The logical fallacy behind "Bonds Are For Safety"

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HEDGEFUNDIE
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by HEDGEFUNDIE » Sat Jun 08, 2019 3:30 pm

gips wrote:
Sat Jun 08, 2019 2:22 pm
are you sure intermediate or long term bonds have higher expected returns than CDs? Those of us who invest in CDs typically do so because a) the after-tax returns are higher than intermediate and long term treasuries and b) we look for low EWPs which allow us to break the CD if rates move sharply higher.

anecdotally, over the last two years, I've opened several CDs where the rate > 4.0% with low EWPs (one has a zero EWP).
https://www.portfoliovisualizer.com/fun ... F07%2F2019

If you had invested in VGLT in Jan 2017, your CAGR would be 6.7%. If you invested in Jan 2018, your CAGR would be 5.4%

If you had invested in EDV in Jan 2017, your CAGR would be 9.3%. If you invested in Jan 2018, your CAGR would be 6.1%

And as Treasury bonds, these are both exempt from state income tax.

Show me a CD that did better.

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whodidntante
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by whodidntante » Sat Jun 08, 2019 5:07 pm

Broken Man 1999 wrote:
Fri Jun 07, 2019 3:47 pm
Fruitcake soaked with rum is very good!
Have you tried rum ham? :D

To the OP: thanks for starting this interesting thread.

gips
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by gips » Sat Jun 08, 2019 5:23 pm

>>Usually it is in the context of an admonition and/or self-affirmation to use the safest available bond category, or even cash/CDs, without any acknowledgement of the overall portfolio behavior

Is it? I don’t care enough to verify but that’s not my perception. Or perhaps it’s an admonition to not chase yield in return for credit risk.

I don’t know but I don’t think you really know either However, if you’re correct, point taken.

stlutz
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by stlutz » Sat Jun 08, 2019 5:40 pm

gips wrote:
Sat Jun 08, 2019 2:22 pm
vineviz wrote:
Fri Jun 07, 2019 2:36 pm
One context I often see ""bonds are for safety" employed is as justification for using short-term bonds (or even cash vehicles, like CDs or stable value funds) to derisk a portfolio, even when intermediate or long term bonds would not only derisk the portfolio even more while also improving its diversification and expected return.
are you sure intermediate or long term bonds have higher expected returns than CDs? Those of us who invest in CDs typically do so because a) the after-tax returns are higher than intermediate and long term treasuries and b) we look for low EWPs which allow us to break the CD if rates move sharply higher.

anecdotally, over the last two years, I've opened several CDs where the rate > 4.0% with low EWPs (one has a zero EWP).

best,
A few years back I did a bit of a backtest to see if direct-from-the-bank CDs were advantageous over an intermediate term treasury fund in a 60/40 portfolio. I found that for the 1972-2014 period the CD portfolio on average needed to yield 1.2% more than the treasury fund to break even with it. Over this time IT Treasuries has basically a 0 correlation to the stock market.

viewtopic.php?t=176932#p2681356

Further down in that thread Kevin M pointed out that he had not found it that difficult to obtain such a yield premium. But my backtest indicated that the overall benefit from the higher yielding CDs was less than might have been expected.

All of that said, you would get different results using a different asset allocation and for different periods, so I'm not suggesting that 1.2% represents some type of economic law.

My own position is that the fixed income portfolio that will produce the best returns/Sharpe ratio/portfolio risk reduction is hard to predict in advance. As such, I think it's more important to stick with an approach that is at least sensible than to come up with the optimal bond portfolio.

Where that puts me on the question of whether "bonds are for safety," I have no idea. :D

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by stlutz » Sat Jun 08, 2019 5:57 pm

vineviz wrote:
Sat Jun 08, 2019 9:45 am

To make things simple, I usually recommend using US treasury funds for the bond allocation and just matching the duration of the fund to your investment horizon (which for a retirement portfolio can be roughly approximated as your life expectancy minus your age).

So . . . for most investors under the age of 60, a long-term Treasury fund is probably the best choice in my view. As a rule I'd expect it to lower your interest rate exposure, maximize diversification, and maximize expected return for any given level of expected volatility.
Actually, that's not quite correct according to your approach. Suppose someone retires at 60 and expects to live to 90, and plans to spend down the fixed-income portion of their portfolio. She will spend the average dollar of her portfolio in 15 years, not 30 (i.e. money is getting withdrawn over time as opposed to being spent all at once at age 90). So, the preferred duration for this person would be 15, not 30.

gips
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by gips » Sat Jun 08, 2019 6:01 pm

^ yes, with Kevin on this but it would be tough to model the way we invest in CDs due to utilization of the ewp. Also, I’m in a treasury fund when I’m out of the cd market (basically waiting for an above market returm).

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by stlutz » Sat Jun 08, 2019 6:06 pm

Some of these recent threads talking about how well long-term bonds backtest are a little amusing to those of who who have been around here for 10+ years. It used to the be that the best backtesting showed that short-term bonds were advantageous over long-term bonds both from a standalone and from an overall portfolio perspective (one example of many such posts: viewtopic.php?t=99591#p1440660). That view of course has changed over time.

It used to be those those who advocated for long-term bonds were considered fools who were rejecting the clear evidence of history. This is one of my favorite such threads: viewtopic.php?t=95809

The [humorous] conclusion in the OP of that thread is well worth remembering: "A reminder to anyone investing based on historical data - the market doesn't consult the history books when deciding where to stick tomorrow's free lunch."

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sat Jun 08, 2019 6:48 pm

stlutz wrote:
Sat Jun 08, 2019 5:57 pm
vineviz wrote:
Sat Jun 08, 2019 9:45 am

To make things simple, I usually recommend using US treasury funds for the bond allocation and just matching the duration of the fund to your investment horizon (which for a retirement portfolio can be roughly approximated as your life expectancy minus your age).

So . . . for most investors under the age of 60, a long-term Treasury fund is probably the best choice in my view. As a rule I'd expect it to lower your interest rate exposure, maximize diversification, and maximize expected return for any given level of expected volatility.
Actually, that's not quite correct according to your approach. Suppose someone retires at 60 and expects to live to 90, and plans to spend down the fixed-income portion of their portfolio. She will spend the average dollar of her portfolio in 15 years, not 30 (i.e. money is getting withdrawn over time as opposed to being spent all at once at age 90). So, the preferred duration for this person would be 15, not 30.
As investors get closer to their retirement age, it is important for them to review whatever assumptions they've made to ensure they are still the best possible assumptions.

