What are the disadvantages of taking all risk on equity side?

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delrinson
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What are the disadvantages of taking all risk on equity side?

Post by delrinson » Fri Jan 11, 2019 7:38 am

While I've tried to muster enthusiasm for a broadly diversified fixed income portfolio, I find myself leaning against taking much of any risk at all on the fixed income side. Part of my thinking is simply the irritation/frustration of losing any money at all in the portion of my portfolio that is designed to preserve assets. So I'm gravitating toward having all fixed income assets in money market, CDs, and short term treasuries, putting all the risk on the equity side of the ledger.

What are the disadvantages of this approach? Is it simply the foregoing of the marginal gains I would otherwise reap if I had a more diversified fixed income portfolio? If that's all it is, I can live with that.

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Re: What are the disadvantages of taking all risk on equity side?

Post by Leesbro63 » Fri Jan 11, 2019 7:44 am

delrinson wrote:
Fri Jan 11, 2019 7:38 am
While I've tried to muster enthusiasm for a broadly diversified fixed income portfolio, I find myself leaning against taking much of any risk at all on the fixed income side. Part of my thinking is simply the irritation/frustration of losing any money at all in the portion of my portfolio that is designed to preserve assets. So I'm gravitating toward having all fixed income assets in money market, CDs, and short term treasuries, putting all the risk on the equity side of the ledger.

What are the disadvantages of this approach? Is it simply the foregoing of the marginal gains I would otherwise reap if I had a more diversified fixed income portfolio? If that's all it is, I can live with that.
This is exactly what Dr. Bernstein recommends. Keeping your safe money safe via shorter term fixed income. And taking the risk on the equity side. What are the disadvantages? Possible lower longer term rewards than if you had longer term fixed income. Offhand I can't think of other disadvantages.

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Re: What are the disadvantages of taking all risk on equity side?

Post by nisiprius » Fri Jan 11, 2019 7:49 am

Part 1: Introduction, Appendix: Methodology
Brief notes: 1) In these Monte Carlo simulations, the return for a given month is varied by randomly choosing the actual historical return or the actual historic return for an adjacent month. 2) They show the final value from $100 monthly contributions made over the whole time period. 4) Green and red crosses mark actual historical values. 5) Green and red bars show the 10% percentile, median, and 90% percentile of the range of outcomes. 5) The actual data source is PortfolioVisualizer.com, Backtest Portfolio, Monthly Returns; this is used as calculation input; and no PV content or numeric values are directly reproduced.
The crosses and centerpoints are what they are. They are subject to all the issues and problems of comparing two portfolios over one specific period in time. They have exactly the same endpoint issues of all such comparisons. These charts do not help decide which portfolio is better than another, or how much better. Their purpose to compare the size of difference between portfolios to the general variability of the portfolio. They are based on Monte Carlo simulations of random walks around the historical data. The value of this approach has been questioned; see discussion

I looked into this a little, using this particular approach, in this post. I'm going to reproduce part of that posting below.

My personal judgement is, first, that "stay the course" is the Prime Directive and that since the course I chose involved Total Bond for my non-stock allocation, I would need a very convincing reason to change a reasonably sound decision; second, that the extra risk of bonds-over-cash is almost invisible if there is any meaningful stock allocation at all, while the extra return is visible. I also think that going to good cash-like options is a perfectly reasonable choice if you just don't like bonds, although it is much better as a right-from-the-start choice than a changing-course-because-I-think-things-are-different-now choice.

Do not treat my pretty pictures as hard numbers. Treat them as reasonable impressionistic views of the relative amount of average different between two choices, versus the approximate range of differences that might be expected in parallel universes.

The blue dots show a 60/40 portfolio where the "40" is in intermediate-term bonds. The red dots show the effect of changing that "40" to to cash (as represented by PortfolioVisualizer's CASHX asset, Treasury bills), which is basically what you are proposing to do. To the extent that you believe the simulation, you should ask yourself "how do I feel about a plan that gives me the range of outcomes shown in red, rather than the range of outcomes shown in blue?" This is not a case where the difference is so small that it is "lost in the noise." On the other hand, it is clear that the range of differences due to "fate" is much larger than the range of differences due to "portfolio choice."

Image
Last edited by nisiprius on Fri Jan 11, 2019 7:59 am, edited 5 times in total.
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Re: What are the disadvantages of taking all risk on equity side?

Post by Call_Me_Op » Fri Jan 11, 2019 7:50 am

One reason that we are told to take risk on equity side is that upside is theoretically unlimited.

In any case, I find it very helpful to dichotiomize portfolio into safe and risky assets. Doing so allows transparency with respect to the risk you are taking.
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Re: What are the disadvantages of taking all risk on equity side?

Post by Jags4186 » Fri Jan 11, 2019 7:56 am

The risk is that you could cost yourself some nice returns while taking very tolerable risk. Over 40 years the biggest drawdown was 10% for ITT.

Image

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Re: What are the disadvantages of taking all risk on equity side?

Post by rkhusky » Fri Jan 11, 2019 8:02 am

What is the probability that over 20+ years a treasury bond fund with a duration of 1 year will out-perform a treasury bond fund with a duration of 5 years?

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Re: What are the disadvantages of taking all risk on equity side?

Post by delrinson » Fri Jan 11, 2019 9:32 am

I should add that I readily admit that my aversion to a broadly diversified fixed income portfolio is a bit irrational and flies in the face of the facts. And I suppose I remain open to intermediate term bonds...especially if/when I get to the point where I want to take the dividends as income to live on.

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Re: What are the disadvantages of taking all risk on equity side?

Post by danielc » Fri Jan 11, 2019 10:51 am

nisiprius wrote:
Fri Jan 11, 2019 7:49 am
My personal judgement is, first, that "stay the course" is the Prime Directive and that since the course I chose involved Total Bond for my non-stock allocation, I would need a very convincing reason to change a reasonably sound decision; second, that the extra risk of bonds-over-cash is almost invisible if there is any meaningful stock allocation at all, while the extra return is visible. I also think that going to good cash-like options is a perfectly reasonable choice if you just don't like bonds, although it is much better as a right-from-the-start choice than a changing-course-because-I-think-things-are-different-now choice.
Well said. I made a different choice than you -- I chose short-term (1 year) Treasuries instead of Total Bond. I don't know whether this choice is theoretically optimal, but I know that it is a perfectly good choice and I strongly feel that it fits my temperament better. I find it easier to ignore the ups and downs of my risky investments when I feel very confident in the safety of my safe investments.

