The limitations (and strength ?) of balanced funds...

[FIREd]

Well it happened, MIL called, the DOW is down another 200 points, she is freaking out. But at least she understand that she shouldn't sell everything and run for the hills, but she feels very insecure about the current situation.

Right now, all of her retirement money (in her only IRA) is invested in Vanguard Target Retirement 2015. This fund has lost almost 29% YTD.

When she purchased the fund last year, she wasn't supposed to need the money until 2017, so the 2015 fund made sense for her. But her income has unexpectedly dried up this year (and it might remain that way for a few years), so she is currently living on her taxable savings and maturing CDs. Her CD ladder and savings will take her to the end of 2009, but after that she'll have to start taking money out of her IRA.

Now, a balanced fund, like TR2015, automatically sells bonds to buy more stocks when the stock market drops (i.e. it rebalances automatically and it's is supposed to be a good thing). The problem she is facing is that the amount of money invested in safer bonds keeps going down as the stock market goes down.

When she started with $200K in the TR2015 fund in 2007, she had about $80K in bonds. Now that the fund is down 30%, she has just about $56K left in bonds.

Right now, between her CDs and the bond portion of TR2015, she could cover 5 years worth of expenses. So she wants to secure the $56K worth of bonds in TR2015 to make sure the money will be there no matter what the market does. She is willing to leave the rest ride the market and get a chance to recoup her losses.

So here is my plan:

VG TR2015 is pretty much allocated as follows:
38% VG total bond market
50% VG total stock market
12% international (close to VG total international)

I want to advise her to sell her shares of VG TR2015, and purchase the individual VG total bond market, VG total stock market and VG total international funds keeping an AA similar to TR2015. This maneuver will not immediately impact her AA but it will do 2 things: 1) if the stock market recovers, she still participate in the recovery and 2) if the market keeps going down, only the stock portion of her portfolio will be impacted and the bond portion will remain safe (no more continuous rebalancing on the way down).

This solution would ease her mind because her income for the next 5 years would be more secure. She might then stop watching CNBC all day and go back to living her life.

Do you think that plan make sense? Is there any pitfall I didn't think of?

 

[W2R]

I sure can sympathize with her. With only $200K in her retirement nestegg, this must be hitting her pretty hard.

Your plan sounds OK to me, but maybe others will have more to add.

A couple of thoughts/musings:

I think rebalancing works better in building wealth if you rebalance at bottoms as well as at peaks in the market.

What will you do to calm her if her VG total bond market starts dropping? I suppose maybe some of that could go to more CD's, temporarily, but then that money would just sit there. She might feel more secure about it, though.

Maybe she needs a bigger bond/cash allocation than this fund provides, in order to sleep at night, so to speak.

This is a tough problem.

 

[headingout]

>> I think rebalancing works better in building wealth if you rebalance at bottoms as well as at peaks in the market. <<

Sure, but how do you identify those bottoms and peaks at the time?

I read (maybe here) about a study that showed many successful investors made most of their money from buying on the way down....

 

[FIREd]

I sure can sympathize with her. With only $200K in her retirement nestegg, this must be hitting her pretty hard.

Your plan sounds OK to me, but maybe others will have more to add.

A couple of thoughts/musings:

I think rebalancing works better in building wealth if you rebalance at bottoms as well as at peaks in the market.

What will you do to calm her if her VG total bond market starts dropping? I suppose maybe some of that could go to more CD's, temporarily, but then that money would just sit there. She might feel more secure about it, though.

Maybe she needs a bigger bond/cash allocation than this fund provides, in order to sleep at night, so to speak.

This is a tough problem.

It is a difficult time for her because she has been hit hard by both the loss of her income and the stock market declines.

VG total bond market has held up pretty well so far (-1% YTD). I think it suffered from the flight to quality we have seen lately but I expect that, as the government works on solving the credit crunch, it will go up again as people focus more on yield and less on safety once again. If I am wrong, then, as you pointed out, we could always buy more CDs. The important thing is to stop the endless rebalancing. At this point she is more worried about limiting the downside than missing any potential upside on her fixed income portfolio.

As far as her bond / cash allocation goes, she is the one who wants to keep a pretty aggressive portfolio (last year she was 90-95% foreign stocks before I convinced her to come to the light and become more conservative with her money). She wants to have a chance to recoup her losses and to (hopefully) continue growing her money enough to retire in relative comfort.

 

[Bikerdude]

Do you think that plan make sense? Is there any pitfall I didn't think of?

Just the possible market fluctuations when you try to do the sell/buy transactions. You know sell low buy high.

 

[FIREd]

Just the possible market fluctuations when you try to do the sell/buy transactions. You know sell low buy high.

I was thinking about doing an overnight exchange:

Sell TR2015 and simultaneously buy 38% VG total bond, 50% VG total market and 12% VG international (same proportions as in TR2015). I figure that it should take care of the problem, no?

 

[W2R]

I was thinking about doing an overnight exchange:

Sell TR2015 and simultaneously buy 38% VG total bond, 50% VG total market and 12% VG international (same proportions as in TR2015). I figure that it should take care of the problem, no?