The rough approximation I provided, for instance, is just that: a rough approximation and does depend on several implicit assumptions. One assumption is retirement age that is roughly the average (not 60). Another assumption that withdrawals will be spread over their lifetime, not end at a fixed age (i.e. at 90). A third assumption is that the investor would strongly prefer to not run out of money while they are alive.

This third assumption is important, because it is the one that causes the duration calculation for an individual's expenditures to differ from the calculation for an institution that can pool its mortality exposure. Such an institution can reasonably assume, due to the law of large numbers that their realized outcome will reasonably approximate the actuarial outcome.

An individual investor is not usually in that position. If they live longer than average, they generally want to have some wealth remaining with which they can buy stuff. Let's say things like food, and shelter. This dictates that - generally - some accommodation be made for a post-mortem cash flow in the duration calculation to account for the portion of the portfolio that is spent as a bequest instead of as consumption. Under reasonable assumptions, this is the factor that extends the duration of liabilities to match the remaining life expectancy.

As I said, any particular investor might be able to estimate the duration of their liabilities more precisely. And their iindividual circumstances may differ from the ones I assume (e.g they purchased some form of longevity insurance that allows them to spend all their wealth by date X). Those things are a lot easier to account for at 2 years before retirement than at 20 years before retirement.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Mountain Doc
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Mountain Doc » Sat Jun 08, 2019 7:30 pm

siriusblack wrote:
Sat Jun 08, 2019 10:52 am
Mountain Doc wrote:
Fri Jun 07, 2019 1:20 pm
I have little doubt that a portfolio of stocks and long-term bonds has been the most efficient. Honestly, it has been a thing of beauty to see MPT at work.

However, I have little confidence that our historical record includes all possible crises. It is entirely possible that a future crisis might be one that is uniquely detrimental to both stocks and long-term bonds in favor of short-term bonds. Since I try to choose a portfolio that minimizes the risk of severe regret, and therefore one I can stick with through all circumstances, I default to broad diversification (in the sense of more asset classes - even within bonds).

So, yes, I guess I am raising objection #1 in earnest :D
Does the Vanguard Total Bond Market fund offer broad diversification within bonds? What would it look like to broadly diversify within bonds? What % of TIPS, corporate, US, non-US, short term, long term, etc.? (This is genuine question-- not an argument. I've really never thought seriously about achieving bond diversification or how to go about it. This thread is really an eye opener for me.)
If I'm not mistaken, there was a time when Rick Ferri suggested 60% Total Bond, 20% TIPS, and 20% junk bonds to better reflect the entirety of the bond market. In recent years, due to his increased appreciation for simplicity, I think he has decided Total Bond is "good enough," and that is pretty much where I land when trying to balance diversification with simplicity.

To elaborate on my point about diversification... the risks associated with being under-diversified are far greater than the risks associated with being over-diversified.** The potential for regret is not symmetric. Suppose the next crisis is one of severe inflation. In that scenario, both stocks and long-term bonds might really suffer, whereas short-term bonds would likely shine. If I had chosen to use only long-term bonds in that scenario, I would probably chastise myself for having a narrow bond portfolio and might be tempted to diversify into short-term bonds after painful underperformance. Now, instead, suppose the future is similar to the last 30 years, and a portfolio of stocks and long-term bonds shines. If I had chosen to use the Total Bond Market in that scenario, I probably wouldn't even notice!

To summarize, I would rather over-diversify and be wrong than under-diversify and be wrong.

**I am referring to diversification in the sense of asset classes. Vineviz is discussing a different perspective on diversification that includes historical correlation, which may or may not hold true in the future.
Last edited by Mountain Doc on Sat Jun 08, 2019 7:38 pm, edited 1 time in total.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by columbia » Sat Jun 08, 2019 7:38 pm

stlutz wrote:
Sat Jun 08, 2019 6:06 pm
Some of these recent threads talking about how well long-term bonds backtest are a little amusing to those of who who have been around here for 10+ years. It used to the be that the best backtesting showed that short-term bonds were advantageous over long-term bonds both from a standalone and from an overall portfolio perspective (one example of many such posts: viewtopic.php?t=99591#p1440660). That view of course has changed over time.

It used to be those those who advocated for long-term bonds were considered fools who were rejecting the clear evidence of history. This is one of my favorite such threads: viewtopic.php?t=95809

The [humorous] conclusion in the OP of that thread is well worth remembering: "A reminder to anyone investing based on historical data - the market doesn't consult the history books when deciding where to stick tomorrow's free lunch."
The more didactic one is about being right about financial markets (particularly in the long run), the more likely it is that one will be wrong.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Northern Flicker » Sat Jun 08, 2019 9:40 pm

An even larger error is measuring variance and the effectiveness of diversification in nominal terms for investments with a long time horizon.

It should be obvious that over a long time horizon real returns are what matters. When inflation tail risk is properly quantified, the diversification of equities with long-term nominal treasuries is exposed as taking considerable risk. The diversification fails to protect the investor in this scenario, which realistically can happen.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by willthrill81 » Sat Jun 08, 2019 9:49 pm

stlutz wrote:
Sat Jun 08, 2019 6:06 pm
Some of these recent threads talking about how well long-term bonds backtest are a little amusing to those of who who have been around here for 10+ years. It used to the be that the best backtesting showed that short-term bonds were advantageous over long-term bonds both from a standalone and from an overall portfolio perspective (one example of many such posts: viewtopic.php?t=99591#p1440660). That view of course has changed over time.

It used to be those those who advocated for long-term bonds were considered fools who were rejecting the clear evidence of history. This is one of my favorite such threads: viewtopic.php?t=95809
Over the 1970-1981 period, LTT were hit particularly hard.

I can't help but wonder how many of the analyses done around here involving bonds in Portfolio Visualizer are so biased by the bull market in bonds from 1982-2012.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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JoMoney
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by JoMoney » Sat Jun 08, 2019 10:17 pm

willthrill81 wrote:
Sat Jun 08, 2019 9:49 pm
...
Over the 1970-1981 period, LTT were hit particularly hard.

