Why bonds? How to allocate across accounts?

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Why bonds? How to allocate across accounts?

Postby longinvest » Fri Jul 26, 2013 6:10 pm

Hi,

Here is our profile.

Emergency funds: Six months of expenses, in a (taxable) high interest savings account.
Debt: none (mortgage paid-off)
Province of Residence: Quebec
Age: mid 40s
Current Asset allocation: 100% stocks / 0% bonds

Current and desired stock allocation breakdown:
Canada: 25%
USA: 25%
Developed ex North America: 25%
Emerging markets: 25%

Size of current total portfolio: low six-figures

Current retirement assets
[removed]

Notes

We started saving (very little money!) in the late 1990s. At that point, he was trading (for the couple) individual stocks. Made some money on some stocks only to lose it on others. Learned, the hard way, not to follow recommendations found in the financial press. Overall, he didn't lose much in the early 2000 debacle, but it hurt his feelings. Luckily, she didn't kill him for the $1000 she lost.

We started saving seriously in the early 2000s, but invested very little of it; instead, built up a big down payment for a house. Bought a house a few years later and put most of the savings towards the mortgage. Started to learn more about finances. Figured out they needed some financial plan. Started reading books. Learned about index investing and mutual funds, passive investing, and the importance of understanding something before investing in it.

We sold our last individual stocks and moved our savings into index mutual funds in January 2008. Having never invested into bonds, and having ridden successfully the roller coaster of stocks for years, we had no trouble going all in, at once, with our current 100%/0% stock/bond asset allocation. As for our luck, the markets dropped the instant after we got in. Fortunately, we had no trouble staying in and continuing to invest money at every pay check; we saw it as an opportunity to buy at low prices. (Had no trouble sleeping, either). Would have been nicer, though, to get all-in just a few months later.

We continued to learn. Unfortunately, index funds don't come cheaply, in Canada. Our average portfolio expense ratio was 0.925%. When Vanguard finally started offering ETFs in Canada, we read and learned about what we considered complex products: ETFs. Given our high expense ratios and Vanguard's ETF-only Canadian offering, we switched all our money to ETFs in 2012.

He discovered the Bogleheads forums in early 2012. He has since read and learned a lot. He has come to somewhat understands how bonds and bond funds work, at least well enough to be able to invest in them, if necessary.

Every asset allocation questionnaire he fills in says that he has the ability to pick a very aggressive asset allocation. (As you can guess, she doesn't care about details, but she understands how our money is allocated and has high tolerance to market variations; she just ignores the market!). Yet, he keeps reading, in the Bogleheads forums, that having bonds in a portfolio is important.

If we were to add bonds, we would probably use Vanguard's Canadian Aggregate Bond Index ETF (VAB : Canada) (MER 0.26).

Questions:
1. Is it necessary to have bonds, in a portfolio, even if we know that we won't panic when the markets misbehave? What will that gain us?
2. He is a fan of simple portfolio divisions. They are so much easier to explain to Her! So if we were to add bonds, we would go for a 50/50 s/b allocation. Wouldn't that result in a much smaller portfolio, in 20-25 years?
3. He originally decided to apply identical allocations in each sub-account, to simplify rebalancing, as he found it too difficult to estimate the proper future tax ratios to do a proper tax-adjusted asset allocation (taxable to RRSP to TFSA adjustment ratios) (see http://www.bogleheads.org/wiki/Tax-Adju ... Allocation). With mutual funds, transactions were free. With ETFs, this turns out to be a pain, and regular investing can be costly. We have to keep money sitting in the accounts for weeks (or months) to avoid paying $10 for each transaction. Do you have a better solution to propose?
4. Any other comment?

Thanks.

2013/07/27: Edited to fix a copy/paste error in the MER of VFV.
2013/12/18: Edited to remove precise retirement assets breakdown.
Last edited by longinvest on Wed Dec 18, 2013 9:16 pm, edited 2 times in total.
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Re: Why bonds? How to allocate across accounts?

Postby FinancialRamblings » Fri Jul 26, 2013 6:54 pm

As you're likely aware, bonds provide a diversification benefit. As for percentages, there are better ways of deciding on your optimal allocation then splitting it in half simply b/c that's easiest to explain to your spouse. Yes, increasing bond allocation will typically result in a reduction in the expected future value of your portfolio due to their lower expected return. But nobody has a crystal ball.

As for how to apply the allocation, we treat all accounts as one big bucket'o'money. We then apply our allocation overall vs. on a per-account basis. The primary benefit of this (aside from simplicity) is that we're able to stash tax inefficient assets in tax-advantaged accounts while keeping tax efficient assets in taxable accounts. Rebalancing is then typically done in a single account that has a mix of holdings while the others are "locked in" with a single asset type.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Fri Jul 26, 2013 8:10 pm

Thanks, FinancialRamblings.

But I am looking for a deeper answer.

FinancialRamblings wrote:As you're likely aware, bonds provide a diversification benefit.


I know that, but I don't understand it.

For example, we could go with a 50% stock / 50% cash portfolio. It would be more diversified, too. What would that gain us?

We already are able to take advantage of dips in some markets to rebalance. Lately, US and Developed ex-North America were up, and Canada and Emerging Markets were down. So, our new contributions went into the beat down markets.

I am seeking some mathematical/rational (not emotional) justification to include bonds. (And I don't care about the current fuss about so called interest risks; our horizon is longer than the duration).

FinancialRamblings wrote:As for percentages, there are better ways of deciding on your optimal allocation then splitting it in half simply b/c that's easiest to explain to your spouse. Yes, increasing bond allocation will typically result in a reduction in the expected future value of your portfolio due to their lower expected return. But nobody has a crystal ball.


Actually, 80% stocks / 20% bonds would be simpler (giving a 20/20/20/20/20 allocation). She has to be able to manage the portfolio, if I'm not there, and she's not a fan of using spreadsheets. A rule that says "buy the lowest one" has worked for her, so far.

I've learned not to underestimate the importance of simplicity, in financial matters, for her.

FinancialRamblings wrote:As for how to apply the allocation, we treat all accounts as one big bucket'o'money. We then apply our allocation overall vs. on a per-account basis. The primary benefit of this (aside from simplicity) is that we're able to stash tax inefficient assets in tax-advantaged accounts while keeping tax efficient assets in taxable accounts. Rebalancing is then typically done in a single account that has a mix of holdings while the others are "locked in" with a single asset type.


Somehow, I got stuck with this idea of tax-adusted asset allocation. Why don't bogleheads worry about that? If you've got all your bonds in your tax deffered account, don't you have a tax liability that reduce their effective weight in your portfolio? (You thought you were 80/20, but you're effectively 85/15).
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Re: Why bonds? How to allocate across accounts?

Postby FinancialRamblings » Fri Jul 26, 2013 8:25 pm

Essentially, the addition of bonds is risk reduction at the cost of expected returns. Interestingly, the situation isn't quite the same at the other end of the spectrum. When comparing all bonds to 90% bonds and 10% stocks, there's actually a (historical) benefit to holding those stocks in terms of both increasing expected returns and reducing risk.

See this graph for an illustration of what I'm talking about:

Image

Note that at the 0% stock/100% bond end of the graph (bottom left), the returns go up and the standard deviation goes down when you add 10% stocks. But you're talking about the other end, which is likewise illustrated here (top right).

The thing that stands out to me is that, at extreme equity allocations, you're increasing risk (the standard deviation) disproportionately as compared to the increase in expected returns.

Does that help?

As for tax-adjusting your allocation... I thought you were trying to keep things simple! ;-)
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Re: Why bonds? How to allocate across accounts?