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Re: What are the disadvantages of taking all risk on equity side?

Post by dbr » Fri Jan 11, 2019 11:17 am

delrinson wrote:
Fri Jan 11, 2019 7:38 am
While I've tried to muster enthusiasm for a broadly diversified fixed income portfolio, I find myself leaning against taking much of any risk at all on the fixed income side. Part of my thinking is simply the irritation/frustration of losing any money at all in the portion of my portfolio that is designed to preserve assets. So I'm gravitating toward having all fixed income assets in money market, CDs, and short term treasuries, putting all the risk on the equity side of the ledger.

What are the disadvantages of this approach? Is it simply the foregoing of the marginal gains I would otherwise reap if I had a more diversified fixed income portfolio? If that's all it is, I can live with that.
It is irrational to be intolerant of risk in one portion of one's assets while tolerating risk in another portion of one's assets. The outcome in the end depends on the result of the whole. Nisi has referenced some comparisons there. I don't think there is any difference worth debating over building two portfolios of similar return based on one having less risky fixed income and more in stocks vs another having more risky fixed income and less in stocks. Taking that path sends one down a rabbit hole to Wonderland.

If one does want a serious approach along those lines one might consider the arguments for the "Larry (Swedroe)" portfolio using a massive tilt to small and value stocks together with a reduction in overall stock allocation and the rest in short Treasuries or something like that.

Note that Bernstein is really coming from a liability matching point of view which does attempt to align risks with assets. I think there can be some merit there if understood correctly. I also think there is some mental accounting that can plague that approach. When LMP gets to the point of insuring longevity risk using annuities I think it makes more sense. When the outcome is thinking that a 50/50 portfolio of stocks and bonds is better off if the bonds are CDs rather than a diversified low cost intermediate term bond fund, then I think the issue is tilting at windmills.

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Re: What are the disadvantages of taking all risk on equity side?

Post by dbr » Fri Jan 11, 2019 11:19 am

danielc wrote:
Fri Jan 11, 2019 10:51 am
nisiprius wrote:
Fri Jan 11, 2019 7:49 am
My personal judgement is, first, that "stay the course" is the Prime Directive and that since the course I chose involved Total Bond for my non-stock allocation, I would need a very convincing reason to change a reasonably sound decision; second, that the extra risk of bonds-over-cash is almost invisible if there is any meaningful stock allocation at all, while the extra return is visible. I also think that going to good cash-like options is a perfectly reasonable choice if you just don't like bonds, although it is much better as a right-from-the-start choice than a changing-course-because-I-think-things-are-different-now choice.
Well said. I made a different choice than you -- I chose short-term (1 year) Treasuries instead of Total Bond. I don't know whether this choice is theoretically optimal, but I know that it is a perfectly good choice and I strongly feel that it fits my temperament better. I find it easier to ignore the ups and downs of my risky investments when I feel very confident in the safety of my safe investments.
I suppose one sometimes feels more secure with a firm grip on a tippy ladder than with a looser grip on a solid ladder.

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Re: What are the disadvantages of taking all risk on equity side?

Post by magneto » Fri Jan 11, 2019 11:29 am

One risk that Wm Bernstein talks about in later editions of The Four Pillars, is a repeat of 2008/9 where investors would have needed to take a 'haircut', on those supposedly defensive but not quite so riskless assets, to release monies for Stock purchases to rebalance at the then advantageous prices.
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Re: What are the disadvantages of taking all risk on equity side?

Post by HEDGEFUNDIE » Fri Jan 11, 2019 11:30 am

Two disadvantages:

1. Lower returns in the long run
2. Worse diversification of your equity allocation

If your time horizon is not the long run, and/or you have a small equity allocation, neither of these points will matter as much.

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Re: What are the disadvantages of taking all risk on equity side?

Post by delamer » Fri Jan 11, 2019 11:38 am

I found Bill Bernstein’s argument to be persuasive regarding taking risk on the stock side.

So I have chosen to limit my fixed income holdings to cash and short term government bonds, but I did increase my stock allocation as a result. (I also have access to the TSP G fund, which is an exceptionally good stable value fund.)

I think this is what dbr above was referring to above with “I don't think there is any difference worth debating over building two portfolios of similar return based on one having less risky fixed income and more in stocks vs another having more risky fixed income and less in stocks.”

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Re: What are the disadvantages of taking all risk on equity side?

Post by dbr » Fri Jan 11, 2019 12:46 pm

delamer wrote:
Fri Jan 11, 2019 11:38 am
I found Bill Bernstein’s argument to be persuasive regarding taking risk on the stock side.

So I have chosen to limit my fixed income holdings to cash and short term government bonds, but I did increase my stock allocation as a result. (I also have access to the TSP G fund, which is an exceptionally good stable value fund.)

I think this is what dbr above was referring to above with “I don't think there is any difference worth debating over building two portfolios of similar return based on one having less risky fixed income and more in stocks vs another having more risky fixed income and less in stocks.”
Yes, exactly so. It always comes to the risk and return of the total.

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Re: What are the disadvantages of taking all risk on equity side?

Post by MotoTrojan » Fri Jan 11, 2019 12:55 pm

Less return with only really a perceived reduction in risk.

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Re: What are the disadvantages of taking all risk on equity side?

