Author Topic: "Why You Shouldn't Substitute Stocks for Bonds"  (Read 12423 times)

Interest Compound

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"Why You Shouldn't Substitute Stocks for Bonds"
« on: December 02, 2015, 05:01:07 PM »
Shamelessly copying Taylor's post from Bogleheads, as it's been a topic here lately:

------------------------------------------------------------------------------------
Bogleheads:

Interest rates are low and bond forecasts are scary. Substituting high-dividend stocks for bonds is a strong lure for investors. A recent AARP article by Boglehead Allan Roth explains why substituting stocks for bonds can be a major mistake. These are excerpts:

Quote
"One adviser suggested investors in their 60s invest 70 to 80 percent of their portfolio in stocks. I couldn’t disagree more."

"It’s a misconception that interest rates are near an all-time low. What matters is the real return after taxes and inflation. -- Real rates are actually much better today than when we could get 12 percent nominal returns."

"It may seem like AT&T is a very safe company, but so did General Motors and Eastman Kodak at one time. Both paid high dividend yields and were among the 10 most valuable companies on the planet. Both filed for bankruptcy and common shareholders got nothing."

"So far this century, bonds have far outpaced stocks."

"Many of the top economists have correctly predicted the direction of interest rates less than half the time, meaning their forecasting abilities are less accurate than a coin flip."

"Bonds should be safe and boring." -- "I’ve seen too many “new paradigms” end poorly for investors."

Why-you-shouldnt-substitute-stocks-for-bonds

Thank you, Allan Roth.

Best wishes
Taylor

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #1 on: December 02, 2015, 05:50:27 PM »
This is coincidentally another vote for not trying to 'time the market'.

For some reason, everyone is more than accepting of the detrimental effect of trying to time the stock market to secure superior returns. Albeit, these same investors are more than adamant that the bond market is headed for prolonged negative territory and therefore should be avoided.

Statistically, this is not the truth. Fixed income still holds its own in an adequately constructed portfolio, and regardless of short-term predictions, sticking to an individual asset allocation model is still crucial in regards to the risk-reward trade-off.

Switching out of bond holdings into dividend stocks or REITs is the epitome of an inexperienced market-timing investor trying to capitalize on current conditions, predictions, and a bullish view on equities that is already incorporated into an efficient market.

protostache

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #2 on: December 02, 2015, 05:58:11 PM »
I don't really have an opinion on substituting high-dividend stocks for bonds later in life. Just want to contribute this link, where Joshua Kennon breaks down the Eastman Kodak bankruptcy and how common shareholders definitely did not walk away with just nothing. In fact, holding from 1987 through 2013 (year of the case study) you would have walked away with a 5.5% CAGR even with Kodak stock going to near $0 (they didn't completely die until a few years later).

http://www.joshuakennon.com/eastman-kodak-example/

ImCheap

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #3 on: December 03, 2015, 10:30:29 AM »
I however can see using CD's in lieu of a intermediate bond fund, somewhat sane in my mind.

For the record I don't use CD's I feel I have enough time to ride some rate hikes, that is if the rate hikes come.

If I was closer to needing to drawdown I would think a little different.

johnny847

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #4 on: December 03, 2015, 10:43:41 AM »
This has been shown many many times before on this forum, but here it is again.



VBTLX is Vanguard Total Bond Market Index. It held a nice steady value during the 08-09 crash.
VTSAX is of course Vanguard Total Stock Market Index.
VHDYX is Vanguard High Dividend Yield Index.

VHDYX behaved far more like a stock fund than a bond fund. In fact, it underperformed VTSAX and VBTLX during the downturn.

LAGuy

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #5 on: December 03, 2015, 12:26:26 PM »
While I wouldn't advocate trading out bonds for dividend stocks (I'd just use a total market index), I have a hard time seeing a place for bonds in a portfolio right now especially for the early retirement crowd. Assuming we want our 4% withdrawl rate, a slug of bonds is basically going to be dead money that's not going to even remotely keep up. Yes, I know it can reduce volatility and that's certainly important for getting a good nights rest, but otherwise your money is going to be doing nothing for you. Just look at the chart Johnny posted, but go back just to 2011. Bonds have gone nowhere and they've got nowhere to go.

Here's my take on why you may as well be in stocks. It used to be you bought a bond for the yield, and you were happy with whatever it was. If you got appreciation, that was just a bonus. But at current yields, if you want a 4% withdrawl rate you're basically speculating on capital appreciation as well. And if you're going to speculate on capital appreciation, there's a better instrument for that: stocks.

Aphalite

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #6 on: December 03, 2015, 12:31:56 PM »
Unless you think interest rates will spike quickly and suddenly, there's no substance to the worry that bonds will perform poorly/negatively in the future, since bonds are generally rolled as rates move (even the total bond fund only has an average duration of ~6 years)

Not only that, "High" dividend stocks are usually riskier as you climb into the top quintile of dividend payers sorted by yield - these represent companies that are going out of business, and as div yield is a backwards looking metric, you don't get any sort of warning. 4th quintile of div yield as a class of stocks tend to do okay over the long term
« Last Edit: December 03, 2015, 12:33:28 PM by Aphalite »

Wolf359

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #7 on: December 03, 2015, 02:51:03 PM »
While I wouldn't advocate trading out bonds for dividend stocks (I'd just use a total market index), I have a hard time seeing a place for bonds in a portfolio right now especially for the early retirement crowd. Assuming we want our 4% withdrawl rate, a slug of bonds is basically going to be dead money that's not going to even remotely keep up. Yes, I know it can reduce volatility and that's certainly important for getting a good nights rest, but otherwise your money is going to be doing nothing for you. Just look at the chart Johnny posted, but go back just to 2011. Bonds have gone nowhere and they've got nowhere to go.

Here's my take on why you may as well be in stocks. It used to be you bought a bond for the yield, and you were happy with whatever it was. If you got appreciation, that was just a bonus. But at current yields, if you want a 4% withdrawl rate you're basically speculating on capital appreciation as well. And if you're going to speculate on capital appreciation, there's a better instrument for that: stocks.

For the early retirement crowd, a high savings rate trumps high returns.  That means that capital preservation should be the primary driver during the accumulation phase.

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the end of 2013, or nearly 7 years. 

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, and contributing 10% of the initial balance annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the middle of 2012, or nearly 5 years. 

I don't recommend a 50/50 stock/bond mix.  That's a bit conservative for many here.  But it shows how a diversified portfolio with a lot of bonds would perform in a market crash. 

Bonds aren't for return.  Bonds are for safety.  If you're shooting for early retirement and you could avoid adding an additional 5-7 years to your accumulation phase due to a market crash, would that be useful to you?  That's the value of bonds. 