Postby dbr » Fri Jul 26, 2013 8:27 pm

Bonds are included to increase the certainty in what one will get for returns at the cost of lower returns on average.

I started to write a long discourse on what certainty in getting returns is all about and why one should care and decided that was too much work for now. A good approach is to start reading and studying how investments behave until one is comfortable with the concepts.

PS The reply above posted as I was typing is an aspect of the picture in question. The part about standard deviation is the uncertainty in what you will actually get.
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Re: Why bonds? How to allocate across accounts?

Postby FinancialRamblings » Fri Jul 26, 2013 8:38 pm

FWIW, if you're really interested in learning more this topic (and it seems that you are), I would recommend reading "The Four Pillars of Investing" by William Bernstein as a good starting point.
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Re: Why bonds? How to allocate across accounts?

Postby Chris M » Fri Jul 26, 2013 11:03 pm

FinancialRamblings wrote:The thing that stands out to me is that, at extreme equity allocations, you're increasing risk (the standard deviation) disproportionately as compared to the increase in expected returns.


longinvest,

I think FinancialRamblings point is as close as you can come to the "mathematical/rational (not emotional)" explanation you requested. But it doesn't truly separate the mathematical from the emotional, because that cannot be done when the subject is risk.

I think there is an emotional and an objective element to market risk, and maybe a good way to distinguish the two is via the concept of time horizon. If you are investing with a short-term goal in mind--say, paying for a college education in three years--then the objective aspect of market risk becomes very important. Within such a short time horizon, the market could quite possibly rise 50%--or decline 50%. If the latter happens, then a 100% equity portfolio will be cut in half--and you may have to send your kid to Joe's Automotive School instead of Harvard. In other words, in the short-run, market risk can have very real consequences. The objective aspect of risk comes to the fore (though the emotional aspect doesn't go away). Portfolios designed to fund short-term goals therefore need a significant helping of bonds to avoid the very real damage that a market downturn can do.

However, as your time horizon lengthens, the objective aspect of risk becomes much less important relative to the emotional aspect. Over long-term horizons of 20 years or more the stock market has pretty much always delivered positive returns (though the size of the returns can still vary significantly), and so you are not likely to see a situation where you will wind up with only half of your current nest egg 20 or 30 years from now. The main risk faced by long-term investors is not so much a massive loss in their portfolio's value when they are finally ready to spend it, but the possibility that their emotions will get to them during a bear market and cause them to sell at the worst time. For long-term investors the emotional aspect of risk comes to the fore (though the objective aspect never goes away completely—for example, you could lose your job and be forced to spend your retirement savings much sooner than you planned).

Since you appear to have a long time horizon, the emotional aspect of risk is likely more relevant to your situation than the objective aspect. And since you have actual experience of sleeping soundly through a major bear market with an all-stock portfolio (2008), indicating that you truly do have a very high emotional tolerance for market risk, I think you are right to question whether you need any bonds. For long-term investors the primary role of bonds is to smooth out the bumps on the way to the long-term goal, so that you can sleep better. But this comes at a great cost--a reduction in your expected returns. If you can sleep soundly regardless of the bumps with a 100% stock portfolio, I see no reason to incur this cost.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Fri Jul 26, 2013 11:19 pm

FinancialRamblings wrote:Essentially, the addition of bonds is risk reduction at the cost of expected returns. Interestingly, the situation isn't quite the same at the other end of the spectrum. When comparing all bonds to 90% bonds and 10% stocks, there's actually a (historical) benefit to holding those stocks in terms of both increasing expected returns and reducing risk.

See this graph for an illustration of what I'm talking about:

Image

Note that at the 0% stock/100% bond end of the graph (bottom left), the returns go up and the standard deviation goes down when you add 10% stocks. But you're talking about the other end, which is likewise illustrated here (top right).

The thing that stands out to me is that, at extreme equity allocations, you're increasing risk (the standard deviation) disproportionately as compared to the increase in expected returns.

Does that help?


I've seen this graph many times, before, and it's in part why I am 100% in equities. But, as I learn more, I tend to revisit things in order to see if I really understand them right.

In this graph, for instance, what does the 10.75% return for 100/0 mean? Is that an average annual nominal return, or an average annualized (obviously nominal) return? If it's the former, then taking the standard deviation into account is quite important, when estimating long-term returns. That changes things dramatically, and incites newbies, seeking higher returns, to over estimate long-term returns.

Also, most of the reporting in books and graphs are about end-point returns. (Invest in year x, sell in year y). It would seem to me that the reality of a small passive investor like me is far more complex. I buy by small increments, over time, and I'll be selling the same way, in many years. Maybe bonds do have an important impact, in such cases, even during the accumulation stage.

This is why I am asking the question, today. It's not because I didn't do my homework and read the Wiki, many good blogs, and many books, including a couple by Mr Bogle. I know the usual stuff, but I am looking for a better understanding.

FinancialRamblings wrote:As for tax-adjusting your allocation... I thought you were trying to keep things simple! ;-)


OK, you're right.

In my defense: It WAS super easy with mutual funds. It's the transition to ETFs that broke my model, and why I asked for help here.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Fri Jul 26, 2013 11:38 pm

dbr wrote:Bonds are included to increase the certainty in what one will get for returns at the cost of lower returns on average.

I started to write a long discourse on what certainty in getting returns is all about and why one should care and decided that was too much work for now. A good approach is to start reading and studying how investments behave until one is comfortable with the concepts.

PS The reply above posted as I was typing is an aspect of the picture in question. The part about standard deviation is the uncertainty in what you will actually get.


Thanks for the insight. Effectively, it's "how do investments really behave in presence of bonds?" that I'm trying to grasp.
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Re: Why bonds? How to allocate across accounts?

Postby JoMoney » Fri Jul 26, 2013 11:38 pm

Chris M wrote:For long-term investors the primary role of bonds is to smooth out the bumps on the way to the long-term goal, so that you can sleep better. But this comes at a great cost--a reduction in your expected returns. If you can sleep soundly regardless of the bumps with a 100% stock portfolio, I see no reason to incur this cost.


What he said... :happy
Myself, I have a >95% equity portfolio.... BUT I sleep soundly because the reality is I have a lot of "fixed income" like security. I have a good job and no intention to stop working, I have "emergency funds", if I lost my job there would probably be severance, unemployment, or disability pay. At retirement I'm owed a small fixed pension (from an employer that has since stopped adding to the program), there will most likely be some form of Social Security payment. When I start drawing down my stocks there's not some end date or big purchase where I'll want it all cashed in at once, I won't be jumping off the roller coaster because of some emotional reaction. I have such such a dis-taste for the effects of inflation that I'm constantly fighting the urge to "invest" my emergency funds, but it is important to have SOMETHING to smooth over the bumps.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Fri Jul 26, 2013 11:40 pm

FinancialRamblings wrote:FWIW, if you're really interested in learning more this topic (and it seems that you are), I would recommend reading "The Four Pillars of Investing" by William Bernstein as a good starting point.


That's one I have not read. Thanks for the recommendation!
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Re: Why bonds? How to allocate across accounts?

Postby dbr » Fri Jul 26, 2013 11:41 pm

longinvest wrote:ns.

Also, most of the reporting in books and graphs are about end-point returns. (Invest in year x, sell in year y). It would seem to me that the reality of a small passive investor like me is far more complex. I buy by small increments, over time, and I'll be selling the same way, in many years. Maybe bonds do have an important impact, in such cases, even during the accumulation stage.


