AA question for 30 y/o

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AA question for 30 y/o

Postby menlo » Sun Jul 10, 2011 1:22 pm

Hey everyone,

I've been reading posts here for a few weeks now and I've been blown away by all of the in-depth discussions on this forum! I just can't believe I didn't find this site sooner. I've been a fan of the boglehead style of investing ever since I read William Bernstein's The Intelligent Asset Allocator ~4 years ago, but I haven't made a concerted effort to implement that strategy until now. I'd love some advice on my proposed AA. I would say I'm fairly risk tolerant although I've never had to test that in any significant way. I've never wanted to pull money from the market (either in 2000 or 2007) but I also didn't have much skin in the game back then. I did buy aggressively into the S&P 500 in stages from 900 down to 700 (using nearly all of my free cash) when the market looked cheap.

Age: 30
Emergency funds = 9 months
Debt: $52,000 in student loans (70% at 4.5% / 30% at 2.9%).
Tax Filing Status: Single
Tax Rate: 33% Federal 10% State
Current portfolio: Mid 6-figures (currently ~70% taxable, ~30% tax exempt/deferred).

Desired Asset allocation: 85/15
36% Large Caps (right now at 55%)
16% Small/Mid Caps (right now at 0%)
5% REIT (right now at 0%)
11% International Developed Stocks (right now at 7%)
17% International Emerging Stocks (right now at 12%)
15% Bonds (right now at 0%)
0% Cash (right now at 26%)

New annual Contributions
$16,500 401k (no match)
$5,000 IRA (non-deductible)
$50,000 taxable

Questions:
1. Does my proposed AA look reasonable? Specifically, the relatively lower allocation to bonds and higher allocation to emerging markets?

2. I just read The Ivy Portfolio yesterday (a very good book, notwithstanding its market timing advice) and was wondering if anyone has thoughts on its proposed 20/20/20/20/20 AA (in domestic equity, foreign equity, bonds, real estate, and commodities). That would effectively give an 80/20 allocation between equity-like investments and bonds and could be implemented with 5 ETFs/funds.

The proposition in the book is that this is closer to the allocation of the Harvard/Yale endowments (without the absolute return and private equity components), which have outperformed pure stock bond mixes in terms of both absolute return and volatility. From 1985-2008 the proposed 20/20/20/20/20 portfolio would have had roughly the same return as a 60/40 portfolio but with lower volatility and a better Sharpe ratio. Including a direct allocation to commodities and real estate (and not just to stocks in commodities companies) seems to make a lot of sense to me given the correlation charts in William Bernstein's books (i.e., low correlation with other equity classes).
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Re: AA question for 30 y/o

Postby Noobvestor » Sun Jul 10, 2011 3:02 pm

menlo wrote:Hey everyone,

I've been reading posts here for a few weeks now and I've been blown away by all of the in-depth discussions on this forum! I just can't believe I didn't find this site sooner. I've been a fan of the boglehead style of investing ever since I read William Bernstein's The Intelligent Asset Allocator ~4 years ago, but I haven't made a concerted effort to implement that strategy until now. I'd love some advice on my proposed AA. I would say I'm fairly risk tolerant although I've never had to test that in any significant way. I've never wanted to pull money from the market (either in 2000 or 2007) but I also didn't have much skin in the game back then. I did buy aggressively into the S&P 500 in stages from 900 down to 700 (using nearly all of my free cash) when the market looked cheap.


Welcome to the forum! I'll take a stab.

menlo wrote:Desired Asset allocation: 85/15
36% Large Caps (right now at 55%)
16% Small/Mid Caps (right now at 0%)
5% REIT (right now at 0%)
11% International Developed Stocks (right now at 7%)
17% International Emerging Stocks (right now at 12%)
15% Bonds (right now at 0%)
0% Cash (right now at 26%)


IMHO 85/15 is too aggressive for anyone - I follow the Ben Graham logic that 75 and 25 should be the upper and lower limits for equities. This is debatable, of course. Also, my gut says you are slicing too finely - why all of these non-rounded percentages (11, 16, 17, etc...)? Again: might just be me and my mild OCD ;) Also, you don't say what *kind* of bonds - and that is critical. I'd recommend intermediate treasuries as a starting point.