LAGuy

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #8 on: December 03, 2015, 05:51:00 PM »
While I wouldn't advocate trading out bonds for dividend stocks (I'd just use a total market index), I have a hard time seeing a place for bonds in a portfolio right now especially for the early retirement crowd. Assuming we want our 4% withdrawl rate, a slug of bonds is basically going to be dead money that's not going to even remotely keep up. Yes, I know it can reduce volatility and that's certainly important for getting a good nights rest, but otherwise your money is going to be doing nothing for you. Just look at the chart Johnny posted, but go back just to 2011. Bonds have gone nowhere and they've got nowhere to go.

Here's my take on why you may as well be in stocks. It used to be you bought a bond for the yield, and you were happy with whatever it was. If you got appreciation, that was just a bonus. But at current yields, if you want a 4% withdrawl rate you're basically speculating on capital appreciation as well. And if you're going to speculate on capital appreciation, there's a better instrument for that: stocks.

For the early retirement crowd, a high savings rate trumps high returns.  That means that capital preservation should be the primary driver during the accumulation phase.

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the end of 2013, or nearly 7 years. 

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, and contributing 10% of the initial balance annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the middle of 2012, or nearly 5 years. 

I don't recommend a 50/50 stock/bond mix.  That's a bit conservative for many here.  But it shows how a diversified portfolio with a lot of bonds would perform in a market crash. 

Bonds aren't for return.  Bonds are for safety.  If you're shooting for early retirement and you could avoid adding an additional 5-7 years to your accumulation phase due to a market crash, would that be useful to you?  That's the value of bonds.

Well, if one was still in the accumulation phase over that time frame presumably everything wouldn't have been bought in one chunk at the top of the market. I'm not going to bother with the math, but dollar cost averaging over the same period of time probably favors the 100% stock scenario.

But, historically over a long enough time period stocks have outperformed bonds. Thus, by putting funds into 100% stocks would be the most likely way to avoid adding an additional number of years to your accumulation phase. Of course, there's always going to be outliers...I'm sure somebody can point to some period of time where bonds were a better bet. Pocket Aces in Hold em Poker still doesn't win 100% of the time.

However, I'm not really trying to argue that bonds were a bad investment over the time period you used. Certainly they didn't do half bad. I'm more talking about what bonds look like right NOW and in the recent past (say the past 4 years). Safety is about all they really offer. And by safety you're pretty much talking "marks time with inflation at best." I have a hard time seeing how being in bonds right now is going to allow you to achieve a 4% withdrawl rate unless 1) You expect bond capital appreciation or 2) You expect your the stock portion of your portfolio to do the heavy lifting. Both instances seem to favor just saying, "Screw it. I'll just buy all stocks instead."

mrpercentage

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #9 on: December 04, 2015, 12:13:00 AM »
I feel the need to respond here as I might be one of the culprits in the forum that this is addressing.

Instead of arguing for or against I just want to point out a few things.

Dividend based investing is a different strategy:
1. The chart for equity doesnt mean anything if you are living off of dividends.
2. So to argue this point you would need to review split adjusted dividend payout charts for each fund to determine how a dividend fund is effected during a downturn. It really depends on the fund.

The goal is dividend growth
1. can be accomplished through company raises of dividends
2. can be accomplished through the compounding effect of reinvesting dividends
3. to work right withdrawl rate can never pass dividend payout

The idea is to never sell your shares.

So if stability is the issue-- it should be stability of distribution. Dividend Distribution (for DGI) vs. Withdrawl rate of (total return). Keep inmind hypothetically dividends go on forever, so to compare you should not withdrawl more than maybe 3% or 4% max on a total return account for accurate comparison (it should last forever).

If dividends have been adjusted ask why-- a stock split (dosent mean anything), change of holdings by management (could happen depending on fund), or cuts by individual securities

Would you have to adjust your withdrawl rate on a standard equity investing account? Would you recieve less of a payout on a dividend account?

That would be how to compare the two different strategies. The charts don't mean as much if you have a different strategy and charts also often are often inaccurate: They don't display reinvested dividends, or they don't even display dividends at all, they dont show the difference between monthly vs lump sum investing, or they don't take into account of fees, or they are based of bad information, or they have a flaw in their algo--- honestly there have been a few I have run into that were way off from reality.


Shane

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #10 on: December 04, 2015, 12:57:42 AM »
As we're almost ready to FIRE, I've been thinking a lot about our long-term asset allocation strategy. So, this discussion of stocks vs. bonds is very relevant to me. I'm not considering substituting dividend stocks or REITs for bonds. I'm not planning on buying any bonds at all. But I want to make sure I'm doing the right thing...

All through the accumulation phase, since I was 21 years old, I've been invested in 100% stocks. In 2008, when the market tanked, I just continued dumping all of my excess money into the stock market. I have absolutely no problem with big draw downs in my accounts. So, I don't need bonds for any psychological reasons. I only want to buy bonds if they will, in some way, add actual value to my investing strategy.

A few months ago I quit working. After we sell our house, sometime next year, we will be FIRE. I don't want to ever have to work at a job again.

One third of our net worth is invested (100% stocks) in tax deferred tIRAs, Roths and 401k accounts. Two thirds of our net worth is tied up in our house, which we're about to put onto the market in the next couple of months. We've also got around one year's worth of living expenses in savings and checking accounts which is what we are living off of now.

When we sell our house in 2016 we will have ~$600K in cash to invest. My inclination is to put all of it into VTSAX. If we had to, we could live on only the dividends from VTSAX, but we'd obviously like to spend more if market returns support that.

No matter how many scenarios I run on cFIREsim, the same results appear: the more bonds in my portfolio, the higher probability I will run out of money in fewer than 40 years. To me, this is the only thing that matters. I don't want to run out of money!

Would someone please explain to me why bonds make a portfolio safer? People keep saying that bonds in their portfolios make it easier for them to sleep at night. WTF? Why would knowing that you are more likely to run out of money make you sleep better at night? I understand that bonds smooth out volatility in a portfolio, and I can see how a very small percentage of bonds, say up to 10%, actually increases CAGRs. But, overall, higher percentages of bonds in my portfolio correlate with a higher probability of running out of money before we run out of life. This is what the data tell me. Am I missing something here? If so, please explain.

Sorry this is getting long, but one more thing. The other day I was listening to a podcast on econtalk.org, and in the comments someone posted a recent quote from one of Warren Buffet's letters to his Berkshire Hathaway shareholders. When I read WBs letter it pretty much confirmed what I'd been thinking all along - holding cash is NOT safe. Short term t-bills are paying less than inflation right now. Sorry, I'm not interested. Anyway, check out WBs letter, and I'll be interested to hear what you guys have to say. Any advice on my particular situation will also be greatly appreciated, as I'm a little scared to dump a big chunk of change into the stock market right now, but it's the only thing I can think of to do with it that makes any sense to me.

Here's WBs letter:

Quote
"Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index).

There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."

