10% bonds in TDF

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andrige
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10% bonds in TDF

Post by andrige » Tue Jun 30, 2020 6:10 am

I am currently in my 20s and have been debating if I should invest in a 60 US/40 INT portfolio or TDF in my retirement account. I'm trying to figure out why Vanguard/Fidelity invests in 10% bonds despite being decades away from retirement. It seems like 10% bonds will be a drag on my portfolio (especially with current interest rates). Does anyone have any insight into this?

In terms of risk tolerance, I personally feel equally comfortable with 0% bonds as 10% bonds at this stage of my life. I'm not planning on touching the money either way.

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firebirdparts
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Re: 10% bonds in TDF

Post by firebirdparts » Tue Jun 30, 2020 6:16 am

andrige wrote:
Tue Jun 30, 2020 6:10 am
Does anyone have any insight into this?
As you can guess, every person with money has faced this. You have to assume that nobody can predict the future, and as the market is free and open to all, the prices of everything are correct. The prices reflect the aggregate ideas of all of us about what things are worth.

So when I was your age, I determined that price volatility was meaningless to me, and I was 100% stock. It turns out there was a huge bond bull market in my lifetime, but I didn't know that. It seems that bonds can't do that again, starting at the interest rates we have now. You would think that is the case.

10% is pretty close to zero, so it's not a big decision either way.
A fool and your money are soon partners

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vineviz
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Re: 10% bonds in TDF

Post by vineviz » Tue Jun 30, 2020 6:19 am

andrige wrote:
Tue Jun 30, 2020 6:10 am
I am currently in my 20s and have been debating if I should invest in a 60 US/40 INT portfolio or TDF in my retirement account. I'm trying to figure out why Vanguard/Fidelity invests in 10% bonds despite being decades away from retirement. It seems like 10% bonds will be a drag on my portfolio (especially with current interest rates). Does anyone have any insight into this?

In terms of risk tolerance, I personally feel equally comfortable with 0% bonds as 10% bonds at this stage of my life. I'm not planning on touching the money either way.
My first response is to point out investors who use TDFs outperform, on average, DIY investors by about 1% annually due to the TDF preventing the very common behavioral errors that investors tend to commit. In other words, the average investor using your 90/10 TDF will still have more wealth than the average DIY investor using 100% stocks, even after accounting for the low yield on bonds.

That said, the 10% bond allocation is NOT financially optimal. Target Date Funds include bonds for young investors primarily for regulatory, not economic, reasons. 100% stock would be the rational allocation for someone your age.

Just be SURE that you are rational, and not normal :)
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

rkhusky
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Re: 10% bonds in TDF

Post by rkhusky » Tue Jun 30, 2020 7:20 am

The 10% in bonds allows the fund to buy stocks when they have dropped a lot. They also allow the fund to sell stocks when they soar. Buy low and sell high is the key to making money. Unfortunately, many investors do the opposite by letting their emotions get in the way or trying to time the market - they end up buying high and selling low.

sycamore
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Re: 10% bonds in TDF

Post by sycamore » Tue Jun 30, 2020 10:46 am

To add to the good replies above, I'll suggest there's some insight to be gained by backtesting.

Portfolio visualizer is a good tool for that. Here's a comparison of portfolio 1 with 10% bonds, the rest 60/40 US/Intl stocks against portfolio 2 with 100% stocks and also 60/40 US/Intl. Also included is portfolio 3 with 40% in bonds for comparison. For simplicity I didn't include Intl bonds like the target date funds have now.

Basically the 10% in bonds were a tiny tiny drag on performance. And they did slightly lessen the max and min volatility, but whether that's significant/helpful is up to you. To me that says 90/10 is about the same as 100/0 portfolio. There are some benefits to having that 10% in bonds (rebalancing) so if it doesn't really hurt to have it, then why not?

That's a retrospective look at things. Whether it holds true going forward, I dunno...

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vineviz
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Re: 10% bonds in TDF

Post by vineviz » Tue Jun 30, 2020 11:13 am

sycamore wrote:
Tue Jun 30, 2020 10:46 am
That's a retrospective look at things. Whether it holds true going forward, I dunno...
That this won't hold true going forward is one of the few things in investing we can be quite confident about.

At the beginning of the time period you illustrated, VBMFX was yielding nearly 7% whereas now it's yielding just 1.35% or so. Given the starting yields at this point, it's virtually impossible to come up with a scenario in which the difference between bond returns and stock returns is a small in the future as it has been in the recent past.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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David Jay
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Re: 10% bonds in TDF

Post by David Jay » Tue Jun 30, 2020 11:31 am

vineviz wrote:
Tue Jun 30, 2020 6:19 am
Just be SURE that you are rational, and not normal :)
Cute! (...been reading a lot of behavioral finance recently)
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

sycamore
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Re: 10% bonds in TDF

Post by sycamore » Tue Jun 30, 2020 11:35 am

vineviz wrote:
Tue Jun 30, 2020 11:13 am
sycamore wrote:
Tue Jun 30, 2020 10:46 am
That's a retrospective look at things. Whether it holds true going forward, I dunno...
That this won't hold true going forward is one of the few things in investing we can be quite confident about.