New annual Contributions
$16,500 401k (no match)
$5,000 IRA (non-deductible)
$50,000 taxable


Awesome. This here is the most important part!

1. Does my proposed AA look reasonable? Specifically, the relatively lower allocation to bonds and higher allocation to emerging markets?


I don't think your international is out of whack, as a believer that geographical diversification is a good thing. That said, it does add volatility to the portfolio and again makes me think a higher bond allocation might be a good idea.

2. I just read The Ivy Portfolio yesterday (a very good book, notwithstanding its market timing advice) and was wondering if anyone has thoughts on its proposed 20/20/20/20/20 AA (in domestic equity, foreign equity, bonds, real estate, and commodities). That would effectively give an 80/20 allocation between equity-like investments and bonds and could be implemented with 5 ETFs/funds.


That real estate and commodities allocation are a bit high for my tastes, but all in all it sounds like a reasonable, nice and simple portfolio. If I were to use those five classes, I'd go with 25% domestic, 25% foreign, 30% bonds, 10% real estate and 10% commodities - real estate and commodities make good diversifiers, but aren't necessarily great to have as larger/substantial holdings (various reasons).

The proposition in the book is that this is closer to the allocation of the Harvard/Yale endowments (without the absolute return and private equity components), which have outperformed pure stock bond mixes in terms of both absolute return and volatility. From 1985-2008 the proposed 20/20/20/20/20 portfolio would have had roughly the same return as a 60/40 portfolio but with lower volatility and a better Sharpe ratio. Including a direct allocation to commodities and real estate (and not just to stocks in commodities companies) seems to make a lot of sense to me given the correlation charts in William Bernstein's books (i.e., low correlation with other equity classes).
[/quote]

Remember that the Yale endowment is made for a long-lived institution with very different goals, and outperformance in the past does not guarantee it in the future. I think commodities and real estate can add diversification, but let them 'take over' and it can also add rather than subtract volatility. Commodities also don't, as I understand it, have themselves an expected real return - their power comes from correlations.

Going back to your current portfolio/proposal though, I'd maybe simplify it as follows:

Desired Asset allocation: 75/25
30% Large Caps
15% Small/Mid Caps (note this has extra REITs, etc)
15% International Developed Stocks
15% International Emerging Stocks
25% Bonds - intermediate or short treasuries and/or TIPS

And if you wanted to add commodities or real estate, 5% might be a good amount (taken from the equities side in either/each case).

Desired Asset allocation: 75/25
20% Large Caps
15% Small/Mid Caps (note this has extra REITs, etc)
15% International Developed Stocks
15% International Emerging Stocks
05% REITs
05% Commodities
25% Bonds - intermediate or short treasuries and/or TIPS
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe
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Re: AA question for 30 y/o

Postby menlo » Sun Jul 10, 2011 4:02 pm

Thanks so much for taking the time to go through my post and for the advice!

Noobvestor wrote:
IMHO 85/15 is too aggressive for anyone - I follow the Ben Graham logic that 75 and 25 should be the upper and lower limits for equities. This is debatable, of course. Also, my gut says you are slicing too finely - why all of these non-rounded percentages (11, 16, 17, etc...)? Again: might just be me and my mild OCD ;) Also, you don't say what *kind* of bonds - and that is critical. I'd recommend intermediate treasuries as a starting point.

I agree that the slicing and dicing is sort of odd, but it's what I came up with using the handy spreadsheet linked to on the wiki when I put in my category and sub-category allocations (e.g., 80% stocks / 65% domestic / 65% large cap = 34% domestic large cap). I'm happy to round these out given that a few percentage points either way shouldn't matter in the big scheme. I haven't gotten to the specific investment vehicles portion of the plan yet but I would plan to hold high quality bonds with mid to long durations in order to get the lowest correlation with equities.

Noobvestor wrote:
I don't think your international is out of whack, as a believer that geographical diversification is a good thing. That said, it does add volatility to the portfolio and again makes me think a higher bond allocation might be a good idea.

Thanks, I'm also a believer in a relatively higher allocation to foreign equity (and EM), although the trend of increasing correlation with domestic equity markets in recent years might mitigate some of the diversification benefit. I'll have to give some more thought to what kind of volatility I'm comfortable with in pursuit of higher expected returns. Right now I feel like given my expected contributions relative to current portfolio size I can live with a higher level of volatility.