Post by EfficientInvestor » Fri Jan 11, 2019 1:51 pm

The disadvantage is that the portion of your funds that are "at-risk" are allocated in a very inefficient manner. Take a look at the below efficient frontier curves, for example. The Total Stock Market and 10-year treasury bond fund data used to generate these efficient frontier curves came from PV. Whether you are in a rising interest rate environment (1972 - 1984) or falling to neutral rate environment (1985 - present), the pattern remains the same. That pattern being that the use of 100% equity for the portion of your portfolio that is "at-risk" is not a very efficient use of capital. The dot plotted on each curve represents a 60/40 portfolio. Let's just look at the curve for 1972-2018. At 60/40, you have an expected return of 9.8% and a SD of 9.9%. If you go up to 100/0, you have an expected return of 11.4% and a SD of 15.4%. So your expected return goes up 16% but your SD goes up 56%. I'm not sure I like that trade-off. However, some may be ok taking on the extra downside risk for the marginal additional return of having "at-risk" funds 100% in equities.

Image

Here are return differences of 60/40 vs 100/0 over that time frame:

Jan 1972 - Dec 2018
100/0 - CAGR = 10.1%, Max DD = -50.9%
60/40 - CAGR = 9.4%, Max DD = -28.5%

https://www.portfoliovisualizer.com/bac ... yNotes2=40

Here are return differences if you assume 1/2 of your money is in cash/money market but with same "at-risk" allocations:

Jan 1972 - Dec 2018
50/0/50 - CAGR = 7.8%, Max DD = -26.8%
30/20/50 - CAGR = 7.2%, Max DD = -12.8%

https://www.portfoliovisualizer.com/bac ... yNotes2=20

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Re: What are the disadvantages of taking all risk on equity side?

Post by 2015 » Fri Jan 11, 2019 2:21 pm

The risk is that you will tell yourself stories that are not rational; that is, they fail to map to reality. Narrative will always serve to undermine human decision making which is why luck falls for the most part on the side of simplicity, particularly in complex adaptive systems which both humans and investing reside in.

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Re: What are the disadvantages of taking all risk on equity side?

Post by delamer » Fri Jan 11, 2019 2:37 pm

EfficientInvestor wrote:
Fri Jan 11, 2019 1:51 pm
The disadvantage is that the portion of your funds that are "at-risk" are allocated in a very inefficient manner. Take a look at the below efficient frontier curves, for example. The Total Stock Market and 10-year treasury bond fund data used to generate these efficient frontier curves came from PV. Whether you are in a rising interest rate environment (1972 - 1984) or falling to neutral rate environment (1985 - present), the pattern remains the same. That pattern being that the use of 100% equity for the portion of your portfolio that is "at-risk" is not a very efficient use of capital. The dot plotted on each curve represents a 60/40 portfolio. Let's just look at the curve for 1972-2018. At 60/40, you have an expected return of 9.8% and a SD of 9.9%. If you go up to 100/0, you have an expected return of 11.4% and a SD of 15.4%. So your expected return goes up 16% but your SD goes up 56%. I'm not sure I like that trade-off. However, some may be ok taking on the extra downside risk for the marginal additional return of having "at-risk" funds 100% in equities.

Image

Here are return differences of 60/40 vs 100/0 over that time frame:

Jan 1972 - Dec 2018
100/0 - CAGR = 10.1%, Max DD = -50.9%
60/40 - CAGR = 9.4%, Max DD = -28.5%

https://www.portfoliovisualizer.com/bac ... yNotes2=40

Here are return differences if you assume 1/2 of your money is in cash/money market but with same "at-risk" allocations:

Jan 1972 - Dec 2018
50/0/50 - CAGR = 7.8%, Max DD = -26.8%
30/20/50 - CAGR = 7.2%, Max DD = -12.8%

https://www.portfoliovisualizer.com/bac ... yNotes2=20
This is interesting.

But by using 10-year treasuries — admittedly not short term — it avoids corporate bonds, which are a big part of Bernstein’s argument about taking risk in stocks.

So how would this look if you substituted a big chunk of corporate bonds for the treasuries?

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Re: What are the disadvantages of taking all risk on equity side?

Post by UpperNwGuy » Fri Jan 11, 2019 3:02 pm

Whenever I see a post that mentions "take your risk on the equity side," I grit my teeth and get myself ready to hear very conservative advice about limiting my fixed income investments to certificates of deposit and pure Treasury funds. This advice seems to me to be no different than the advice to pay off mortgages early — much too conservative for me. I prefer to take that small bit of extra risk that comes from holding Total Bond and Intermediate Term Tax Exempt as my only fixed income holdings. I doubt I will ever own a pure Treasury fund because such funds would duplicate what I already have in Total Bond, so it would be tilting my portfolio. I prefer to hold Total Bond's broad-based mixture of Treasury, corporate, mortgage-backed, short, intermediate, and long bonds, and to supplement that with a municipal bond fund. I don't consider this to be a risky approach. I avoid long bond funds and high yield funds because these do seem risky to me, but Total Bond and other intermediate term bond funds do not. I consider most of my risk to be on the equity side, but you will never hear me use the phrase "take your risk on the equity side."

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Re: What are the disadvantages of taking all risk on equity side?

Post by EfficientInvestor » Fri Jan 11, 2019 3:04 pm

delamer wrote:
Fri Jan 11, 2019 2:37 pm
This is interesting.

But by using 10-year treasuries — admittedly not short term — it avoids corporate bonds, which are a big part of Bernstein’s argument about taking risk in stocks.

So how would this look if you substituted a big chunk of corporate bonds for the treasuries?
Can you clarify? I am not familiar with Bernstein's argument. Are you saying that he avoids corporate bonds because he already has enough exposure to corporations via stocks? If so, I am in agreement with him and that is why I prefer to not use corporate bonds.

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Re: What are the disadvantages of taking all risk on equity side?

Post by rj49 » Fri Jan 11, 2019 3:10 pm

All the fancy charts and graphs take into account an unprecedented bull market in bonds, just as charts for stock returns would look vastly different in 2008 (after two historic stock collapses) and 2018 (after historic bull market). Ask yourself about risks of bonds in 2018: first of all, with rates still at comparatively low levels, where is the room for capital gains through interest rate declines, versus room for loss through interest rate increases? Secondly, for government debt, who is going to buy the trillions of deficit spending and outstanding government debt, now that all pretenses to fiscal restraint have been abandoned, and the Fed and ECB is starting to unwind its unprecedented buying? Third, for corporate bonds, look at the historic levels of corporate debt, not tested by recession for a decade--do you think that's a positive sign for future returns and risks?

