Taking risk on the equity side?

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jmg229
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Taking risk on the equity side?

Post by jmg229 » Mon Jun 13, 2011 8:56 am

I have been reading the board here for about a year or so now and am now beginning to put together my investment plan for the future. I just finished reading Rick Ferri's All About Asset Allocation and am having trouble reconciling it with something from grok's tips series. There seemed to be general agreement on grok's post that risk should be taken on the equity side (easier to diversify, riskier bonds have higher correlations with stocks than safer bonds).

This is at odds with what Mr. Ferri mentions in his book, which is that any diversification by use of an asset class with an expected real return after costs is good diversification. He also points out that the corporate credit risk premium/equity risk premium correlation varies from about -.2 to +.9 and contends that even high yield bonds can be valuable in a portfolio because the default risk is not identical to equity risk (although they may be similar).

I am having trouble understanding the argument for consolidating risk on the equity side of your investments. Perhaps this gets to the point about the role of bonds in the portfolio, which has been discussed many times here, but to me the role of bonds is to add extra diversification/rebalancing benefits while still achieving my target risk profile. With that as the goal, it seems to make sense to diversify in bonds as much as possible (given costs) rather than just upping the equity holdings I already have.

I would greatly appreciate any input on this as I go about writing out my investment plan.

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kenyan
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Post by kenyan » Mon Jun 13, 2011 9:09 am

I'm finishing up that book as well right now, and it's clear that Rick disagrees on that general point. Of course, there are plenty of things that Bogleheads disagree on - take risk on the equity side is a tendency (probably a strong tendency), but nothing writ in stone. Rick also suggests splitting up Pacific/Europe developed markets, which very few do here. Granted, that's likely for convenience's sake and the existence of the wonderful Vanguard Total International funds rather than any ideological difference.

I think you have a good feel for the argument. Many like the bonds to be the stable portion of their portfolio; the increased correlation of corporates to equities make them less desirable than higher-quality bonds. It basically comes down to personal preference. One could delve into the mathematics of backtested portfolios, but I doubt there would be much difference - and whatever you found might not hold in the future.

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few thoughts

Post by larryswedroe » Mon Jun 13, 2011 10:39 am

first, one can diversify equity risks much more effectively. Our clients typically own about 12 thousand stocks
Second, you earn the premium in much more effective way in terms of tax efficiency, so if location is an issue at all, this becomes an issue
Third, while corporate credit risk has some unique characteristics they are relatively minor and the worst part is that their risks tend to highlyt correlate with equity risks at wrong time.

So whatever you decide make sure to do what almost all investors in corporate debt (and most advisors also in my experience) ACCOUNT for the equity like exposure in corporate debt in your AA. For example, if own a true junk bond fund I would consider 50% equity and if Vanguard fund 20-25%, And EM bond fund would have to be accounted for as equity risk also. Otherwise fooling yourself about the risks in portfolio

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Post by jebmke » Mon Jun 13, 2011 10:44 am

What would be a good rule of thumb for the equity tilt from something like VG Investment Grade funds? 5-10 %?
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LH
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Post by LH » Mon Jun 13, 2011 11:26 am

take risk on the equity side is a rule of thumb.

It would be easy to conflate high yield (junk) bonds, as bonds, when thinking about a junk bond split.

Humans are not supercomputers, we think in emotional/behavoiral/abstract ways. When it comes down to it, we are going to think gut level, stocks = risk, bonds = less risk. And the junk bonds are gonna be tossed in with the other bonds.

Or maybe not, one cannot easily do a study of course : )

So its just a rule a thumb. If you want, throw some high yield bonds in, but the big difference between them and TIPS or Aggregate is, during a GD II say, they will get hammered, and may go to near zero. whereas your actual bonds, TIPS certainly, and nominals if deflationary/nonhighinflation will be what saves your butt. This type of things comes down to the "real deal" and to get a sense of the real deal, not many left who have experienced it.

http://www.amazon.com/Great-Depression- ... 158648799X

gives some sense of it. Bonds are Bonds, were reportedly nice to have then. High yield in that sense, not bonds in the sense the author is talking about.

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Post by RobG » Mon Jun 13, 2011 2:26 pm

It is pretty easy to say take the "risk on the equity side" but what is the equivalent risk-free/equity mix for, say, corporate bonds? What should the "age in bonds" rule of thumb be adjusted for?