At the beginning of the time period you illustrated, VBMFX was yielding nearly 7% whereas now it's yielding just 1.35% or so. Given the starting yields at this point, it's virtually impossible to come up with a scenario in which the difference between bond returns and stock returns is a small in the future as it has been in the recent past.
I agree it's very unlikely we'll continue to get the tailwind of declining interest rates. So a next step for the OP would be to consider how 10% in bonds would work out if we assume bonds will be about as good as "cash" does. That's not to predict that bonds will be as stable as cash but that bonds' return might be relatively low like cash typically was/is. Here's another portfoliovisualizer comparison this time replacing the 60/40 US/Intl portfolio with 10% in "CASHX" and 90% in 60/40 US/Intl.

This time the drag is more obvious. The CAGR is 0.4% lower but no change in volatility.

What are some good questions for the OP to help decide whether to go from 90/10 to 100/0? One way to frame it is: is a 0.4% lower CAGR too much to pay for the benefits that a fixed income allocation would provide? Another thing to consider is how the portfolio behaves in a market sell-off. For some people just knowing there's a cash or bond allocation is helpful, even if practically speaking it's not much.

(There's also the personality aspect - can you stick with 100% stocks during a downturn - but presumably if you made it through March at 90% you'd do ok at 100.)

jason2459
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Re: 10% bonds in TDF

Post by jason2459 » Tue Jun 30, 2020 11:49 am

Is this in something like a 401k with limited options? I would do the target date in that case or if there's a good blend index option like SP500. In my 20's I would do the 100% stock index fund. Unless you really want some international exposure and the target date fund helps give that. Then you could do what I do to help increase stock exposure and still get international exposure by combining investments in both the target date fund and the index fund. In my case I do a 50/50 split between target date fund and sp500 fund.

If this isn't a 401k then I would not go with a fund of funds like that to have more control and lower expenses but still go with broad market indexes like vtsax and vtiax in an IRA or or ITOT and IXUS in a taxable account.
Last edited by jason2459 on Tue Jun 30, 2020 11:51 am, edited 1 time in total.

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willthrill81
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Re: 10% bonds in TDF

Post by willthrill81 » Tue Jun 30, 2020 11:51 am

sycamore wrote:
Tue Jun 30, 2020 11:35 am
vineviz wrote:
Tue Jun 30, 2020 11:13 am
sycamore wrote:
Tue Jun 30, 2020 10:46 am
That's a retrospective look at things. Whether it holds true going forward, I dunno...
That this won't hold true going forward is one of the few things in investing we can be quite confident about.

At the beginning of the time period you illustrated, VBMFX was yielding nearly 7% whereas now it's yielding just 1.35% or so. Given the starting yields at this point, it's virtually impossible to come up with a scenario in which the difference between bond returns and stock returns is a small in the future as it has been in the recent past.
I agree it's very unlikely we'll continue to get the tailwind of declining interest rates. So a next step for the OP would be to consider how 10% in bonds would work out if we assume bonds will be about as good as "cash" does.
There's a decent chance that bonds will underperform cash for a long time. From 1941-1981, T-bills had slightly higher real returns than intermediate-term Treasuries (and much more than long-term Treasuries). T-bills also fared much better during the 1970s stagflation than did ITT.
“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

Jayhawker
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Re: 10% bonds in TDF

Post by Jayhawker » Tue Jun 30, 2020 12:05 pm

vineviz wrote:
Tue Jun 30, 2020 11:13 am
Given the starting yields at this point, it's virtually impossible to come up with a scenario in which the difference between bond returns and stock returns is a small in the future as it has been in the recent past.
This is very interesting to me - can you explain your thinking a little further? I’ve long been operating under the assumption of a relatively constant long run equity risk premium, which implies expected stock returns have moved down right along with bond yields. The idea being that the value of future earnings are discounted by bond rates. I would be happy to be wrong on this!

