What is the unknowability of the market?

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TomCat96
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What is the unknowability of the market?

Post by TomCat96 »

One of the most frequently cited rationales used here is that no one knows what the market will do.

In a general sense, I agree with that. Predicting whichever way the stock markets will go is a nearly impossible task. Timing the market because of fear or expected events is more likely to result in losses than gains.

But where I disagree with and where I run into issues is when people impute this "unknowability" of the market to other assets besides the stock market.
In order to remain cordial, let me then pose my points as a series of questions.

Is the bond market every bit as unknowable and unpredictable as the stock market?
Is the bond market MORE unknowable than the stock market?
Is the bond market LESS unknowable than the stock market?

In my opinion, the greatest criticism of boglehead philosophy can be ascribed this time to the bond market. I don't believe the bond market to be every bit as unknowable as the stock market.

There are two major differences:

1. Central banks are allowed to purchase and sell bonds to implement rate policy. They engage in open market operations.
Large institutions which do not have profit motive will warp market forces. Central banks will not go bankrupt if they measure risk improperly. Collectively they have an enormous amount and power relative to other market participants in the bond market.
As of october 26th, the Fed alone has 4.454 trillion dollars of Assets on its balance sheets it's trying to get rid of. it's taking its time. Since last year it sold about 35 billion worth of bonds.


2. Rates were at record lows and negative in many cases. How low? They haven't been this low in 5000 years of human history.
http://www.businessinsider.com/chart-50 ... tes-2015-9
http://www.cnbc.com/2016/06/13/12-trill ... -this.html
http://www.marketwatch.com/story/charti ... 2016-06-14

Rates for German, Belgian, and Japanese government bonds are currently negative at the low end of their yield curves.

How can the markets possibly be efficient if rates are negative? Would any of you like to pay me for the illustrious pleasure of loaning money to me? I promise to only charge -.790, the current yield of the german 1 month sovereign debt at this very moment.

If you asked me to predict whether a 30 year bond paying 5% is going to rise to 5.5% or drop to 4.5%, I would say I have no idea.
But if you asked me to predict what a bond that's already paying negative rates is going to do, I would say I'm pretty sure it's going to go up at some point. When is it going to up? Negative rates already defy a free market, so the prediction would depend on observing the action of central banks in this case.

With rates at 5000 year record lows, investing my money long term in bonds at this time seemed like a fools errand.

I admit I don't know what the stock market is going to do today to tomorrow. I admit I don't know what the bond market is going to do when rates look more normal. But I do have an inkling of what's going to happen when I have to start paying people to lend money to them. That rate is going to rise.

If the rate rises, the bond price falls by mathematical definition.

I have 30 years to go before I retire. I could have dumped my entire portfolio in 25% bonds. I'm glad I chose not to, and instead opted for a 100% stock allocation. The writing was on the wall that bonds would drop because the rates defied common sense. lowest rates in 5000 years of history? Based on PCE computations of zero inflation? and the advice was to get in now because no one knows what the market will do?

My analysis was not for naught. In fact it saved me quite a bit this time.

I don't follow dogma. I follow logic. Boglehead philosophy prevails because not because we say it does, but because it actually, empirically works.
The stock market is unknowable. The bond market under such extreme conditions in this case was not.
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Re: What is the unknowability of the market?

Post by livesoft »

OK, I don't follow convential wisdom either, but I think that it is not unknowable that equity markets fall much much more than bond markets.

My wife heard about negative interest rates yesterday and asked me why anybody would want to have to pay to invest in bonds. My answer was:

One can invest and get a guaranteed -0.8% return or invest and get a possible loss of 10%. What would you rather do?
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Re: What is the unknowability of the market?

Post by Valuethinker »

TomCat96 wrote:
I don't follow dogma. I follow logic. Boglehead philosophy prevails because not because we say it does, but because it actually, empirically works.
The stock market is unknowable. The bond market under such extreme conditions in this case was not.
You are ignoring black swan risk.

If Deutsche Bank goes, or the Middle East really cooks off, or Italy moves into default, then the market could retest the Lehman bottom. Heck it could be *worse* than the Lehman bottom.

At which point, bonds are going to look relatively clever.

Just because something didn't happen, doesn't mean it won't. Credit Anstalt went down in 1931. Lehman went down in 2008. Who knows what the financial future will bring?
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Re: What is the unknowability of the market?