I can't help but wonder how many of the analyses done around here involving bonds in Portfolio Visualizer are so biased by the bull market in bonds from 1982-2012.
They were "hit hard" for a longer period than that, by 1970 they were starting to gain some ground :shock: ...

Image

Even looking at what PortfolioVisualizer shows and the good returns from Long-Term bonds over that specific period, the "correlation" to US Stock Market was 0.05 ... practically zero, so if you were hoping for it to "zig" when stocks "zagged" , it didn't inversely 'zig' about as often as it did 'zig'...
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by fennewaldaj » Sun Jun 09, 2019 12:08 am

HEDGEFUNDIE wrote:
Sat Jun 08, 2019 10:01 am
JoMoney wrote:
Sat Jun 08, 2019 9:57 am
Person A can easily ignore the interaction of their bond fund and other portfolio components.
They are, of course, free to ignore it.

And I am free to point out the obvious mental accounting that involves, and the suboptimal portfolio that results.
Sure. I am not sure mental accounting is illogical for everone though. I think for many some degree of mental accounting give them a lot of peace of mind. So it maximizes their utility (and I think it is often logical to maximize utility). For example emergency funds are commonly used even by people with large taxable accounts. This is clearly mental accounting but I think it would be a stretch to call it illogical. So I think having buckets is not necessary illogical. I don't myself but I understand why one would. Now you could argue it is illogical to rebalance while ignoring the interaction of portfolio components and I would agree. But I think the use of any financial asset requires something of a leap of faith that the future will resemble the past to some degree. I think most on this forum are willing to make that leap re equities. Less are willing to make that leap regarding long term bonds and factors. Many simply will not be convinced enough be backtest to consider a certain option like long term bonds vs total bond superior. So they pick a middle ground that will be unlikely to be totally horrible. The evidence we have is simply not strong enough for no value judgments/leaps of faith to be required.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by fennewaldaj » Sun Jun 09, 2019 12:18 am

vineviz wrote:
Sat Jun 08, 2019 3:23 pm
gips wrote:
Sat Jun 08, 2019 2:22 pm
what is the context of the oft-repeated statement "bonds are for safety"?
Usually it is in the context of an admonition and/or self-affirmation to use the safest available bond category, or even cash/CDs, without any acknowledgement of the overall portfolio behavior.

And the broader point is this: the aggregate behavior the portfolio is what matters, not the pieces in isolation.
It seems like it gets used to steer people away from HY bonds a lot. The funny thing is that HY bonds are a mediocre asset class because they don't add that much to the portfolio as a whole not because there is anything wrong with them in isolation.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by YRT70 » Sun Jun 09, 2019 3:05 am

Vanguard seems to have a good rationale for using global bonds (hedged), yet I don't see anyone talking about them in this thread. Why is that?
An allocation to global bond markets gives investors exposure to a greater number of
securities, markets, and economic and inflation environments than they would have with
a portfolio composed purely of local market fixed income. In theory, this diversification
can help reduce a portfolio’s volatility without necessarily decreasing its total return.

■ We tested the empirical reality across five markets: the United States, Canada, the
United Kingdom, the euro area, and Australia. In each market, reality confirms theory—
but with a critical qualifier: The key to realizing the diversification potential of global
bonds is to hedge the currency exposure back to the investor’s local currency.

■ Although the benefits of global bond diversification are clear, the optimal strategic
allocation depends on investor-specific factors such as the desire to mitigate risk, the
cost of implementation, and liability management objectives. We explore how these
factors influence the size of an investment in hedged global bonds.
https://personal.vanguard.com/pdf/ISGGLBD.pdf

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by rkhusky » Sun Jun 09, 2019 4:07 am

fennewaldaj wrote:
Sun Jun 09, 2019 12:18 am
vineviz wrote:
Sat Jun 08, 2019 3:23 pm
gips wrote:
Sat Jun 08, 2019 2:22 pm
what is the context of the oft-repeated statement "bonds are for safety"?
Usually it is in the context of an admonition and/or self-affirmation to use the safest available bond category, or even cash/CDs, without any acknowledgement of the overall portfolio behavior.

And the broader point is this: the aggregate behavior the portfolio is what matters, not the pieces in isolation.
It seems like it gets used to steer people away from HY bonds a lot. The funny thing is that HY bonds are a mediocre asset class because they don't add that much to the portfolio as a whole not because there is anything wrong with them in isolation.
Or steer people away from the idea that dividend paying stocks can replace bonds.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Slick8503 » Sun Jun 09, 2019 6:26 am

Risk parity portfolios are the five years ago permanent portfolios it seems. Just substitute gold and st bonds with more equities and lt bonds because gold has had a rough patch so it doesn’t backrest as well in comparison now.

No doubt the story regarding holding only lt bonds with equities seems very logical or even optimal, but so did the pp or any number of other recent top performers over the years.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 7:49 am

rkhusky wrote:
Sun Jun 09, 2019 4:07 am
fennewaldaj wrote:
Sun Jun 09, 2019 12:18 am
vineviz wrote:
Sat Jun 08, 2019 3:23 pm
gips wrote:
Sat Jun 08, 2019 2:22 pm
what is the context of the oft-repeated statement "bonds are for safety"?
Usually it is in the context of an admonition and/or self-affirmation to use the safest available bond category, or even cash/CDs, without any acknowledgement of the overall portfolio behavior.

And the broader point is this: the aggregate behavior the portfolio is what matters, not the pieces in isolation.
It seems like it gets used to steer people away from HY bonds a lot. The funny thing is that HY bonds are a mediocre asset class because they don't add that much to the portfolio as a whole not because there is anything wrong with them in isolation.
Or steer people away from the idea that dividend paying stocks can replace bonds.
I didn't mention this in the OP, but it's likely that the "bonds are for safety" aphorism (at least in the context I was describing) is a combination of both a logical fallacy (fallacy of composition) and a behavioral bias (loss aversion).