Personally, in order to be diversified and avoid worry and dangers about bond risk, I'd put bonds in some sort of retirement account where you wouldn't be bothered by interest rate movements and bond declines, and where reinvestment and increased yields would eventually compound and overcome NAV declines, and where you wouldn't suffer the pain of yearly taxation of dividends.

For current income, I choose both ultra-safe sources (Discover savings at 2%, VG Prime MMF, 72T withdrawals from a TSP G fund, and high-yield sources that don't fluctuate but run the risk of losing all of the limited funds I put into them (streetshares 5% veterans bonds, 7% or so illiquid Fundrise real estate investing. Just as I don't want NAV fluctuations, I also don't want to chase CD or bank rates the create extra hassle or lock up my savings.

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Re: What are the disadvantages of taking all risk on equity side?

Post by delamer » Fri Jan 11, 2019 3:31 pm

EfficientInvestor wrote:
Fri Jan 11, 2019 3:04 pm
delamer wrote:
Fri Jan 11, 2019 2:37 pm
This is interesting.

But by using 10-year treasuries — admittedly not short term — it avoids corporate bonds, which are a big part of Bernstein’s argument about taking risk in stocks.

So how would this look if you substituted a big chunk of corporate bonds for the treasuries?
Can you clarify? I am not familiar with Bernstein's argument. Are you saying that he avoids corporate bonds because he already has enough exposure to corporations via stocks? If so, I am in agreement with him and that is why I prefer to not use corporate bonds.
Not so much that he has enough corporate exposure via stocks, but that corporate decision-making is driven by the interests of stockholders not bondholders. Therefore, corporate bondholders take on risk while the stockholders drive policy. So bondholders get the short end of the stick, so to speak.

(Unfortunately, I can’t find a link to the article that I read.)

Part of the problem is the fact that although bonds come in wide variety of forms, people sometimes talk about bonds as if they are monolithic. However, TIPS are entirely different than corporate junk bonds, to take two extremes.

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Re: What are the disadvantages of taking all risk on equity side?

Post by danielc » Fri Jan 11, 2019 3:41 pm

dbr wrote:
Fri Jan 11, 2019 11:19 am
danielc wrote:
Fri Jan 11, 2019 10:51 am
Well said. I made a different choice than you -- I chose short-term (1 year) Treasuries instead of Total Bond. I don't know whether this choice is theoretically optimal, but I know that it is a perfectly good choice and I strongly feel that it fits my temperament better. I find it easier to ignore the ups and downs of my risky investments when I feel very confident in the safety of my safe investments.
I suppose one sometimes feels more secure with a firm grip on a tippy ladder than with a looser grip on a solid ladder.
I honestly don't know what you are trying to say. I can't even figure out if this comment is meant to be supportive or critical.

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Re: What are the disadvantages of taking all risk on equity side?

Post by danielc » Fri Jan 11, 2019 3:48 pm

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 11:30 am
Two disadvantages:

1. Lower returns in the long run
2. Worse diversification of your equity allocation
I don't see how those are true. (1) The total return can be brought back up by increasing the size of the stock allocation. Presumably the debate is between some baseline Total Bond / Total Stock portfolio against a portfolio with safer bonds but a higher percentage in stocks. (2) How is the equity portfolio less diversified? Presumably you're getting the same index fund.

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Re: What are the disadvantages of taking all risk on equity side?

Post by EfficientInvestor » Fri Jan 11, 2019 4:16 pm

delamer wrote:
Fri Jan 11, 2019 3:31 pm
EfficientInvestor wrote:
Fri Jan 11, 2019 3:04 pm
delamer wrote:
Fri Jan 11, 2019 2:37 pm
This is interesting.

But by using 10-year treasuries — admittedly not short term — it avoids corporate bonds, which are a big part of Bernstein’s argument about taking risk in stocks.

So how would this look if you substituted a big chunk of corporate bonds for the treasuries?
Can you clarify? I am not familiar with Bernstein's argument. Are you saying that he avoids corporate bonds because he already has enough exposure to corporations via stocks? If so, I am in agreement with him and that is why I prefer to not use corporate bonds.
Not so much that he has enough corporate exposure via stocks, but that corporate decision-making is driven by the interests of stockholders not bondholders. Therefore, corporate bondholders take on risk while the stockholders drive policy. So bondholders get the short end of the stick, so to speak.

(Unfortunately, I can’t find a link to the article that I read.)

Part of the problem is the fact that although bonds come in wide variety of forms, people sometimes talk about bonds as if they are monolithic. However, TIPS are entirely different than corporate junk bonds, to take two extremes.
The efficient frontier at the first link below would lead me to believe that I should exclusively use long-term corporate bonds instead of 10-year treasuries. (Used long-term corporate due to longer track record). Also, if using a 60/40 portfolio, it shows that with long term corporate bonds, you could have reduced your stocks to 55% and maintained a higher expected return than the 60/40 w/ treasuries, while at the same SD. However, when comparing 60/40 w/ treasuries to 55/45 with corporates in the second link, the exclusive use of treasuries seem to provide better protection against drawdown, at least during this time period. But, you would have received slightly less return over the time period in order to get that downside protection.

https://www.portfoliovisualizer.com/eff ... d&sf3=true

https://www.portfoliovisualizer.com/bac ... rpBond2=45

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Re: What are the disadvantages of taking all risk on equity side?

Post by WoodSpinner » Fri Jan 11, 2019 4:26 pm

EfficientInvestor wrote:
Fri Jan 11, 2019 1:51 pm
The disadvantage is that the portion of your funds that are "at-risk" are allocated in a very inefficient manner. Take a look at the below efficient frontier curves, for example. The Total Stock Market and 10-year treasury bond fund data used to generate these efficient frontier curves came from PV. Whether you are in a rising interest rate environment (1972 - 1984) or falling to neutral rate environment (1985 - present), the pattern remains the same. That pattern being that the use of 100% equity for the portion of your portfolio that is "at-risk" is not a very efficient use of capital. The dot plotted on each curve represents a 60/40 portfolio. Let's just look at the curve for 1972-2018. At 60/40, you have an expected return of 9.8% and a SD of 9.9%. If you go up to 100/0, you have an expected return of 11.4% and a SD of 15.4%. So your expected return goes up 16% but your SD goes up 56%. I'm not sure I like that trade-off. However, some may be ok taking on the extra downside risk for the marginal additional return of having "at-risk" funds 100% in equities.