And, in fact, it is more complex. An illustration of that is when one studies the fate of portfolios under withdrawal there is a broad tendency for the outcome to not depend very strongly on stock/bond allocation except when stock allocations become too little, at which point outcomes go downhill in a hurry. 100% stock is not an optimum, but it isn't particularly disastrous when the measure of outcome is probability of running out of money before a certain period of time. Now it does seem there are some nuances. I am persuaded that when one is high in stocks then failures that do occur may be earlier and more severe. That would be a problem worth worrying about.

I think I saw some results somewhere that show that for the continuous accumulator variability in returns is not too much a problem as one continues to buy low when things are down and profit as they recover, and so on.

But there are other dimensions. A person who is 100% stocks is going to experience some severe downturns. Some of those people don't understand what they are up against and make the one really serious mistake of selling out at a market bottom and not participating in the recovery. People can claim they can handle these ups and downs, but to truly know oneself can be a very hard task. Of course, just because you are paranoid does not mean they are not really out to get you; stocks could suffer a severe decline and not recover within a useful time frame to the investor.

Larry Swedroe points out in his analysis of need, ability, and willingness to take risk that it is only sensible to take the least risk compatible with reaching objectives. He points out that there is a diminishing marginal utility of additional wealth and that people often underestimate actual risk, especially in the area of assuming the unlikely is impossible.
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Re: Why bonds? How to allocate across accounts?

Postby dbr » Fri Jul 26, 2013 11:43 pm

longinvest wrote:
dbr wrote:Bonds are included to increase the certainty in what one will get for returns at the cost of lower returns on average.

I started to write a long discourse on what certainty in getting returns is all about and why one should care and decided that was too much work for now. A good approach is to start reading and studying how investments behave until one is comfortable with the concepts.

PS The reply above posted as I was typing is an aspect of the picture in question. The part about standard deviation is the uncertainty in what you will actually get.


Thanks for the insight. Effectively, it's "how do investments really behave in presence of bonds?" that I'm trying to grasp.


I would put it a bit differently. Bonds are investments just the same as stocks. A better phrasing is "How does a portfolio of stocks and bonds behave at different ratios of stocks to bonds?". That, of course, is what is displayed on that "efficient frontier" curve the other poster put up.
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Re: Why bonds? How to allocate across accounts?

Postby nedsaid » Fri Jul 26, 2013 11:58 pm

Good to see our Canadian friends visit the Boglehead forums. Welcome.

Below is a Boglehead type forum for Canadians. They are more familiar with Canadian taxes, retirement accounts, etc.

http://www.financialwebring.org/forum/index.php

I like the asset allocation you have for your stocks. Good job. 1/4 Canada, 1/4 US, 1/4 Developed Markets, and 1/4 Emerging Markets. I like this because Canadians are tempted to have most of their money in their own country. The Canadian Stock Market is not as Diversified as the US Stock Market because it is very heavy in natural resource stocks and in financials.

For those of us Yankees, the Registered Retirement Savings Plan is our Traditional IRA and the Tax Free Savings Account is like our Roth IRAs.

At your age, an appropriate asset mix would be 70% stocks and 30% bonds or even 60/40. You buy bonds to dampen the portfolios volatility. As you get older and closer to retirement, you may not be able to emotionally handle the sight of your portfolio dropping 50% or more. This is what a 100% stock portfolio has done twice during the decade of the 2000's. A 70/30 mix (I have stayed close to this mix) saw a drop of about 35% rather than over 50%. I am 54 now, and I don't want to see those wide swings. So the bonds will dampen your returns a bit. The swings in the value of your portfolio will also be dampened. You have bonds in your portfolio so you can sleep at night.

Again, welcome to the Bogleheads.
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Re: Why bonds? How to allocate across accounts?

Postby dbr » Sat Jul 27, 2013 12:09 am

longinvest wrote:In this graph, for instance, what does the 10.75% return for 100/0 mean? Is that an average annual nominal return, or an average annualized (obviously nominal) return? If it's the former, then taking the standard deviation into account is quite important, when estimating long-term returns. That changes things dramatically, and incites newbies, seeking higher returns, to over estimate long-term returns.


That return is the expected return. The word "expected" in there does not mean what you expect to get but rather is a technical term from statistics referring to the average value of a probability distribution of returns. The model one has in mind for understanding investments this way is that one imagines the return in any given year to be a random draw from a probability distribution of possible returns. That distribution has an average and also some measure of spread, reported as the standard deviation. If life were so cooperative that the distribution involved were a normal distribution, then lots of simple conclusions can be drawn from these numbers. In real life things might be more complicated including the fact that no one has a proposed distribution or distributions of types that really work well Note the word average is used at this point as average of a hypothetical distribution, not the average of a set of successive returns over the years.

The next step that one might take is to compute what happens if the investment compounds by repeated application of successive random samples of the return distribution. This is the stage at which end-point wealth is computed and where we could compute the average and standard deviation of that result. Said calculated values can then be annualized in a compound growth model. A more complicated calculation would be to compound the result assuming some schedule of contributions or withdrawals being made every year. At this point the mathematics becomes sufficiently dicey that people use Monte-Carlo simulations to obtain the results.

But, back to bonds. The essence of having bonds is very simple. By mixing stocks and bonds one can select a value of the spread of the underlying annual probability distribution and take the return that goes with it that causes the results* to come out closest to all the various objectives and trade-offs the investor might have. Naturally if one prefers to select on return, then one takes the spread that goes with that.

*Results can mean whatever financially meaningful statistic one can find a way to compute. That could be the expected compound annual return and standard deviation of same. It could be the end point wealth, average and range. It could be the probability of accumulating more than x dollars in y years. It could mean the probability of never falling below x dollars at any point in the course of y years. It could be the probability that the higher returning investment could somehow still produce less wealth than the lower returning investment at the end of y years. It could mean the probability of failure of a retirement at a certain withdrawal rate before y years are elapsed. ETC.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sat Jul 27, 2013 9:26 am

Chris M,

Chris M wrote:I think there is an emotional and an objective element to market risk, and maybe a good way to distinguish the two is via the concept of time horizon. If you are investing with a short-term goal in mind--say, paying for a college education in three years--then the objective aspect of market risk becomes very important. Within such a short time horizon, the market could quite possibly rise 50%--or decline 50%. If the latter happens, then a 100% equity portfolio will be cut in half--and you may have to send your kid to Joe's Automotive School instead of Harvard. In other words, in the short-run, market risk can have very real consequences. The objective aspect of risk comes to the fore (though the emotional aspect doesn't go away). Portfolios designed to fund short-term goals therefore need a significant helping of bonds to avoid the very real damage that a market downturn can do.


I see. This would effectively justify that, as I get nearer to the distribution period, I should gradually start adding bonds. 10 years, or so, before retirement, I should move 1 year of expenses into bonds (as a weight of asset allocation), another one a year later, until it's up to 10 years of expenses, and maintain it so during retirement (I guess the maximal weighted average duration should be (10+9+8+...+1)/10 = 5.5). Does that make sense?

Chris M wrote:However, as your time horizon lengthens, the objective aspect of risk becomes much less important relative to the emotional aspect. Over long-term horizons of 20 years or more the stock market has pretty much always delivered positive returns (though the size of the returns can still vary significantly), and so you are not likely to see a situation where you will wind up with only half of your current nest egg 20 or 30 years from now. The main risk faced by long-term investors is not so much a massive loss in their portfolio's value when they are finally ready to spend it, but the possibility that their emotions will get to them during a bear market and cause them to sell at the worst time. For long-term investors the emotional aspect of risk comes to the fore (though the objective aspect never goes away completely—for example, you could lose your job and be forced to spend your retirement savings much sooner than you planned).