Noobvestor wrote:
That real estate and commodities allocation are a bit high for my tastes, but all in all it sounds like a reasonable, nice and simple portfolio. If I were to use those five classes, I'd go with 25% domestic, 25% foreign, 30% bonds, 10% real estate and 10% commodities - real estate and commodities make good diversifiers, but aren't necessarily great to have as larger/substantial holdings (various reasons).

I think I probably feel the same way. I think I could get a marked improvement in volatility with a relatively smaller allocation to commodities (10%?) as a result of the low correlation with other equity asset classes.

Noobvestor wrote:
Remember that the Yale endowment is made for a long-lived institution with very different goals, and outperformance in the past does not guarantee it in the future. I think commodities and real estate can add diversification, but let them 'take over' and it can also add rather than subtract volatility. Commodities also don't, as I understand it, have themselves an expected real return - their power comes from correlations.

My feeling on this is that only some of the asset classes in the Yale portfolio are geared only toward longer time horizons (the illiquid real asset holdings like timberland and positions in certain absolute return and private equity funds). I wouldn't have these in my portfolio. As for commodities, I'm not sure whether they have real returns but I also understand them as being valuable based on low correlation with other asset classes and (I think) a generally inverse correlation with inflation.

Noobvestor wrote:
Going back to your current portfolio/proposal though, I'd maybe simplify it as follows:
Desired Asset allocation: 75/25
30% Large Caps
15% Small/Mid Caps (note this has extra REITs, etc)
15% International Developed Stocks
15% International Emerging Stocks
25% Bonds - intermediate or short treasuries and/or TIPS

And if you wanted to add commodities or real estate, 5% might be a good amount (taken from the equities side in either/each case).

Desired Asset allocation: 75/25
20% Large Caps
15% Small/Mid Caps (note this has extra REITs, etc)
15% International Developed Stocks
15% International Emerging Stocks
05% REITs
05% Commodities
25% Bonds - intermediate or short treasuries and/or TIPS

Thanks! I'll have to give this some thought. Overall I'm inclined to have a bigger weighting to equity because I feel I can get good volatility smoothing with a lower amount of the right types of bonds. I think the main reason I would want to increase the bond allocation is for purposes of being able to rebalance in really large market dislocations. But maybe 10-15% is sufficient in all but the most extreme cases?
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Postby Default User BR » Sun Jul 10, 2011 6:34 pm

$5,000 IRA (non-deductible)

Hopefully, this is in preparation to a back-door Roth (assuming you can't directly contribute to one.



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Re: AA question for 30 y/o

Postby Noobvestor » Mon Jul 11, 2011 3:33 am

menlo wrote:Thanks so much for taking the time to go through my post and for the advice!


You're quite welcome!

I think the big thing with percentages is not to get too attached to the numbers to the point of trying to slice down by percent - it can be annoying to keep track of, but in a more serious way I think it can also lead to behavioral risks (i.e. the desire to fidget around numbers, justifying it as some kind of 'rounding' etc). In the end, it doesn't matter too much as long as you're within the right range - 3 percent either way isn't going to break or make a portfolio.


I agree that the slicing and dicing is sort of odd, but it's what I came up with using the handy spreadsheet linked to on the wiki when I put in my category and sub-category allocations (e.g., 80% stocks / 65% domestic / 65% large cap = 34% domestic large cap). I'm happy to round these out given that a few percentage points either way shouldn't matter in the big scheme. I haven't gotten to the specific investment vehicles portion of the plan yet but I would plan to hold high quality bonds with mid to long durations in order to get the lowest correlation with equities.


It might be a good time to start looking at what the vehicles are going to be, or could be. If you're using Vanguard, which I recommend by default, they have most of what you need covered, though you'll have to pick an outside ETF for your commodities exposure. I've been looking at GCC - even basket of all commodities - but am not adding that to my portfolio (yet) per self-imposed waiting rules, etc...


Thanks, I'm also a believer in a relatively higher allocation to foreign equity (and EM), although the trend of increasing correlation with domestic equity markets in recent years might mitigate some of the diversification benefit. I'll have to give some more thought to what kind of volatility I'm comfortable with in pursuit of higher expected returns. Right now I feel like given my expected contributions relative to current portfolio size I can live with a higher level of volatility.