Post by qwertyjazz »

My limited understanding of interest rates are that they are a function of other uses of the money and odds of return of investment. Despite some interpretation of the past month, people in the US are arguably the safest we have even been and the economy is as measured as it has ever been. There probably has never been a safer place to lend money and record keeping has never been better to get lent money returned. Other countries are still less secure than ours (although there has been a narrowing since WW2). I appreciate your comments before on inflation and bonds. But given the fundementals of this country, I see no problem with near zero percent interest rates for a large portion of the next 30 years. I also am not sure about the flow of moneys in the future and see no problem with interest rates being double digits in the near future. I am not sure the fundementals of lending over the past 5000 years and over the past 60 years are definetely going to predict the future pattern of lending funds. I still have a lot to learn about this field but I feel less sure about any absolutes in lending then I do in equity.
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Re: What is the unknowability of the market?

Post by k66 »

TomCat96: I think you are asking for some type of quantification of a non-quantifiable property. As Valuethinker points out, Black Swans exist (we know that), but we can't dimensionslize them because, by their very nature, we don't know what they are or when they will actually manifest themselves.
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Re: What is the unknowability of the market?

Post by marco49 »

I say to the original poster: If 100% equity allocation allows you to sleep more soundly at night, then that's the correct allocation for you.

There is no "correct" answer to the allocation dilemma other than each individual's comfort level.

As it turns out, I agree with the original poster. The existence of negative interest rates in our global economy is a screaming warning sign. One of the basic foundations of economic "science" is the zero lower bound on interest rates. If there is not a positive cost of money, our assumptions about the nature of money are called into question. It begs the question: "What is money?"

In the history of money and economics, this has NEVER happened before. Given this new development, setting current strategies based upon our perception of reliable historical patterns seems pretty dicey to me.

Sometimes, I feel like Chicken Little, screaming that the sky is falling. I know that nobody wants to hear it. But, it is what it is...
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Re: What is the unknowability of the market?

Post by patrick013 »

TomCat96 wrote: The writing was on the wall that bonds would drop because
the rates defied common sense.
Actually to start a long term trend of higher rates it's going to
take more time. Prices going down a few dollars every year as
small FFR rate increases actually happen. Nobody likes it when
their gains on bond holdings disappear but that's the market
saying yes and no to certain spreads, and other opportunities.

If interest rates increase and become stable at a higher level I
think PE's will go down and stock returns will slow again. So the
winner is the consumer who buys the new bonds at higher rates.
age in bonds, buy-and-hold, 10 year business cycle
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Re: What is the unknowability of the market?

Post by qwertyjazz »

marco49 wrote:I say to the original poster: If 100% equity allocation allows you to sleep more soundly at night, then that's the correct allocation for you.

There is no "correct" answer to the allocation dilemma other than each individual's comfort level.

As it turns out, I agree with the original poster. The existence of negative interest rates in our global economy is a screaming warning sign. One of the basic foundations of economic "science" is the zero lower bound on interest rates. If there is not a positive cost of money, our assumptions about the nature of money are called into question. It begs the question: "What is money?"

In the history of money and economics, this has NEVER happened before. Given this new development, setting current strategies based upon our perception of reliable historical patterns seems pretty dicey to me.

Sometimes, I feel like Chicken Little, screaming that the sky is falling. I know that nobody wants to hear it. But, it is what it is...
"What is money?" was the framework I have been searching for. I have no problem with considering some bank in the old west charging to watch over gold deposits. If it were not for trust networks, I have no problem imagining a charge to someone ostracized from Athens to have someone watch over their goods. Money is a mechanism of exchange between greater than two parties in which we place our full faith and credit - except when it is not. If the federal government attempted to manipulate interest rates to decrease bond costs (outside of scope of this forum why I am wondering about this- politics), then it is only partially about classic inflation models - it is about the full faith that everyone with money has about it. Now if someone has less faith about their own currency and had difficulty obtaining dollars, yen whatever, negative interest rates could come from the market without any federal manipulation.
In a relatively safe world where relative position might matter, then the question of what is money will become of greater importance
Interesting
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Re: What is the unknowability of the market?