Seppia

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #11 on: December 04, 2015, 06:26:41 AM »


. I'm more talking about what bonds look like right NOW and in the recent past (say the past 4 years). Safety is about all they really offer. And by safety you're pretty much talking "marks time with inflation at best." I have a hard time seeing how being in bonds right now is going to allow you to achieve a 4% withdrawl rate unless 1) You expect bond capital appreciation or 2) You expect your the stock portion of your portfolio to do the heavy lifting. Both instances seem to favor just saying, "Screw it. I'll just buy all stocks instead."

You're looking back at a short time frame, that coincides with one of the great bull markets we have had.
By ANY metric, US stocks are extremely high right now, they sure could go even higher in the near future, but history says returns on stocks bought now will not be as high.
I personally see bonds as a better version of cash, a way to come in and average down in case of big downturns.
As someone else said, bonds are for stability.

Wolf359

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #12 on: December 04, 2015, 07:50:55 AM »
While I wouldn't advocate trading out bonds for dividend stocks (I'd just use a total market index), I have a hard time seeing a place for bonds in a portfolio right now especially for the early retirement crowd. Assuming we want our 4% withdrawl rate, a slug of bonds is basically going to be dead money that's not going to even remotely keep up. Yes, I know it can reduce volatility and that's certainly important for getting a good nights rest, but otherwise your money is going to be doing nothing for you. Just look at the chart Johnny posted, but go back just to 2011. Bonds have gone nowhere and they've got nowhere to go.

Here's my take on why you may as well be in stocks. It used to be you bought a bond for the yield, and you were happy with whatever it was. If you got appreciation, that was just a bonus. But at current yields, if you want a 4% withdrawl rate you're basically speculating on capital appreciation as well. And if you're going to speculate on capital appreciation, there's a better instrument for that: stocks.

For the early retirement crowd, a high savings rate trumps high returns.  That means that capital preservation should be the primary driver during the accumulation phase.

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the end of 2013, or nearly 7 years. 

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, and contributing 10% of the initial balance annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the middle of 2012, or nearly 5 years. 

I don't recommend a 50/50 stock/bond mix.  That's a bit conservative for many here.  But it shows how a diversified portfolio with a lot of bonds would perform in a market crash. 

Bonds aren't for return.  Bonds are for safety.  If you're shooting for early retirement and you could avoid adding an additional 5-7 years to your accumulation phase due to a market crash, would that be useful to you?  That's the value of bonds.

Well, if one was still in the accumulation phase over that time frame presumably everything wouldn't have been bought in one chunk at the top of the market. I'm not going to bother with the math, but dollar cost averaging over the same period of time probably favors the 100% stock scenario.

But, historically over a long enough time period stocks have outperformed bonds. Thus, by putting funds into 100% stocks would be the most likely way to avoid adding an additional number of years to your accumulation phase. Of course, there's always going to be outliers...I'm sure somebody can point to some period of time where bonds were a better bet. Pocket Aces in Hold em Poker still doesn't win 100% of the time.

However, I'm not really trying to argue that bonds were a bad investment over the time period you used. Certainly they didn't do half bad. I'm more talking about what bonds look like right NOW and in the recent past (say the past 4 years). Safety is about all they really offer. And by safety you're pretty much talking "marks time with inflation at best." I have a hard time seeing how being in bonds right now is going to allow you to achieve a 4% withdrawl rate unless 1) You expect bond capital appreciation or 2) You expect your the stock portion of your portfolio to do the heavy lifting. Both instances seem to favor just saying, "Screw it. I'll just buy all stocks instead."

I actually used the time frame selected by someone else, starting in 2005.  2007 was the top of the market.

I gave two examples.  The first one used the scenario most often employed for comparisons, which is a single lump sum at the beginning of the period. 

The second scenario involved an initial lump sum followed by a significant dollar cost averaging contribution.  This was intended to mimic someone in accumulation mode with high savings. 

Stocks do in fact outperform bonds over long periods of time like 20, 30, or 40 years.  However, if your timeframe is a 30-40 year accumulation phase, you are not an early retiree. 

I'm just pointing out that bonds are a valuable stabilizer that is worth consideration for someone who has a high savings rate and is attempting to collect a large amount of assets in a short period of time.  If you're shortening the timeframe, bonds become more useful for their stabilizing aspect.  In a 5-10 year accumulation period, preservation of capital is more valuable than total return.

Once you have accumulated the assets and want them to grow over time, your timeframe is lengthened, and the long-term growth prospects of stocks come into play.  So do the benefits of compounding. 

The crash in 2008 was followed by a 7-year bull market that allowed the all-stock portfolio to pull ahead.  But it still took 5-7 years for the stocks to recover from that crash.  Tell me what the next 5-7 years will hold.  If stocks outperform bonds, then an all-stock portfolio is better.  If there's another crash, bonds will reduce your losses.  The problem is that no one can predict the future accurately.  Putting bonds in the mix is reasonable.

The traditional retirement approach is to accumulate assets for 30-40 years.  When you're in your 20's, 100% stocks makes sense because you can handle the risk.  Also, you typically have fewer assets to save, so maximizing return is also important.

However, the early retirement aspirant is a different beast altogether.  He/She is saving 50-80% of their income, so there are more assets being accumulated.  The intent is to build assets in 5-10 years, so compounding and high return don't have as much of an impact.  Bonds may  help so that a crash in year 8 doesn't force you to reset the clock. 

Dicey

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #13 on: December 04, 2015, 08:36:01 AM »
Interesting thread. Posting to draft.

Wolf359

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #14 on: December 04, 2015, 11:43:26 AM »
As we're almost ready to FIRE, I've been thinking a lot about our long-term asset allocation strategy. So, this discussion of stocks vs. bonds is very relevant to me. I'm not considering substituting dividend stocks or REITs for bonds. I'm not planning on buying any bonds at all. But I want to make sure I'm doing the right thing...

All through the accumulation phase, since I was 21 years old, I've been invested in 100% stocks. In 2008, when the market tanked, I just continued dumping all of my excess money into the stock market. I have absolutely no problem with big draw downs in my accounts. So, I don't need bonds for any psychological reasons. I only want to buy bonds if they will, in some way, add actual value to my investing strategy.

A few months ago I quit working. After we sell our house, sometime next year, we will be FIRE. I don't want to ever have to work at a job again.

One third of our net worth is invested (100% stocks) in tax deferred tIRAs, Roths and 401k accounts. Two thirds of our net worth is tied up in our house, which we're about to put onto the market in the next couple of months. We've also got around one year's worth of living expenses in savings and checking accounts which is what we are living off of now.

When we sell our house in 2016 we will have ~$600K in cash to invest. My inclination is to put all of it into VTSAX. If we had to, we could live on only the dividends from VTSAX, but we'd obviously like to spend more if market returns support that.

No matter how many scenarios I run on cFIREsim, the same results appear: the more bonds in my portfolio, the higher probability I will run out of money in fewer than 40 years. To me, this is the only thing that matters. I don't want to run out of money!