Maybe I don't have the emotional fears because I was in individual stocks for many years, and I don't see stocks as an abstract asset class that behaves like a lottery, but as certificates of partial ownership of goods-producing companies. I have no fear that all stocks would get to $0; if that was to happen, it would mean that all the banks, insurance companies, energy companies, etc. were either shut down or nationalized. In other words, there would be a complete political, financial, and social revolution where money has probably lost all its value and the notion of ownership has been changed or eliminated. So, I would be no safer (financially) holding bonds or money.

If both my wife and I were to lose our jobs, tomorrow, we have a pretty sizable emergency fund that would hold us probably for a full year, as we would cut expenses below current level. So, we would have time to seek new employment or revenue-generating activities. We wouldn't raid our retirement funds!

Chris M wrote:Since you appear to have a long time horizon, the emotional aspect of risk is likely more relevant to your situation than the objective aspect. And since you have actual experience of sleeping soundly through a major bear market with an all-stock portfolio (2008), indicating that you truly do have a very high emotional tolerance for market risk, I think you are right to question whether you need any bonds. For long-term investors the primary role of bonds is to smooth out the bumps on the way to the long-term goal, so that you can sleep better. But this comes at a great cost--a reduction in your expected returns. If you can sleep soundly regardless of the bumps with a 100% stock portfolio, I see no reason to incur this cost.


Thanks. Your rational explanation of the different risks, and the role of bonds to temper them does help.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sat Jul 27, 2013 9:42 am

JoMoney wrote:
Chris M wrote:For long-term investors the primary role of bonds is to smooth out the bumps on the way to the long-term goal, so that you can sleep better. But this comes at a great cost--a reduction in your expected returns. If you can sleep soundly regardless of the bumps with a 100% stock portfolio, I see no reason to incur this cost.


What he said... :happy
Myself, I have a >95% equity portfolio.... BUT I sleep soundly because the reality is I have a lot of "fixed income" like security. I have a good job and no intention to stop working, I have "emergency funds", if I lost my job there would probably be severance, unemployment, or disability pay. At retirement I'm owed a small fixed pension (from an employer that has since stopped adding to the program), there will most likely be some form of Social Security payment. When I start drawing down my stocks there's not some end date or big purchase where I'll want it all cashed in at once, I won't be jumping off the roller coaster because of some emotional reaction. I have such such a dis-taste for the effects of inflation that I'm constantly fighting the urge to "invest" my emergency funds, but it is important to have SOMETHING to smooth over the bumps.


Thanks for sharing! Keeping our emergency fund liquid in a savings account giving negative returns after taxes and inflation is a pain for me, too.
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Re: Why bonds? How to allocate across accounts?

Postby stevewolfe » Sat Jul 27, 2013 9:53 am

JoMoney wrote:What he said... :happy
Myself, I have a >95% equity portfolio.... BUT I sleep soundly because the reality is I have a lot of "fixed income" like security. I have a good job and no intention to stop working, I have "emergency funds", if I lost my job there would probably be severance, unemployment, or disability pay.


It's off topic but I'd caution to be as confident as you seem to be about these things. A good job can go away - lots of folks have lost their good paying job with no intention of stopping working and due to shifts or dislocations in the economy - no fault of their own necessarily - they are under / unemployed. I also would question the severance - I worked for a megacorp that did a 10-15% layoff - they told those of us left that it was dead wood they were letting go. They gave those folks a severance, relatively generous at that. About 7-8 months later, a last minute, very harsh 40% layoff happened. I wasn't impacted in either thankfully, but the folks let go in the second wave - they didn't try and tell us they were dead wood - no one would go for that. Those folks got the following severance: whatever vacation that they had not yet used (it was the second week in November so many had little to none left). So here were the folks that were core people, dependable, good workers on the street with no severance. The difference between the two layoffs was by the time the second happened, the lenders were calling the shots - management essentially had no say.

Keep your emergency fund.
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Re: Why bonds? How to allocate across accounts?

Postby nedsaid » Sat Jul 27, 2013 10:02 am

Yes, keep your emergency fund. Stuff happens and stuff happens in the way one doesn't expect.

Retirement accounts make terrible emergency funds.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sat Jul 27, 2013 10:25 am

dbr wrote:
longinvest wrote:ns.

Also, most of the reporting in books and graphs are about end-point returns. (Invest in year x, sell in year y). It would seem to me that the reality of a small passive investor like me is far more complex. I buy by small increments, over time, and I'll be selling the same way, in many years. Maybe bonds do have an important impact, in such cases, even during the accumulation stage.


And, in fact, it is more complex. An illustration of that is when one studies the fate of portfolios under withdrawal there is a broad tendency for the outcome to not depend very strongly on stock/bond allocation except when stock allocations become too little, at which point outcomes go downhill in a hurry. 100% stock is not an optimum, but it isn't particularly disastrous when the measure of outcome is probability of running out of money before a certain period of time. Now it does seem there are some nuances. I am persuaded that when one is high in stocks then failures that do occur may be earlier and more severe. That would be a problem worth worrying about.


That's interesting. One would think, rationally, that during the withdrawal phase, holding some bonds would be important (having a definite spending horizon for money). I guess that the risk of a pure equity portfolio, during retirement, increases as the withdrawal-size to portfolio-size ratio increases.

dbr wrote:I think I saw some results somewhere that show that for the continuous accumulator variability in returns is not too much a problem as one continues to buy low when things are down and profit as they recover, and so on.

But there are other dimensions. A person who is 100% stocks is going to experience some severe downturns. Some of those people don't understand what they are up against and make the one really serious mistake of selling out at a market bottom and not participating in the recovery. People can claim they can handle these ups and downs, but to truly know oneself can be a very hard task. Of course, just because you are paranoid does not mean they are not really out to get you; stocks could suffer a severe decline and not recover within a useful time frame to the investor.


What I understood, when I learned about asset allocation, was that the most important is not really how you allocate your portfolio (as long as you remain within reasonable guidelines), but that you hold into your allocation in the future. The benefit of asset allocation is the discipline of buying mechanically (and rebalance, when necessary), that eventually causes you to buy low and sell high. This benefit is lost when you continually change your asset allocation (unless it's a gradual, planned change, such as increasing bonds with time). So, this is why I have no intention to change my stock sub-allocation, no matter what. I am certain that we are more likely to lose money shifting our portfolio some new trend (FF 3-factors, or was that 4 or 5 factors?) than stay the course.

dbr wrote:Larry Swedroe points out in his analysis of need, ability, and willingness to take risk that it is only sensible to take the least risk compatible with reaching objectives. He points out that there is a diminishing marginal utility of additional wealth and that people often underestimate actual risk, especially in the area of assuming the unlikely is impossible.


I really like this division into 3 aspects: need, ability, and willingness. The concept of marginal utility is relatively new to me, having learned about it not so long ago on the Bogleheads forums. Yet, I started to intuitively realize it, when I projected our portfolio forward. There are good chances that we will end up, one day, with too much money (if such a concept exists). Yet, increasing our current spending level would be riskier, until we have accumulated enough assets; it could lead us to spend above than our long-term means.

I know that we have the ability. What I struggle with, sometimes, is need vs willingness. We might have no need to hold as much stocks, as we do, but why settle for less money? There might not be any fundamental need for the additional money, but that does not mean that we couldn't find some good use for it, if we had it. (I know, there are no guarantees.)

I should probably read one of Mr. Swedroe's books. Any specific recommendation?
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Re: Why bonds? How to allocate across accounts?

Postby dbr » Sat Jul 27, 2013 10:36 am

longinvest wrote:
That's interesting. One would think, rationally, that during the withdrawal phase, holding some bonds would be important (having a definite spending horizon for money). I guess that the risk of a pure equity portfolio, during retirement, increases as the withdrawal-size to portfolio-size ratio increases.