Post by nisiprius »

By the bond "market," do you mean the difference between the price of a bond today and the price of the same bond a week from today? In that respect, I think both the bond market and the stock market are "unknowable" because the market is reasonably efficient. That is to say, what is knowable is almost perfectly priced in, and what is left over in the form of short-term market fluctuations is almost unknowable. I say "almost" because I think that full-time professional experts who specialize in a limited number of issues can get a small edge over the market, and earn their living by exploiting this edge. That is, I think there are small inefficiencies that motivate professionals to work at price discovery. But it's hard work, and I think the magnitude of the "edge" is no more than 0.5% or so.

On the other hand, I think it is quite predictable that the fluctuations in the market value of bonds will be much smaller than those of stocks for the simple and obvious reason that a bond is a contract to pay specific numbers of dollars on specific dates, and a stock is nothing of the kind; so both the risk of bonds and their fluctuations are smaller. To know the value of a bond at maturity, all you need to know is whether the issuer will still be in operating and paying its debts on the maturity date. To know the value of a stock, you need to know a thousand imponderables about the company's business.

It's hard to make any sensible or actionable appraisal of the chances of an apocalyptic collapse of the bond market, other than to say that on the one hand the fears usually far exceed the reality, but on the other hand sometime stuff happens. However, I think it's insane to suppose that the forces that could cause a bond market collapse--not an event like the "massacre" of 1994 which is only a 4% blip in the Vanguard Total Bond Market Index Fund, but an event comparable in magnitude to 1987 or 2000-2 or 2008-2009 in stocks--would not also produce a comparable disasters in every other asset class as well.

Here's a chart that includes 2008-2009 in stocks (blue) and bonds (orange). I challenge you to find me a similar chart from any time in history that shows the asset classes changing place--with bonds dropping 50% and stocks riding straight through.

Source
Image
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Re: What is the unknowability of the market?

Post by randomguy »

Valuethinker wrote:
TomCat96 wrote:
I don't follow dogma. I follow logic. Boglehead philosophy prevails because not because we say it does, but because it actually, empirically works.
The stock market is unknowable. The bond market under such extreme conditions in this case was not.
You are ignoring black swan risk.

If Deutsche Bank goes, or the Middle East really cooks off, or Italy moves into default, then the market could retest the Lehman bottom. Heck it could be *worse* than the Lehman bottom.

At which point, bonds are going to look relatively clever.

Just because something didn't happen, doesn't mean it won't. Credit Anstalt went down in 1931. Lehman went down in 2008. Who knows what the financial future will bring?
Black swan risk applies to bonds also. It is hard to imagine what would cause the US bonds to go to zero but that doesn't mean that possibility doesn't exist. I am sure the early 1914 german bond buyer didn't imagine that those bonds would be worthless in 10 years. Obviously the most likely bond disaster is the more the paper cut one where rising in inflation and rates, slowly eats away at your portfolio and you don't last long enough to make to the back side where you benefit from the lowering rates and falling inflation.

In 1997-8 there was talk about how bonds were at ~30 year lows and how buying them was a suckers bet. At some point obviously things will change but those people were 15+ years early. But lets say we are right that rates are going up. Do you want to predict by how much and when. Between 1935->1956, 10 years traded pretty much traded in 2-3% range. We could very well see the same thing where .5% raises are followed by a couple of .25% drops and we spend 20 years bouncing around. Or we could do the late 60s thing and just watch soar into uncharted territory. Do you buy at the historically high rates of 5,6, and 7% since they are 70 year highs?

The question with buying bonds is what is your alternative. Buy a 5year bond paying 1.5% or a 5 year CD paying 1.5%, then you have a choice if you want to take interest rate risk or not. If your option is that 5 year bond or a money market paying 0%, you have to make guesses about if you will make enough interest to make up for the risk
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Re: What is the unknowability of the market?

Post by Phineas J. Whoopee »

I get that Business Insider, CNBC, and Market Watch all said interest rates are the lowest in 5,000 years, but I want to see their data sets, and I want to know whether they're averaging what interest rates may have meant in gift economies spread all across the world thousands of years ago.

Do they take into account religious or cultural, depending on one's viewpoint, limitations about charging interest? How about intrafamily loans? How about those which were forgiven? How about those that were structured as co-ownership?

How about those that simply didn't pay? It takes a lot of interest to make up for defaulted principal.

The bond market is unknowable.

OP, it seems as if you've fallen for the money illusion, in which the quantity of money is thought to be some real, objective thing, when really it is purchasing power that's important. If deflation is more negative than interest rates savers come out ahead.

