Just Say No to Bonds?

[Rich_by_the_Bay]

Has anyone studied this: since the likelihood historically is that the stock market will not have longer than about a 7 year protracted "down" period (or so I have read), suppose you put 7 years worth in cash and near-cash, and the rest in diversified stocks. Skip bonds altogether, other than t-notes as a cash-equivalent. Let your big cash balance insulate you from volatility concerns - knowing you can wait it out for 5-7 years would make me pretty blase about the ups and downs of stocks on a week to week basis.

1) That is, with a $1mm nest egg and needing $40K per year, put $40 x 7 in cash up front, and laddered CDs or T-notes, for a total of $280K or 28% of assets.

2) Put the rest, or $720k in stocks and "let the big dogs run."

3) Prune and sweep the winners as needed.

You could benefit from a higher net return than if you had bonds at the typical 60:40 allocation, no? With lots of sound sleep knowing 7 yrs of piggy bank is behind you.

You might need b*lls of brass to watch the market go down with 72% of your assets, but since you can wait it out for a long time in the end would you win since stocks will outperform? Bonds? We don't need no bonds, right?

Just curious if this has been looked at. Anyone taking this approach?

 

[Nords]

I think Frank Armstrong pushes seven years, but I can't remember if he mixes the cash with bonds.

I bet one of the buckets gurus does the same.

We're doing it with ~92-95% stocks and the rest in cash (one year's expenses in a MM, a second year in a CD). No bonds. We're expecting/hoping that somewhere in the two years at least one of our equity categories will rise enough to give us the money for a third years' cash, or we'll cut back and take a little less.

We started this in 2002 and the cash balance got a bit of attention in early 2003, but everything was on the road to recovery by 2004.

 

[LOL!]

http://www.fundadvice.com/fehtml/bhstrategies/0108/0108a.html

has the following

In the 36 years under study here, the longest maturity you needed in order to achieve high bond returns was five years. All the data I have seen also indicates that one-year Treasury bills gave investors nearly 95 percent of the return of five-year Treasury notes, with much less volatility.

 

[wabmester]

Has anyone studied this: since the likelihood historically is that the stock market will not have longer than about a 7 year protracted "down" period (or so I have read)

Remember that country that we used to think was going to take us over in the 1980's?    Tell them about the 7-year limit on equity downturns.

If you can stomach the volatilty, and can live with a downturn that might outlive you, go for the gusto!

 

[saluki9]

Just like Wab said. Do a little search on "fat tails" Just because it hasn't happened in your lifetime doesn't mean that it will not happen.

Almost every version of the efficient frontier I've seen calculated shows that a 10-15% allocation to bonds has a higher expected return than 100% equities.

That being said, unless you happen to be running an insurance company or pension plan you can do without the long maturities.

 

[samclem]

RIT,
I see your reasoning and don't have a quantitative answer, but I think having bonds would be useful because:
1) As wab points out--there's nothing "holy" about 7 years.
2)Sometimes bonds and socks move in different directions (e.g as folks bail out of stocks and buy bonds, the yield on existing bonds rises). If stocks take a dive but bonds rise, your overall portfolio value would not dip as much as if you just had stocks and MMs. More importantly, if you rebalance every year, you'l be buying stocks as their value declines (thus getting more 'cheap' shares). This wouldn't happen if you just waited out the downturn with MMs.


samclem

 

[Rich_by_the_Bay]

Remember that country that we used to think was going to take us over in the 1980's? Tell them about the 7-year limit on equity downturns.

Do you think that the Japanese historic returns are a good match for our domestic returns?

Not to say it couldn't happen, but after > 7 years of a down market here, most all SWR schemes would be pretty bruised up, no? And wouldn't all that cash offer protection against the nightmare of both stocks and bonds being down for a long time?

 

[Rich_by_the_Bay]

We're doing it with ~92-95% stocks and the rest in cash (one year's expenses in a MM, a second year in a CD). No bonds.

Wow. What huevos.