As you have identified, I think there is an entire constellation of investor behaviors where this particular combination of logical fallacy and behavioral bias interact in varying degrees to provoke what can be counterproductive investment approaches (e.g. bonds are for safety, reach for yield, preference for dividends over total return, etc.). Add in recency bias and you've got a dangerous cocktail.

Investing is simple, but it isn't easy. As they say.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Jmh04j » Sun Jun 09, 2019 9:41 am

What about active bond funds? Would this be a better strategy than a long term bond index fund for a young investor?

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 9:43 am

Jmh04j wrote:
Sun Jun 09, 2019 9:41 am
What about active bond funds? Would this be a better strategy than a long term bond index fund for a young investor?
Almost certainly not.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by willthrill81 » Sun Jun 09, 2019 10:06 am

fennewaldaj wrote:
Sun Jun 09, 2019 12:08 am
I think for many some degree of mental accounting give them a lot of peace of mind. So it maximizes their utility (and I think it is often logical to maximize utility). For example emergency funds are commonly used even by people with large taxable accounts. This is clearly mental accounting but I think it would be a stretch to call it illogical.
I'm inclined to agree. Everyone is seeking to maximize something, but exactly what they're trying to maximize can be hard to pin down. It's certainly true that maximizing one's returns is not the goal of many investors, nor is the maximization of risk-adjusted returns. Many investors could be well served by attempting to minimize their maximum regret.

Like it or not, humans aren't robots, and we don't have universal goals, much less universal means of achieving any one particular goal.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by JoMoney » Sun Jun 09, 2019 10:48 am

willthrill81 wrote:
Sun Jun 09, 2019 10:06 am
fennewaldaj wrote:
Sun Jun 09, 2019 12:08 am
I think for many some degree of mental accounting give them a lot of peace of mind. So it maximizes their utility (and I think it is often logical to maximize utility). For example emergency funds are commonly used even by people with large taxable accounts. This is clearly mental accounting but I think it would be a stretch to call it illogical.
I'm inclined to agree. Everyone is seeking to maximize something, but exactly what they're trying to maximize can be hard to pin down. It's certainly true that maximizing one's returns is not the goal of many investors, nor is the maximization of risk-adjusted returns. Many investors could be well served by attempting to minimize their maximum regret.

Like it or not, humans aren't robots, and we don't have universal goals, much less universal means of achieving any one particular goal.
It's notable what the inventor of MPT (Markowitz) is doing...
https://www.thinkadvisor.com/2019/04/15 ... 0509113902
... When long-term tax exempt bonds get to 4%, I’m going to rebalance. I’m just letting it ride and ignoring the bond market until interest rates come up to a level that interests me ...
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by HEDGEFUNDIE » Sun Jun 09, 2019 11:30 am

I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 11:53 am

HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.
Or scour the internet until they find an “expert” who says something that seems to absolve them of their error.

Bonus bias: confirmation bias.
Bonus logical fallacy: appeal to authority.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by abc132 » Sun Jun 09, 2019 12:08 pm

HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.
Bogleheads:
"The forum's members discuss financial news and theory, while also helping less experienced investors develop their portfolios."

I think it's OK to do whatever one wants individually, but if/when there becomes a support group for poor behavior, the site is no longer serving the interests of less experienced investors. Minimizing regret for an inexperienced investor is a recipe for financial disaster - when fear replaces knowledge and understanding, many things can go wrong.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by JoMoney » Sun Jun 09, 2019 12:09 pm

HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...
If it's an inherent human attribute, it may not be something that can be changed (even if they recognize it). If they find working with a particular behavioral bias productive, why would they try to change? Some biases have survived because they are beneficial to survival.
If you can show where someone is doing something that's causing them unnecessary misery or failing to achieve their goals, that might be worthwhile discussion... but so far this thread seems to be full of un-actionable comments about an imagined fallacious straw-man who is both a practitioner of MPT and "illogically" not following the theorized model that requires using back-tested data or guesstimated "expected returns" (neither of which work) to form some optimal portfolio (that even in examples isn't "optimal" accept under certain constraints and time period specific intervals).
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Bfwolf » Sun Jun 09, 2019 12:38 pm

Doesn't CAPM state that the highest return portfolio for any given level of risk is a mixture of the total market of risky investments and a riskless investment? The riskless investment proxy is a very short term Treasury note. So why are you proposing long term treasury notes?

Edit: Originally I said Modern Portfolio Theory but I guess I meant CAPM

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Northern Flicker » Sun Jun 09, 2019 1:09 pm

HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...
Others “validate” their position with a 2-year backtest on portfoliovisualizer.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by willthrill81 » Sun Jun 09, 2019 1:10 pm

JoMoney wrote:
Sun Jun 09, 2019 12:09 pm
HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...
If it's an inherent human attribute, it may not be something that can be changed (even if they recognize it). If they find working with a particular behavioral bias productive, why would they try to change? Some biases have survived because they are beneficial to survival.
If you can show where someone is doing something that's causing them unnecessary misery or failing to achieve their goals, that might be worthwhile discussion... but so far this thread seems to be full of un-actionable comments about an imagined fallacious straw-man who is both a practitioner of MPT and "illogically" not following the theorized model that requires using back-tested data or guesstimated "expected returns" (neither of which work) to form some optimal portfolio (that even in examples isn't "optimal" accept under certain constraints and time period specific intervals).
Loss aversion is one of them. Further, loss aversion has some mathematical basis (i.e. a 50% loss requires a 100% gain to break-even).
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 1:12 pm

Bfwolf wrote:
Sun Jun 09, 2019 12:38 pm
Doesn't CAPM state that the highest return portfolio for any given level of risk is a mixture of the total market of risky investments and a riskless investment? The riskless investment proxy is a very short term Treasury note. So why are you proposing long term treasury notes?

Edit: Originally I said Modern Portfolio Theory but I guess I meant CAPM
There are a number of unrealistic assumptions needed to get that theoretical result under CAPM, never mind that CAPM doesn’t really work that well to begin with.

One problematic assumption is that investors can both borrow AND lend at the risk free rate, to leverage the market portfolio up or down to match their risk aversion levels. This is clearly not possible.