Image

Here are return differences of 60/40 vs 100/0 over that time frame:

Jan 1972 - Dec 2018
100/0 - CAGR = 10.1%, Max DD = -50.9%
60/40 - CAGR = 9.4%, Max DD = -28.5%

https://www.portfoliovisualizer.com/bac ... yNotes2=40

Here are return differences if you assume 1/2 of your money is in cash/money market but with same "at-risk" allocations:

Jan 1972 - Dec 2018
50/0/50 - CAGR = 7.8%, Max DD = -26.8%
30/20/50 - CAGR = 7.2%, Max DD = -12.8%

https://www.portfoliovisualizer.com/bac ... yNotes2=20
I need some help understanding the chart. How do you know where a specific AA allocation falls on the curves?

👴 confused....

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Re: What are the disadvantages of taking all risk on equity side?

Post by EfficientInvestor » Fri Jan 11, 2019 4:30 pm

WoodSpinner wrote:
Fri Jan 11, 2019 4:26 pm
I need some help understanding the chart. How do you know where a specific AA allocation falls on the curves?

👴 confused....
I pulled all the data into a spreadsheet so I could show all three time intervals on the same graph. I manually plotted the data points closest to 60/40 for each time interval. Here is the data from the 1972-2018 interval:

https://www.portfoliovisualizer.com/eff ... tion2_1=40

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Re: What are the disadvantages of taking all risk on equity side?

Post by kolea » Fri Jan 11, 2019 4:52 pm

dbr wrote:
Fri Jan 11, 2019 11:17 am
It is irrational to be intolerant of risk in one portion of one's assets while tolerating risk in another portion of one's assets. The outcome in the end depends on the result of the whole. ....

I also think there is some mental accounting that can plague that approach. When LMP gets to the point of insuring longevity risk using annuities I think it makes more sense. When the outcome is thinking that a 50/50 portfolio of stocks and bonds is better off if the bonds are CDs rather than a diversified low cost intermediate term bond fund, then I think the issue is tilting at windmills.
It seems that answering the OP's question is going to be different depending on one's goals and where one is in the investment cycle. For me, retired and not feeling much pressure to generate a return to have a successful outcome, it feels perfectly rational to partition risk. So instead of 50/50 with TBM for the fixed income, it is 55/45 with the fixed income mostly TIPS. After all, the choice of AA is largely arbitrary, according to one's risk tolerance. If it is OK for the percentage of bonds to be arbitrary, why is it not OK to also be arbitrary in what exactly makes up the fixed income? Anyway, that is how I looked at it.
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Re: What are the disadvantages of taking all risk on equity side?

Post by Northern Flicker » Fri Jan 11, 2019 5:06 pm

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 11:30 am
Two disadvantages:

1. Lower returns in the long run
2. Worse diversification of your equity allocation

If your time horizon is not the long run, and/or you have a small equity allocation, neither of these points will matter as much.
It is not a lower expected return if you hold risk constant. Holding only treasuries instead of a market portfolio of nominal bonds, and simultaneously increasing the equity allocation a little bit can actually increase portfolio return without increasing risk.

Here is an example where I adjusted the stock allocation empirically to get the same volatility (sample standard deviation) between the two portfolios. The portfolio with treasuries and a slightly higher equity allocation had a slightly higher return and lower max drawdown. It perhaps could go the other way in some future period, so the difference is a matter of taste, but many people, including some well respected investment professionals prefer the portfolio with treasuries and a slightly higher equity allocation.

https://www.portfoliovisualizer.com/bac ... alBond1=40
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Re: What are the disadvantages of taking all risk on equity side?

Post by dbr » Fri Jan 11, 2019 5:26 pm

jalbert wrote:
Fri Jan 11, 2019 5:06 pm
HEDGEFUNDIE wrote:
Fri Jan 11, 2019 11:30 am
Two disadvantages:

1. Lower returns in the long run
2. Worse diversification of your equity allocation

If your time horizon is not the long run, and/or you have a small equity allocation, neither of these points will matter as much.
It is not a lower expected return if you hold risk constant. Holding only treasuries instead of a market portfolio of nominal bonds, and simultaneously increasing the equity allocation a little bit can actually increase portfolio return without increasing risk.

Here is an example where I adjusted the stock allocation empirically to get the same volatility (sample standard deviation) between the two portfolios. The portfolio with treasuries and a slightly higher equity allocation had a slightly higher return and lower max drawdown. It perhaps could go the other way in some future period, so the difference is a matter of taste, but many people, including some well respected investment professionals prefer the portfolio with treasuries and a slightly higher equity allocation.

https://www.portfoliovisualizer.com/bac ... alBond1=40
Thanks People continue to forget that it is looking at the whole portfolio and seeing what risk and return can be obtained by the appropriate combinations of all involved.

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Re: What are the disadvantages of taking all risk on equity side?

Post by HEDGEFUNDIE » Fri Jan 11, 2019 5:36 pm

danielc wrote:
Fri Jan 11, 2019 3:48 pm
HEDGEFUNDIE wrote:
Fri Jan 11, 2019 11:30 am
Two disadvantages:

1. Lower returns in the long run
2. Worse diversification of your equity allocation
I don't see how those are true. (1) The total return can be brought back up by increasing the size of the stock allocation. Presumably the debate is between some baseline Total Bond / Total Stock portfolio against a portfolio with safer bonds but a higher percentage in stocks. (2) How is the equity portfolio less diversified? Presumably you're getting the same index fund.
I interpret "taking all the risk on the equity side" to mean taking out risk on the bond side, in other words, keeping the equity allocation the same but shortening duration on your bonds.

Here is a comparison of 60/40 S&P500/Short Treasuries (i.e. taking all the risk on the equity side) with 60/40 S&P500/Long Treasuries:

https://www.portfoliovisualizer.com/bac ... easury2=40

Note the higher return for Portfolio 2 (i.e. my first point about return) as well as lower correlation to US Stocks (i.e. my second point about diversification)

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Re: What are the disadvantages of taking all risk on equity side?