What most studies find is that the strongest driver of retirement success or failure is the withdrawal rate, while asset allocation is a weak effect. Contrary to your supposition, it is at high withdrawal rates that high stock allocations become necessary and high bond allocations are fatal. The problem is that bonds don't return enough to sustain high withdrawals. However, at that point the issue is academic as the failure rates are so high at every allocation that a person would not go there. There is much discussion of the location of the "safe" withdrawal rate, but results usually come out at somewhere between 3% and 4% of initial assets, then inflation indexed. 5% or 6% for thirty years would be a high rate. It is also true that aside from withdrawal rate the other dominating factor is luck. There are good times to retire and bad times to retire. 1965 was a bad year to retire, for example. I don't think we are ready yet to decide if 2013 is a bad year to retire.

dbr wrote:I think I saw some results somewhere that show that for the continuous accumulator variability in returns is not too much a problem as one continues to buy low when things are down and profit as they recover, and so on.



I should probably read one of Mr. Swedroe's books. Any specific recommendation?

I started out reading

http://www.amazon.com/Guide-Winning-Inv ... ds=swedroe
and
http://www.amazon.com/Guide-Winning-Str ... ds=swedroe

Since then he has published this book which might be the best all around:

http://www.amazon.com/Guide-Youll-Right ... ds=swedroe

I am shilling for Amazon because if you go to the top of this page and click the Amazon link to buy there, the Forum will get support from Amazon to help underwrite our costs.


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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sat Jul 27, 2013 10:50 am

nedsaid wrote:Good to see our Canadian friends visit the Boglehead forums. Welcome.

Below is a Boglehead type forum for Canadians. They are more familiar with Canadian taxes, retirement accounts, etc.

http://www.financialwebring.org/forum/index.php


Yes, I know about it and read it quite regularly. I do learn a few things, on FWF, and the Canadian perspective is useful, but there are way fewer active threads than on the "Theory" and "Help" Bogleheads forums.

nedsaid wrote:I like the asset allocation you have for your stocks. Good job. 1/4 Canada, 1/4 US, 1/4 Developed Markets, and 1/4 Emerging Markets. I like this because Canadians are tempted to have most of their money in their own country. The Canadian Stock Market is not as Diversified as the US Stock Market because it is very heavy in natural resource stocks and in financials.


Thanks for the compliment. It seems to me that the Canadian market is so much as small part of the world's markets that I don't want to have too high a concentration in it (regardless of the tax advantage). The experience of owning Nortel shares in the early 2000s (when it was a third of the Canadian market) makes me quite aware of the concentration risks.

nedsaid wrote:For those of us Yankees, the Registered Retirement Savings Plan is our Traditional IRA and the Tax Free Savings Account is like our Roth IRAs.

At your age, an appropriate asset mix would be 70% stocks and 30% bonds or even 60/40. You buy bonds to dampen the portfolios volatility. As you get older and closer to retirement, you may not be able to emotionally handle the sight of your portfolio dropping 50% or more. This is what a 100% stock portfolio has done twice during the decade of the 2000's. A 70/30 mix (I have stayed close to this mix) saw a drop of about 35% rather than over 50%. I am 54 now, and I don't want to see those wide swings. So the bonds will dampen your returns a bit. The swings in the value of your portfolio will also be dampened. You have bonds in your portfolio so you can sleep at night.

Again, welcome to the Bogleheads.


Thanks.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sat Jul 27, 2013 11:24 am

dbr wrote:
longinvest wrote:In this graph, for instance, what does the 10.75% return for 100/0 mean? Is that an average annual nominal return, or an average annualized (obviously nominal) return? If it's the former, then taking the standard deviation into account is quite important, when estimating long-term returns. That changes things dramatically, and incites newbies, seeking higher returns, to over estimate long-term returns.


That return is the expected return. The word "expected" in there does not mean what you expect to get but rather is a technical term from statistics referring to the average value of a probability distribution of returns. The model one has in mind for understanding investments this way is that one imagines the return in any given year to be a random draw from a probability distribution of possible returns. That distribution has an average and also some measure of spread, reported as the standard deviation. If life were so cooperative that the distribution involved were a normal distribution, then lots of simple conclusions can be drawn from these numbers. In real life things might be more complicated including the fact that no one has a proposed distribution or distributions of types that really work well Note the word average is used at this point as average of a hypothetical distribution, not the average of a set of successive returns over the years.


As I suspected, it's never as easy as it seems. I wasn't aware of the distribution aspect. So many things to learn.

dbr wrote:The next step that one might take is to compute what happens if the investment compounds by repeated application of successive random samples of the return distribution. This is the stage at which end-point wealth is computed and where we could compute the average and standard deviation of that result. Said calculated values can then be annualized in a compound growth model. A more complicated calculation would be to compound the result assuming some schedule of contributions or withdrawals being made every year. At this point the mathematics becomes sufficiently dicey that people use Monte-Carlo simulations to obtain the results.


I don't have much confidence in these MC simulations as they assume a totally random sequence of events guarded by some static human-provided characteristics (target average and standard deviation). Seeing some MC simulation graphs is enlightening, but it seems to me that, in real life, there is a relatively good correlation between big swings in the market in consecutive years. If the market falls 50% two years in a row, there is quite a good chance that the market has either gone up a lot during prior years, or that it will go back up soon after to reasonable levels. Stocks are certificate of ownership of companies, not lottery tickets.

I even know about FireCalc (and its limited ability to predict the future). Unfortunately, it only contains US historical data. I can't simulate my current allocation on it nor the effect of adding Canadian bonds to it. My (limited) understanding is that bond behavior is really country-specific, being tied to local inflation and currency valuation.

dbr wrote:But, back to bonds. The essence of having bonds is very simple. By mixing stocks and bonds one can select a value of the spread of the underlying annual probability distribution and take the return that goes with it that causes the results* to come out closest to all the various objectives and trade-offs the investor might have. Naturally if one prefers to select on return, then one takes the spread that goes with that.

*Results can mean whatever financially meaningful statistic one can find a way to compute. That could be the expected compound annual return and standard deviation of same. It could be the end point wealth, average and range. It could be the probability of accumulating more than x dollars in y years. It could mean the probability of never falling below x dollars at any point in the course of y years. It could be the probability that the higher returning investment could somehow still produce less wealth than the lower returning investment at the end of y years. It could mean the probability of failure of a retirement at a certain withdrawal rate before y years are elapsed. ETC.


I tend to view bonds as having an expected long-term real return of 0% (after fees but before taxes). As for stocks, I see them at 5%.

The way I picture an expected return is not as a guaranteed return forward, from current price levels, but as some kind of floor between "normal" price levels at least 50-years apart. That's best I could come up with to get some concrete understanding of it. Does that make sense, or am I completely wrong?
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Re: Why bonds? How to allocate across accounts?

Postby dbr » Sat Jul 27, 2013 12:12 pm

longinvest wrote:I don't have much confidence in these MC simulations as they assume a totally random sequence of events guarded by some static human-provided characteristics (target average and standard deviation). Seeing some MC simulation graphs is enlightening, but it seems to me that, in real life, there is a relatively good correlation between big swings in the market in consecutive years. If the market falls 50% two years in a row, there is quite a good chance that the market has either gone up a lot during prior years, or that it will go back up soon after to reasonable levels. Stocks are certificate of ownership of companies, not lottery tickets.

