your chances of fatally drawing down your portfolio is much less in this situation, say for example if your WR has dropped to 2.5%.

The question here; at what WR during the withdrawal phase would you be willing to move to a 100% equity portfolio? Alternatively, how many years of living expenses would your need in bonds before you would leave the remainder of your portfolio in 100% equities? Alternatively, would you never do this and always maintain some specified equity/bond ratio?

Personally, I believe that once I have 10 years of living expenses in bonds, it is safe to leave the remainder of my portfolio 100% in equities, regardless of the overall equity/bond ratio. The logic here is that a downturn is unlikely to last longer than 10 years, and if it does, the additional length is very unlikely to dangerously deplete your portfolio. This corresponds to a 40% bond allocation at a 4% SWR (which is what most people would advocate anyway) and a 20% bond allocation at a 2% SWR.

I should be honest here and admit that at the current time I only have 16% of my assets in cash/bonds, which corresponds to 5.5 times my basic living expenses (food, clothing, shelter and transportation at current levels). Even worse, I only had about 5% prior to rebalancing at the end of the year. OTOH, I am 5 years out from retirement and expect to have a larger total portfolio when I retire.
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Re: Why Hold Bonds?
Old 01-09-2007, 03:39 PM   #2
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Re: Why Hold Bonds?

Quote:
Originally Posted by bbuzzard
It is widely accepted that this is also the most likely outcome for long-term future market performance.
It is?

Of course we don't have a very long history to look at when trying to guess at future returns. It doesn't help all that much that the past doesn't tell us anything about the future returns. I find that most of those who advocate an 80% or higher allocation to US equities have a pension. It's much easier to write about mean variance calculating, wealth maximizing investors when you're sitting in your endowed chair at the University of Chicago. It's much harder for people in the real world who lose sleep during those 30 or 40% equity downturns

BTW: I wouldn't consider a 40% allocation to fixed income so minor. You will find the 60/40 equity allocation in about 90% of pension funds.
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Re: Why Hold Bonds?
Old 01-09-2007, 03:53 PM   #3
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Re: Why Hold Bonds?

Many years ago, Jonathan Clements wrote a piece in the Wall Street Journal advocating holding 5 years of expenses in cash and putting the rest in the stock market. His rationale was that a typical business cycle (and thus stock market cycle) is about 5 years. This would give you about 75-80% exposure to equities, which would raise the expected return of your portfolio above that of a 60/40 stock-bond mix. I have always thought that was pretty good advice.

In answer to your question, I would feel very secure with a 2% SWR and 100% equities. The current yield on the S&P 500 is about 1.75%, so a 2% yield is easily achievable with a slight dividend tilt, which should still leave adequate diversification. Over the long-term dividend growth has out-paced inflation by a significant margin.
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Re: Why Hold Bonds?
Old 01-09-2007, 03:53 PM   #4
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Re: Why Hold Bonds?

Quote:
Originally Posted by saluki9
BTW: I wouldn't consider a 40% allocation to fixed income so minor. You will find the 60/40 equity allocation in about 90% of pension funds.
I do not disagree, hence my statement regarding 60/40: "which is what most people would advocate anyway."

I would be interested to find out the average bond holdings are for very wealth individuals (say NW greater than 25 M). I bet it is lower than 40%. Also, pension funds have the same short term obligations as someone at a 4% SWR would have. I expect pension fund managers would have lower bond holdings if their short term obligations were lower. Then I could be wrong.
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Re: Why Hold Bonds?
Old 01-09-2007, 03:55 PM   #5
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Re: Why Hold Bonds?

Quote:
Originally Posted by FIRE'd@51
Many years ago, Jonathan Clements wrote a piece in the Wall Street Journal advocating holding 5 years of expenses in cash and putting the rest in the stock market. His rationale was that a typical business cycle (and thus stock market cycle) is about 5 years. This would give you about 75-80% exposure to equities, which would raise the expected return of your portfolio above that of a 60/40 stock-bond mix. I have always thought that was pretty good advice.
He recommends 75/25 in "25 Myths You've Got To Avoid If You Want To Manage Your Money Right"
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Re: Why Hold Bonds?
Old 01-09-2007, 03:57 PM   #6
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Re: Why Hold Bonds?

Quote:
Originally Posted by saluki9
It is?
I think if it wasn't, you and everyone else would have a 0/100 portfolio . Am I wrong?
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Re: Why Hold Bonds?
Old 01-09-2007, 04:00 PM   #7
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Re: Why Hold Bonds?

Quote:
Originally Posted by saluki9
It doesn't help all that much that the past doesn't tell us anything about the future returns.
I have to disagree here. Long-term past performance of the total market tells us much about long-term future performance of the total market. The problem occurs when people try to go short term and narrow market and the chaotic noise kills them.
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Re: Why Hold Bonds?
Old 01-09-2007, 04:06 PM   #8
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Re: Why Hold Bonds?

Quote:
Originally Posted by bbuzzard
I would be interested to find out the average bond holdings are for very wealth individuals (say NW greater than 25 M). I bet it is lower than 40%.
The mega wealthy often have funky portfolios. They may have large allocations to their businesses, a big slug of hedge fnds, commercial real estate, etc. that distorts what might otherwise be a more ideally constructed portfolio.
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Re: Why Hold Bonds?
Old 01-09-2007, 04:07 PM   #9
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Re: Why Hold Bonds?

