[Note: The following is Part II of a guest post that I requested from one of my Gold Sponsors, Johanna Fox, CPA of Fox & Company Wealth Management. In case you missed it, please visit Part I of Bonds: What Are They Good For, then come back for the rest of the story.]
Let’s open this second part of our bond series with a couple of statistics:
- On average, the stock market experiences an intra-year drop of 14.1%.
- On average, we have experienced a bear market (defined as a sustained drop of 20% or more) every 5.5 years since the end of WWII. Excluding the mini-bear in August 2011, we’re going on 8 years since the last bear. That doesn’t mean one is right around the corner, it just means we’re 7 years closer than we were in 2009.
- For more, see Small Stock Market Pullbacks, illustrating the historical frequency by size of drop (“drawdown threshold”) and average length before recovery.
Nobody likes nasty surprises, so preparedness is essential for successful equity investing. If you don’t regard a market drop as the end of the world, but as a normal part of the investing cycle (even an opportunity!), you’re far more likely to act appropriately rather than to react emotionally.
We recite these statistics to our clients at least once a year. We tell them that they should prepare to watch 20% and more of their portfolio vanish, albeit temporarily, in the next bear market. We tell them we will be happy to hold their hands and listen to their terror.
But we also tell them we will not entertain a request to “go to cash” or anything silly like that unless they have decided it’s time for a new financial advisor, at which point we will move mountains to accommodate their request. They may roll their eyes, and say, “I know, I know…” but we field very few panic-driven calls when the market drops 10% or more.
Of course, being a successful equity investor is not easy. In the panic of a falling market, Chicken Little is headlining every media outlet. It’s ok to be afraid, it’s just not ok to give in to your fear.
Remember: the prices of stocks tend to be more volatile than the values of the companies represented by ownership of that stock. And, in the end, that is all we are paying for when we buy shares in a mutual fund or ETF: ownership in a diversified portfolio of living, breathing, operational, valuable businesses, not lottery tickets or poker chips.
What about the “smoothing”?
Smoothing out is just another way of saying, “I don’t trust myself to not go off the cliff with the lemmings, even though I know it’s a mistake, so I am happy to settle for less income in retirement and a reduced legacy for my loved ones.”
If history is our guide (and it’s the only guide we have), we know that market drops don’t mean loss of principle – unless we make the conscious effort to replace a temporary, uncomfortable feeling with a permanent loss – they are opportunities. People often take drugs to “smooth out” the rough edges rather than facing life and solving their problems. Is that what you prefer?
And retirement?
But how about as I “approach retirement”, you say? Retirement is another opportunity for you to be dragged back into the mind-numbing Zombieland of “conventional wisdom”.
It goes something like this: the closer you get to retirement, the higher percentage you should allocate to bonds…or…Subtract your age from 100 and that’s the amount you should allocate to equities and put the rest in bonds, sis boom bah, easy-peasy! We like simple rules of thumb, don’t we? But…I don’t have any clients whose plans run according to rules of thumb (or conventional wisdom, for that matter).
The problem with easing into bonds at retirement is that it assumes:
1) You are going to retire without a plan in place, so you must “protect” yourself by owning bonds (an easy albeit costly substitute);
or
2) You have a plan in place but it stipulates that you will withdraw huge chunks of your portfolio on the day you retire.
or
3) You know you’re going to die in 5 years and will spend all of your savings in that period.
Wouldn’t it make more sense to dispense savings per the dictates of your financial plan, your estate plan, charitable plan, etc. while allowing your principle to grow for the next 3+ decades?
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Make a retirement plan.
As you approach and enter retirement, if you have a real plan in place, I see it going like this:
“When I retire at 62, we will keep 2 years of withdrawal needs (amounts we will need beyond Social Security and other resources for monthly living expenses) in a money market account. Because our joint life expectancy is 30 years and inflation won’t take a break just because I’ve retired, we will keep all but our short-term withdrawal needs invested in the same portfolio that has served me well for the last 30 years. In the event of a bear market, I will not be tempted to risk our long-term financial security by trying to time the market, because I can either cut back on spending and/or turn on the money market spigot while leaving our portfolio undisturbed.”