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willthrill81
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Re: 10% bonds in TDF

Post by willthrill81 » Tue Jun 30, 2020 12:10 pm

Jayhawker wrote:
Tue Jun 30, 2020 12:05 pm
vineviz wrote:
Tue Jun 30, 2020 11:13 am
Given the starting yields at this point, it's virtually impossible to come up with a scenario in which the difference between bond returns and stock returns is a small in the future as it has been in the recent past.
This is very interesting to me - can you explain your thinking a little further? I’ve long been operating under the assumption of a relatively constant long run equity risk premium, which implies expected stock returns have moved down right along with bond yields. The idea being that the value of future earnings are discounted by bond rates. I would be happy to be wrong on this!
I'm not sure that that assumption is well supported by the data or at least that it's so 'macro' as to not be worthwhile to individual investors. From 1941-1981, intermediate-term Treasuries had real annualized real returns of -1.42% while U.S. stocks returned 6.21% real. From 1982-2012, ITT returned 5.44% real while U.S. stock returned 7.69% real.
“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

sycamore
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Re: 10% bonds in TDF

Post by sycamore » Tue Jun 30, 2020 12:14 pm

willthrill81 wrote:
Tue Jun 30, 2020 11:51 am
...
There's a decent chance that bonds will underperform cash for a long time. From 1941-1981, T-bills had slightly higher real returns than intermediate-term Treasuries (and much more than long-term Treasuries). T-bills also fared much better during the 1970s stagflation than did ITT.
Yeah. I have no crystal ball for how bills/notes/bonds of various durations will perform, nor whether inflation or deflation will have a big impact. Those are yet more things to backtest on if one is interested is seeing how a portfolio might've worked in the past in various situations. At 10% bond in a portfolio, it just may not really matter.

Your comment raises the question of whether bonds are really the best fixed income component for an accumulator. AFAIK there's no TDF that has just T-bills/cash in place of intermediate-term bonds. So one could use a TDF plus have a separate allocation to T-bills if inflation is a concern. Or count on one's human capital/salary to keep up with inflation.

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vineviz
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Re: 10% bonds in TDF

Post by vineviz » Tue Jun 30, 2020 1:36 pm

Jayhawker wrote:
Tue Jun 30, 2020 12:05 pm
This is very interesting to me - can you explain your thinking a little further? I’ve long been operating under the assumption of a relatively constant long run equity risk premium, which implies expected stock returns have moved down right along with bond yields. The idea being that the value of future earnings are discounted by bond rates. I would be happy to be wrong on this!
Sure, and it's precisely because the equity risk premium does seem to be a relatively constant addition to the risk-free rate that allocating more to bonds has a bigger drag at lower yields.

Let's say that the expected risk premium for equities is relatively constant at 4% above the risk-free rate (e.g. the 5-year Treasury yield).

For the first half of 1997 the average 5-year Treasury yield was 6.47%. Add 4% to that and you get an expected return (starting in 1997) of about 10.5%. The yield for VBMFX in 1997 was about 6.5%, which would be a reasonable estimate of expected return for bonds (starting in 1997).

Today the 5-year Treasury yield is about 0.7%, making the expected return of stocks (assuming a 4% equity risk premium) about 4.7% and the expected return of VBMFX is about 1.35%.

Because the overall level of expected returns for both stocks and bonds is lower, moving 10% from stocks to bonds has a larger percentage decrease in expected return now than it would have had in the past: a 90/10 portfolio had 96% of the expected return of stocks at the higher yields of 1997 versus just 93% today.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Topic Author
andrige
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Re: 10% bonds in TDF

Post by andrige » Tue Jun 30, 2020 4:23 pm

sycamore wrote:
Tue Jun 30, 2020 10:46 am
To add to the good replies above, I'll suggest there's some insight to be gained by backtesting.

Portfolio visualizer is a good tool for that. Here's a comparison of portfolio 1 with 10% bonds, the rest 60/40 US/Intl stocks against portfolio 2 with 100% stocks and also 60/40 US/Intl. Also included is portfolio 3 with 40% in bonds for comparison. For simplicity I didn't include Intl bonds like the target date funds have now.

Basically the 10% in bonds were a tiny tiny drag on performance. And they did slightly lessen the max and min volatility, but whether that's significant/helpful is up to you. To me that says 90/10 is about the same as 100/0 portfolio. There are some benefits to having that 10% in bonds (rebalancing) so if it doesn't really hurt to have it, then why not?

That's a retrospective look at things. Whether it holds true going forward, I dunno...
I did try to backtest it myself and noticed a similar pattern. However, I did more research and found this (i.e. the recent bond bull run has been absolutely crazy): https://awealthofcommonsense.com/2019/0 ... erm-bonds/

It seems hard to believe that we will have another 40 year period of 9.6% bond returns at the current interest rates. Despite this historic bond market, it still barely kept up (actually performed a bit worse over the period than all equity). This is why I'm beginning to question the 10% allocation for somebody who is over 30 years away from retirement.

If we expect 0% real from bonds and 5-7% from equity then at 10% bonds, we are talking about 50-70 basis points which seems like a lot over 30 years.

nix4me
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Re: 10% bonds in TDF

Post by nix4me » Wed Jul 01, 2020 4:00 pm

All the international stocks and bonds are even worse..

A person in their 20’s should read Simple Path To Wealth and go 100% VTSAX. In my opinion. Focus on income and saving more than portfolio

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