The main practical problem within the CAPM framework is that the market portfolio would be 45% global equities and 55% global bonds. A fund like VTWAX would be a reasonable approximation of global equities, but the bonds would need to include all marketable bonds (including high-yield US and foreign bonds) with no currency hedging. It wouldn’t be simple to build such a bond portfolio even if you wanted too.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 1:14 pm

willthrill81 wrote:
Sun Jun 09, 2019 1:10 pm
JoMoney wrote:
Sun Jun 09, 2019 12:09 pm
HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...
If it's an inherent human attribute, it may not be something that can be changed (even if they recognize it). If they find working with a particular behavioral bias productive, why would they try to change? Some biases have survived because they are beneficial to survival.
If you can show where someone is doing something that's causing them unnecessary misery or failing to achieve their goals, that might be worthwhile discussion... but so far this thread seems to be full of un-actionable comments about an imagined fallacious straw-man who is both a practitioner of MPT and "illogically" not following the theorized model that requires using back-tested data or guesstimated "expected returns" (neither of which work) to form some optimal portfolio (that even in examples isn't "optimal" accept under certain constraints and time period specific intervals).
Loss aversion is one of them. Further, loss aversion has some mathematical basis (i.e. a 50% loss requires a 100% gain to break-even).
Except that isn’t what the behavioral bias known as loss aversion refers to.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by HEDGEFUNDIE » Sun Jun 09, 2019 1:15 pm

Northern Flicker wrote:
Sun Jun 09, 2019 1:09 pm
HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...
Others “validate” their position with a 2-year backtest on portfoliovisualizer.
That was a specific test for a specific question.

Here is a 41 year backtest using all the available data, but I’m guessing this won’t satisfy you either.

https://www.portfoliovisualizer.com/bac ... 0&total3=0

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by willthrill81 » Sun Jun 09, 2019 1:16 pm

vineviz wrote:
Sun Jun 09, 2019 1:14 pm
willthrill81 wrote:
Sun Jun 09, 2019 1:10 pm
JoMoney wrote:
Sun Jun 09, 2019 12:09 pm
HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...
If it's an inherent human attribute, it may not be something that can be changed (even if they recognize it). If they find working with a particular behavioral bias productive, why would they try to change? Some biases have survived because they are beneficial to survival.
If you can show where someone is doing something that's causing them unnecessary misery or failing to achieve their goals, that might be worthwhile discussion... but so far this thread seems to be full of un-actionable comments about an imagined fallacious straw-man who is both a practitioner of MPT and "illogically" not following the theorized model that requires using back-tested data or guesstimated "expected returns" (neither of which work) to form some optimal portfolio (that even in examples isn't "optimal" accept under certain constraints and time period specific intervals).
Loss aversion is one of them. Further, loss aversion has some mathematical basis (i.e. a 50% loss requires a 100% gain to break-even).
Except that isn’t what the behavioral bias known as loss aversion refers to.
Yes it is.
In cognitive psychology and decision theory, loss aversion refers to people's tendency to prefer avoiding losses to acquiring equivalent gains: it is better to not lose $5 than to find $5.
https://en.wikipedia.org/wiki/Loss_aversion

From an investment standpoint, it is better to avoid a 5% decline than to acquire a 5% gain.
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Northern Flicker » Sun Jun 09, 2019 1:31 pm

HEDGEFUNDIE wrote:
Sun Jun 09, 2019 1:15 pm
Northern Flicker wrote:
Sun Jun 09, 2019 1:09 pm
HEDGEFUNDIE wrote:
Sun Jun 09, 2019 11:30 am
I find it interesting how some Bogleheads’ first instinct when confronted with a behavioral anomaly is not to correct the behavior, but rather to build one’s portfolio around it.

Fits in with the general conservatism and pessimism around here, I suppose...
Others “validate” their position with a 2-year backtest on portfoliovisualizer.
That was a specific test for a specific question.

Here is a 41 year backtest using all the available data, but I’m guessing this won’t satisfy you either.

https://www.portfoliovisualizer.com/bac ... 0&total3=0
Try 1967-1981.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by HEDGEFUNDIE » Sun Jun 09, 2019 1:36 pm

fennewaldaj wrote:
Sun Jun 09, 2019 12:08 am
Now you could argue it is illogical to rebalance while ignoring the interaction of portfolio components and I would agree. But I think the use of any financial asset requires something of a leap of faith that the future will resemble the past to some degree. I think most on this forum are willing to make that leap re equities. Less are willing to make that leap regarding long term bonds and factors. Many simply will not be convinced enough be backtest to consider a certain option like long term bonds vs total bond superior. So they pick a middle ground that will be unlikely to be totally horrible. The evidence we have is simply not strong enough for no value judgments/ leaps of faith to be required.
I like this comment a lot. I think we can make a lot of headway on these threads simply by stating what it is you have to believe to accept that the patterns as stated are reliable, and what incremental benefit you gain if you do accept them.

I would say that the fundamental driver of asset correlations is the interest rate environment. If you believe that our low-growth, low-inflation environment is here to stay for the duration of your investment horizon, then you should be buying everything vineviz & I are selling.

If not, then I would not begrudge you for hedging your bets.

And if you don’t know what will happen with interest rates, then what you should fall back on is the term premium, which is almost always positive. In this case you should match your bond duration with your investment horizon, which means long treasuries for almost everyone.
Northern Flicker wrote:
Sun Jun 09, 2019 1:31 pm
Try 1967-1981.
One last point, we get accused a lot of recency bias around here, but surely the opposite bias exists as well. I don’t think it has a pithy name; basically it’s the bias that anything that has happened in the past is just as likely to happen again. Which totally ignores the underlying drivers of why such a thing happened in the first place, and ignores the meaningful (and difficult) analysis of whether those conditions are likely to repeat in the future. It’s just lazy thinking, in line with “nobody knows nuthin’”.
Last edited by HEDGEFUNDIE on Sun Jun 09, 2019 2:30 pm, edited 2 times in total.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Jmh04j » Sun Jun 09, 2019 1:37 pm

vineviz wrote:
Sun Jun 09, 2019 9:43 am
Jmh04j wrote:
Sun Jun 09, 2019 9:41 am
What about active bond funds? Would this be a better strategy than a long term bond index fund for a young investor?
Almost certainly not.
I have read this thread with great interest. Below are what I think are the main takeaways:

- Bonds are for safety is a fallacy. As such, an investor should look for the optimal duration risk given their time horizon. For example, if you are a young investor long term treasuries make sense because you have the opportunity for significant upside (or downside) in price appreciation. Total bond fund does not provide the same level of upside of price appreciation.