I understand the logic behind taking risk on the equity side, but it seems that people will simply replace the corporates, etc with treasuries and end up lowering their expected return.

rg
Last edited by RobG on Mon Jun 13, 2011 4:22 pm, edited 1 time in total.

jmg229
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Post by jmg229 » Mon Jun 13, 2011 3:01 pm

Thank you all for the responses. First off, I meant to say that I am talking about tax-advantaged accounts, so the tax behavior is not something I am currently concerned with. I should've said that from the start.

My thinking is similar to RobG's. To me it is all about expected return. Once you figure out your expected return you are aiming for (your need to take risk), figuring out the way to do that with the most diversification (while accounting for cost) seems to be the way to go. Then, when looking at this allocation, you "gut check" it to make sure that it is within your risk tolerance. As long as you don't kid yourself about the risks of each asset class (yes, I understand high yield bonds are more like equities than bonds in bad times), you should be fine in my mind. To me, it comes down to estimated returns, aiming too high introduces too much risk and aiming too low risks not achieving your investing goals. This, followed by the gut check to try to ensure that you will not capitulate in a down market seems to be the summary of the asset allocation advice I have heard so far on this board.

Please let me know if you think I am mistaken in any part of my logic.

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Post by livesoft » Mon Jun 13, 2011 4:02 pm

I have no problem disagreeing with grok87's tips.

I am very happy to own Vanguard short-term investment grade bond fund as well as the vanguard short-term corporate bond index fund.

I have no problem disagreeing with Swedroe with respect to GNMA bond fund as well.

That's part of the fun of investing: One is allowed to make up one's own mind about things.
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Bond Risks

Post by BillRogers » Mon Jun 13, 2011 4:22 pm

Relative performance in fixed income is largely driven by two dimensions: bond maturity and credit quality. Longer duration bonds are subjected to the risk of unexpected changes in interest rates. Bonds with lower credit quality are subject to default risk. Extending bond maturities and reducing credit quality increases potential returns.

Investors seeking greater expected returns may increase their equity exposure while keeping their bond portfolio short and high-quality.

Alternatively, they may choose to hold bonds with slightly longer maturities and slightly lower credit quality while maintaining their equity allocation.

Source: Dimensional Fund Advisors "The Science of Investing".

Bill Rogers

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Post by stratton » Mon Jun 13, 2011 5:18 pm

RobG wrote:It is pretty easy to say take the "risk on the equity side" but what is the equivalent risk-free/equity mix for, say, corporate bonds? What should the "age in bonds" rule of thumb be adjusted for?

Short duration. Larry would probably say 1-2 year duration. Vanguard's investment grade fund duration is around 2.7 or 2.8 years right now.

Paul
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RobG
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Post by RobG » Mon Jun 13, 2011 5:26 pm

stratton wrote:
RobG wrote:It is pretty easy to say take the "risk on the equity side" but what is the equivalent risk-free/equity mix for, say, corporate bonds? What should the "age in bonds" rule of thumb be adjusted for?

Short duration. Larry would probably say 1-2 year duration. Vanguard's investment grade fund duration is around 2.7 or 2.8 years right now.

Paul

Hi Paul - My point was a little different. Say you were investing in corporate or other non-treasury bonds but "saw the light" and decided to "take the risk on the equity side." How would you do this properly? You'd have to up your equities to get the same expected return. But by how much? It seems like 90% of the people would just trade the corporates for treasuries and lower their expected return.

rg

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Post by yobria » Mon Jun 13, 2011 9:39 pm

Some things have a definite answer (Should you pay 2% for an S&P 500 index fund?)

Some things are a matter of preference, like this issue.

Seems that most people on this board to take some risk on the bond side (eg total bond fund). Whether you want to go farther (eg corporates) is again a matter of taste.

Nick

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some thoughts

Post by larryswedroe » Mon Jun 13, 2011 9:57 pm

First the higher the grade and the shorter the maturity the less equity like risk. So for example for junk bonds 50% equity, for Vanguard high yield 25%, for investment grade intermediate, perhaps 15%, for corporate ST, maybe 10 or so. At least you would know you are in ballpark and not underestimating risks
BTW-age in bonds was never a good idea, that tells you nothing about willingness or need to take risk so makes no sense--it only considers ability, and even then doesn't take into account labor capital, only horizon.

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Re: Taking risk on the equity side?