There are fixed income losses that are not interest.

Unlike most individuals, large organizations may not have the practical opportunity to go to physical currency stored in vast vaults. There isn't enough. Bonds are the means they have to store that much money.

Can we see the training materials by which five-millenia-ago finance professionals were taught to use their abacuses?

I don't mean to single you out personally, TomCat96. It's just that several posters have started threads with the lowest-in-5,000 year claim and it got to be time for me to respond. You are in fact quoting statements made by the press and therefore ask a fair question.

They're engaged in attracting eyeballs, not in emoting anything other than that all of us should buy Ford F-150s, which are like rocks, and whose capabilities definitely were not cheaper 5,000 years before present.

PJW
Last edited by Phineas J. Whoopee on Thu Nov 24, 2016 6:25 pm, edited 3 times in total.
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Re: What is the unknowability of the market?

Post by qwertyjazz »

You do not need an apocalypse for bonds to fall. Interest rates go up and they give back all the gains of the past few years.
Now through in tariffs and inflation and you could see if further decreases - potentially at differential rates from companies making things here at exporting info technology outside of tariffs (reasonable stories I think are possible). Or tariffs and an unsafe world could cause a flight to the dollar and lower interest rates. As pointed out by PJW, this lending and money system is not 5000 years but rather only a few hundred or 70 years old depending on how you look at it. The rules could change
Or conversely, it might only make marginal changes. In my mind, most likely this time is not different. But it might be at a higher chance than a it has been for a while.
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Re: What is the unknowability of the market?

Post by Phineas J. Whoopee »

qwertyjazz wrote:...
"What is money?" was the framework I have been searching for. ...
Indeed, money is a social construct which has meaning only because most of us agree it does. Who would trade perfectly good, edible rutabagas for industrially-nearly-useless metal unless they thought somebody would trade something else for it?

In mainstream economics today money is that which fills three specific functions:

It is a medium of exchange, by which we, mostly, solve the coincidence of wants problem;

It is a store of value, which on Saturday when I go to buy a couple of chickens, some carrots, and some potatoes, retains most, perhaps not all, of the socially-constructed value that it had when I was paid on Friday; and

It is a unit of account, by which we measure the worth of other things that are not themselves money. The value of housing in the United States dropped by perhaps as much as six trillion dollars, even though nobody made off with the money.

If there's some one thing, or some more than one thing, that serves, in a society, as a medium of exchange, a store of value, and a unit of account, it is money, by social construction.

PJW
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Re: What is the unknowability of the market?

Post by itstoomuch »

livesoft wrote:OK, I don't follow convential wisdom either, but I think that it is not unknowable that equity markets fall much much more than bond markets.

My wife heard about negative interest rates yesterday and asked me why anybody would want to have to pay to invest in bonds. My answer was:

One can invest and get a guaranteed -0.8% return or invest and get a possible loss of 10%. What would you rather do?
we buy negative rates, all the time: :oops: :annoyed :greedy

I have considerable $ in Discretionary in cash. It is a negative holding.
I have bought into CD's that yielded 10% but inflation was running 14%.
I have bought EE that yielded 6% with a guaranteed floor of 4%, but current inflation was 10%+ and interest was taxable at 15-25%.
I have checking accounts that yield cents/thousands vs inflation at $1.50/$100.
YMMV :|

It's all unknown. Some of us can guess better. :wink:
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Re: What is the unknowability of the market?

Post by marco49 »

itstoomuch wrote:we buy negative rates, all the time: :oops: :annoyed :greedy

I have considerable $ in Discretionary in cash. It is a negative holding.
I have bought into CD's that yielded 10% but inflation was running 14%.
I have bought EE that yielded 6% with a guaranteed floor of 4%, but current inflation was 10%+ and interest was taxable at 15-25%.
I have checking accounts that yield cents/thousands vs inflation at $1.50/$100.
Don't confuse negative real interest rates, which is what you are describing, with negative nominal interest rates. There is a long history of negative real interest rates resulting from the interplay between inflation and nominal interest rates. The new development is negative nominal interest rates for government debt. That has never happened before.

Its recent genesis, and the economy's acceptance of it, is a tacit admission that money no longer serves its purpose as a store of value, one of the 3 functions pointed out by Phineas J. Whoopee above.