It can be a bit of a catch 22 - most people underestimate the pain they'll feel (and capitulation they'll risk) when markets take a tumble ... some don't though, too, and see stocks truly as being on sale. To me, the worse risk is not having your early-stage, still-small portfolio not perform *quite* a peak but rather making a bad decision that messes you up psychologically, kicking you out of the market, selling at the wrong time, etc... hence I really think 25% is a good bare minimum for bonds.

I think I probably feel the same way. I think I could get a marked improvement in volatility with a relatively smaller allocation to commodities (10%?) as a result of the low correlation with other equity asset classes.


I agree - 5 to 10 seems like a reasonable range - more than that and it starts to get in the way of the 'real' earners in a portfolio IMHO.

Thanks! I'll have to give this some thought. Overall I'm inclined to have a bigger weighting to equity because I feel I can get good volatility smoothing with a lower amount of the right types of bonds. I think the main reason I would want to increase the bond allocation is for purposes of being able to rebalance in really large market dislocations. But maybe 10-15% is sufficient in all but the most extreme cases?


Well, take the last big drop-off, and an *extreme* bond example of Extended-Duration Treasuries. These went up by around 40% as I recall while the market dropped, I dunno, 50% or so. So if you had 10% in EDV (again: I wouldn't recommend going QUITE that long) you'd have that up to 14% ... but your stocks would be down from 90% of your portfolio to 45% of it. Ouch. So even if you spent all 14% (bad idea) to buy stocks at that point, you'd only be buying a third again as much as you already have. And if you just rebalance (better idea) you only are adding 4% on to that 50%. And don't forget: there are times when long bonds take a tumble right along with the stock market - they are volatile, and can experience pain during periods of inflation, for example. My own bond allocation is basically split between intermediate treasuries and TIPS (deflation and inflation fighters, not so far out on the yield curve that I can get crushed, etc...). I think a combination of TIPS and Long-Term Treasuries might be more suited for you, but I'd still up that bond allocation regardless ;)
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe
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Postby Noobvestor » Mon Jul 11, 2011 3:34 am

Default User BR wrote:
$5,000 IRA (non-deductible)

Hopefully, this is in preparation to a back-door Roth (assuming you can't directly contribute to one.



Brian


I agree - if you can add to a Roth, do it while you still can.
"In the absence of clarity, diversification is the only logical strategy" -= Larry Swedroe
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Postby menlo » Tue Jul 12, 2011 9:44 am

Noobvestor wrote:
Default User BR wrote:
$5,000 IRA (non-deductible)

Hopefully, this is in preparation to a back-door Roth (assuming you can't directly contribute to one.

Brian


I agree - if you can add to a Roth, do it while you still can.


Great advice, thank you. I had meant to look into the Roth IRA conversion and, now that I have, it looks like it's a no-brainer. I have ~$21.5K in the IRA, of which $20K is from non-deductible contributions. So it looks like I'd only have to pay tax on ~$1.5K.
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Re: AA question for 30 y/o

Postby menlo » Sat Jun 30, 2012 1:25 pm

It's now almost a year since I posted this and I thought I'd provide an update. Over the past year I've slowly moved much closer to my desired AA. A year ago I basically just had large caps, emerging markets, and cash. I had no small caps, minimal international developed, no bonds, and no REITS. Now I have close to my target allocation in each of these categories except for bonds, where I'm still slowly inching up. And all using Vanguard low-cost index funds!

I'm pleased with the progress I've made in moving towards my AA and I couldn't have done it without the confidence I got from reading this board and input from fellow Bogleheads.

Thanks everyone!

Desired Asset allocation: 85/15 - 50% domestic/30% international/5% REIT/15% Bonds
34% Large Caps (right now at 42%)
14% Small/Mid Caps (right now at 13%)
5% REIT (right now at 4%)
21% International Developed Stocks (right now at 21%)
11% International Emerging Stocks (right now at 11%)
15% Bonds (right now at 7%)
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Re: AA question for 30 y/o

Postby menlo » Sun Mar 31, 2013 12:56 pm

It's now 18 months since I "committed" to my 85/15 AA. Although things have been going very well in terms of portfolio growth, I still haven't been able to force myself to rebalance my holdings to get my bonds up from 7% to the target 15%. Even though I've been buying a reasonable amount of bonds in tax-exempt accounts just to keep the percentage from declining, I'm finding it difficult in the current climate of bond gloom and doom to rebalance equity to bonds to get to 15% (notwithstanding all of the stay-the-course posts I read on here).