Quote:
Originally Posted by bbuzzard

Personally, I believe that once I have 10 years of living expenses in bonds, it is safe to leave the remainder of my portfolio 100% in equities, regardless of the overall equity/bond ratio. The logic here is that a downturn is unlikely to last longer than 10 years, and if it does, the additional length is very unlikely to dangerously deplete your portfolio.
Warning!!! Warning

another "bucket" thread could be emerging!!
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Re: Why Hold Bonds?
Old 01-09-2007, 04:27 PM   #10
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Re: Why Hold Bonds?

Quote:
Originally Posted by brewer12345
The mega wealthy often have funky portfolios. They may have large allocations to their businesses, a big slug of hedge fnds, commercial real estate, etc. that distorts what might otherwise be a more ideally constructed portfolio.
I have a lot of commercial real estate myself. It's called the Vanguard REIT Index building .
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Re: Why Hold Bonds?
Old 01-09-2007, 04:29 PM   #11
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Re: Why Hold Bonds?

Quote:
Originally Posted by bosco
Warning!!! Warning

another "bucket" thread could be emerging!!
Buckets? We don't need no stinkin' buckets!
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Re: Why Hold Bonds?
Old 01-09-2007, 04:30 PM   #12
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Re: Why Hold Bonds?

Quote:
Originally Posted by bbuzzard
I think if it wasn't, you and everyone else would have a 0/100 portfolio . Am I wrong?
Yes.
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Re: Why Hold Bonds?
Old 01-09-2007, 04:45 PM   #13
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Re: Why Hold Bonds?

Quote:
Originally Posted by bbuzzard
Personally, I believe that once I have 10 years of living expenses in bonds, it is safe to leave the remainder of my portfolio 100% in equities, regardless of the overall equity/bond ratio.
Always look at the complete portfolio - so your 10yrs of living expenses translates to roughly 40% bonds in the total portfolio. (assuming 25yrs living expenses to retire 4%SWR) So there you go - if you have more than 25yrs of expenses in your total portfolio you can still use 10yrs in Bonds and increase your stock allocation.

Berstien I think said it best - anything more than 80% in Stocks your portfolio has lot more SD and this might result in your quitting to stick with your AA. Its more psychological than logical - If you are from klingon 100% is the way to go

Oh I forgot someone already said buckets - I need to shutup
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Re: Why Hold Bonds?
Old 01-09-2007, 04:53 PM   #14
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Re: Why Hold Bonds?

Quote:
Originally Posted by lswswein
f you are from klingon 100% is the way to go
Personally, based on my history to date, I am close to 100% klingon when it comes to investments. I have been in the markets making constant investments since 1990 without fliching. I realize that is not THAT long, and includes the 90's bull market, but I did make it though 2000-2002 with 100% in equities without even a minor flinch.
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Re: Why Hold Bonds?
Old 01-09-2007, 04:54 PM   #15
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Re: Why Hold Bonds?

The performance drag of a mixed portfolio is low (10-15%) and really reduces volatility. Probably a good trade off for most humans. Institutions and others with long time frames can afford to wait for the long term.

buying IBonds in January 2000, you would have realized a 50% total return today. Buying the S&P 500 and holding, you would just now be breaking even. DCAing and re-balancing should improve your returns by forcing you to buy low/sell high.

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Re: Why Hold Bonds?
Old 01-09-2007, 04:57 PM   #16
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Re: Why Hold Bonds?

Quote:
Originally Posted by HaHa
Yes.
OK, I exaggerate, but if the market generally expected bonds to do better than equities in the long term, it is clear we would be arguing about 20/80 portfolios vs. 40/60, instead of the other way around.
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Re: Why Hold Bonds?
Old 01-09-2007, 05:09 PM   #17
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Re: Why Hold Bonds?

Quote:
Originally Posted by Will Work 4 Beer
buying IBonds in January 2000, you would have realized a 50% total return today. Buying the S&P 500 and holding, you would just now be breaking even. DCAing and re-balancing should improve your returns by forcing you to buy low/sell high.
No argument that short term bond returns may be greater. When I say long term, I am thinking 10-15 years.
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Re: Why Hold Bonds?
Old 01-09-2007, 05:10 PM   #18
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Re: Why Hold Bonds?

Well... I can't be 100% in stocks... my company has a cash balance account that only gets a bond return.... can't do anything about that money..

And then I do have the 'if you get laid off money' in ST funds... exclude these two and I am then 100%
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Re: Why Hold Bonds?
Old 01-09-2007, 05:17 PM   #19
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Re: Why Hold Bonds?

Quote:
Originally Posted by bbuzzard
When I say long term, I am thinking 10-15 years.
Think longer.

How Long is a Long-Term Investment?

And let's not forget Japan. I know, I know. Japan had lots of speculation. 300% run-up in just 5 years. Could never happen here. (Oops, looks like we also had a 5-year 300% run-up starting in 1995.)
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Re: Why Hold Bonds?
Old 01-09-2007, 05:33 PM   #20
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Re: Why Hold Bonds?

Quote:
Originally Posted by wab
Interestingly, the same paper points out that bonds are also risky, but, as is obvious, the risk for bonds does not decrease with time, while the risk for stocks does.
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