Post by grok87 » Tue Jun 14, 2011 8:55 am

jmg229 wrote:I have been reading the board here for about a year or so now and am now beginning to put together my investment plan for the future. I just finished reading Rick Ferri's All About Asset Allocation and am having trouble reconciling it with something from grok's tips series. There seemed to be general agreement on grok's post that risk should be taken on the equity side (easier to diversify, riskier bonds have higher correlations with stocks than safer bonds).

This is at odds with what Mr. Ferri mentions in his book, which is that any diversification by use of an asset class with an expected real return after costs is good diversification. He also points out that the corporate credit risk premium/equity risk premium correlation varies from about -.2 to +.9 and contends that even high yield bonds can be valuable in a portfolio because the default risk is not identical to equity risk (although they may be similar).

I am having trouble understanding the argument for consolidating risk on the equity side of your investments. Perhaps this gets to the point about the role of bonds in the portfolio, which has been discussed many times here, but to me the role of bonds is to add extra diversification/rebalancing benefits while still achieving my target risk profile. With that as the goal, it seems to make sense to diversify in bonds as much as possible (given costs) rather than just upping the equity holdings I already have.

I would greatly appreciate any input on this as I go about writing out my investment plan.

Some more color may be helpful.
I am an institutional fixed income investor. I am continually amazed at how retail folks fail to realize how lucky they are in terms of their fixed income options. I would love to have these accessible to me as an institutional investor:

1) I bonds: better real return than short term tips with no interest rate risk. Also no expense ratio if you are comparing to VIPSX

2) FDIC insured savings account yielding 1%. Same risks (i.e. none) as tbills which are yielding zero.

3) Longer term cds with easy early withdrawal penalties. If interest rate rise a lot you can cash in, essentially at par, and reinvest at the higher rates. Plus they usually yield more than treasuries. For example its easy to find a 5 year cd yielding 2.5% (some yield 3%) vs. 5 year treasury at 1.66%.

4) The G fund in the federal TSP. the yield of longer dated treasuries without the interest rate risk.

With all of these superior retail fixed income products, I simply can't understand peoples preferences for the total bond market index fund or corporate bond funds. Higher expenses and more risk and lower yields/returns.

They say there is no such thing as a free lunch. But for retail fixed income investors every day is a smorgasboard of tasty free dishes while I am starving for yield here in institutional fixed income land!
;-)
cheers,
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

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Responses

Post by slowmoney » Tue Jun 14, 2011 8:48 pm

Larry wrote:

BTW-age in bonds was never a good idea, that tells you nothing about willingness or need to take risk so makes no sense--it only considers ability, and even then doesn't take into account labor capital, only horizon.


Grok87 wrote:

With all of these superior retail fixed income products, I simply can't understand peoples preferences for the total bond market index fund or corporate bond funds. Higher expenses and more risk and lower yields/returns.

They say there is no such thing as a free lunch. But for retail fixed income investors every day is a smorgasboard of tasty free dishes while I am starving for yield here in institutional fixed income land!



Mmm...very interesting quotes by two REAL LIVE finance professionals. BTW, I don't feel all that bad for the institutional investors low yields. :lol:
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Re: Taking risk on the equity side?

Post by Daffy » Tue Jun 14, 2011 11:37 pm

grok87 wrote:1) I bonds: better real return than short term tips with no interest rate risk. Also no expense ratio if you are comparing to VIPSX

2) FDIC insured savings account yielding 1%. Same risks (i.e. none) as tbills which are yielding zero.

3) Longer term cds with easy early withdrawal penalties. If interest rate rise a lot you can cash in, essentially at par, and reinvest at the higher rates. Plus they usually yield more than treasuries. For example its easy to find a 5 year cd yielding 2.5% (some yield 3%) vs. 5 year treasury at 1.66%.

4) The G fund in the federal TSP. the yield of longer dated treasuries without the interest rate risk.


All true, but keep in mind none of these options are available in tax-deferred accounts where many of us hold our bond or fixed income portfolio. Makes sense if there's room in taxable accounts or where tax rates are indifferent, but not always optimal.

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Re: Taking risk on the equity side?

Post by Kevin M » Wed Jun 15, 2011 6:08 am

Daffy wrote:
grok87 wrote:1) I bonds: better real return than short term tips with no interest rate risk. Also no expense ratio if you are comparing to VIPSX

2) FDIC insured savings account yielding 1%. Same risks (i.e. none) as tbills which are yielding zero.