If you do it in Vanguard, you can do it as an exchange and it will be simultaneous. That is probably what you meant! Never mind.

 

[FIREd]

If you do it in Vanguard, you can do it as an exchange and it will be simultaneous. That is probably what you meant! Never mind.

Yes that's what I meant!

 

[DblDoc]

>> I think rebalancing works better in building wealth if you rebalance at bottoms as well as at peaks in the market. <<

Sure, but how do you identify those bottoms and peaks at the time?

I read (maybe here) about a study that showed many successful investors made most of their money from buying on the way down....

A couple of thoughts:

First - rebalancing is a risk management tool not a wealth building tool. If you look at the studies comparing different time intervals or bands the gain (or loss) in the hypothetical portfolios is very small and pales in comparison to your AA decision.

Second - rebalancing should be done mechanically. Either based on a time interval (annually, every 2 years etc) or bands and not based on some prediction of where the market is going.

Third - I hope your right cause I've been buyin alot on the way down...

DD

 

[W2R]

From Swedroe (2005), p. 201:

Rebalancing - - Buy Low and Sell High
In addition to providing the all-important benefit of avoiding style drift, rebalancing can also add to portfolio returns. [...] Rebalancing over time will likely produce a bonus--the portfolio's annualized return will exceed the weighted average of the annualized returns of the component asset classes.

That is what I meant by wealth building. Perhaps I was embellishing a little, unintentionally.

Rebalancing in bands, while ignoring the bottom of the band, will hamper the increases in annual returns. Both the top and the bottom of the band need to trigger rebalancing for better results. Many of us rebalance when our AA has wanded by 5% one way or another, for example. I rebalanced last week because I was over 5% off of my AA, but I don't claim last week to be "the" market bottom.

 

[Rich_by_the_Bay]

One disadvantage of target funds and other balanced products is the loss of your ability to selectively sell shares of just one of its components. Same trait makes them very convenient during accumulation but inflexible during withdrawal.

If it were me, I'd hold off as long as I could for markets to rebound a little, then split it up. Tough situation - hang in.

 

[samclem]

Just an echo of W2R's comments. If your MIL needs money within the next few years, would it not be more prudent to build a CD ladder for her? FDIC insured (things could get worse, and this will be some comfort to her) and not subject to the interst rate/default risk bonds can have.

Other than that, dividing up the $$ into separate funds (rather than allowing the continual rebalancing) will probably meet your short term objective of stabilizing her account. When the market turns around, though, she'll obviously have less growth potential than f she'd continued to buy equities on the way down.

Providing hands-on investment advice to your MIL? What, were all the "fun" jobs on the bomb squad already filled?

 

[FIREd]

Just an echo of W2R's comments. If your MIL needs money within the next few years, would it not be more prudent to build a CD ladder for her? FDIC insured (things could get worse, and this will be some comfort to her) and not subject to the interst rate/default risk bonds can have.

Other than that, dividing up the $$ into separate funds (rather than allowing the continual rebalancing) will probably meet your short term objective of stabilizing her account. When the market turns around, though, she'll obviously have less growth potential than f she'd continued to buy equities on the way down.

Providing hands-on investment advice to your MIL? What, were all the "fun" jobs on the bomb squad already filled?

I understand that splitting the balanced fund is not a perfect solution, but I am thinking that it might be the least damaging solution given the situation (at least she gets to keep some money in the market and -hopefully- recoup some of her losses). MIL did not seem to want more CDs (because the money is "locked up"), but I will carefully present the pros and cons of both bond funds and CDs and let her decide which one she prefers.

I wish I didn't have to provide her with investment advice. But, she is clueless when it comes to her finances (she is not stupid, she is just not very good with numbers and money). She even has trouble balancing her own checkbook sometimes (last week I got a worried phone call because her checkbook register showed a -$10,000 balance)... So I (or someone else) have to help her. Her brother-in-law (who is a financial adviser in one of those wall street firms) proposed to help her with her retirement portfolio for a... fee and commissions that she couldn't afford (he wouldn't even give her a discount).

The truth is that I have a vested interest in her financial success. If her retirement plan fails, guess who's going to have to support her financially or worse, guess in whose guest bedroom she (and her pets) will end up crashing...

 

[FIREd]

One disadvantage of target funds and other balanced products is the loss of your ability to selectively sell shares of just one of its components. Same trait makes them very convenient during accumulation but inflexible during withdrawal.

If it were me, I'd hold off as long as I could for markets to rebound a little, then split it up. Tough situation - hang in.

Thanks for your encouragements Rich.

I keep hearing that we should expect a bear market rally anytime soon and I had told her that we should take advantage of that rally to do some selling. The problem is where is that darn rally! At this point, her patience is running thin...

I have heard this argument many times about that disadvantage of balanced funds which you pointed out and I must say that I had a hard time understanding it. But now that I look at it from the withdrawal perspective, I think I get it.