Would someone please explain to me why bonds make a portfolio safer? People keep saying that bonds in their portfolios make it easier for them to sleep at night. WTF? Why would knowing that you are more likely to run out of money make you sleep better at night? I understand that bonds smooth out volatility in a portfolio, and I can see how a very small percentage of bonds, say up to 10%, actually increases CAGRs. But, overall, higher percentages of bonds in my portfolio correlate with a higher probability of running out of money before we run out of life. This is what the data tell me. Am I missing something here? If so, please explain.

Sorry this is getting long, but one more thing. The other day I was listening to a podcast on econtalk.org, and in the comments someone posted a recent quote from one of Warren Buffet's letters to his Berkshire Hathaway shareholders. When I read WBs letter it pretty much confirmed what I'd been thinking all along - holding cash is NOT safe. Short term t-bills are paying less than inflation right now. Sorry, I'm not interested. Anyway, check out WBs letter, and I'll be interested to hear what you guys have to say. Any advice on my particular situation will also be greatly appreciated, as I'm a little scared to dump a big chunk of change into the stock market right now, but it's the only thing I can think of to do with it that makes any sense to me.

Here's WBs letter:

Quote
"Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index).

There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities."
Bonds let you sleep at night because when you're dependent on your portfolio for your current income and the balance drops to 1/2 to 1/3 of the value you thought was enough to live on, a lot of people tend to worry about how they're going to live.  If you have a slug of bonds in your portfolio, your balance doesn't drop as much.

The scenario I was describing previously is a shortened accumulation phase desired by an early retiree.  For a short intense savings program, bonds make sense so a stock market crash doesn't set you back.

What you're asking about is the flip side, which is a very long distribution phase.  At that point, being mostly stocks makes a lot of sense.  You have to beat inflation, and stocks have a lot more upside than bonds over long time periods.  And many early retirees are looking at 40-50 year time periods -- more than enough to justify high stock allocations.

Your primary risk is a sequence of returns risk.  That is, if you retire just before a crash, and the subsequent bear market extends for a number of years.  Your balance may drop and never really recover (because you're drawing from them while the market is down.)  It's the first decade that is critical. 

There are lots of ways to address this:

1) Be flexible.  If there's an extended market downturn, reduce spending and maybe go back to work.  Get a rental property.  Do something that generates income.

2) Plan for it.  Some people do this by using a 3% or 2% SWR, building in a safety buffer.

3) Use a rising stock glidepath.  That is, you start with a higher bond allocation during the critical early years, and reduce it over time.  Once you pass the first 10 years, you're good to go.

Even Warren Buffet believes in SOME bonds.  When he left instructions for how his wife's bequest will be invested, he specified 90% stock market index and 10% bonds.  It also helps to start with a billion dollars.

TomTX

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #15 on: December 05, 2015, 07:33:34 AM »
While I wouldn't advocate trading out bonds for dividend stocks (I'd just use a total market index), I have a hard time seeing a place for bonds in a portfolio right now especially for the early retirement crowd. Assuming we want our 4% withdrawl rate, a slug of bonds is basically going to be dead money that's not going to even remotely keep up. Yes, I know it can reduce volatility and that's certainly important for getting a good nights rest, but otherwise your money is going to be doing nothing for you. Just look at the chart Johnny posted, but go back just to 2011. Bonds have gone nowhere and they've got nowhere to go.

Here's my take on why you may as well be in stocks. It used to be you bought a bond for the yield, and you were happy with whatever it was. If you got appreciation, that was just a bonus. But at current yields, if you want a 4% withdrawl rate you're basically speculating on capital appreciation as well. And if you're going to speculate on capital appreciation, there's a better instrument for that: stocks.

For the early retirement crowd, a high savings rate trumps high returns.  That means that capital preservation should be the primary driver during the accumulation phase.

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the end of 2013, or nearly 7 years. 

If you bought in 2005 (as per the example) and held a 50/50 Total stock market/intermediate treasure bond portfolio, rebalancing annually, and contributing 10% of the initial balance annually, you would have been outperforming a 100% Total Stock Market Portfolio from 2007 until almost the middle of 2012, or nearly 5 years. 

I don't recommend a 50/50 stock/bond mix.  That's a bit conservative for many here.  But it shows how a diversified portfolio with a lot of bonds would perform in a market crash. 

Bonds aren't for return.  Bonds are for safety.  If you're shooting for early retirement and you could avoid adding an additional 5-7 years to your accumulation phase due to a market crash, would that be useful to you?  That's the value of bonds.

Are your comparison charts reinvesting dividends on the stock side? Many don't, they just use stock price - which ignores the ~2% dividend on something like VTSAX.

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #16 on: December 06, 2015, 11:27:55 PM »


. I'm more talking about what bonds look like right NOW and in the recent past (say the past 4 years). Safety is about all they really offer. And by safety you're pretty much talking "marks time with inflation at best." I have a hard time seeing how being in bonds right now is going to allow you to achieve a 4% withdrawl rate unless 1) You expect bond capital appreciation or 2) You expect your the stock portion of your portfolio to do the heavy lifting. Both instances seem to favor just saying, "Screw it. I'll just buy all stocks instead."

You're looking back at a short time frame, that coincides with one of the great bull markets we have had.
By ANY metric, US stocks are extremely high right now, they sure could go even higher in the near future, but history says returns on stocks bought now will not be as high.
I personally see bonds as a better version of cash, a way to come in and average down in case of big downturns.
As someone else said, bonds are for stability.

I'm not talking about how bonds perform compared to stocks. I think an investment needs to hold its own weight. Bonds in and of themselves just look like a poor investment choice right now unless your goal is to just mark time with inflation. I have a hard time how anybody can look at a bond yield of 2% and say, "Yeah that looks like a solid investment choice to me." Unless you think they're going to see capital appreciation due to a depression type event. To me, personally, you need to be able to look at a bond yield and be happy with that...because there's a good chance that's all you're going to see of it. 2% bond yields don't let me retire on a 4% withdrawl rate. To me, again, that's just the end of the story. If they were yielding more like 5% (like they were at the beginning of the period going back to 2005 that everybody is using here as an example), then sure. I think bonds would have a place in my portfolio.

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #17 on: December 07, 2015, 12:05:32 AM »


. I'm more talking about what bonds look like right NOW and in the recent past (say the past 4 years). Safety is about all they really offer. And by safety you're pretty much talking "marks time with inflation at best." I have a hard time seeing how being in bonds right now is going to allow you to achieve a 4% withdrawl rate unless 1) You expect bond capital appreciation or 2) You expect your the stock portion of your portfolio to do the heavy lifting. Both instances seem to favor just saying, "Screw it. I'll just buy all stocks instead."