3) Longer term cds with easy early withdrawal penalties. If interest rate rise a lot you can cash in, essentially at par, and reinvest at the higher rates. Plus they usually yield more than treasuries. For example its easy to find a 5 year cd yielding 2.5% (some yield 3%) vs. 5 year treasury at 1.66%.

4) The G fund in the federal TSP. the yield of longer dated treasuries without the interest rate risk.


All true, but keep in mind none of these options are available in tax-deferred accounts where many of us hold our bond or fixed income portfolio. Makes sense if there's room in taxable accounts or where tax rates are indifferent, but not always optimal.


Actually, you can get options 2 and 3 in IRA accounts, but if your IRA is somewhere like Vanguard, you must transfer or roll over to another institution. The question then is is it worth the paperwork to transfer over, and then perhaps back again once bond rates rise.

Option 4 is a tax advantaged account, but of course only available to federal employees.

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Re: Taking risk on the equity side?

Post by grok87 » Wed Jun 15, 2011 7:02 am

Kevin M wrote:
Daffy wrote:
grok87 wrote:1) I bonds: better real return than short term tips with no interest rate risk. Also no expense ratio if you are comparing to VIPSX

2) FDIC insured savings account yielding 1%. Same risks (i.e. none) as tbills which are yielding zero.

3) Longer term cds with easy early withdrawal penalties. If interest rate rise a lot you can cash in, essentially at par, and reinvest at the higher rates. Plus they usually yield more than treasuries. For example its easy to find a 5 year cd yielding 2.5% (some yield 3%) vs. 5 year treasury at 1.66%.

4) The G fund in the federal TSP. the yield of longer dated treasuries without the interest rate risk.

All true, but keep in mind none of these options are available in tax-deferred accounts where many of us hold our bond or fixed income portfolio. Makes sense if there's room in taxable accounts or where tax rates are indifferent, but not always optimal.


Actually, you can get options 2 and 3 in IRA accounts, but if your IRA is somewhere like Vanguard, you must transfer or roll over to another institution. The question then is is it worth the paperwork to transfer over, and then perhaps back again once bond rates rise.

Option 4 is a tax advantaged account, but of course only available to federal employees.

Ibonds are obviously tax advantaged.
Re the fdic savings aCcount, I actually hold in taxable. On an after tax basis it yields about 60 bps more than a tax exempt muni money market, and of course it has better credit risk.
Cheers,
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Post by LH » Wed Jun 15, 2011 4:15 pm

RobG wrote:
stratton wrote:
RobG wrote:It is pretty easy to say take the "risk on the equity side" but what is the equivalent risk-free/equity mix for, say, corporate bonds? What should the "age in bonds" rule of thumb be adjusted for?

Short duration. Larry would probably say 1-2 year duration. Vanguard's investment grade fund duration is around 2.7 or 2.8 years right now.

Paul

Hi Paul - My point was a little different. Say you were investing in corporate or other non-treasury bonds but "saw the light" and decided to "take the risk on the equity side." How would you do this properly? You'd have to up your equities to get the same expected return. But by how much? It seems like 90% of the people would just trade the corporates for treasuries and lower their expected return.

rg


You are thinking backwards (to my way of thinking : P)

I think aggregate, with what, 16 percent corporate, is ok. One would have to look at Great Depression, but I think the bonds of the top notch companies, largely survived in a relative sense (this maybe dead wrong, a weak gestalt only). So anyway, I accept in general in a deflationary depression, aggregate bond would do ok.

So anyway, you would not start with a portfolio that has 15 percent high yield bonds in it, and think, how would I change my stock/bond ratio to adjust for taking OUT high yield, because you are coming from the position that the rule "take risk on the equities side" was designed for and to prevent:

Not really having a clue what the risk is

I would say, look at it from the point of view that you want something, that if the GDII hits, would likely survive, and not plummet. Then look at your stocks, and figure out what your number of stock loss is, 50 percent was my old gestalt, but for worse case, say 90 percent of your stocks get wiped out. Pick some number "rationally" from you brain/gut or whatever you propose to pick the number from.

Then look at what happens to your portfolio.

Assume the bonds survive, the stocks take the hit that you have picked as your max drop in stocks.

Pick your poison like that, and see what you are comfortable with.

