Assessing risk between two investments

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JustThisGuy
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Assessing risk between two investments

Post by JustThisGuy »

Hello, Bogleheads! I hope that you and yours are doing well!

I am currently looking at two different alternatives for a specific investment need. I already own shares of the first alternative. With Treasury yields rising, I am now trying to answer the following question: How much do Treasuries of a given duration have to yield before I’m not being adequately compensated for the risk I’m taking in my present investment?

I’m intentionally leaving this a little vague because I want to focus on how to answer this question (thus the post in “Theory”, and not “Investing”). If the specifics would matter, I can provide them.

Thank you, as always, for your guidance and knowledge!
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vineviz
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Re: Assessing risk between two investments

Post by vineviz »

JustThisGuy wrote: Thu May 12, 2022 12:10 pm How much do Treasuries of a given duration have to yield before I’m not being adequately compensated for the risk I’m taking in my present investment?
There is no theoretical answer to this.

For one thing, even if we just limit the discussion to interest rate risk it is a fact that Treasuries of a "given duration" might be very risky for one investor and relatively risk-free for another.

For a second thing, investors have heterogenous amounts of risk aversion. For one investor even a small amount of interest rate risk will require huge amounts of compensation in terms of expected return, while another investor might require very little such compensation.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
secondopinion
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Re: Assessing risk between two investments

Post by secondopinion »

vineviz wrote: Thu May 12, 2022 12:21 pm
JustThisGuy wrote: Thu May 12, 2022 12:10 pm How much do Treasuries of a given duration have to yield before I’m not being adequately compensated for the risk I’m taking in my present investment?
There is no theoretical answer to this.

For one thing, even if we just limit the discussion to interest rate risk it is a fact that Treasuries of a "given duration" might be very risky for one investor and relatively risk-free for another.

For a second thing, investors have heterogenous amounts of risk aversion. For one investor even a small amount of interest rate risk will require huge amounts of compensation in terms of expected return, while another investor might require very little such compensation.
You beat me to the post.

This is the key reason. The risks taken are not comparable because the short-term risks are not the only ones that matter; the long-term risks matter. Longer durations place more risk in the short-term by securing the long term; vice versa for short durations.

To the OP: in short, we have to ask if we are being compensated for the mismatching of durations, which is speculative.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
mega317
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Re: Assessing risk between two investments

Post by mega317 »

vineviz wrote: Thu May 12, 2022 12:21 pm For a second thing, investors have heterogenous amounts of risk aversion. For one investor even a small amount of interest rate risk will require huge amounts of compensation in terms of expected return, while another investor might require very little such compensation.
And to provide an example of this point. When we were younger my wife and I were house shopping, and targeted ~500k price and had 100k exactly in a savings account. If it were up to me I would have bought a short bond fund or something with the knowledge that our timing wasn't definite and I would have wanted to squeeze a little more return, while understanding that if it dropped and we suddenly needed the difference there were other options (borrow from family, 401k loan, margin, whatever). However if my wife had logged in to our accounts and saw, say, 99k where there used to be 100k, she would not have been happy. Hopefully that is one type of example of the point I quoted.
https://www.bogleheads.org/forum/viewtopic.php?t=6212
garlandwhizzer
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Re: Assessing risk between two investments

Post by garlandwhizzer »

How much do Treasuries of a given duration have to yield before I’m not being adequately compensated for the risk I’m taking in my present investment?
IMO this is a judgement call. You have to take into account the specifics of your own situation and whether or not it's more important for you to have stability of principal in fixed income and greater inflation protection (which favors shorter duration) versus theoretical greater diversification to equity volatility and greater certainty of long term nominal yield (which favor longer duration). These are the theoretical advantages and disadvantages of each approach. It's important to realize these theoretical strengths may not be reliable and in fact can backfire big time. Long Treasuries which are promoted to offer greater diversification to equity volatility, have instead offered less diversification and greater losses over the last 2 years. As inflation increased, LTT tanked big time (much more so than STT), and then the equity market tanked big time YTD 2022. The increased volatility risk of LTT showed up and it did so at precisely the wrong time as equity also tanked. Usually when stocks go down, bonds go up, but not always as those in love with LTT have learned recently.