I'm not sure what to do. On the one hand, I know that 15% is already a very low percentage - bordering on insignificant for purposes of diversification. On the other hand, I have a significant risk appetite (I was more or less 100% equity from 1999 to 2011, and only forced myself to buy bonds after finding Bogleheads and Bill Bernstein), and I've sort of bought into the idea that bond returns are not going to be great in the next few year given where rates stand.

I need your sage advice. I feel like the options that I can actually convince myself to do are: (1) continue with my current "target" 15% bond AA, but only move there at a rate of 3% per year so that I get there by 2016 or so (i.e., market timing), or (2) change my bond AA to 10%. I'm not sure which is right for me. In terms of need/willingness/ability to take risk, my need is moderate but my willingness is high, and my ability is relatively high.

So what do you think?
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Re: AA question for 30 y/o

Postby stan1 » Sun Mar 31, 2013 1:23 pm

It's been almost 2 years since your original post.
I know this isn't your question, but have you paid off the student loans?

Rest is your call. You have the willingness and ability to take more risk than you need to. At that point its a personal decision.
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Re: AA question for 30 y/o

Postby regularguy » Sun Mar 31, 2013 3:08 pm

Dear Menlo,

It seems like you have a psychological block to really committing to your asset allocation. I am in a similar position (right down to the "trying hard to transition to bonds" part). As I move toward my target allocation (which also happens to be 15% bonds), here are the things I try to keep in mind.

First, you should be indifferent to interest-rates changes if you are willing to hold your bonds equal to their duration. If wiser posters are correct, this means that if interest rates drop, you will be worse off until you reach the duration, but better off after you exceed the duration (because reinvested dividends will buy "cheaper" bonds and you will make up your money. If you have an intermediate-term bond fund, that probably means a duration of 4-7 years. It's perverse, but if you are really committed to holding for the long term, you should relish short-term drops in interest rates because it gives you a good value for your money.

Second, maybe stocks are about to crash. Do you ever get nervous looking at the S&P 500 shooting ever higher? Think about banking those losses by selling stocks and buying bonds. Even if your intermediate-term bonds "crash," it would be nothing like a crash in equities.

Third, it's not going to make a huge difference to your long-term returns. You can run the numbers, but 10% vs. 15% to bonds (with proper rebalancing) is not really going to affect your long-term return. It should help with your volatility, however.

On your question about changing your asset allocation over time, I would think of that as less market timing than what you're doing now, because at least it gets you closer to your actual asset allocation. As long as you are serious about actually moving 3% a year, that seems fine to me. But what do I know.

Good luck,
~RG

P.S.: If you're scared of bond funds, you can always buy I bonds like everyone on this board talks about, and fudge the difference between calling them the end of your emergency fund and the beginning of your bond portfolio. These can't go down in value like a bond fund, because you can always sell them back for what you paid. They're giving better return right now than anything you can get in an online savings account, with only a little less liquidity.
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Re: AA question for 30 y/o

Postby stilts1007 » Sun Mar 31, 2013 7:13 pm

regularguy wrote:First, you should be indifferent to interest-rates changes if you are willing to hold your bonds equal to their duration. If wiser posters are correct, this means that if interest rates drop, you will be worse off until you reach the duration, but better off after you exceed the duration (because reinvested dividends will buy "cheaper" bonds and you will make up your money. If you have an intermediate-term bond fund, that probably means a duration of 4-7 years. It's perverse, but if you are really committed to holding for the long term, you should relish short-term drops in interest rates because it gives you a good value for your money.