Not sure I'd have the stomach for 92-25%, but I am beginning to like the concept. In some ways, bonds not so sexy: mediocre returns with an unimpressive increment over cash, with little likelihood of high returns. Ballast mostly, I guess.

Just exploring the idea a bit.

 

[Rich_by_the_Bay]

Almost every version of the efficient frontier I've seen calculated shows that a 10-15% allocation to bonds has a higher expected return than 100% equities.

I think that is higher expected survival rather than returns, but point well taken. Didn't these studies look at stocks alone v. bonds + stocks? Wasn't survivability the main criterion?

If so, I wonder what the effect is of looking at this with a big cash pocketbook thrown in. So, instead of (8% cash, 56% stocks and 36% bonds) vs. (8% cash, 92% stocks) the valid comparison would be (8% cash, 56% stocks and 36% bonds) vs. (28% cash, 72% stocks).

 

[wabmester]

Do you think that the Japanese historic returns are a good match for our domestic returns?

Not to say it couldn't happen, but after > 7 years of a down market here, most all SWR schemes would be pretty bruised up, no?

All stock markets are subject to the same risk.   Our situation is obviously different than Japan's, but some of the similarities wrt debt, real estate bubbles, and our recent stock bubble are kind of interesting.    Interesting enough that I think it would be nuts to be 100% invested in US equities.

The whole concept of "SWR" is supposed to be a worst-case planning exercise, right?   I include Japan-1990 in my planning.

And I'll let Nords talk about his huevos if he wants to, but keep in mind that he has a fat pension to fall back on.   Probably not true for the majority here.

 

[haha]

Wow. What huevos.

Not sure I'd have the stomach for 92-25%, but I am beginning to like the concept. In some ways, bonds not so sexy: mediocre returns with an unimpressive increment over cash, with little likelihood of high returns. Ballast mostly, I guess.

Just exploring the idea a bit.

While you are contemplating his huevos, remember that he has one naval officers pension, and will soon have another. I don't remember if you have any defined benefit, COLA pension with healthcare, but if you do not your mileage may vary, as they so quaintly say.

Ha

 

[Rich_by_the_Bay]

Sometimes bonds and socks move in different directions (e.g as folks bail out of stocks and buy bonds, the yield on existing bonds rises). If stocks take a dive but bonds rise, your overall portfolio value would not dip as much as if you just had stocks and MMs.

That's a valid point I've thought about.

Not sure if that non-correlation is also achieved by all that cash, which in effect "never" correlates -- the market (stocks and bonds) always seems to be up or down relative to any baseline

Cash coasts ahead with lower returns but never wavering. Even in the protracted 8-10 year bear market, bonds may outpace stocks, but may also sink for a long time. Cash would protect you best from that scenario, no?

Wish I were smart enough to answer my own questions..

 

[Rich_by_the_Bay]

While you are contemplating his huevos, remember that he has one naval officers pension, ands will soon have another.

Good point. I had huevo-envy, but now feel secure again with my own.

I hereby retract any inadvertent exaggeration about Nords' huevos.

 

[Chris24]

Rich, aren't you really looking at a 72/28 equity/fixed income split to start. Aggresive maybe, but not hanging off a cliff. How far are you willing to go , before you feel you might fall off a cliff. Prunning and sweeping may keep you at that ratio, esp. if you go into this with an up market.

 

[haha]

That's a valid point I've thought about.

Not sure if that non-correlation is also achieved by all that cash, which in effect "never" correlates -- the market (stocks and bonds) always seems to be up or down relative to any baseline

Cash coasts ahead with lower returns but never wavering. Even in the protracted 8-10 year bear market, bonds may outpace stocks, but may also sink for a long time. Cash would protect you best from that scenario, no?

Wish I were smart enough to answer my own questions..

US treasury Bonds differ form cash only in their duration. So if you keep it relatively short, and use a ladder, I can't see any real problem to going out maybe a max of 5 years, unless of course you expect rising rates, as many of us correctly did over the last couple of years.

Also, don't forget TIPS. They offer real pre-tax post inflation return that should IMO always be compared to what the riskier alternative of equities seems to offer.