In my opinion, this is an end-point of a progression, starting with hard precious metal coinage, going through convertible paper, fiat paper, fiat coinage, and finally ending up in digital smoke and mirrors. That's where we are today and that's why I question bonds' function as a store of value.
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Re: What is the unknowability of the market?

Post by itstoomuch »

ok, i won't.
:wink:
macro49 wrote:In my opinion, this is an end-point of a progression, starting with hard precious metal coinage, going through convertible paper, fiat paper, fiat coinage, and finally ending up in digital smoke and mirrors. That's where we are today and that's why I question bonds' function as a store of value.
I've come to same conclusion. I've off-loaded my bond risk to an annuity/insurance company in 2008.
Last edited by itstoomuch on Thu Nov 24, 2016 7:28 pm, edited 1 time in total.
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Re: What is the unknowability of the market?

Post by Phineas J. Whoopee »

marco49 wrote:...
Its recent genesis, and the economy's acceptance of it, is a tacit admission that money no longer serves its purpose as a store of value, one of the 3 functions pointed out by Phineas J. Whoopee above.
...
I, in my example, spoke of one day. Of course in the most extreme of circumstances even that got to be a problem, and click the link because it's not what the Austrian-school economists always bring up, but you're speaking of years on end and only in a nominal sense, not a real sense, and inflation can be negative.

Instead of 5mg of gold, let's speak of the value of a same-size same-nutrition rutabaga. One can choose any standard they like, but it's an arbitrary choice. How much is 38 kcal of swede worth today? How much is it worth in late spring in the southern hemisphere? What if it's rotten? What if it's the Siege of Leningrad?

Money is meaningful in terms of its purchasing power, not in the nominal way you seem to have written about it. If I've misunderstood you, please correct, but I don't think what I wrote supports what you wrote. I went to the grocery store yesterday and bought boneless skinless chicken thigh meat for $2.29 per pound, even though it's been a while since I was last paid. It seemed like a fair trade, and it was very nice to eat. Your economic values may be different than mine.

And anyhow, what's to admit? It is or it ain't. Who would admit what, other than they?

PJW
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Re: What is the unknowability of the market?

Post by marco49 »

Hi Phineas,

Chicken breast and rutabaga? Sounds good! Bon Appetit on this Thanksgiving day.

I have in my hand 4 US quarter coins from 1964 or earlier. These coins have 90% silver content by weight. Face value = $1.00. According to the website coinflation.com, the silver content of those coins is worth $11.73 as of the closing price of silver on the bullion market yesterday. Four quarters which were issued from 1965 until now have no silver, rather a copper content worth about $0.14 at today's prices.

My pre-1965 silver coins were real money because they are a store of value. What have we got today? Digital records of your account in the bank, brokerage, mutual fund company. I'm not seeing a store of value in today's "money", not with negative nominal interest rates.

Marco
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Re: What is the unknowability of the market?

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Re: What is the unknowability of the market?

Post by Christine_NM »

I took up nisi's challenge to find an equivalent chart for bonds like 2008. The bond market massacre of 1994 immediately occurred to me, but it turns out that the chart is not what is important.

When rates (yields) rise bond prices fall as we all know. That is not important if stocks hold up. In 1994 the S&P was down 1% and yields rose 250 basis points via Fed action so any allocation probably lost money. Maybe it was a comparatively good year for international, idk. It was not the end of the world, since, in my view, the whole nature of the market changed in 1995 as recovery from the 1991 recession finally took hold.

How much protection do bonds actually offer from stock volatility? How much protection do stocks offer from rising rates? In my search I found a useful quote from fool.com:
Vanguard has calculated that, between 1973 and 2010, the average 12-month real return on a 60% stocks/ 40% bonds portfolio during periods in which interest rates increased by at least 200 basis points is negative.


Source http://www.fool.com/investing/general/2 ... s-day.aspx

I added this quote to my IPS. It is not terrible to have a negative year as long as I am prepared for it in retirement with a sufficient cash allocation and enough annual income to put up a fight to future inflation.

Tom, no quarrel here with spending some years at 100% stocks as long as you have a stable income and a strong stomach.
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Re: What is the unknowability of the market?

Post by randomguy »

Christine_NM wrote:I took up nisi's challenge to find an equivalent chart for bonds like 2008. The bond market massacre of 1994 immediately occurred to me, but it turns out that the chart is not what is important.