Yep, you are in good company there. One should be very circumspect regarding predicitions about the financial future, at least ones that ascribe a lot of accuracy to any given numerical result. That may be an argument for holding significant allocations to both bonds and stocks from a naive diversification concept. The concept is no more than the old saw not to put all one's eggs in one basket, even if one doesn't know much about what any one basket will do.

I even know about FireCalc (and its limited ability to predict the future). Unfortunately, it only contains US historical data. I can't simulate my current allocation on it nor the effect of adding Canadian bonds to it. My (limited) understanding is that bond behavior is really country-specific, being tied to local inflation and currency valuation.

FireCalc and Jim Otar's planner are an attempt to avoid the pitfalls of MC simulations by just looking at what actually happened in past periods. As you say, there are limits to that approach as well. Even so, many of the large structural features do seem to have the same shape by whatever method.

dbr wrote:But, back to bonds. The essence of having bonds is very simple. By mixing stocks and bonds one can select a value of the spread of the underlying annual probability distribution and take the return that goes with it that causes the results* to come out closest to all the various objectives and trade-offs the investor might have. Naturally if one prefers to select on return, then one takes the spread that goes with that.


I tend to view bonds as having an expected long-term real return of 0% (after fees but before taxes). As for stocks, I see them at 5%.

The topic of how much stock returns would exceed returns on safe, ie short, bonds appears under "equity risk premium." I am not an expert on that but I think 5% premium (real returns) is more than conventionally assumed, but I could be wrong.

The way I picture an expected return is not as a guaranteed return forward, from current price levels, but as some kind of floor between "normal" price levels at least 50-years apart. That's best I could come up with to get some concrete understanding of it. Does that make sense, or am I completely wrong?

No, that is not it at all. A better picture is that it is the middle of all the possible experiences that might materialize in a given year. You should probably imagine that returns in any given year will be widely distributed around the expected return as a center. For stocks, if we imagine nominal expected returns to be 10% with a standard deviation of 20%, then about 2/3 of the time the annual return will be somewhere between -10% and +30%, more often nearer +10%. About 5% of the time the annual return could be more negative than -50% or more positive than +70%. Numbers like this are very rough because this 2/3 and 95% business are the number when the distribution is a normal distribution. The stock market is famous for being much wilder than that. A 90% loss in a year or two happened at least once in the last hundred years, and 50% losses are probably more likely than normal distributions would suggest. There are more risks than that. We don't know if the behavior of the next hundred years will be like that of the last hundred years. There is also a major problem that markets are really time series phenomena. The stock market has long runs of bull and bear periods. The last bull was roughly 1982-2000, and the current market looks like a bear the duration of which we don't know. I don't think you can replicate this structure from simplistic random sampling of return models. That is one reason one falls back on the statement that one's fate is a matter of historical luck as much as anything else. There is, however, no clear statement about asset allocation in any of that.



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Re: Why bonds? How to allocate across accounts?

Postby nimo956 » Sat Jul 27, 2013 1:05 pm

Thank you dbr for that excellent explanation. Whenever I've seen one of these expected return charts, they are always the same shape. Have there ever been long periods which show the right tail of the graph lower than the middle part?
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Re: Why bonds? How to allocate across accounts?

Postby dbr » Sat Jul 27, 2013 1:32 pm

nimo956 wrote:Thank you dbr for that excellent explanation. Whenever I've seen one of these expected return charts, they are always the same shape. Have there ever been long periods which show the right tail of the graph lower than the middle part?


From time to time people have posted the actual curves from different selected periods of time. Maybe someone has some of those results handy. Both the shape and the location in the risk/return space move around quite a bit and would be different for the US market from other markets. There would certainly be periods of time in which the return from stocks is less than that from bonds, and the curve would slope downward to the right.

However, there is an important methodological point here. Displaying the average past history of risk and return for any period is not the same thing as displaying expected risk and expected return. If we go back to the basic thought of a distribution of possible returns from which each year's returns is a random sample, then displaying, for example, the actual results for an x year period, say ten years, would be the display of the compound average return resulting from compounding ten actual random draws. If one were to repeat that experience for a different ten year period, then one would get the result of ten different random draws. It would be like comparing fraction of heads in ten tosses if we did ten tosses twice. We might get 4 heads one time and 6 heads the next time. What a person looking forward wants to know is the expected return, which is the actual average of the distribution. The trick is the standard statistical problem of estimating the properties of a distribution from a sample of the distribution. In the case of coin tossing, we estimate the average chance of tossing heads by tossing ten times and counting the heads. We got an estimate of 40%. We do it again and we get an estimate of 60%. The fact that those numbers are different tells us that our estimate is going to have some error, and we know for a true coin the real expected rate is 50%. In the case of coin tossing the solution to the dilemma is to make lots of tosses. If we are tossing in an unbiased manner, then after a thousand tosses we will assuredly have an estimate of the real expected value very close to that 50%. You could do this for stock returns by using all the data we have that makes sense, for example, stock returns between 1926 and 2012. If at this point you want to complain that the stock market in the US was not the same animal from 1926 to 1941 as it was from 1941 to 2000 and is not the same animal from 2000 to 2040 as it was . . . . then welcome to the club. There is nothing you can do to get more certainty in the face of these issues.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sat Jul 27, 2013 1:51 pm

dbr wrote:
longinvest wrote:
dbr wrote:But, back to bonds. The essence of having bonds is very simple. By mixing stocks and bonds one can select a value of the spread of the underlying annual probability distribution and take the return that goes with it that causes the results* to come out closest to all the various objectives and trade-offs the investor might have. Naturally if one prefers to select on return, then one takes the spread that goes with that.


I tend to view bonds as having an expected long-term real return of 0% (after fees but before taxes). As for stocks, I see them at 5%.

The topic of how much stock returns would exceed returns on safe, ie short, bonds appears under "equity risk premium." I am not an expert on that but I think 5% premium (real returns) is more than conventionally assumed, but I could be wrong.


My expected return for Canadian bonds is too low, I know. I'll change it to 2%. (The Credit Suisse Global Investment Yearbook reports historical real returns of 2.2% for bonds and 5.7% for Canadian stocks. For all-world stocks, it was 5%.)

I hope a 3% premium is not out of line. (Yet, my retirement plan won't fail because of it).

dbr wrote:
longinvest wrote:The way I picture an expected return is not as a guaranteed return forward, from current price levels, but as some kind of floor between "normal" price levels at least 50-years apart. That's best I could come up with to get some concrete understanding of it. Does that make sense, or am I completely wrong?


No, that is not it at all. A better picture is that it is the middle of all the possible experiences that might materialize in a given year. You should probably imagine that returns in any given year will be widely distributed around the expected return as a center. For stocks, if we imagine nominal expected returns to be 10% with a standard deviation of 20%, then about 2/3 of the time the annual return will be somewhere between -10% and +30%, more often nearer +10%. About 5% of the time the annual return could be more negative than -50% or more positive than +70%. Numbers like this are very rough because this 2/3 and 95% business are the number when the distribution is a normal distribution. The stock market is famous for being much wilder than that. A 90% loss in a year or two happened at least once in the last hundred years, and 50% losses are probably more likely than normal distributions would suggest. There are more risks than that. We don't know if the behavior of the next hundred years will be like that of the last hundred years. There is also a major problem that markets are really time series phenomena. The stock market has long runs of bull and bear periods. The last bull was roughly 1982-2000, and the current market looks like a bear the duration of which we don't know. I don't think you can replicate this structure from simplistic random sampling of return models. That is one reason one falls back on the statement that one's fate is a matter of historical luck as much as anything else. There is, however, no clear statement about asset allocation in any of that.



I guess there's no magical solution. We have to live with a high level of uncertainty.