Other things you have to take into account in your judgement on this issue are the current and expected future direction of inflation and interest rates. Higher inflation and higher rates going forward favor shorter term, while lower inflation/lower rates favor longer duration. Also, how much at current yield curve do you get paid to take on duration risk. Currently, the 30 Year Treasury yields 3.05% and the current 5 Year Treasury yields 2.89%, which means the Treasury currently reimburses you for accepting 25 years of duration risk at 0.16%/yr..That to me seems absurdly low reimbursement for 2.5 decades of potential inflation risk to such low nominal returns going forward.

If you don't know what to do, putting new dollars into 5 year Treasuries gives you almost the same yield as the 30 year without locking you into today's low yield for the next 3 decades. It may well turn out that over the next 30 years inflation will considerably exceed 2.89%/yr, not to mention the principal value swings along the way from long duration. The optimal time to load up on long duration bonds is when interest rates are very high at a secular inflation/yield peak (Early 1980s 30 yr. yield 15%). The worst time to load on long duration is at the end of a long secular period of decreasing inflation/yield declines (1940 and 2020). Personally, I'm avoiding LTT except as they are represented in TBM whose intermediate duration is fine for my taste. I also hold considerable MMF and ST TIPS to further shorten my fixed income average duration. At some point during this correction/bear market a buying opportunity in equity or bonds may present itself. If so, I may move some MMF which have suffered no principal loss during the bond sell off, into what appears to a good risk/reward tradeoff. I see no such clear signal now.

Garland Whizzer
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JustThisGuy
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Re: Assessing risk between two investments

Post by JustThisGuy »

vineviz wrote: Thu May 12, 2022 12:21 pm There is no theoretical answer to this.
Thank you for the feedback. I was hoping there would be simple-but-not-easy answer along the lines of, "Compare these ratios/Plug into this formula and check the output. If the answer is >X, you're likely ok, but make sure. . . . " Unfortunately, it sounds like my hope for a quantitative answer has been dashed.

You raise a great point about heterogeneous risk aversion as mega317's response illustrates nicely. Even if I think that Treasuries coming within 1% actual yield of the other investment tips the scales towards Treasuries, others may be happy with half a percent or 3% depending on their needs and what the feel the "cost of safety" is.

As always, your input is appreciated!
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JustThisGuy
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Re: Assessing risk between two investments

Post by JustThisGuy »

secondopinion wrote: Thu May 12, 2022 12:27 pm To the OP: in short, we have to ask if we are being compensated for the mismatching of durations, which is speculative.
It certainly seems that way. As I mentioned above, I was hoping some far-more-knowledgeable soul came up with a quantitative way to answer my question at some point along the way. Unfortunately, both our colleagues and you indicated such a thing doesn't appear to exist.

Thanks for your input!
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JustThisGuy
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Re: Assessing risk between two investments

Post by JustThisGuy »

mega317 wrote: Thu May 12, 2022 2:04 pm And to provide an example of this point.
That's a great illustration of the point -- thank you! Fortunately, I am answering only to myself on this one. If I get it wrong (or, perhaps, "less right"), I get all the credit for myself.
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JustThisGuy
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Re: Assessing risk between two investments

Post by JustThisGuy »

garlandwhizzer wrote: Thu May 12, 2022 2:53 pm IMO this is a judgement call. You have to take into account the specifics of your own situation (...)
Thank you for this! There's a lot here to digest, and much of it will be valuable well beyond this narrow situation. The money involved is not -- and will not be -- large enough to get into the "paralysis of analysis" game to be worth five-nine-ing this. The larger interest was in the theoretical discussion, but as our colleagues pointed out, there's no theoretical answer to this.
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