And so forth. If you have a plan like that in place and you trust that your financial planner is doing her job, why would you need to disrupt your beautifully-designed and efficiently-operating portfolio?
There is no such thing as no risk. There is only the choice of what to risk and when. For early retirees, the risk is even greater and the prospects are grimmer. To retire in your forties or fifties, your plan must incorporate a portfolio that will sustain you for 50 – 60 years.
You choose what is preferable: a plan that exploits the long-term growth of the equity portfolio you have planted, diversified and tended to provide an ever-increasing source of shade and nourishment for decades to come (and beyond as your legacy)?
It all gets back to the plan. If you have planned ahead, knowing that you will experience intra-year drops and bear markets and that “this, too, shall pass”, the emotion of the moment (or the weeks or months) does not have to turn you into a bond zombie or force you to jump off the roller coaster at just the moment your portfolio will splat all over the pavement.
Instead, you can focus on the long-term plan. And if you aren’t sure you can do that all on your own, this is a perfect example of how a trustworthy fee-only financial planner who crafts and collaborates on your plan can be worth her weight in long-term results.
[Thank you, Johanna, for this excellent 2-part guest post. Readers, what are your thoughts? Still good with 100 – age in bonds?]
I appreciate the article written by someone much smarter than me about the specifics of investment asset classes. It appears that the author has completely thrown out human behavior as an equation to investment success.
To be fair, she has mentioned working with a financial advisor and having an official investment plan. However, for DIYers who have yet to see a bear market or the majority of Americans who don’t have access to a financial advisor, they will probably need some “smoothing” from fixed income/cash assets. How much is an individual matter of risk tolerance, previous experience with market crashes, etc. After all, isn’t it better to have a portion of your AA in bonds than selling in a panic?
To use the analogy of using drugs to smooth out life…there are plenty of people who have serious psychiatric conditions that have used the medicines to restore themselves to functional status is society.
Certainly, a 50 year old veteran investor who has seen several downturns and kept his/her cool would be fine with a 100% equities portfolio. I don’t think the same allocation would serve a 33 year old out of training with little investment experience.
As for myself, i’m at a 80/20 stock/bond allocation and am waiting for the next downturn to see if I can be more aggressive with my AA.
A balanced portfolio would have dropped but not nearly as much as a 100% stock allocation. Depending on your risk profile, you might be tempted to sell when your portfolio falls 40% but that is exactly the worst time to sell! Holding a good part of your assets in bonds will lower the swings of your portfolio and might save you from selling at the bottom.
If you are risk-averse, the worst thing you can do is sell at as soon as you see your portfolio drop 43% but having bonds would have enabled you to keep your calm, hold on, and ride the market back up.
Strong point by PoF. Volatility smoothing with lower correlation assets is certainly a more powerful sustainer of a retirement portfolio if you have 25x expenses vs 50x expenses. At the 50x level, you can better afford to drastically cut back withdrawals and more selectively withdraw from down asset classes.
Also a big fan of Darrow Kirkpatrick’s work on selective valuation based withdrawals. Note sure what method I’ll end up using. I’m sure by then there will be better metrics than CAPE 10 in 10-20 years, but having a portfolio that includes many poorly correlated asset types only improves upon this opportunity.
I am at the very beginning of my investing journey and I don’t intend to own any bonds for decades, if ever. I know how little I can live on. When I approach ER, I’ll have 2 years of expenses saved outside of my investment accounts. That seems like enough of a cushion to me since I don’t have to use all of the set-aside cash if I don’t want. More time in the market feels good to me.
It’s just a totally different approach. The portfolio I construct will never reflect either of your above portfolios. I have no use for gold which has little practical value and does well to mimic inflation over the long term. And I don’t use rules of thumb in a real plan. The “safe and sustainable withdrawal rate” that someone has calculated has no bearing on following a financial plan based upon historical market returns and history is really all we have to go on, when you get right down to it.