When rates (yields) rise bond prices fall as we all know. That is not important if stocks hold up. In 1994 the S&P was down 1% and yields rose 250 basis points via Fed action so any allocation probably lost money. Maybe it was a comparatively good year for international, idk. It was not the end of the world, since, in my view, the whole nature of the market changed in 1995 as recovery from the 1991 recession finally took hold.

How much protection do bonds actually offer from stock volatility? How much protection do stocks offer from rising rates? In my search I found a useful quote from fool.com:
Vanguard has calculated that, between 1973 and 2010, the average 12-month real return on a 60% stocks/ 40% bonds portfolio during periods in which interest rates increased by at least 200 basis points is negative.


Source http://www.fool.com/investing/general/2 ... s-day.aspx

I added this quote to my IPS. It is not terrible to have a negative year as long as I am prepared for it in retirement with a sufficient cash allocation and enough annual income to put up a fight to future inflation.

Tom, no quarrel here with spending some years at 100% stocks as long as you have a stable income and a strong stomach.

How many periods were there were there were 200 basis point increases? I am sure that having a headwind like that (losing say 10%+ in your bond fund) makes it hard to make money but you might be drawing a conclusion from like 2 or 3 samples. I am thinking 199 and maybe 1980/81 when you look at annual changes and maybe a couple more from intrayear. It just doesn't happen very often.
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Re: What is the unknowability of the market?

Post by sabhen »

we can only try to understand the future by looking at history. there are known unknown (Euro break-up) and unknown unknown (comet hitting earth). but nobody knows the future. typical 60/40 asset may not be suitable. history of interest rates in the modern era - after WWII shows between 1946 and 1981 i.e 35 years, interest rates have been trending up. between 1982 and the present -almost 35 years - have been trending down to near zero. the chance are high that we have seen the lows on interest rates and these are likely to trend upwards in future. bonds may not be the anchor of a portfolio as in the past. i am a sort of in the camp of those that advocate equities over bonds. if the holding period is greater than say 20-30 years. 80-100% diversified portfolio with index funds is sensible.
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Re: What is the unknowability of the market?

Post by Valuethinker »

randomguy wrote:
Valuethinker wrote:
TomCat96 wrote:
I don't follow dogma. I follow logic. Boglehead philosophy prevails because not because we say it does, but because it actually, empirically works.
The stock market is unknowable. The bond market under such extreme conditions in this case was not.
You are ignoring black swan risk.

If Deutsche Bank goes, or the Middle East really cooks off, or Italy moves into default, then the market could retest the Lehman bottom. Heck it could be *worse* than the Lehman bottom.

At which point, bonds are going to look relatively clever.

Just because something didn't happen, doesn't mean it won't. Credit Anstalt went down in 1931. Lehman went down in 2008. Who knows what the financial future will bring?
Black swan risk applies to bonds also. It is hard to imagine what would cause the US bonds to go to zero but that doesn't mean that possibility doesn't exist. I am sure the early 1914 german bond buyer didn't imagine that those bonds would be worthless in 10 years. Obviously the most likely bond disaster is the more the paper cut one where rising in inflation and rates, slowly eats away at your portfolio and you don't last long enough to make to the back side where you benefit from the lowering rates and falling inflation.

In 1997-8 there was talk about how bonds were at ~30 year lows and how buying them was a suckers bet. At some point obviously things will change but those people were 15+ years early. But lets say we are right that rates are going up. Do you want to predict by how much and when. Between 1935->1956, 10 years traded pretty much traded in 2-3% range. We could very well see the same thing where .5% raises are followed by a couple of .25% drops and we spend 20 years bouncing around. Or we could do the late 60s thing and just watch soar into uncharted territory. Do you buy at the historically high rates of 5,6, and 7% since they are 70 year highs?

The question with buying bonds is what is your alternative. Buy a 5year bond paying 1.5% or a 5 year CD paying 1.5%, then you have a choice if you want to take interest rate risk or not. If your option is that 5 year bond or a money market paying 0%, you have to make guesses about if you will make enough interest to make up for the risk
Agree re CDs (there is actually still the volatility, but the way CDs work that is invisible to the holder, mathematically it would be equivalent to buying a bond at the same maturity date and YTM).

The thing with bonds is by the construction of the instrument, the nominal return is certain (barring default). Now you have inflation risk, but of course you could buy TIPS instead (certain real return).