You're looking back at a short time frame, that coincides with one of the great bull markets we have had.
By ANY metric, US stocks are extremely high right now, they sure could go even higher in the near future, but history says returns on stocks bought now will not be as high.
I personally see bonds as a better version of cash, a way to come in and average down in case of big downturns.
As someone else said, bonds are for stability.

I'm not talking about how bonds perform compared to stocks. I think an investment needs to hold its own weight. Bonds in and of themselves just look like a poor investment choice right now unless your goal is to just mark time with inflation. I have a hard time how anybody can look at a bond yield of 2% and say, "Yeah that looks like a solid investment choice to me." Unless you think they're going to see capital appreciation due to a depression type event. To me, personally, you need to be able to look at a bond yield and be happy with that...because there's a good chance that's all you're going to see of it. 2% bond yields don't let me retire on a 4% withdrawl rate. To me, again, that's just the end of the story. If they were yielding more like 5% (like they were at the beginning of the period going back to 2005 that everybody is using here as an example), then sure. I think bonds would have a place in my portfolio.

In 2005, inflation was 3.4%



and US Bonds were yielding 4.90%, a real after-inflation yield of 1.5%.



Today inflation is 0.2%, and US bonds are yielding 2.36%, a real after-inflation yield of 2.16%.



Bonds are yielding more today than in 2005.

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #18 on: December 07, 2015, 09:35:49 AM »
Bonds let you sleep at night because when you're dependent on your portfolio for your current income and the balance drops to 1/2 to 1/3 of the value you thought was enough to live on, a lot of people tend to worry about how they're going to live.  If you have a slug of bonds in your portfolio, your balance doesn't drop as much.

The scenario I was describing previously is a shortened accumulation phase desired by an early retiree.  For a short intense savings program, bonds make sense so a stock market crash doesn't set you back.

What you're asking about is the flip side, which is a very long distribution phase.  At that point, being mostly stocks makes a lot of sense.  You have to beat inflation, and stocks have a lot more upside than bonds over long time periods.  And many early retirees are looking at 40-50 year time periods -- more than enough to justify high stock allocations.

Your primary risk is a sequence of returns risk.  That is, if you retire just before a crash, and the subsequent bear market extends for a number of years.  Your balance may drop and never really recover (because you're drawing from them while the market is down.)  It's the first decade that is critical. 

There are lots of ways to address this:

1) Be flexible.  If there's an extended market downturn, reduce spending and maybe go back to work.  Get a rental property.  Do something that generates income.

2) Plan for it.  Some people do this by using a 3% or 2% SWR, building in a safety buffer.

3) Use a rising stock glidepath.  That is, you start with a higher bond allocation during the critical early years, and reduce it over time.  Once you pass the first 10 years, you're good to go.

Even Warren Buffet believes in SOME bonds.  When he left instructions for how his wife's bequest will be invested, he specified 90% stock market index and 10% bonds.  It also helps to start with a billion dollars.

Honestly, this just sounds like timing the market to me.

If you're in the accumulation phase, the market dropping 1/2 isn't a bad thing. If you need bonds to "sleep at night" for that kind of drop, you're probably not going to make it as an early retiree to begin with.

If you're getting ready to retire or at early retirement already, you're likely counting on the returns to be able to have a portfolio that lasts. Holding bonds isn't going to somehow mitigate a massive drop in the market.

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #19 on: December 09, 2015, 10:48:42 AM »



"Even Warren Buffet believes in SOME bonds.  When he left instructions for how his wife's bequest will be invested, he specified 90% stock market index and 10% bonds.  It also helps to start with a billion dollars."

@Wolf359 - I think you are mis-reading the situation.  He's NOT investing in bonds.   He's using short term US treasuries because you can't safely put that much cash in the bank.

It's really 90% S&P 500, and 10% cash, where the cash is only reliant on the US government, not a bank.

See: http://www.joshuakennon.com/where-do-millionaires-invest-their-cash-to-keep-it-safe/

-J

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #20 on: December 09, 2015, 12:47:37 PM »
Shamelessly copying Taylor's post from Bogleheads, as it's been a topic here lately:

------------------------------------------------------------------------------------
Bogleheads:


Quote
"One adviser suggested investors in their 60s invest 70 to 80 percent of their portfolio in stocks."

No, no, fuckity-no!  Someone in their 60s should begin to be more concerned with preservation of their capital.  The whole "growth" portion of their portfolio should be moderate and slowly winding down.  70-80% in equity is for people 20-40 who have time to ride out more bumps.

« Last Edit: December 09, 2015, 12:50:22 PM by Kaspian »

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #21 on: December 09, 2015, 08:05:45 PM »
@Kaspian -

I am not convinced you should have that much in bonds, even at that age.  Maybe enough bonds to cover 5 to 10 years of expenses if stocks really tank.   If you are 60, you could easily live to 100.

I'd also say it depends on what stocks.   I am not convinced that bonds are that much safer than blue chip dividends.


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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #23 on: December 10, 2015, 03:00:50 PM »

TJ,

a) VDIGX isn't a dividend fund you would have in retirement if you were looking for income.  It is currently yielding 1.94%.    VHDYX would be a better fit at 3.18%

b) Does that graph include dividends?  If not, it proves *nothing*.  It drives me nuts that they never document that on the graphs.

c) A much better analysis would be the performance of those funds if you were removing money at a regular rate, especially if that rate was less than the 3.18%.   

I don't think we have the data to know the relative performance even in this specified case.   


tj

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #24 on: December 10, 2015, 04:58:50 PM »

TJ,

a) VDIGX isn't a dividend fund you would have in retirement if you were looking for income.  It is currently yielding 1.94%.    VHDYX would be a better fit at 3.18%

b) Does that graph include dividends?  If not, it proves *nothing*.  It drives me nuts that they never document that on the graphs.

c) A much better analysis would be the performance of those funds if you were removing money at a regular rate, especially if that rate was less than the 3.18%.   

I don't think we have the data to know the relative performance even in this specified case.

OK, then how does this data work for you? It shows the annual income in the annual return link.

https://www.portfoliovisualizer.com/backtest-portfolio?s=y&endDate=12%2F10%2F2015&allocation2_2=100&lastMonth=12&symbol1=VHDYX&endYear=2015&frequency=4&symbol2=VBMFX&inflationAdjusted=true&annualAdjustment=0&showYield=true&startYear=1985&rebalanceType=1&timePeriod=4&annualPercentage=0.0&allocation1_1=100&annualOperation=0&firstMonth=1&reinvestDividends=true&initialAmount=10000

Quote
c) A much better analysis would be the performance of those funds if you were removing money at a regular rate, especially if that rate was less than the 3.18%.   

I think you  are overlooking the fact that your invested capital is at a much higher risk in the high dividend fund, which has dropped by as much as 33% over the same period where the bond fund only dropped by 2%.
« Last Edit: December 10, 2015, 05:03:18 PM by tj »

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #25 on: December 10, 2015, 05:06:45 PM »
To the OP, these cannot be substituted since bonds are bonds and stocks are stocks. Totally different tools for the investing trade.