If only to lay out, follow, and ascribe to the dictates of a true financial plan were common and generic, I might not have a job. However, it’s actually a bit radical in our age of cerebral people who prefer smart and complicated systems proposed by other cerebral people. That is not who I am or what I do. A portfolio is not a plan, yet the portfolio is what you circle back to. I’m afraid that is where our paths diverge.
That was my post under Anonymous above (forgot to leave name or sign in). Would be curious to hear PoF’s opinion on bonds and opinion on Tyler’s work at portfoliocharts.com. Has a big following at Bogleheads forum. I’ve become a believer. Where do you stand on bonds? Gold? Increasing exposure to high return asset classes with lower correlation even if that means going up to 15-20% on things like REITs, gold, international small caps, mid cap value, long term treasuries, etc… Or will you stick with your portfolio and stay the course in retirement?
Good morning, Gipper, Was your question directed at me or PoF?
It was to PoF, but I always like hearing your take. I think I know where you stand on bonds overall, but I would like to hear your rebuttal of Tyler’s arguments from portfoliocharts.com. Seems pretty mathematically clear to me that volatility can damage a retirement portfolio, and in particular lower the safe withdrawal rate, particularly if unlucky with sequence of return. After playing around with the portfolio finder and reading his supporting pieces, do you disagree with the methods, math, or conclusions? To me, they are particularly powerful because they include every possible starting point of the historical data.
In my mind bonds on not just for short term goals, but they serve as a unique diversifying piece of a retirement portfolio that not only improves risk adjusted returns, but actually can IMPROVE the safe withdrawal rate if paired with the appropriate equities and alternatives.
You are overlooking the plan. All I would ask is that you tell me how my model can go wrong. Sorry, but I do what I do and have no interest in rebutting the various mathematical theories. Suppose I might if somebody would tell me where I am wrong.
Seems a bit of a generic response to say I am overlooking “the plan”. Your model is solid. But what if your clients could choose between two retirement portfolios A & B.
Portfolio A is a well diversified 100% equity portfolio containing 60% total US and 30% total international index mutual funds, with 5% in small cap value and 5% in REIT funds, expected to yield 6% average annual real return, but have years of up to -30%. Expected 30 year safe withdrawal rate is about 5.5%.
Portfolio B contains 20% total US stock, 20% small cap value, 10% total international, 10% international small cap, 10% REITs, 10% gold, 20% long or intermediate term treasuries. This portfolio would also be expected to yield 6% average annual real returns. Might it surprise you that it would be considerable less volatile giving the lower correlations of the components, with a significantly lower worst year loss, number of years down, and time to recover. So what you might say. Volatilty is not risk and is no worry to us. Would it surprise you to learn than portfolio B would support a HIGHER safe and sustainable withdrawal rate, by about 0.5%, despite the presence of 20% bonds. Would this not persuade you that bonds may in fact have a place in a retirement portfolio?
No chime in from PoF?
Sorry, TheGipper. The day job still keeps me busy, but I was working on a reply as you posted. I’d take your portfolio B over portfolio A, but it wouldn’t surprise me to see A outperform B over the short, medium, or long term.. An expected 0.5% additional return may never materialize. My portfolio is a bit more complicated than the 3-fund portfolio, but I think I’d be comfortable with that one, too.
I will be spending some time (when I find some) poring over portfoliocharts.com. Thanks for the heads up!
Best,
-PoF
My portfolio is probably closer to Portfolio A (close to all-equity, US-centric). I doubt that my portfolio or your portfolio A will get to 6% real return with today’s rich valuations (CAPE ratio is too high to get much above 4% real).
The one portfolio that will have the hardest time reaching 6% real is your portfolio B:
Gold has had less than 1% real return over the last 100+ years.