Post by danielc » Fri Jan 11, 2019 6:27 pm

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 5:36 pm
I interpret "taking all the risk on the equity side" to mean taking out risk on the bond side, in other words, keeping the equity allocation the same but shortening duration on your bonds.
Ok. That's not how I interpret it. To me it means that all the risky assets are equities. But the bond/stock ratio is chosen independently to match your risk goals.

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 5:36 pm
Here is a comparison of 60/40 S&P500/Short Treasuries (i.e. taking all the risk on the equity side) with 60/40 S&P500/Long Treasuries:

https://www.portfoliovisualizer.com/bac ... easury2=40

Note the higher return for Portfolio 2 (i.e. my first point about return) as well as lower correlation to US Stocks (i.e. my second point about diversification)
I notice that you chose Long Treasuries instead of Total Bond. The suggestion to take risk on the equity side is mainly an argument against corporate bonds and especially junk bonds. Also, others in this forum have pointed out that Long Treasuries have had an uncharacteristically high return this past decade. I think it's because of the low interest rate environment. Here's another portfolio:

https://www.portfoliovisualizer.com/bac ... alBond3=40

Code: Select all

Portfolio 1:    35% Short Treasuries        / 65% Total Stock
Portfolio 2:    40% Intermediate Treasuries / 60% Total Stock
Portfolio 3:    40% Total Bond              / 60% Total Stock

Code: Select all

        CAGR     Stdev    Sharpe
P1      8.36%    9.58%    0.57
P2      8.73%    8.95%    0.64
P3      8.59%    9.15%    0.62
So... yeah. The portfolio with the short treasuries does have the lowest Sharpe ratio, but overall the portfolios are not THAT different. I would also consider intermediate treasuries an acceptable compromise. They have zero credit risk, and not as much interest rate risk as long treasuries.

For now I'm going to keep buying shorts because I'm building an emergency fund and there's no way I'm going to put that in intermediates. But after that's done, I will consider adding intermediates... Maybe a bled of shorts and intermediates wouldn't be too bad for me.

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Re: What are the disadvantages of taking all risk on equity side?

Post by kolea » Fri Jan 11, 2019 6:34 pm

Of course this debate is going to devolve into the "what is risk" discussion. For me, risk is more than just volatility, so using MPT techniques like efficiency frontiers and portfolio optimization based on volatility-as-risk just don't quite cut it.
Last edited by kolea on Fri Jan 11, 2019 6:34 pm, edited 1 time in total.
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Re: What are the disadvantages of taking all risk on equity side?

Post by Northern Flicker » Fri Jan 11, 2019 6:34 pm

I interpret "taking all the risk on the equity side" to mean taking out risk on the bond side, in other words, keeping the equity allocation the same but shortening duration on your bonds.
Well you are choosing to add additional constraints to the statement. The proponents of the statement “take risk on the equity side” are actually referring to credit risk of bonds, which is equity like, hence suggesting transferring that risk to the equity allocation.
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Re: What are the disadvantages of taking all risk on equity side?

Post by HEDGEFUNDIE » Fri Jan 11, 2019 6:52 pm

danielc wrote:
Fri Jan 11, 2019 6:27 pm
I notice that you chose Long Treasuries instead of Total Bond. The suggestion to take risk on the equity side is mainly an argument against corporate bonds and especially junk bonds. Also, others in this forum have pointed out that Long Treasuries have had an uncharacteristically high return this past decade. I think it's because of the low interest rate environment. Here's another portfolio:

https://www.portfoliovisualizer.com/bac ... alBond3=40

Code: Select all

Portfolio 1:    35% Short Treasuries        / 65% Total Stock
Portfolio 2:    40% Intermediate Treasuries / 60% Total Stock
Portfolio 3:    40% Total Bond              / 60% Total Stock

Code: Select all

        CAGR     Stdev    Sharpe
P1      8.36%    9.58%    0.57
P2      8.73%    8.95%    0.64
P3      8.59%    9.15%    0.62
So... yeah. The portfolio with the short treasuries does have the lowest Sharpe ratio, but overall the portfolios are not THAT different. I would also consider intermediate treasuries an acceptable compromise. They have zero credit risk, and not as much interest rate risk as long treasuries.

For now I'm going to keep buying shorts because I'm building an emergency fund and there's no way I'm going to put that in intermediates. But after that's done, I will consider adding intermediates... Maybe a bled of shorts and intermediates wouldn't be too bad for me.
You are missing the true measure of diversification, which is the portfolio's correlation to stock market. When the stock market crashes, how likely is it that the rest of your portfolio will crash with it?

The portfolio with Long Treasuries has the lowest correlation with the stock market, therefore it is more diversified and less risky than a portfolio with short bonds and/or intermediate bonds. As an aside, obviously corporate bonds are the most correlated with the stock market, so those should definitely be out of the picture.

As far the return of Long Treasuries, no matter whether the interest rate environment is high or low, in the long run longer duration bonds should pay more than shorter duration bonds, and this has been proven out in both rising and declining interest rate environments.

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Re: What are the disadvantages of taking all risk on equity side?

Post by Random Walker » Fri Jan 11, 2019 8:07 pm

kolea wrote:
Fri Jan 11, 2019 6:34 pm
Of course this debate is going to devolve into the "what is risk" discussion. For me, risk is more than just volatility, so using MPT techniques like efficiency frontiers and portfolio optimization based on volatility-as-risk just don't quite cut it.
I agree that there is more to risk than just volatility. But still I think we can use MPT effectively to build portfolios. If anything, different definitions of risk may increase the importance of diversification. What an asset adds to a portfolio depends on expected return, volatility, correlations, when correlations tend to change, costs. Adding uncorrelated individual assets with skewed and kurtotic return distributions should make the portfolio behavior as a whole more normal.

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Re: What are the disadvantages of taking all risk on equity side?