So, this brings me back to square one! Maybe we should add 20% bonds to our portfolio, just because of this uncertainty. It might be that it won't really change its effective expected return, given all the flaws (distribution problems, etc.) of current mathematical/statistical tools that tell us about "expected returns".

I'll have to sleep on that. Or, maybe I should stop overthinking it (as there are no definitive answers) and simply go on, staying the course.

Thanks a lot, dbr, for having taken the time to write all these clear and detailed answers. It was very generous of you.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sat Jul 27, 2013 2:58 pm

dbr wrote:However, there is an important methodological point here. Displaying the average past history of risk and return for any period is not the same thing as displaying expected risk and expected return. If we go back to the basic thought of a distribution of possible returns from which each year's returns is a random sample, then displaying, for example, the actual results for an x year period, say ten years, would be the display of the compound average return resulting from compounding ten actual random draws. If one were to repeat that experience for a different ten year period, then one would get the result of ten different random draws. It would be like comparing fraction of heads in ten tosses if we did ten tosses twice. We might get 4 heads one time and 6 heads the next time. What a person looking forward wants to know is the expected return, which is the actual average of the distribution. The trick is the standard statistical problem of estimating the properties of a distribution from a sample of the distribution. In the case of coin tossing, we estimate the average chance of tossing heads by tossing ten times and counting the heads. We got an estimate of 40%. We do it again and we get an estimate of 60%. The fact that those numbers are different tells us that our estimate is going to have some error, and we know for a true coin the real expected rate is 50%. In the case of coin tossing the solution to the dilemma is to make lots of tosses. If we are tossing in an unbiased manner, then after a thousand tosses we will assuredly have an estimate of the real expected value very close to that 50%. You could do this for stock returns by using all the data we have that makes sense, for example, stock returns between 1926 and 2012. If at this point you want to complain that the stock market in the US was not the same animal from 1926 to 1941 as it was from 1941 to 2000 and is not the same animal from 2000 to 2040 as it was . . . . then welcome to the club. There is nothing you can do to get more certainty in the face of these issues.

That is the most enlightening text I've ever read about expected returns.
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Re: Why bonds? How to allocate across accounts?

Postby Chris M » Sat Jul 27, 2013 3:20 pm

longinvest wrote:Chris M,

Chris M wrote:I think there is an emotional and an objective element to market risk, and maybe a good way to distinguish the two is via the concept of time horizon. If you are investing with a short-term goal in mind--say, paying for a college education in three years--then the objective aspect of market risk becomes very important. Within such a short time horizon, the market could quite possibly rise 50%--or decline 50%. If the latter happens, then a 100% equity portfolio will be cut in half--and you may have to send your kid to Joe's Automotive School instead of Harvard. In other words, in the short-run, market risk can have very real consequences. The objective aspect of risk comes to the fore (though the emotional aspect doesn't go away). Portfolios designed to fund short-term goals therefore need a significant helping of bonds to avoid the very real damage that a market downturn can do.


I see. This would effectively justify that, as I get nearer to the distribution period, I should gradually start adding bonds. 10 years, or so, before retirement, I should move 1 year of expenses into bonds (as a weight of asset allocation), another one a year later, until it's up to 10 years of expenses, and maintain it so during retirement (I guess the maximal weighted average duration should be (10+9+8+...+1)/10 = 5.5). Does that make sense?

Yes, one of the implications of this is that as you get closer to retirement the time you have available to recover from a major downturn declines. For this reason approaching retirement with a 100% equity portfolio presents significant objective risks to your savings, even if you can handle the emotional risks. As long as you are on track to meet a goal of having a 4% or (preferably) lower withdrawal rate in retirement you can afford to start gradually adding bonds in the manner you describe. Where a problem can arise is if you are not on track for this goal. As dbr notes in one of the above replies, for high withdrawal rates the probability of bankrupting your portfolio increases as you increase your allocation to bonds. However, rather than sticking with a 100% stock portfolio in this situation other alternatives could be considered, like working longer, taking a part time job in retirement, etc. In this situation your primary goal should be to get your withdrawal rate down to 4%, and this can likely be accomplished with less risk using one of these alternative approaches rather than going for broke with 100% stocks.

Chris M wrote:However, as your time horizon lengthens, the objective aspect of risk becomes much less important relative to the emotional aspect. Over long-term horizons of 20 years or more the stock market has pretty much always delivered positive returns (though the size of the returns can still vary significantly), and so you are not likely to see a situation where you will wind up with only half of your current nest egg 20 or 30 years from now. The main risk faced by long-term investors is not so much a massive loss in their portfolio's value when they are finally ready to spend it, but the possibility that their emotions will get to them during a bear market and cause them to sell at the worst time. For long-term investors the emotional aspect of risk comes to the fore (though the objective aspect never goes away completely—for example, you could lose your job and be forced to spend your retirement savings much sooner than you planned).


Maybe I don't have the emotional fears because I was in individual stocks for many years, and I don't see stocks as an abstract asset class that behaves like a lottery, but as certificates of partial ownership of goods-producing companies. I have no fear that all stocks would get to $0; if that was to happen, it would mean that all the banks, insurance companies, energy companies, etc. were either shut down or nationalized. In other words, there would be a complete political, financial, and social revolution where money has probably lost all its value and the notion of ownership has been changed or eliminated. So, I would be no safer (financially) holding bonds or money.

Yes, I see this the same way as you. As long as you are still in the accumulation phase and not withdrawing money from your portfolio, then there is no practical risk (in the sense of a risk that you can do something about) of losing everything. There's still risks of revolution, asteroids hitting the earth, etc., but in these cases no need to worry about retirement--we will have much bigger things to worry about, and no one will be retiring (except maybe the people who control the guns).

If both my wife and I were to lose our jobs, tomorrow, we have a pretty sizable emergency fund that would hold us probably for a full year, as we would cut expenses below current level. So, we would have time to seek new employment or revenue-generating activities. We wouldn't raid our retirement funds!

Chris M wrote:Since you appear to have a long time horizon, the emotional aspect of risk is likely more relevant to your situation than the objective aspect. And since you have actual experience of sleeping soundly through a major bear market with an all-stock portfolio (2008), indicating that you truly do have a very high emotional tolerance for market risk, I think you are right to question whether you need any bonds. For long-term investors the primary role of bonds is to smooth out the bumps on the way to the long-term goal, so that you can sleep better. But this comes at a great cost--a reduction in your expected returns. If you can sleep soundly regardless of the bumps with a 100% stock portfolio, I see no reason to incur this cost.


Thanks. Your rational explanation of the different risks, and the role of bonds to temper them does help.
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Re: Why bonds? How to allocate across accounts?

Postby parvus » Sun Jul 28, 2013 9:01 pm

longinvest wrote:
Thanks for the insight. Effectively, it's "how do investments really behave in presence of bonds?" that I'm trying to grasp.

The question is problematic on a number of levels -- if you're looking at a mathematical reason to hold bonds. Here's two. Modern portfolio theory depends on the distinction between risky and risk-free assets. Risky assets -- basically equities -- follow a random walk (depending on whether there is serial correlation). But the risk-free asset, either cash or bonds, is not random, at least according to the theory. And that's understandable because just as one can buy and hold a stock that moves up and down, one can buy a bond whose price may fluctuate, but if held to maturity, is a certainty.

Financial theory, in broad strokes, depends on modelling investor preferences towards risk. It says little about the riskiness of bonds themselves. One can model expected returns on equities and build a mean-variance portfolio with risk defined as standard deviation.

Bond allocations can improve the risk profile -- the standard deviation -- but are not themselves treated as a source of risk. (But of course there's lots of risk, depending on the randomness of central banker pronouncements, among other things.)