Ha

 

[wabmester]

Not sure if that non-correlation is also achieved by all that cash, which in effect "never" correlates -- the market (stocks and bonds) always seems to be up or down relative to any baseline

Cash coasts ahead with lower returns but never wavering. Even in the protracted 8-10 year bear market, bonds may outpace stocks, but may also sink for a long time. Cash would protect you best from that scenario, no?

Cash can act as a cushion, but not as a diversifier in the MPT sense as I understand it.    Since cash by definition has zero volatility and zero covariance, it simply acts to dampen both returns and volatility, whereas the goal of MPT is to dampen volatility without dampening returns.   Bonds can do that.

 

[Jarhead*]

While you are contemplating his huevos, remember that he has one naval officers pension, ands will soon have another. I don't remember if you have any defined benefit, COLA pension with healthcare, but if you do not your mileage may vary, as they so quaintly say.

Ha

Ha: Speaking about Nords Huevos in this context, reminds me of the time that Lee Trevino was on the Johnny Carson show. (He made his living hustling high roller golfers on his local course (Tennyson in Dallas), prior to turning pro.

Johnny Carson remarked how pro golfers have to be packing a set to be able sink a side-hill 15 foot putt with all the pressure they're under.

"Hell, that's not pressure. They're playing for prize money. (Not their own).

Pressure is when you're playing a $5,000 Nassau with a known member of an organized crime family, without a dime in your pocket. "

 

[Nords]

Good point. I had huevo-envy, but now feel secure again with my own.
I hereby retract any inadvertent exaggeration about Nords' huevos.

Sorry, guys, I answered in haste and dined repented leisurely.  Perhaps for our convenience the board software should detect answers of this sort and automatically add hyperlinks to our full financial profiles, SWRs (to three digits), and a complete discussion of all calculations.

Besides, Rich, you've probably seen a lot more huevos than I have...

Full disclosure:  I have a $35K annual pension with a CPI-U COLA and TRICARE Retired.  Last year we spent about $42K plus an additional $22,700/year P&I on our home mortgage (until 2034).  (When I retired that mortgage was at 8% but we've beaten it down to 5.375%.  Property taxes and TRICARE premiums are low for now but could rise rapidly.  We do not carry long-term care insurance.)  Spouse will draw her military pension in 2022 so our portfolio only has to make it until roughly 2025, when I'm drawing ~$10K/year SS and closer to paying off the home mortgage.  We're keeping our portfolio's SWR under 4%.  Our rental property (27 years old) appears to have good long-term tenants and we carry that on the books at a wash against its expenses/mortgage.  

With those numbers it makes sense to have a high-volatility all-equity retirement portfolio.  Others considering that type of portfolio should probably include a safety net of I bonds or TIPS or (*gasp*) an annuity to pay the mortgage during a savage Japanese-style bear market.  

I don't know anyone foolish enough to stay fully invested in the Nikkei for the duration of that bear market, just like I don't know anyone doing the same with the S&P500 from 2000-04.  Today we're tilted toward small-cap value & Berkshire Hathaway with a large slug of international index fund PID, so our recent volatility has been much much lower than that hypothetical S&P500 fool.

Cash can act as a cushion, but not as a diversifier in the MPT sense as I understand it. Since cash by definition has zero volatility and zero covariance, it simply acts to dampen both returns and volatility, whereas the goal of MPT is to dampen volatility without dampening returns. Bonds can do that.

OTOH withdrawing cash has a much smaller impact on total portfolio return than withdrawing bonds, and when you're withdrawing cash in a bear market you may not rebalance the portfolio for years. I think most MPT studies rebalance annually, which might have a significant difference from a cash-equity portfolio. So I don't know how much those latter effects help to boost the returns of the rest of the portfolio.

I don't think Bernstein has really studied the performance of the cash-equity portfolio that replenishes the cash bucket only during good years.

 

[wabmester]

I don't think Bernstein has really studied the performance of the cash-equity portfolio that replenishes the cash bucket only during good years.