Shane

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #26 on: December 10, 2015, 06:12:57 PM »
As was stated earlier in this thread, just because bonds tend to be less volatile than equities, does NOT mean they are less risky.

The main risk early retirees face is RUNNING OUT OF MONEY! The more bonds in a portfolio, the higher probability of running out of money before you run out of life. If you don't believe me, just go on cFIREsim and run the numbers for yourself. The more bonds you put into your retirement portfolio, the worse your chances of success become. I'm not making this up.

Rather than saving twice as much money so that you'll be able to live off of "safe" bonds in retirement and you'll never have to see the balance in your investment accounts go down very much, why not just invest in stocks, VTSAX for example which pays almost 2% in dividends, and then when the stock market tanks you can just be flexible and cut back to living off of 3% or even down to 2%, which would mean that your portfolio would NEVER fail? If you only spend dividends from VTSAX, by definition your portfolio cannot ever fail. Right now, bonds are returning around the same % as VTSAX pays in dividends, so why buy bonds? They're not safer! I repeat, bonds are not safer than stocks!

If you didn't read it the first time, please read Warren Buffet's letter (below) to his shareholders. If you read it, please re-read it:

Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index).

There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

tj

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #27 on: December 10, 2015, 07:26:18 PM »
Quote
The main risk early retirees face is RUNNING OUT OF MONEY! The more bonds in a portfolio, the higher probability of running out of money before you run out of life. If you don't believe me, just go on cFIREsim and run the numbers for yourself. The more bonds you put into your retirement portfolio, the worse your chances of success become. I'm not making this up.

I don't think anyone would disagree with you on that. I already stated that I was talking people who are retired in their 60's should be 50/50 max. "Early retirees" obviously need higher equity exposure to even have a chance.


Shane

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #28 on: December 10, 2015, 10:53:18 PM »
Quote
The main risk early retirees face is RUNNING OUT OF MONEY! The more bonds in a portfolio, the higher probability of running out of money before you run out of life. If you don't believe me, just go on cFIREsim and run the numbers for yourself. The more bonds you put into your retirement portfolio, the worse your chances of success become. I'm not making this up.

I don't think anyone would disagree with you on that. I already stated that I was talking people who are retired in their 60's should be 50/50 max. "Early retirees" obviously need higher equity exposure to even have a chance.

A retiree in his 60's can easily have 30+ years of life left.

Shamelessly copying Taylor's post from Bogleheads, as it's been a topic here lately:

------------------------------------------------------------------------------------
Bogleheads:


Quote
"One adviser suggested investors in their 60s invest 70 to 80 percent of their portfolio in stocks."

No, no, fuckity-no!  Someone in their 60s should begin to be more concerned with preservation of their capital.  The whole "growth" portion of their portfolio should be moderate and slowly winding down.  70-80% in equity is for people 20-40 who have time to ride out more bumps.

I think you need to readjust your thinking here. People often live well into their 90's, some till over 100 years old. A retiree in his 60's shouldn't be "winding down" anything, because he's got to plan for 30+ more years of life, and the only way to do that is with high percentages of equities in his portfolio.

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #29 on: December 11, 2015, 07:39:57 AM »
Quote
A retiree in his 60's can easily have 30+ years of life left.

And I hold my stance that  50/50 would be appropriate for a 30 year horizon. There is no reason to take extra risk. The only reason to take more risk is if you are investing for a future generation, endowment etc.

fattest_foot

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #30 on: December 11, 2015, 08:12:16 AM »
Except a 30+ year time horizon will cause that 60 year old's portfolio to get eroded by inflation.

To me that seems riskier than equities. Really, the risk in equities comes from volatility. With 30+ years, volatility shouldn't really be a concern, nor should you be in preservation mode yet.

tj

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #31 on: December 11, 2015, 08:46:28 AM »
Except a 30+ year time horizon will cause that 60 year old's portfolio to get eroded by inflation.

To me that seems riskier than equities. Really, the risk in equities comes from volatility. With 30+ years, volatility shouldn't really be a concern, nor should you be in preservation mode yet.

That is why you keep 50% of the portfolio in equities, to combat the potential inflation. Retirees need income more than growth. If you are willing to pick up another job later in life, then by all means, go 100% equities at 65 when you don't need to. You can't keep selling equities on the way down, you have a greater risk of running out.

I don't know that I would agree that volatility isn't a concern over a 30 year horizon, but I would disagree if the consensus here is that most people in their 60s are going to live another 30 years. Volatility is much less of a concern over 50-60+ years, hence why those who retiree before traditional retirement age would be doomed without high equity exposure (unless they have 100x annual expenses or something.

Shane

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #32 on: December 11, 2015, 08:49:18 AM »
Quote
A retiree in his 60's can easily have 30+ years of life left.

And I hold my stance that  50/50 would be appropriate for a 30 year horizon. There is no reason to take extra risk. The only reason to take more risk is if you are investing for a future generation, endowment etc.

I agree that up to 50% bonds in a portfolio over a 30 year investment has a pretty good success rate. That's what the Trinity Study found.

What I'm questioning is the commonly accepted belief that having 50% bonds in a portfolio is "safer" than 25% or 0% bonds. When I look at the data, it seems like the more bonds I put into my portfolio, the more likely my portfolio is to fail, thus the riskier it is.

When I run a 30-year simulation on cFIREsim with 100% stocks and a 4% withdrawal rate, it tells me ~96% of the time I would've been okay with that allocation. If I increase bonds in my portfolio to 50%, cFIREsim says I would've had a 94% success rate. I admit, this is a really small difference, but still it seems to me like making my portfolio 50% bonds/50% stocks would have made it 2% more likely to fail, which to me says that it makes my portfolio riskier. For time horizons longer than 30 years more bonds in a portfolio makes it much more likely to fail = more risky.

Based on what I read in the letter from WB posted above in the thread and the results I see on cFIREsim, it seems to me like conventional wisdom is wrong. More bonds in a portfolio makes it more risky, not less. What am I not understanding here? Maybe I'm misinterpreting the data. If so, would someone please explain why?

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #33 on: December 11, 2015, 08:50:42 AM »
Shamelessly copying Taylor's post from Bogleheads, as it's been a topic here lately:

------------------------------------------------------------------------------------
Bogleheads:


Quote
"One adviser suggested investors in their 60s invest 70 to 80 percent of their portfolio in stocks."

No, no, fuckity-no!  Someone in their 60s should begin to be more concerned with preservation of their capital.  The whole "growth" portion of their portfolio should be moderate and slowly winding down.  70-80% in equity is for people 20-40 who have time to ride out more bumps.