Am I missing something? I am in my early 30s and am currently invested 90% stock and 10% bonds. My bond allocation is total bond. I am OK with price volatility. Should I be looking towards long term treasuries to try and capture some price appreciation as my time horizon is very long?

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by willthrill81 » Sun Jun 09, 2019 1:41 pm

Jmh04j wrote:
Sun Jun 09, 2019 1:37 pm
vineviz wrote:
Sun Jun 09, 2019 9:43 am
Jmh04j wrote:
Sun Jun 09, 2019 9:41 am
What about active bond funds? Would this be a better strategy than a long term bond index fund for a young investor?
Almost certainly not.
I have read this thread with great interest. Below are what I think are the main takeaways:

- Bonds are for safety is a fallacy. As such, an investor should look for the optimal duration risk given their time horizon. For example, if you are a young investor long term treasuries make sense because you have the opportunity for significant upside (or downside) in price appreciation. Total bond fund does not provide the same level of upside of price appreciation.

Am I missing something? I am in my early 30s and am currently invested 90% stock and 10% bonds. My bond allocation is total bond. I am OK with price volatility. Should I be looking towards long term treasuries to try and capture some price appreciation as my time horizon is very long?
With interest rates being as low as they are now, long-term Treasuries don't have nearly the upside potential that they did 40 years ago.

Even if we look at the 42 period from 1978-2019, which included the 31 year bond bull market from 1982-2012, a portfolio with 90% TSM and 10% long-term Treasuries only had a .19% higher annual return and essentially identical volatility to a portfolio with 10% in intermediate-term Treasuries, which is roughly equivalent to the total bond market.

I find it interesting how many folks around here advocate owning LTT, which are currently yield 2.57%, rather than paying down a mortgage with a rate that's 1% higher or even more.
Last edited by willthrill81 on Sun Jun 09, 2019 1:43 pm, edited 1 time in total.
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 1:42 pm

willthrill81 wrote:
Sun Jun 09, 2019 1:16 pm
Yes it is.
In cognitive psychology and decision theory, loss aversion refers to people's tendency to prefer avoiding losses to acquiring equivalent gains: it is better to not lose $5 than to find $5.
https://en.wikipedia.org/wiki/Loss_aversion
You should read that quoted sentence again. Loss aversion, in this example, refers to a preference for losing $0 over gaining $5.

Of course people prefer to gain $5 rather than lose $5: that's not loss aversion, that's just an arbitrage.

Here's another hypothetical example of loss aversion: a loss averse investor would prefer an investment that loses $5 over one that loses $10 then gains $7.

Anyway, if you're really interested in this topic you'll probably need to read beyond Wikipedia.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Jmh04j » Sun Jun 09, 2019 1:46 pm

willthrill81 wrote:
Sun Jun 09, 2019 1:41 pm
Jmh04j wrote:
Sun Jun 09, 2019 1:37 pm
vineviz wrote:
Sun Jun 09, 2019 9:43 am
Jmh04j wrote:
Sun Jun 09, 2019 9:41 am
What about active bond funds? Would this be a better strategy than a long term bond index fund for a young investor?
Almost certainly not.
I have read this thread with great interest. Below are what I think are the main takeaways:

- Bonds are for safety is a fallacy. As such, an investor should look for the optimal duration risk given their time horizon. For example, if you are a young investor long term treasuries make sense because you have the opportunity for significant upside (or downside) in price appreciation. Total bond fund does not provide the same level of upside of price appreciation.

Am I missing something? I am in my early 30s and am currently invested 90% stock and 10% bonds. My bond allocation is total bond. I am OK with price volatility. Should I be looking towards long term treasuries to try and capture some price appreciation as my time horizon is very long?
With interest rates being as low as they are now, long-term Treasuries don't have nearly the upside potential that they did 40 years ago.

Even if we look at the 42 period from 1978-2019, which included the 31 year bond bull market from 1982-2012, a portfolio with 90% TSM and 10% long-term Treasuries only had a .19% higher annual return and essentially identical volatility to a portfolio with 10% in intermediate-term Treasuries, which is roughly equivalent to the total bond market.

I find it interesting how many folks around here advocate owning LTT, which are currently yield 2.57%, rather than paying down a mortgage with a rate that's 1% higher or even more.
I understand the math but I think a lot of people (including me) are willing to pay a “liquidity premium” in case the money is needed later. You can’t get partial principal payments back.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by willthrill81 » Sun Jun 09, 2019 1:47 pm

vineviz wrote:
Sun Jun 09, 2019 1:42 pm
willthrill81 wrote:
Sun Jun 09, 2019 1:16 pm
Yes it is.
In cognitive psychology and decision theory, loss aversion refers to people's tendency to prefer avoiding losses to acquiring equivalent gains: it is better to not lose $5 than to find $5.
https://en.wikipedia.org/wiki/Loss_aversion
You should read that quoted sentence again. Loss aversion, in this example, refers to a preference for losing $0 over gaining $5.

Of course people prefer to gain $5 rather than lose $5: that's not loss aversion, that's just an arbitrage.

Here's another hypothetical example of loss aversion: a loss averse investor would prefer an investment that loses $5 over one that loses $10 then gains $7.

Anyway, if you're really interested in this topic you'll probably need to read beyond Wikipedia.
In your example, the losses and gains are not equivalent.

The Wikipedia page is not inaccurate; other sources provide similar explanations. I'm not saying that loss aversion is entirely logical, but it partly is.

And by the way, I've published work in the area of loss aversion, so I've been deemed by my peers to understand the topic well.
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by willthrill81 » Sun Jun 09, 2019 1:48 pm

Jmh04j wrote:
Sun Jun 09, 2019 1:46 pm
willthrill81 wrote:
Sun Jun 09, 2019 1:41 pm
Jmh04j wrote:
Sun Jun 09, 2019 1:37 pm
vineviz wrote:
Sun Jun 09, 2019 9:43 am
Jmh04j wrote:
Sun Jun 09, 2019 9:41 am
What about active bond funds? Would this be a better strategy than a long term bond index fund for a young investor?
Almost certainly not.
I have read this thread with great interest. Below are what I think are the main takeaways:

- Bonds are for safety is a fallacy. As such, an investor should look for the optimal duration risk given their time horizon. For example, if you are a young investor long term treasuries make sense because you have the opportunity for significant upside (or downside) in price appreciation. Total bond fund does not provide the same level of upside of price appreciation.