I can't speak for the man, but I don't think "buckets" are part of MPT.    The basic premise is that cash always dampens returns (look at the straight line part of the efficient frontier curve), but that you should have a diverse enough set of assets that *something* is always up relative to the others, so you can always rebalance (or withdraw, in the retirement case) from the appreciated asset class(es).

 

[wabmester]

I look upon equities yielding less than 4% or so as speculations, and I expect whatever I have invested in them to return to cash within several years.

That's an interesting take. I look at high-yielding stocks as speculative. PFE, MRK, T, VZ, etc all have a bunch of embedded uncertainty and downside risk. If they would only guarantee that dividend, I'd agree with you.

 

[haha]

Pressure is when you're playing a $5,000 Nassau with a known member of an organized crime family, without a dime in your pocket. "

Jarhead,

I wish I had this kind of cool. I am reading a terrific book called Deep Survival, which tells lots of stories of survival against heavy odds, and also of more routine situations where you really have to keep cool- such as landing your Hornet on a carrier deck. This stuff puts me in awe of people who can do it. Trevino's story is just this type.

Ha

 

[haha]

That's an interesting take.   I look at high-yielding stocks as speculative.   PFE, MRK, T, VZ, etc all have a bunch of embedded uncertainty and downside risk.   If they would only guarantee that dividend, I'd agree with you. 

Of these, I only own PFE. I agree the others are specs. Also, I won't reach for them, and I will always own quite a few.

I have taken many small to moderate sized positions in high yield situations, but never when background bond yields are as low as today. Often (as in O &G royalty trusts over the last 10 years or so) the positions have grown large. I always trim them down, even though so far it has always cost me money.

I agree that reaching for yield can be quite risky. But I view the risk in PFE as a business to be smaller than the risk in a very highly diversified portfolio of equities, if I may have to sell some of this basket to provide cash flow.

Ha

 

[mathjak107]

im starting to like bonds.im thinking about agg or fidelity total bond index at this point..i figure we are near the bottom of the cycle..if i can collect interest for almost a year and hopefully catch a 2-4% captital gain on the next pereception of a rate cut in 2007 that aint a bad return for getting in a little early and waiting .....
i use the 3 bucket system which takes me out 14 years before i hit my stock bucket...you would be hard pressed to find many 14 year periods that didnt make money..especially in the last 2 decades

 

[brewer12345]

Rich, what you are in effect asking is what does a bond allocation do for you that cash doesn't. The answer is pretty simple. In the ugly downdrafts, cash sits there and throws off a little interest, which tends to decline in extended drops as central banks lower rates. In contrast, bonds throw off some interest (used to be more than cash, not any more), but high grade bonds (treasuries, MBS/GNMAs, lilly white corporates) tend to also see an appreciation in their market value as the market runs to "safety." So not only do you get the interest, but you also have a chance at capital appreciation at exactly the time when your equity position is taking a pounding.

I wanted to draw you a chart with VBMFX and VFINX to illustrate the point, but I can't find a total return chart (because stadard charts ignore bond interest and div payments). But in 200 through 2002 when the equity market was plotzing (VFINX had an average annual total return of -14%), VBMFX averaged almost a 10% total return per year.

 

[Rich_by_the_Bay]

The answer is pretty simple. In the ugly downdrafts, cash sits there and throws off a little interest, which tends to decline in extended drops as central banks lower rates. In contrast, bonds throw off some interest (used to be more than cash, not any more), but high grade bonds (treasuries, MBS/GNMAs, lilly white corporates) tend to also see an appreciation in their market value as the market runs to "safety."

I see your points. Plus the ability to pick up some sales merchandise by rebalancing when stocks are low.

I wonder whether those advantages of stocks over cash are offset by the fact that 1) cash won't go down in value even in a bull market like bonds might, and 2) by confining cash to 28% of assets (7 x 4y expenses) rather than 40% as is often done with bonds, you get to keep a larger proportion in stocks which over the long haul will probably do a lot better.