That would be my way of approaching it. to kinda go off on an extreme here, an unfair one for sure, but let me say your approach is akin to someone saying:

hey I have the following portfolio:

10 JGBT - PowerShares DB 3x Japanese Govt Bond Futures ETN
10 percent HealthShares Enabling Technologies ETF (HHV)
10 Claymore MACROshares Oil Down Tradable Shares (DCR)
10 percent iShares MSCI Belgium Index (EWK)
30 percent Direxion Daily 20+ Year Treasury Bull 3x Shares (NYSE: TMF)
20 PCY (the PowerShares Emerging Markets Sovereign Debt Portfolio ETF)

Tell me how I would convert that to an equivalent boglehead stock/bonds split......

the answer is: dude, I dunno. I take my risk on the equity side so I can avoid having to even think about it. I know where I stand then if things get really bad. That is the real utility of the rule of thumb. Makes things much easier. its not necessary per se, just easier.

So, junk the conversion, the problem with the conversion, is you do not really know where you stand to begin with per se.

Set your stock/bond split the traditional Boglehead way from scratch.

Again, some high yield is fine, as long as you know what it is you have, and do not conflate them with "bonds" just because they are called "bonds" human : )

I cede the above example is absurd relatively, and please do not sik the estimable Mr. Ferri on me : )

(Note nominal bonds can get killed in inflation, but that is easy to understand)

[/u]

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Re: few thoughts

Post by Bongleur » Wed Jun 15, 2011 5:56 pm

larryswedroe wrote:So whatever you decide make sure to do what almost all investors in corporate debt (and most advisors also in my experience) ACCOUNT for the equity like exposure in corporate debt in your AA. For example, if own a true junk bond fund I would consider 50% equity and if Vanguard fund 20-25%, And EM bond fund would have to be accounted for as equity risk also. Otherwise fooling yourself about the risks in portfolio


Is the downside tail risk for junk bonds approximately the same as equities, or is it significantly more or less?

Currently the "not too junky" bond funds like Vanguard High Yield seem to be achieving my requirement of 2% real return on the whole portfolio.

So if I were to put 100% into it, then I'd have a 25/75 equity/bond portfolio. What's wrong with that?

TIPS currently at 1.8% don't yet meet my minimum requirements; although I could put the portfolio's 15% of tax-advantaged money into them and offset it with TSM or even small/value. Have to do some math to figure out the quantities and net risk to see if the risk would be less than the junk bond risk. But with inflation expected to rise, I don't see why I should lock myself into TIPS just yet. I guess this is a situation where I'd like to hire someone to do the calculations.

I guess my plan is to stick with the high yield and cash/short term until the TIPS get better.

Have to start paying attention FDIC bank account & CD rates too, as a bond-like offset for risk on the equity side. My credit union is paying 0.50% on large savinga account balances -- where is the 1%?
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Re: few thoughts

Post by Kevin M » Wed Jun 15, 2011 8:58 pm

Bongleur wrote:Have to start paying attention FDIC bank account & CD rates too, as a bond-like offset for risk on the equity side. My credit union is paying 0.50% on large savinga account balances -- where is the 1%?

A number of internet banks are paying around 1%. Also, a 5-year CD paying about 2.4% with a 2 month early withdrawal penalty will start to exceed 1% after about 4 months, and will increase from there.

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Re: few thoughts

Post by grok87 » Wed Jun 15, 2011 9:09 pm

Kevin M wrote:
Bongleur wrote:Have to start paying attention FDIC bank account & CD rates too, as a bond-like offset for risk on the equity side. My credit union is paying 0.50% on large savinga account balances -- where is the 1%?

A number of internet banks are paying around 1%. Also, a 5-year CD paying about 2.4% with a 2 month early withdrawal penalty will start to exceed 1% after about 4 months, and will increase from there.

Here's a list
http://www.depositaccounts.com/savings/
cheers,
"...people always live for ever when there is any annuity to be paid them"- Jane Austen

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Post by Bongleur » Thu Jun 16, 2011 12:48 pm

Why does Swedroe say he always takes the TIP having the higher interest rate?

If a $1000 buys an on-the-run 1%, then shouldn't $2000 buy an off-the-run 2% having the same amount of time to maturity?

And both going to cost the same amount in current taxes, no matter what the unexpected inflation rate?

Is unexpected inflation defined as the inflation factor for the bond + current CPI ?

I gotta closely read the _understanding TIPS_ book by The Finance Buff...
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