Post by Northern Flicker » Fri Jan 11, 2019 8:51 pm

The portfolio with Long Treasuries has the lowest correlation with the stock market, therefore it is more diversified and less risky than a portfolio with short bonds and/or intermediate bonds.
If you mean historical sample correlations, that is not always the case:

https://www.portfoliovisualizer.com/ass ... ingDays=60

Given the the situation also can be flipped with LT treasuries having the lowest correlation, and given that we don’t know which outcome will occur, it is quite possible the the lowest correlation of the three with equities in the joint distribution of future returns is intermediate treasuries.
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Re: What are the disadvantages of taking all risk on equity side?

Post by danielc » Fri Jan 11, 2019 9:44 pm

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 6:52 pm
You are missing the true measure of diversification, which is the portfolio's correlation to stock market. When the stock market crashes, how likely is it that the rest of your portfolio will crash with it?
If that's the definition you want to use (and I think it's a very good definition) then a very safe instrument like short treasuries is a very defensible option. Short treasuries don't crash when stocks crash. Of course, the argument you make about long treasuries having a lower correlation with the market is entirely valid as well; though my understanding is that they don't always have lower correlations. In any case, I don't have anything against long treasuries. I'm not interested in them right now because, quite simply, the term premium is negative.

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 6:52 pm
As an aside, obviously corporate bonds are the most correlated with the stock market, so those should definitely be out of the picture.
:thumbsup
HEDGEFUNDIE wrote:
Fri Jan 11, 2019 6:52 pm
As far the return of Long Treasuries, no matter whether the interest rate environment is high or low, in the long run longer duration bonds should pay more than shorter duration bonds, and this has been proven out in both rising and declining interest rate environments.
Have you looked at the yield curve recently?

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Re: What are the disadvantages of taking all risk on equity side?

Post by Random Walker » Fri Jan 11, 2019 10:19 pm

I think longer duration bonds would have increased correlation to equities. Growth stocks, and most market cap weighted TSM portfolios are basically large growth portfolios, have some exposure to the term premium. My understanding is that if one is really taking his risk on the equity side, he should keep the bonds high grade and short to intermediate term.

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Re: What are the disadvantages of taking all risk on equity side?

Post by bluquark » Fri Jan 11, 2019 10:28 pm

OP, perhaps the problem is that your emergency fund is not large enough for comfort? Increasing the size of it might satisfy your need for a "risk-free asset bucket".

If it winds up large enough to seriously affect your yield, you could hold an equal amount of long bonds so that your overall fixed income averages out to intermediate duration. This might be a psychological trick but a lot of personal investment is about psychological tricks :)

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Re: What are the disadvantages of taking all risk on equity side?

Post by galeno » Fri Jan 11, 2019 10:50 pm

There is NO disadvantage to taking HIGH risk on the equity side and LOW risk on the FI side.

For Bogleheads the choices are easy.

Equities: own "the whole USA haystack" (VTI) if you believe in the superiority of the USA. Or own the whole "world haystack" (VT) if you don't.

Fixed Income: own "investment grade bonds". Basically US Treasuries, investment grade corporate bonds, and TIPS if your equity allocation is less than 50%. Investment grade bonds have little to no credit risk. They are also more liquid. You may want to hold some CASH. CASH is the "safest" FI instrument. We like to start the year with 5% of port in CASH.

USA Treasury bonds have the best "ballast effect" but lower yields. Investment grade corportate bonds have higher yields but little or no "ballast effect". Any bonds that are not "investment grade" (i.e. JUNK bonds) will melt along with your equities. A NEGATIVE ballast effect.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 4.0%. TER = 0.4%. Port Yield = 2.82%. Term = 33 yr. FI Duration = 6.0 yr. Portfolio survival probability = 95%.

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Re: What are the disadvantages of taking all risk on equity side?

Post by HEDGEFUNDIE » Fri Jan 11, 2019 10:52 pm

danielc wrote:
Fri Jan 11, 2019 9:44 pm
HEDGEFUNDIE wrote:
Fri Jan 11, 2019 6:52 pm
You are missing the true measure of diversification, which is the portfolio's correlation to stock market. When the stock market crashes, how likely is it that the rest of your portfolio will crash with it?
If that's the definition you want to use (and I think it's a very good definition) then a very safe instrument like short treasuries is a very defensible option. Short treasuries don't crash when stocks crash. Of course, the argument you make about long treasuries having a lower correlation with the market is entirely valid as well; though my understanding is that they don't always have lower correlations. In any case, I don't have anything against long treasuries. I'm not interested in them right now because, quite simply, the term premium is negative.

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 6:52 pm
As an aside, obviously corporate bonds are the most correlated with the stock market, so those should definitely be out of the picture.
:thumbsup
HEDGEFUNDIE wrote:
Fri Jan 11, 2019 6:52 pm
As far the return of Long Treasuries, no matter whether the interest rate environment is high or low, in the long run longer duration bonds should pay more than shorter duration bonds, and this has been proven out in both rising and declining interest rate environments.
Have you looked at the yield curve recently?
30 years are still yielding more than 10 years. It’s the middle of the curve that’s inverted.

But regardless of what the curve is doing now, long tends to beat medium tends to beat short. Betting on anything else is just market timing.

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Re: What are the disadvantages of taking all risk on equity side?

Post by fennewaldaj » Fri Jan 11, 2019 11:17 pm

Random Walker wrote:
Fri Jan 11, 2019 10:19 pm
I think longer duration bonds would have increased correlation to equities. Growth stocks, and most market cap weighted TSM portfolios are basically large growth portfolios, have some exposure to the term premium. My understanding is that if one is really taking his risk on the equity side, he should keep the bonds high grade and short to intermediate term.

Dave
My understanding is empirically this is not true (the correlation is lower for longer bonds). More significantly they have a higher standard deviation so the low correlation is more likely to be helpful. There is a bunch of discussion in a recent thread about this.

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Re: What are the disadvantages of taking all risk on equity side?

Post by Northern Flicker » Fri Jan 11, 2019 11:19 pm

Random Walker wrote:
Fri Jan 11, 2019 10:19 pm
I think longer duration bonds would have increased correlation to equities. Growth stocks, and most market cap weighted TSM portfolios are basically large growth portfolios, have some exposure to the term premium. My understanding is that if one is really taking his risk on the equity side, he should keep the bonds high grade and short to intermediate term.