So here's the second point. History defies the expected return profile. On the one hand, over the past 30 years, bonds actually beat stocks in both Canada and the U.S. So there was no risk premium. Yet, much of modern financial theory is built on the assumption of an equity risk premium.

There appear to be long historical periods where it is perishingly small.

So I can't give you a mathematical reason for holding bonds because they are the baseline. But I can give you historical reasons for holding bonds, not just as a safety valve, but as a net contributor to the portfolio.

It's a very intriguing question. As William Sharpe once said, we'd need 1000 years of market data to get a scientific read on expected returns.
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Re: Why bonds? How to allocate across accounts?

Postby LadyGeek » Sun Jul 28, 2013 9:39 pm

FYI - Our sister Canadian forum, Financial Webring Forum, has just created a format similar to Asking Portfolio Questions, but modified for Canadian investors. Please take a look at My Portfolio: Seeking Advice. The OP's post appears to match that format.

(In case anyone was wondering how that thread got created, mea culpa. We collaborate on a lot of topics. :wink: )
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Sun Jul 28, 2013 11:27 pm

LadyGeek wrote:FYI - Our sister Canadian forum, Financial Webring Forum, has just created a format similar to Asking Portfolio Questions, but modified for Canadian investors. Please take a look at My Portfolio: Seeking Advice. The OP's post appears to match that format.

(In case anyone was wondering how that thread got created, mea culpa. We collaborate on a lot of topics. :wink: )


Thanks, LadyGeek. I bit the bullet and I asked the question on FWF. :-)
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Mon Jul 29, 2013 12:06 am

parvus wrote:So here's the second point. History defies the expected return profile. On the one hand, over the past 30 years, bonds actually beat stocks in both Canada and the U.S. So there was no risk premium. Yet, much of modern financial theory is built on the assumption of an equity risk premium.

There appear to be long historical periods where it is perishingly small.

So I can't give you a mathematical reason for holding bonds because they are the baseline. But I can give you historical reasons for holding bonds, not just as a safety valve, but as a net contributor to the portfolio.

It's a very intriguing question. As William Sharpe once said, we'd need 1000 years of market data to get a scientific read on expected returns.


Very interesting! I really like how you explain this. What you say is in line with what I just started to read in Larry Swedroe's book that dbr recommended to me. In "The Only Guide You'll Ever Need for the Right Financial Plan" he explains the difference between risk and uncertainty. He says that "the mistake many investors make is to view equities as closer to risk where the odds can be precisely calculated". I might actually be making this mistake.

He also writes about the ability, willingness, and need to take risk. He has clear guidelines to evaluate each of these 3 aspects. As a couple, we clearly have both the ability and the willingness to take risk. But, if I take into consideration the marginal utility of wealth, we have a lower need for risk. We would be able to reach our objectives (based on current risk/reward models!) using a safer asset allocation. His recommendation is not to take more risk than necessary, and illustrates this with the example of a couple that lost $10 millions in the tech debacle.

Of course, luck has it that I have to realize this when bonds have low expected returns for their expected duration. Whatever we decide, for our asset allocation, it will be important to diversify our buys across time! No "all-in" at once, this time. :annoyed
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Re: Why bonds? How to allocate across accounts?

Postby parvus » Mon Jul 29, 2013 12:24 am

longinvest wrote:Thanks, LadyGeek. I bit the bullet and I asked the question on FWF. :-)


Best wishes, longinvest. I''m one of the managers at FWF. I'm sure you'll get a few responses. (And no, there is no conspiracy between me and LG. But we do collaborate.)
Last edited by parvus on Mon Jul 29, 2013 4:21 pm, edited 2 times in total.
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Re: Why bonds? How to allocate across accounts?

Postby patrick » Mon Jul 29, 2013 12:29 am

parvus wrote:So here's the second point. History defies the expected return profile. On the one hand, over the past 30 years, bonds actually beat stocks in both Canada and the U.S. So there was no risk premium. Yet, much of modern financial theory is built on the assumption of an equity risk premium.


Bonds beat stocks over the last 30 years in the US? Are you sure?

I checked this on Morningstar, over the 30 years ended 6/30/2013 (closest match I could easily set ... it doesn't seem to let me specify the exact day in 1983). It indicates that 10K in the Barclay's Aggregate would have grown to 96K, while 10K in the S&P 500 would have grown to 202K. The actual Vangaurd 500 index comes in at 192K, still twice as much as in the theoretical bond index. Actual bond funds also lagged quite a bit, at least the ones I tried.
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Re: Why bonds? How to allocate across accounts?

Postby parvus » Mon Jul 29, 2013 12:43 am

patrick wrote:
parvus wrote:So here's the second point. History defies the expected return profile. On the one hand, over the past 30 years, bonds actually beat stocks in both Canada and the U.S. So there was no risk premium. Yet, much of modern financial theory is built on the assumption of an equity risk premium.


Bonds beat stocks over the last 30 years in the US? Are you sure?

I may be off a little in my timing/end date, but here's Bloomberg.
The biggest bond gains in almost a decade have pushed returns on Treasuries above stocks over the past 30 years, the first time that’s happened since before the Civil War.

<snip>
The bond market posted its first 30-year gain over the stock market in more than a century during the period ended Sept. 30 [2011}. The last time was in 1861, leading into the Civil War, when the U.S was moving from farm to factory, according to {Jeremy} Siegel, author of the 1994 book “Stocks for the Long Run,” in a telephone interview Oct. 25.

‘Millennium Event’

“The rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward whereas stock returns can repeat themselves, and are likely to outperform,” he said. “If you missed the rally in bonds, well, then that’s it.”
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Re: Why bonds? How to allocate across accounts?

Postby ogd » Mon Jul 29, 2013 12:58 am

parvus wrote:
“The rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward whereas stock returns can repeat themselves, and are likely to outperform,” he said. “If you missed the rally in bonds, well, then that’s it.”

The article does an elaborate dance around the difference between bond prices and returns. The truth of the matter is that if prices and yields of bonds hadn't moved at all, an investor would have made 3000% since 1983 (no that's not an extra zero), instead of the 710% they actually did. That's right, four times as much.

There's a very simple and very mathematically possible way for bonds to get much higher returns going forward: rates increase to 10% and stay there, without inflation. Bonds are not like stocks, and bond bear markets and bull markets are rather ill-defined and have more to do with inflation than anything else.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Tue Jul 30, 2013 11:23 am

Some feedback.

After discussing it with Her, she wasn't convinced there was any urgent need to change our asset allocation. She didn't get the importance of having bonds (maybe I wasn't completely convinced myself).

She's open to change our distributions across accounts, but she prefers the way things are set up currently because it is easy to decide what to buy in each account, and she doesn't need to open my computer to get the spreadsheet (that's probably the real reason).

She wasn't convinced of going back to using Mutual Funds (as suggested on the Financial Webring Forums) while accumulating for the next ETF purchase. She said: why don't you just put it in a savings account for a few months? Maybe she's right and it's not a few months that will make much of a difference.

Thanks, all, for your input.
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Re: Why bonds? How to allocate across accounts?

Postby longinvest » Mon Aug 12, 2013 3:33 pm

FinancialRamblings wrote:FWIW, if you're really interested in learning more this topic (and it seems that you are), I would recommend reading "The Four Pillars of Investing" by William Bernstein as a good starting point.


FinancialRamblings, thank you so much, for this recommendation. I have just finished devouring the book. That was exactly the kind of reading I needed to better understand roles of various assets using mathematics and history. (The level of mathematics was just perfect for me, not too deep, but not too shallow either). What an extraordinary book!
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