("certain" ignoring the problem of fluctuating interest rates, only the zero coupon bond for a given maturity is actually risk free in terms of return variation; nonetheless Yield To Maturity is a pretty good estimate of the return you will get for holding a given bond).

Stocks are on a whole different level of risk. The pattern is that "there are no patterns". Like housing prices, stock returns look fractal. This very high level of risk is paid for by a high expected return (that might be lower in the future).
qwertyjazz
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Re: What is the unknowability of the market?

Post by qwertyjazz »

If a bond fund can go up by 10 percent in a year, why could it not give that up and go down by another 10 percent (for a 20 percent swing)? I am not talking about end of world or even that bonds on average do not pay back. I am talking about interest rate could change and the world relative risk view of bonds could change. A nominal bond would still pay back. I think I am asking what percentage of bond funds are marked with bonds trading above their nominal value and how secure is that. If you held the fund for a decade or two, it might all come out in the wash. But you could say the same things about equities (with the debate of whether small changes lead to a more or less stable system).
Still learning
QJ
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Valuethinker
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Re: What is the unknowability of the market?

Post by Valuethinker »

qwertyjazz wrote:If a bond fund can go up by 10 percent in a year, why could it not give that up and go down by another 10 percent (for a 20 percent swing)? I am not talking about end of world or even that bonds on average do not pay back. I am talking about interest rate could change and the world relative risk view of bonds could change. A nominal bond would still pay back. I think I am asking what percentage of bond funds are marked with bonds trading above their nominal value and how secure is that. If you held the fund for a decade or two, it might all come out in the wash. But you could say the same things about equities (with the debate of whether small changes lead to a more or less stable system).
Still learning
QJ
By the mathematics of it, except for things like 30 year bonds (and 50 year bonds are now a thing, too, in the Eurozone) bonds are less volatile than stocks-- the redemption at 100 par value at the maturity date ensures that.

You get to some odd macroeconomic stances where bonds are more volatile than stocks. One would be rapidly varying inflation year on year. Another (which is closer to what we have now) is when coupons are so low that most of the return to investors is embedded in the redemption.

Nonetheless an equity has no end date (exceping odd ones like redeemable preference shares) and so it is inherently more volatile. Also shareholders rank behind bondholders in creditor ranking, so again that makes equities inherently more risky. And of course there's no legal promise of buybacks or dividends being paid-- it's up to the Board.

The lines get blurred with HY/ junk bonds, of course. But that's not primarily about interest rate risk.
qwertyjazz
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Re: What is the unknowability of the market?

Post by qwertyjazz »

Back of an envelope calculation to understand process. The current 10 year TBill is 2.37 (I think) If in 2 years it goes up to 5% then a TBill bought today is worth about 17 percent less. The TBill was lower in the past so someoneone could have an even larger loss. This is still far less than stocks dropping on a day, but still significant.
Conversely if in the next 2 years, interest rates drop to 1% then the value goes up by 10 percent.
Add in factors for bonds not as secure as TBills and changing sentiment, then I am not so sure about bond funds stability per what I understand. As you point out the math is different with absolute value of interest rate being low as compared to possible changes (I think)
Is this an argument for individual bonds or CDs for a short term investor?

Thank you
QJ
G.E. Box "All models are wrong, but some are useful."
longinvest
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Re: What is the unknowability of the market?

Post by longinvest »

qwertyjazz wrote:Back of an envelope calculation to understand process. The current 10 year TBill is 2.37 (I think) If in 2 years it goes up to 5% then a TBill bought today is worth about 17 percent less. The TBill was lower in the past so someoneone could have an even larger loss. This is still far less than stocks dropping on a day, but still significant.
Conversely if in the next 2 years, interest rates drop to 1% then the value goes up by 10 percent.
Add in factors for bonds not as secure as TBills and changing sentiment, then I am not so sure about bond funds stability per what I understand. As you point out the math is different with absolute value of interest rate being low as compared to possible changes (I think)
Is this an argument for individual bonds or CDs for a short term investor?
QJ,

Instead of doing inaccurate back of the envelope calculations, I urge you to come up with a plausible scenario using our simulator's Bond Fund 10 to 2-years, so that we can carefully assess your yield assumptions and study their consequences.