Treasury yields are 2.27% for 30Y and 1.56% for the 10Y Treasury. If we already handicap 30% of the portfolio to, say, 0.5% real return then the remainder of the portfolio has to have 8.36% real (!) return. That will be difficult in today’s environment.
Try out the calculators on portfolocharts.com and see if this changes your opinions on these numbers. I think many get seduced by CAPE ratios and current bond yields. What makes gold so vital to a portfolio is not its low long term return but its very negative correlation with equities. The smoothing manages to improve withdrawal rates, even though gold would not return much on its own. I was surprised by this as well.
Gold helped once: during the 1970s when stocks and bonds tanked at the same time (oil shock, inflation and Volcker sank both equities and bonds). So, the bad start years for annual withdrawals 1965 and 1966 will look better if you mix in a little bit of gold. True. I’d be afraid pinning my hope on that one episode.
Also: I still don’t see how an asset with low correlation and essentially zero expected return can suddenly lift the expected return to 6% real. I could see that if one asset with low returns had a *very negative* correlation and you lever up the portfolio you can lift the portfolio E(r) higher. But a) the gold correlation is not negative enough and b) your portfolio B has no leverage. Maybe you can explain to me what you were using as underlying E(r) for the assets in Portfolio B and the whole story becomes a bit clearer.
I didn’t believe it at first either. But using all possible running 30 year historical periods, adding as little as 5% gold to a portfolio will significantly help the safe withdrawal rate of a portfolio. The answer lies in that gold is zigging while equities are zagging. You’d be harpressed to find an asset class with a lower correlation to equities. Thus even with only a 1-2% long term return, gold can still significantly help maintain a retirement portfolio, by decreasing volatility. This conclusion in based on the math done at portfoliocharts.com, but also by others.
My sample portfolios were not meant to be what you should use or what I use, just an illustration of a point. I believe Tyler at portfolio charts uses Vanguard index funds as the basis of his calculators and frequently updates ERs, but you’d have to read his methods on that.
“Volatility smoothers” with low correlation or inverse correlation to the markets will help preserve a portfolio’s value during a market downturn. I won’t deny that.
I think people who will benefit the most are those who insist on a consistent withdrawal rate and / or are “cutting it close” in terms of having just enough (less than or equal to 25x spending) to support them in retirement.
Rather than supplement with a significant proportion of “smoothers” I will have More than Enough, and be willing to cut back on spending in bad years. A couple years’ cash (or CD ladder or equivalent) is probably an excellent idea as well.
Another Ace up my sleeve will be ongoing income. As I stated on the WCI forum, there’s always money in this banana stand, as long as I can keep you all engaged, informed, or entertained.
Cheers!
-PoF
I think Johanna presents a good argument against owning bonds “just because” you’re a certain age or risk averse. Thanks again for the thoughtful posts and responses!
I structured my portfolio based on quite a few factors: my reading on Bogleheads, WCI, and a few books. Also, funds available to me (in employer retirement plans), tax loss harvesting opportunities, a high risk tolerance, etc… I revisit the IPS annually, so it’s not set in stone.
My portfolio and recent and long-term performance have been covered in previous posts. It would be interesting to run it through portfoliocharts to make some comparisons. That could easily be another interesting post.
As you can see, I do some tilting to small and mid-cap value, emerging markets, and REIT, all of which have the potential for higher volatility and long-term return. I hold 10% bonds / cash (most in Vanguard total bond index). In my mind, that 10% allocation serves as a counterbalance to the more risky tilts, and increases diversification. I haven’t added any precious metals; owning Total Stock Market gives me exposure the mining stocks, etc… I’ve gone into further discussion of my motivations in my IPS post.
I think if you’re doing the Big things right, keeping investing and personal expenses reasonably low (mostly index funds and a high savings rate, respectively), minimizing taxes, and keeping track of your net worth, and sticking to your plan, you’ll easily find yourself among the top decile in terms of being a successful investor. The particulars of your allocation (0%, 10%, or 25% bonds), TLH, rebalancing, tilting, etc… will play a role in determining where in that top decile you end up, but if you’re above the 90th percentile, I wouldn’t lose any sleep over the details. But that’s just me. Some people find the details to be the most exciting part of investing.