Agree. If you are planning on staying invested for the next 30 years or more (my guess based on your age), being invested in a short-term or intermediate-term bond fund means that although initial numbers may hurt as interest rates rise, in the long run you will more than make it up. If you want to read the nitty-gritty numbers behind it, search "bubble" in the forum and you will find contributors much smarter than I (advisory board, etc.) weighing in on the issue. Consensus seems to be what it usually seems to be on the board when bubbles are discussed: buy and hold, stay the course, etc.
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Re: AA question for 30 y/o

Postby Noobvestor » Mon Apr 01, 2013 12:45 am

You have to remember you just can't know the future. I was nervous about some bond funds a year or two back ... but they've just gone up since then. And if stocks tank again (seems plausible) they may go up further yet. Sure, my bonds aren't up as much as my stocks, but you never know what tomorrow will bring ;)
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Re: AA question for 30 y/o

Postby RobInCT » Mon Apr 01, 2013 7:16 am

My 401k plan has an auto rebalancing feature. Something for you to look into? Keeps me honest. Also reduces the psychological "pain" of having to manually sell assets that a doing well to acquire more of those that are lagging.
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Re: AA question for 30 y/o

Postby fatmike91 » Mon Apr 01, 2013 7:42 am

15% is low. It's been a year or two. Just do it already.


IF you choose not to do it, then consider holding cash for the balance of that 15% (or maybe even up it to 20% cash + bonds). You can think of cash as just a really short duration bond fund.



/
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Re: AA question for 30 y/o

Postby menlo » Fri Apr 05, 2013 11:58 am

Thanks everyone for your advice. All really good points and very helpful. Okay, I think my immediate plan is to buy my full I-Bond allocation for 2013, buy BND with whatever cash is in my tax advantaged accounts, and then increase slightly the amount of money going to bonds in my monthly retirement contributions. That will get me a little closer to my AA than the status quo. Small steps.

stan1 wrote:I know this isn't your question, but have you paid off the student loans?

Good question. I'm down to $25,000 on my student loans. It's at a low interest rate (1.85%) so I haven't felt an urgency to pay it down faster. I understand that 1.85% is well above the short-term risk-free rate of return, but I like the flexibility and am not too worried about the 1% per year cost for that.

regularguy wrote:First, you should be indifferent to interest-rates changes if you are willing to hold your bonds equal to their duration.

Second, maybe stocks are about to crash.

Third, it's not going to make a huge difference to your long-term returns.

On your question about changing your asset allocation over time, I would think of that as less market timing than what you're doing now, because at least it gets you closer to your actual asset allocation. As long as you are serious about actually moving 3% a year, that seems fine to me. But what do I know.

P.S.: If you're scared of bond funds, you can always buy I bonds like everyone on this board talks about, and fudge the difference between calling them the end of your emergency fund and the beginning of your bond portfolio. These can't go down in value like a bond fund, because you can always sell them back for what you paid. They're giving better return right now than anything you can get in an online savings account, with only a little less liquidity.

Thanks regularguy. These are all great points. The first is the most convincing - although I guess I'm more worried about expected low returns over the next several years than I am with a crash. But I guess the worry is minor given the percentages involved and the plan to hold this for the long term. I have maxed out I-Bonds each of the last two years and, as you suggest, I'll do so again this year.

stilts1007 wrote:Consensus seems to be what it usually seems to be on the board when bubbles are discussed: buy and hold, stay the course, etc.

Yes, that's good advice and the main reason I want to convince myself to buy bonds at this time.

Noobvestor wrote:You have to remember you just can't know the future. I was nervous about some bond funds a year or two back ... but they've just gone up since then. And if stocks tank again (seems plausible) they may go up further yet. Sure, my bonds aren't up as much as my stocks, but you never know what tomorrow will bring

Noobvestor, good advice as always. Yes, this is really about having the sense to stick to my longterm AA.

RobInCT wrote:My 401k plan has an auto rebalancing feature. Something for you to look into? Keeps me honest. Also reduces the psychological "pain" of having to manually sell assets that a doing well to acquire more of those that are lagging.

That's a good idea, although I'm not sure if I could force myself to give up control over that sort of thing. Again theory butting up against psychology.

fatmike91 wrote:15% is low. It's been a year or two. Just do it already.

IF you choose not to do it, then consider holding cash for the balance of that 15% (or maybe even up it to 20% cash + bonds). You can think of cash as just a really short duration bond fund.

You won't get any argument from me. I do hold a lot more cash than I should under my AA precisely because I'm supposed to use that to buy bonds and I can't bring myself to do it (would involve rebalancing retirement accounts into bonds). I think the plan I outline above will get me moving again in the right direction.
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