Yes, yes, fuckity-yes! Run the damn simulations yourself. There is greater chance of portfolio failure with more bonds. Someone in their 60s should have a 30+ year time horizon.

tj

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #34 on: December 11, 2015, 08:54:13 AM »
Quote
Based on what I read in the letter from WB posted above in the thread and the results I see on cFIREsim, it seems to me like conventional wisdom is wrong. More bonds in a portfolio makes it more risky, not less. What am I not understanding here? Maybe I'm misinterpreting the data. If so, would someone please explain why?

You're missing the sequence of returns risk. Say you have a huge bull market during your working career, then it crashes the year you retire, and stays flat for the next 2 decades. Bond funds are not going to lose 50% of their value in a given year.

Shane

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #35 on: December 11, 2015, 09:17:51 AM »
Quote
Based on what I read in the letter from WB posted above in the thread and the results I see on cFIREsim, it seems to me like conventional wisdom is wrong. More bonds in a portfolio makes it more risky, not less. What am I not understanding here? Maybe I'm misinterpreting the data. If so, would someone please explain why?

You're missing the sequence of returns risk. Say you have a huge bull market during your working career, then it crashes the year you retire, and stays flat for the next 2 decades. Bond funds are not going to lose 50% of their value in a given year.

What you're saying about sequence of returns risk makes sense, and for that reason the idea of a rising stock glide path, mentioned in the thread above, seems interesting to me. Holding some bonds in the beginning of a 30 year retirement would allow a retiree to sell the bonds in a downturn, sometime during the first 10 years or so of his retirement, and use the money to buy stocks more cheaply, with the goal being eventually getting to 100% equities.

This is, however, the opposite of what has been conventionally recommended to retirees. Normally, as some posters have said above, as a retiree gets older, he should "wind down" his portfolio and rebalance to more bonds and less stocks...

tj

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #36 on: December 11, 2015, 09:28:57 AM »
Quote
Based on what I read in the letter from WB posted above in the thread and the results I see on cFIREsim, it seems to me like conventional wisdom is wrong. More bonds in a portfolio makes it more risky, not less. What am I not understanding here? Maybe I'm misinterpreting the data. If so, would someone please explain why?

You're missing the sequence of returns risk. Say you have a huge bull market during your working career, then it crashes the year you retire, and stays flat for the next 2 decades. Bond funds are not going to lose 50% of their value in a given year.

What you're saying about sequence of returns risk makes sense, and for that reason the idea of a rising stock glide path, mentioned in the thread above, seems interesting to me. Holding some bonds in the beginning of a 30 year retirement would allow a retiree to sell the bonds in a downturn, sometime during the first 10 years or so of his retirement, and use the money to buy stocks more cheaply, with the goal being eventually getting to 100% equities.

This is, however, the opposite of what has been conventionally recommended to retirees. Normally, as some posters have said above, as a retiree gets older, he should "wind down" his portfolio and rebalance to more bonds and less stocks...

It does not make sense to me why you would lose your bonds later in life, that is when you are in more need of the income from your portfolio. You have 10% bonds to buy stocks "on sale", but what are you going to use to fund your life if dividends from the stock funds are not enough?

I feel like you're making it too complicated. It's all about your available capital and your expenses. if you know that you need to spend $20,000 a year and you have 1 million of available capital, it is incredibly unlikely that a 50/50 allocation will not grow by at least 2% real per year. A 100/0 has higher odds of increasing more, but why put your capital at risk? You're more interested in preserving your capital than growing it. You're thinking about maximum POSSIBLE account value, and then calculating the odds of getting to the highest number, but you're overlooking that you do not need to take the risk on having excess cash, because you already have enough, and someday you'll be dead. That's my logic anyway. I'm 100/0 now, but no way will I keep that up at retirement, depending on how much of my expenses is covered by social security.
« Last Edit: December 11, 2015, 09:35:05 AM by tj »

Shane

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #37 on: December 11, 2015, 10:23:25 AM »
Quote
Based on what I read in the letter from WB posted above in the thread and the results I see on cFIREsim, it seems to me like conventional wisdom is wrong. More bonds in a portfolio makes it more risky, not less. What am I not understanding here? Maybe I'm misinterpreting the data. If so, would someone please explain why?

You're missing the sequence of returns risk. Say you have a huge bull market during your working career, then it crashes the year you retire, and stays flat for the next 2 decades. Bond funds are not going to lose 50% of their value in a given year.

What you're saying about sequence of returns risk makes sense, and for that reason the idea of a rising stock glide path, mentioned in the thread above, seems interesting to me. Holding some bonds in the beginning of a 30 year retirement would allow a retiree to sell the bonds in a downturn, sometime during the first 10 years or so of his retirement, and use the money to buy stocks more cheaply, with the goal being eventually getting to 100% equities.

This is, however, the opposite of what has been conventionally recommended to retirees. Normally, as some posters have said above, as a retiree gets older, he should "wind down" his portfolio and rebalance to more bonds and less stocks...

It does not make sense to me why you would lose your bonds later in life, that is when you are in more need of the income from your portfolio. You have 10% bonds to buy stocks "on sale", but what are you going to use to fund your life if dividends from the stock funds are not enough?

I feel like you're making it too complicated. It's all about your available capital and your expenses. if you know that you need to spend $20,000 a year and you have 1 million of available capital, it is incredibly unlikely that a 50/50 allocation will not grow by at least 2% real per year. A 100/0 has higher odds of increasing more, but why put your capital at risk? You're more interested in preserving your capital than growing it. You're thinking about maximum POSSIBLE account value, and then calculating the odds of getting to the highest number, but you're overlooking that you do not need to take the risk on having excess cash, because you already have enough, and someday you'll be dead. That's my logic anyway. I'm 100/0 now, but no way will I keep that up at retirement, depending on how much of my expenses is covered by social security.

I understand what you're saying, tj, and it makes sense. During the accumulation phase, I can't understand why anyone would own any bonds, period. Once you've already got enough to live on, it makes sense to try to preserve that capital, so that you don't lose it, and as long as they're keeping up with inflation, I guess bonds are one way to do that. It's possible, though, that focusing too much on preserving capital, e.g., keeping too high a percentage of your assets in low yielding investments like t-bills, savings accounts, CDs, or bonds, may give the illusion that you are preserving your assets, but the purchasing power of your money slowly becomes eroded by inflation. I don't think we really disagree that much, if at all. I'm just thinking out loud, trying to decide for myself what's best for me and my family. It sounds like I may be a little more willing than you are to take risks in retirement with the hope that more growth in our portfolio will mean we may have opportunities to spend more later on in our retirement. It also could mean we'll have less. That's the gamble...