Am I missing something? I am in my early 30s and am currently invested 90% stock and 10% bonds. My bond allocation is total bond. I am OK with price volatility. Should I be looking towards long term treasuries to try and capture some price appreciation as my time horizon is very long?
With interest rates being as low as they are now, long-term Treasuries don't have nearly the upside potential that they did 40 years ago.

Even if we look at the 42 period from 1978-2019, which included the 31 year bond bull market from 1982-2012, a portfolio with 90% TSM and 10% long-term Treasuries only had a .19% higher annual return and essentially identical volatility to a portfolio with 10% in intermediate-term Treasuries, which is roughly equivalent to the total bond market.

I find it interesting how many folks around here advocate owning LTT, which are currently yield 2.57%, rather than paying down a mortgage with a rate that's 1% higher or even more.
I understand the math but I think a lot of people (including me) are willing to pay a “liquidity premium” in case the money is needed later. You can’t get partial principal payments back.
There is a case to be made for liquidity, to be sure, but is that liquidity worth 1% or more negative arbitrage? How much is the need for liquidity logical vs. emotional?
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Jmh04j » Sun Jun 09, 2019 1:54 pm

willthrill81 wrote:
Sun Jun 09, 2019 1:48 pm
Jmh04j wrote:
Sun Jun 09, 2019 1:46 pm
willthrill81 wrote:
Sun Jun 09, 2019 1:41 pm
Jmh04j wrote:
Sun Jun 09, 2019 1:37 pm
vineviz wrote:
Sun Jun 09, 2019 9:43 am


Almost certainly not.
I have read this thread with great interest. Below are what I think are the main takeaways:

- Bonds are for safety is a fallacy. As such, an investor should look for the optimal duration risk given their time horizon. For example, if you are a young investor long term treasuries make sense because you have the opportunity for significant upside (or downside) in price appreciation. Total bond fund does not provide the same level of upside of price appreciation.

Am I missing something? I am in my early 30s and am currently invested 90% stock and 10% bonds. My bond allocation is total bond. I am OK with price volatility. Should I be looking towards long term treasuries to try and capture some price appreciation as my time horizon is very long?
With interest rates being as low as they are now, long-term Treasuries don't have nearly the upside potential that they did 40 years ago.

Even if we look at the 42 period from 1978-2019, which included the 31 year bond bull market from 1982-2012, a portfolio with 90% TSM and 10% long-term Treasuries only had a .19% higher annual return and essentially identical volatility to a portfolio with 10% in intermediate-term Treasuries, which is roughly equivalent to the total bond market.

I find it interesting how many folks around here advocate owning LTT, which are currently yield 2.57%, rather than paying down a mortgage with a rate that's 1% higher or even more.
I understand the math but I think a lot of people (including me) are willing to pay a “liquidity premium” in case the money is needed later. You can’t get partial principal payments back.
There is a case to be made for liquidity, to be sure, but is that liquidity worth 1% or more negative arbitrage? How much is the need for liquidity logical vs. emotional?
It is definitely emotional. For example, last month I was sitting on a pile for cash and spent a week trying to find the best money market / ultra short term bond fund to put it in. It was getting a little ridiculous harping over a few bps here or there when I came to the obvious conclusion to just payoff my 3% auto loan.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by Bfwolf » Sun Jun 09, 2019 1:58 pm

vineviz wrote:
Sun Jun 09, 2019 1:12 pm
Bfwolf wrote:
Sun Jun 09, 2019 12:38 pm
Doesn't CAPM state that the highest return portfolio for any given level of risk is a mixture of the total market of risky investments and a riskless investment? The riskless investment proxy is a very short term Treasury note. So why are you proposing long term treasury notes?

Edit: Originally I said Modern Portfolio Theory but I guess I meant CAPM
There are a number of unrealistic assumptions needed to get that theoretical result under CAPM, never mind that CAPM doesn’t really work that well to begin with.

One problematic assumption is that investors can both borrow AND lend at the risk free rate, to leverage the market portfolio up or down to match their risk aversion levels. This is clearly not possible.

The main practical problem within the CAPM framework is that the market portfolio would be 45% global equities and 55% global bonds. A fund like VTWAX would be a reasonable approximation of global equities, but the bonds would need to include all marketable bonds (including high-yield US and foreign bonds) with no currency hedging. It wouldn’t be simple to build such a bond portfolio even if you wanted too.
So what I'm trying to get at is: forgetting about the empirical evidence for a minute, what is the theoretical underpinning which would suggest that a Total Stock Market + Long Term Treasury Bond approach would be close to the ideal way of maximizing risk/return?

I think that markets are mostly efficient and that past behavioral inefficiencies can't be counted on in the future. It's one of the reasons I don't invest in Momentum, no matter how many Nobel prize winners say they believe in it.

So what's the logic here that makes this proposed combination less risky for its level of return?

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by jmk » Sun Jun 09, 2019 3:13 pm

vineviz wrote:
Fri Jun 07, 2019 12:31 pm
jmk wrote:
Fri Jun 07, 2019 12:12 pm
You are not correct: there is no "fallacy of composition" in saying "Bonds are for Safety".
That's not my saying: I've lost track of how many times I've seen that exact phrase here, but Google tells me it's over 500.
Whomever says it, and even if true, it is not the fallacy of composition. A bond which I purchase to equal liability 20 years later is for practical purposes as safe as a collection of liability matching bonds, and many times over safer than equities. The fallacy of composition implies the collection is somehow different from the sum of its parts.

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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 3:23 pm

willthrill81 wrote:
Sun Jun 09, 2019 1:47 pm
In your example, the losses and gains are not equivalent.