Best,
-PoF
Very good points.
I particularly like this quote: “volatility is what allows equity investors to reap great rewards”
That’s what people forget sometimes. Investors get paid to take risk (CAPM). The higher the risk the higher the reward. Hedge out too much of your risk and you’re left with returns too small to reach retirement or to live comfortably in retirement.
This one is also very true: “There is no such thing as no risk”
Bonds have lower short-term (daily, monthly, quarterly, annual) volatility, but can sometimes have long stretches of very poor returns: 1901-1920, 1941-1981. One 20y and one 40y window of very, very bad average returns. Monthly vol was low, but returns were bad. The mother of all risks!
Same with cash: Essentially zero volatility, but the risk of not keeping up with inflation (especially in today’s environment with zero rates).
Thanks for your comments, ERN. We are on the same wavelength (except I don’t equate volatility with risk – unless there is no plan in place).
Johanna, this was a great part II to your story, thanks for sharing the great info. I currently have about 10-15% in bonds, which I am OK with for now. I think the tricky part is figuring out the rights allocation once you are within a few years plus or minus of retirement. Managing the withdrawal rate against the potential returns in order to maximize the portfolio is not straightforward without a plan as you mentioned. Great food for thought!
Thanks for your comments, Jon. Of course, you’ll continue to need growth during retirement. The plan is the key.
For a long time I was a 100% equities proponent. Slowly I was persuaded the value of adding in higher and higher percentages of diversifying alternatives and more volatile equities such as REITs, gold, microcaps, and international small caps vs just total market funds with minor small and value tilts. Only recently have I been convinced that adding some bonds will actually INCREASE your safe (money won’t runout) and sustainable (preserve value) withdrawal rates in retirement.
The logic is somewhat counterintuitive, but let me take a crack at it. Volatility is most certainly not risk, but volatility does certainly have a real and damaging effect to a portfolio’s safe and sustainable withdrawal rate. As such, it is possible to construct a portfolio of 4-8 asset classes with by focusing on minimizing correlation that together will maintain long-term returns, decrease volatility, and by decreasing volatility increase your portfolio’s sustainable withdrawal rate.
Check out the incredible work done over at portfoliocharts.com, and particularly check out the portfolio finder. I was surprised to see that a portfolio with 20% bonds could provide a far better long term sustainable withdrawal rate than say a 60/40 total US stock/total international stock portfolio. Once more, the bonds that are most favorable to long term success are not what you may suspect. Check it out.
All that said, I think Johanna’s arguments are more correct than not and probably right on the market for early accumulators. But think twice before you dismiss the damaging effects of volatility. There are better ways to maintain long term returns and decrease volatility which in tern will preserve the portfolio longer in retirement, and yes these strategies usually will include some bonds and other frowned upon alternatives such as gold. The key is diversification. Real diversification. While we all like to think that owning the whole US stock market in a total stock fund and much of the international market in a total international find, as well as maybe throwing in some small caps, value stocks, and REITs for good measure is diversification enough. The truth is that these assets still move together and in a sense do not provide great overall diversification.
Thank you so much for this addition to the discussion. This kind of information and accessible resource is fantastic for the accumulator and the preserver alike. This is another one to add to my bookmark list. Awesome.
I also find the portfoliovisualizer.com site very useful also for backtesting.
Such tools give investors the choice whether to manage their own assets or go with advisors. As they say, Personal Finance is, well, personal. A choice you make to suit your personal needs. And hopefully using all the information at hand as we continue to educate ourselves.
Will be checking in today now and then to see how the discussion on this great topic unfolds.
Appreciate your thoughts. The difference between my method/philosophy and those of all the calculators and chartists is the introduction of a financial plan. With a live plan driving the investment process, it is quite easy to structure a portfolio to yield optimum results.