I have previously reported about one scenario. If Treasury yields were to play in reverse during upcoming years, the consequences would be mild, specially when compared to the doom and gloom we often hear about:

viewtopic.php?f=1&t=168007#p3073222
longinvest wrote:Using our Bond Fund Simulator, I ran a simulation to see what would happen if historical yields from 1999 to 2016 (based on FRED data) were to play in reverse.

But, before I run the "reverse yield sequence" simulation, here's the result of a bond fund simulation using (normal sequence) historical yields compared to Vanguard's Total Bond Market index fund:
Image

I hope you'll agree that our simulator seems good enough to get a rough idea of what happens to bonds given a sequence of annual yields.

So, what would happen if in 2017, yields were identical to 2015, yields in 2018 identical to 2014, and so on? Here's the result of the simulation:
Image

In the reverse simulation, most annual returns were positive. The worst annual return was -3.46 in 2023 (2009), followed by another negative return of -3.20 in 2024 (2008), for a cumulative 2-year drawdown of -6.54%, which is recovered from in 2027 (2005). On the positive side, from 2025 (2007) to 2027 (2005), there was a three-year sequence of returns higher than +6%. There were various years with returns of +7.17%, +8.80%, and even +15.60%.

That's what a bear market could look like, in bonds.
Variable Percentage Withdrawal (bogleheads.org/wiki/VPW) | One-Fund Portfolio (bogleheads.org/forum/viewtopic.php?t=287967)
qwertyjazz
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Re: What is the unknowability of the market?

Post by qwertyjazz »

Ok so what I have been missing in bond funds is that they do not buy in all at once but have bonds of different dates - sort of DCA vs lumpsum - thank you longinvest for the point and especially for coming up with this cool model to play with
You need some pretty extreme assumption to cause an index like bond fund to plummet a lot - bond funds that are more speculative could but that is not what I have been interested in and worried about
So I either hold bonds to term - minus surrender issue, CDs to term except if I choose to get out early or bond funds to avoid large drops
Thank you
QJ
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nisiprius
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Re: What is the unknowability of the market?

Post by nisiprius »

qwertyjazz wrote:...Interest rates go up and they give back all the gains of the past few years...
Please, please, please put some numbers on this and flesh it out. Certainly, they could give back all of their price increases, their capital appreciation gains, but in my opinion if your reason for buying bonds is capital appreciation you are either misguided, misinformed, or doing a kind of speculation that's very different from what I do.

Over the past ten years the Vanguard Total Bond Market Index Fund has experienced
a capital appreciation of about 10%
and I agree that it would give back those capital appreciation gains, why not? It has recently given back 4% of that 10%. (Notice though that it's done that a couple of times before without giving back the rest or staying down).

Source

Image

Over the same period of time, it has grown $10,000 to $15,000, i.e.
a cumulative total return of 50%.

You can see the same ups and downs you see on the price chart, but they're riding on an overall rise that's five times as large. Three-foot waves on a fifteen-foot tide. If interest rates rise, that tide doesn't reverse, it rises faster.

Image

So, let's say I, sticking to Total Bond, "give back all the gains" in capital appreciation. I made 50%, I lose 10%. It's not cause for celebration. It's a medium bummer. A pie-in-the-face if there was some alternate strategy with the same risk/volatility/standard deviation that made the 50% without then losing the 10%. An opportunity for people to humiliate me by saying "I told you so."

But not a wealth-vaporizing apocalypse, and in no way comparable to the egg the NASDAQ laid in 2000 or any number of other stock market crashes.

I don't get why everyone gets that stock dividends are important, but can overlook that bond interest is even more important, and talk as if it were only bond prices that mattered.
Last edited by nisiprius on Fri Nov 25, 2016 10:19 am, edited 1 time in total.
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Re: What is the unknowability of the market?

Post by qwertyjazz »

Nisiprius
I put numbers into bond calculator and I completely agree with you. I was wrong. I now understand bond funds a little better.

Thank you
QJ
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Re: What is the unknowability of the market?

Post by nisiprius »

qwertyjazz wrote:Nisiprius
I put numbers into bond calculator and I completely agree with you. I was wrong. I now understand bond funds a little better.

Thank you
QJ
You're welcome. I'm not saying bond funds are the best thing to be in. I am very respectful of Kevin M's arguments of plain old bank CDs. I am also not arguing against individual bonds instead of a bond fund. I don't know, and it's your money and your responsibility.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
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