The Wikipedia page is not inaccurate; other sources provide similar explanations. I'm not saying that loss aversion is entirely logical, but it partly is.
That in equivalence in my example was intentional: if the losses and gains are equivalent then the rational investor should be indifferent between those outcomes. Having a preference anyway is what I'd call a weak form of loss aversion. Curious, but not usually deleterious in an investment context.

Far worse though, and relevant to the current discussion, is loss aversion so strong that it causes a preference for an inferior outcome merely because the investor frames it as a loss. This is the case my last example was illustrating.

Obviously, a rational person will prefer a gain to a loss. That's not in dispute, and it is also not loss aversion.

Loss aversion is, indeed accurately described in that Wikipedia article: a "tendency to prefer avoiding losses to acquiring equivalent gains". A classic example is that loss aversion will cause people to prefer to avoid paying a $5 surcharge rather than pay the surcharge and also receive a $5 discount.

These are objectively equivalent outcomes (i.e. X = X + 5 -5) but people with loss aversion don't perceive them as being equivalent.

In the context of my original comment (with fallacy of composition thrown in), imagine the two following choices:

Fund A has a 5% chance of having a -3% return and 95% chance of having a +6% return.

Fund B has a 5% chance of having a -12% return and 95% chance of having a +7% return.

Any behavioral economist will tell you that picking Fund A is an example of loss aversion.
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 3:26 pm

jmk wrote:
Sun Jun 09, 2019 3:13 pm
The fallacy of composition implies the collection is somehow different from the sum of its parts.
Sort of. The fallacy of composition involves attributing the characteristics of one (or more) components to the whole.

Example: Bob is from New Jersey. Bob is rude. Therefore people from New Jersey are rude.

It is ALSO true that portfolio IS different from the sum of its parts, but that's ancillary to the fallacy of composition.
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by vineviz » Sun Jun 09, 2019 3:45 pm

Bfwolf wrote:
Sun Jun 09, 2019 1:58 pm
So what I'm trying to get at is: forgetting about the empirical evidence for a minute, what is the theoretical underpinning which would suggest that a Total Stock Market + Long Term Treasury Bond approach would be close to the ideal way of maximizing risk/return?
The theoretical argument would flow (in HIGHLY simplified form) something like this:

1) the market portfolio reflects that aggregate (or average) of everyone's highest risk-adjusted (or mean-variance optimal) portfolio;
2) variance does not reflect every risk that investors face;
3) every investor faces a different combination of risks;
4) therefore, the market portfolio cannot have the highest risk-adjusted return for every investor;
5) each investor's optimal risk-adjusted portfolio may be different from the market portfolio.

Your highest risk-adjusted return portfolio will be one that is heavily exposed to risks that don't affect you and weakly exposed to risks that affect you a lot.

Follow?

A slight aside that is critically important: term risk (or duration risk) is one of the risks associated with bond investing, but many people assume that allow investors in long-term bonds experience term risk the same way. This isn't true. Term risk is not merely a function of the bond's duration, but instead is a function of the difference between the bond's duration and the investor's investment horizon.

In other words, not all owners of a particular bond have the same term risk. If the bond's duration precisely matches the investor's investment horizon, that bond presents ZERO term risk to that investor.

In an efficient market, investors whose investment horizon DOES NOT match the duration of that bond will pay a premium to avoid that bond. Investors whose investment horizon DOES MATCH the duration of that bond can collect that premium (i.e. higher return) without exposing themselves to additional risk. Because that bond doesn't present term risk to them.

Ergo, for any given investor their highest risk-adjusted return will result from a portfolio which contains bonds having a duration that matches as closely as possible the investor's investment horizon.

For a long-term investor that means long-term bonds.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Northern Flicker
Posts: 4241
Joined: Fri Apr 10, 2015 12:29 am

Re: The logical fallacy behind "Bonds Are For Safety"

Post by Northern Flicker » Sun Jun 09, 2019 4:33 pm

One last point, we get accused a lot of recency bias around here, but surely the opposite bias exists as well. I don’t think it has a pithy name; basically it’s the bias that anything that has happened in the past is just as likely to happen again. Which totally ignores the underlying drivers of why such a thing (i.e. inflation) happened in the first place, and ignores the meaningful (and difficult) analysis of whether those conditions are likely to repeat in the future. It’s just lazy thinking, in line with “nobody knows nuthin’”.
Actually, I would categorize the belief that inflation won’t happen again in the foreseeable future in the US as recency bias. But that misses the point, which is that the main purpose of diversification is to reduce the risk of a portfolio to be less than, for lack of a better phrase, the sum of the risk of its parts. Risk management should not be based on an analysis of what you think is likely to happen, but on what could happen. When adverse conditions actually have happened they absolutely are a possible risk to be accounted for. Moreover, the 1970’s was not the only period in the 20th century when the US experienced accelerating inflation.

I don’t know whether TIPS or nominal treasuries will have the higher return of the two moving forward, but it does appear that a 50-50 mix of the two has significantly lower volatility than either asset class alone if long-term durations are used:

https://www.portfoliovisualizer.com/bac ... total3=100

In light of that benefit, why would you want to amplify inflation risk with a long duration bond portfolio that was exclusively nominal treasuries?

stlutz
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Re: The logical fallacy behind "Bonds Are For Safety"

Post by stlutz » Sun Jun 09, 2019 5:34 pm

vineviz wrote:
Sun Jun 09, 2019 3:45 pm
...
Ergo, for any given investor their highest risk-adjusted return will result from a portfolio which contains bonds having a duration that matches as closely as possible the investor's investment horizon.

For a long-term investor that means long-term bonds.
I think you're trying to have it both ways here. Your [good] argument here and in other threads is that the "safest" approach to fixed income to to consider the bond portfolio in isolation and match your duration to your investment horizon.

Now, on that point I disagree with you that inflation is a minimal risk, which makes me think you are on track duration-wisse if we are talking about long-term TIPS. (I'll save the "why" in my disagreement for a future discussion).

But of course you don't really like LT TIPS as much because of that whole correlation thing. Long-term nominals are have been less correlated to stocks than LT TIPS, and thus for the person who is trying to optimize their diversification, the nominals are better. Problem, for this person their investment horizon for their bonds is no longer for the rest of their life but it's until the next rebalance point. But if that's your horizon then you should be using short-term bonds under the prior logic! Which means we're going in circles.

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