Without a plan, you definitely need to allow for “unexpected” consequences as you really are at the mercy of the markets (and your feelings). Therefore, without a plan, you will need to guess and/or use some kind of formulaic buffer for your portfolio.
It continues to amaze me that the plan itself is given short shrift. Is there more work in creating and following a plan that will drive your decisions? Absolutely, but it makes financial decisions, including investment portfolio management, quite simple.
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Great post, Johanna! I agree and love the statistics up front. No hiding the truth those stats tell you, but embracing it and the long term opportunity for growth is key.
It was tough going through the great recession as my first major sell off in the market, but now I’m more emotionally prepared for the next one.
I have really formulated my plan yet for retirement but I envision it being somewhat similar to what you detailed. I may want up to three years in liquidity to allow time for a market rebound if we experience a big drop again.
Green Swan – I responded to you earlier this morning but the comment is not showing, so I’ll try to recreate it:
If 3 years liquidity is what it takes for you to not react emotionally during a downturn and if the lowered long-term returns will not significantly impact your standard of living, then that’s fine by me. However, you might want to consider that 2 years of liquidity may easily stretch to 3 years as we typically are able and willing to adjust our spending/standard of living down in a recession.
As time goes by and you become more comfortable with a plan-driven strategy, I wouldn’t be surprised if you were able to gradually dial back to 2 years of living expenses, either.
Just remember that your 2-yr. slush fund is only for cash flow needed beyond what other income will cover, not the whole budget. Of course, for early retirees, 100% of the set-aside may be necessary until Social Security distributions begin…which brings up a whole new topic – when to begin drawing SS?
Awesome series. I had always thought I was more aggressive doing (age in bonds)/2 but this series has about converted me to wondering what the point of that is at all.
My only thought then, I’m coming out of residency and know in 5 years we will upgrade our home and I’ll need a nice chunk of cash for that down payment. Because I have an end date needing that cash, does that change the above thinking?
Do I save in cash for 5 years?
Do I invest that equivalent cash in total bond fund for 5 years for the lower volatility but much lower reward?
Do I invest that cash in my portfolio same as always, accepting the possiblity of an ill timed market but higher rewards?
All above options still include max retirement accounts and chuck to taxable portfolio yearly.
Interesting thoughts.
Great questions. Since 5 years is our demarcation line separating the short- from the long-term, you could
1. Begin paring back your diversified equity portfolio over the next year if 5 years is the drop-dead date,
2. Buy high-quality corporate bonds set to mature in 5 years,
3. Gradually move to cash/bonds over the next few years and be prepared to be flexible on your timeline if the market happens to nosedive at precisely the wrong time.
Chances are, you’ll be fine with #3 (the market is up 70% of the time) but I don’t like taking chances with people’s money (either direction) so if you cannot be flexible with the date or amount, best bet is bonds. please note that I Did Not Say “Bond Fund”. We do not “invest” in bonds in any way, and that is what a bond fund purports to be: an investment. Bonds should be used to meet liquidity needs over the short term, not as an investment.
This Q&A is a great example of how a real financial plan should drive your decisions.
Great 2-part post. As a holder of dividend-paying equities and no bonds, I am glad to see someone from mainstream finance not praising bonds much in this environment. Yes, volatility can be scary but worse is the silent killer called inflation which extracts a far heavier price at the end for having enjoyed a ‘smoother’ ride. Before anyone jumps in to say that dividends can get cut, I will admit it does, so that’s why we need a cushion there as well among dividend-payers across multiple sectors. I stayed invested through the 2008-09 bottom with no money in or out (in hindsight, should have put money in), but was made ‘whole’ by early 2012. Lesson I learned: Time in the market and not timing the market! The biggest bubble, if there is one, is right now in bonds.
I agree with your bond bubble theory, even though it is irrelevant to our current clients. Just follow your plan. Obviously, I would never recommend this strategy without a current financial plan in place. The plan must be updated for changes in your goals, resources, and situation so that the investment strategy can be modified when necessary.