Dave
That may apply to the actual correlation of future returns for the reasons you give, but sample correlations from historical outcomes have varied both ways. I posted above where sample correlation was higher for long-term treasuries. The last 10 years generated the opposite result (both with respect to large caps or small-cap value):

https://www.portfoliovisualizer.com/ass ... ingDays=60
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Re: What are the disadvantages of taking all risk on equity side?

Post by Northern Flicker » Fri Jan 11, 2019 11:56 pm

fennewaldaj wrote:
Fri Jan 11, 2019 11:17 pm
Random Walker wrote:
Fri Jan 11, 2019 10:19 pm
I think longer duration bonds would have increased correlation to equities. Growth stocks, and most market cap weighted TSM portfolios are basically large growth portfolios, have some exposure to the term premium. My understanding is that if one is really taking his risk on the equity side, he should keep the bonds high grade and short to intermediate term.

Dave
My understanding is empirically this is not true (the correlation is lower for longer bonds). More significantly they have a higher standard deviation so the low correlation is more likely to be helpful. There is a bunch of discussion in a recent thread about this.
Examples seem to show that when treasuries exhibit positive sample correlation with equities, longer-term bonds have higher correlation, but when sample correlation of treasuries with equities is negative, longer-term bonds have lower correlation.

I think the fundamental issue is the sample correlation of equities with interest rates. When equities have a positive sample correlation to interest rates, they will have negative sample correlation to treasuries, and when equities have negative sample correlation to interest rates, they will have positive sample correlation to treasuries.

Because of the greater sensitivity to interest rates of longer duration bonds, the magnitude of the correlation of longer bonds with equities generally is higher than the magnitude of the correlation for shorter bonds. The sign of the correlations (positive or negative) then becomes what determines whether longer-term bonds have higher or lower correlation to equities.

When the sample correlations with equities are positive, the correlation of longer bonds is greater than correlation for shorter duration bonds, but when sample correlations with equities are negative, the correlation of longer bonds is lower than the correlation for shorter-term bonds.
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Re: What are the disadvantages of taking all risk on equity side?

Post by phantom0308 » Sat Jan 12, 2019 12:19 am

Note: I think putting all your risk in equities makes sense.

One reason it could be bad is that you’ll likely hear about it before other investments which could cause you to deviate from your plan. You’re more likely to hear about a crash in S&P than a downturn in REITs, high yield bonds, or small value international. Financial security through obscurity??

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Re: What are the disadvantages of taking all risk on equity side?

Post by delrinson » Sat Jan 12, 2019 6:47 am

bluquark wrote:
Fri Jan 11, 2019 10:28 pm
OP, perhaps the problem is that your emergency fund is not large enough for comfort? Increasing the size of it might satisfy your need for a "risk-free asset bucket".

If it winds up large enough to seriously affect your yield, you could hold an equal amount of long bonds so that your overall fixed income averages out to intermediate duration. This might be a psychological trick but a lot of personal investment is about psychological tricks :)
This is an interesting observation. While my emergency fund is currently large enough, I'm more thinking 10-15 years down the road. Perhaps if I simply had, say, two years in cash and short treasuries, I would more feel the freedom to have the rest of my fixed income in total bond.

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Re: What are the disadvantages of taking all risk on equity side?

Post by hdas » Sat Jan 12, 2019 8:17 am

nisiprius wrote:
Fri Jan 11, 2019 7:49 am

The blue dots show a 60/40 portfolio where the "40" is in intermediate-term bonds. The red dots show the effect of changing that "40" to to cash (as represented by PortfolioVisualizer's CASHX asset, Treasury bills), which is basically what you are proposing to do. To the extent that you believe the simulation, you should ask yourself "how do I feel about a plan that gives me the range of outcomes shown in red, rather than the range of outcomes shown in blue?" This is not a case where the difference is so small that it is "lost in the noise." On the other hand, it is clear that the range of differences due to "fate" is much larger than the range of differences due to "portfolio choice."

Image
It would be useful to add another portfolio to the comparison, where the 40% is equal parts:

>> Emerging Market Bonds
>> Long Term Bonds
>> High Yield Corporate Debt
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Re: What are the disadvantages of taking all risk on equity side?

Post by danielc » Sat Jan 12, 2019 8:38 am

HEDGEFUNDIE wrote:
Fri Jan 11, 2019 10:52 pm
30 years are still yielding more than 10 years. It’s the middle of the curve that’s inverted.

But regardless of what the curve is doing now, long tends to beat medium tends to beat short. Betting on anything else is just market timing.
You make it sound like looking at the yield curve is gambling. I don't understand why you object so strongly. When I borrow money shop around for a low interest rate. When I lend money, I shop around for a high interest rate. Also, there is always the question of whether you are being fairly compensated for the risk. A while ago @jalbert was explaining to me that long treasuries usually have a very poor return considering the length of the maturity because the main buyers of those treasuries are organizations (pension funds? annuities?) that have very specific long-term liabilities.

Some people in this forum (e.g. Larry Swedroe) have recommended that you require at least 20bp of yield for each additional year of maturity. Right now the yield on 1-year Treasuries is 2.57% and 30-year Treasuries return 3.04%. That's a difference of only 47 bp for an additional 29 years. According to Swedroe's rule, 30-year Treasuries would not be a good deal unless their yield was 14.9% at least.

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Re: What are the disadvantages of taking all risk on equity side?

Post by danielc » Sat Jan 12, 2019 8:45 am

phantom0308 wrote:
Sat Jan 12, 2019 12:19 am
Note: I think putting all your risk in equities makes sense.

One reason it could be bad is that you’ll likely hear about it before other investments which could cause you to deviate from your plan. You’re more likely to hear about a crash in S&P than a downturn in REITs, high yield bonds, or small value international. Financial security through obscurity??
On the flip side, REITS, high-yield bonds, and SV Intl will have a high "tracking error" relative to the S&P.

--- "Why are my stocks going down when everyone else's are going up??!!11!"

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