JinBoston

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #38 on: December 11, 2015, 11:33:56 AM »

OK, then how does this data work for you? It shows the annual income in the annual return link.

https://www.portfoliovisualizer.com/backtest-portfolio?s=y&endDate=12%2F10%2F2015&allocation2_2=100&lastMonth=12&symbol1=VHDYX&endYear=2015&frequency=4&symbol2=VBMFX&inflationAdjusted=true&annualAdjustment=0&showYield=true&startYear=1985&rebalanceType=1&timePeriod=4&annualPercentage=0.0&allocation1_1=100&annualOperation=0&firstMonth=1&reinvestDividends=true&initialAmount=10000



Thanks tj!  Great link!   I agree that this is a reasonable comparison.  I was able to put in a 4% yearly withdrawal rate and the results were still similar.  You saw a huge drop in value of the stock account in the middle.  *If you needed to sell during that time, OR if seeing the number drop caused you to sell it would be a major issue.*

That said, at today's market prices you end up with more money in the dividend fund.   I'm starting to think that this is *less* about where you end up numbers wise, and more about your tolerance/reaction to seeing the account value rise and drop.


Jack

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #39 on: December 11, 2015, 12:14:48 PM »
Except a 30+ year time horizon will cause that 60 year old's portfolio to get eroded by inflation.

To me that seems riskier than equities. Really, the risk in equities comes from volatility. With 30+ years, volatility shouldn't really be a concern, nor should you be in preservation mode yet.

That is why you keep 50% of the portfolio in equities, to combat the potential inflation. Retirees need income more than growth. If you are willing to pick up another job later in life, then by all means, go 100% equities at 65 when you don't need to.

I plan to be 100% equities at age 65, but that's because I plan to have already been FIREd for about 2 decades by then, which means that in all but the near-worst-case scenarios I would expect my assets to have grown since retirement (at 100% equities, 4% SWR) such that I would have near-zero realistic risk of portfolio failure. For example, if I FIREd on $1M and $40K annual drawdown at age 45, then the 50th-percentile scenario (7% geometric-average annual stock market return, net of inflation) suggests that at age 65 I'd have about $2.2M, which would make my actual withdrawal rate more like 2%. At that point, there's no downside to 100% equities: it's just a game of "how many millions will my heirs get?"

In the worst-case scenario, I simply wouldn't have retired at 45 in the first place -- or if I didn't notice the bad sequence of returns until later, I'd just go back to work for year or two (in my late 40s/early 50s, not my 60s) to compensate. Or I'd adjust my withdrawal rate or something. Whatever! I'd be in my peak earning years; I'd have options.

The interesting question is the effect of the suggestion upthread: should I buy 20%-40% bonds on (or slightly before) my FIRE date, then taper them off 2%/year or so until the sequence-of-returns risk is over?

brooklynguy

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #40 on: December 11, 2015, 12:38:14 PM »
The interesting question is the effect of the suggestion upthread: should I buy 20%-40% bonds on (or slightly before) my FIRE date, then taper them off 2%/year or so until the sequence-of-returns risk is over?

There have been discussions in the forum before on the rising equity glidepath approach but personally I don't like it because you're just trading more protection against one specific sequence of returns risk (poor early returns) for more exposure to another (good early returns/high early inflation (while you're tilted towards bonds) followed by poor later returns (while you're tilted back towards equities)).  I plan to just stay 100% equities forever.

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #41 on: December 11, 2015, 02:00:14 PM »
Shane, my understanding is that you're correct. This wonk did a thorough analysis to support that:

http://web.iese.edu/jestrada/PDF/Research/Others/Buffett-AA.pdf

A side-note, the trigger for that research was advice Buffett gave regarding his wife's inheritance, so everyone who discusses the article seems caught up on the fact that Buffett's wife need not worry about money at all. That, while true, is not the main point. The main one is that, however you slice it, the failure rate with a high proportion of stocks is low. Risk is key, and the analysis does show that in the worst possible retirement period, all options but 60/40 failed. So if you can't stomach the risk, allocate accordingly.

The question you didn't address (or I didn't read it) is whether you want to have money left. When you bring that into the equation, holding stocks has far greater upside. Risk is still important.

There was another thread about this (somewhat):

http://forum.mrmoneymustache.com/investor-alley/warren-buffett-on-asset-allocation-for-retirees/

tj

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #42 on: December 11, 2015, 02:14:25 PM »
The interesting question is the effect of the suggestion upthread: should I buy 20%-40% bonds on (or slightly before) my FIRE date, then taper them off 2%/year or so until the sequence-of-returns risk is over?

There have been discussions in the forum before on the rising equity glidepath approach but personally I don't like it because you're just trading more protection against one specific sequence of returns risk (poor early returns) for more exposure to another (good early returns/high early inflation (while you're tilted towards bonds) followed by poor later returns (while you're tilted back towards equities)).  I plan to just stay 100% equities forever.

Do you keep a large cash cushion? What happens if you have an unexpected major expense such as as a costly auto or home repair? Are you willing to sell stocks on a down day, such as today?

brooklynguy

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #43 on: December 11, 2015, 02:33:03 PM »
Do you keep a large cash cushion? What happens if you have an unexpected major expense such as as a costly auto or home repair? Are you willing to sell stocks on a down day, such as today?

No, I don't keep a large cash cushion.  Currently I'm still in the accumulation phase and have the firehose of cash that is my salary.  In retirement, I will have enough margins of safety not to have to worry about an unexpected expense forcing me to sell a meaningful portion of my stocks during a down market.  There's lots of discussion in the forum about going (and staying) 100% equities, and this article from Go Curry Cracker summarizes many of the arguments in favor of it:

http://www.gocurrycracker.com/path-100-equities/

In the interest of full disclosure, it just occurred to me that I also have rental income (I own a duplex and live in one unit and rent out the other), but I mentally categorize that as a reduction of expenses and not as part of my investment portfolio, which (in retirement) will exist to cover the remaining portion of my expenses.

Shane

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #44 on: December 11, 2015, 11:02:41 PM »
Shane, my understanding is that you're correct. This wonk did a thorough analysis to support that:

http://web.iese.edu/jestrada/PDF/Research/Others/Buffett-AA.pdf

A side-note, the trigger for that research was advice Buffett gave regarding his wife's inheritance, so everyone who discusses the article seems caught up on the fact that Buffett's wife need not worry about money at all. That, while true, is not the main point. The main one is that, however you slice it, the failure rate with a high proportion of stocks is low. Risk is key, and the analysis does show that in the worst possible retirement period, all options but 60/40 failed. So if you can't stomach the risk, allocate accordingly.

The question you didn't address (or I didn't read it) is whether you want to have money left. When you bring that into the equation, holding stocks has far greater upside. Risk is still important.

There was another thread about this (somewhat):

http://forum.mrmoneymustache.com/investor-alley/warren-buffett-on-asset-allocation-for-retirees/

Thanks FB. The linked article was good. It's interesting. The chart in the article showed that a 100% stock portfolio was 2.5% more likely to fail than a 50/50 portfolio. I wonder why when I run those same numbers in cFIREsim, I get the opposite results???

The question of whether we want to end up with money left over is a good one. Instinctively I want to say yes. It seems to me if we could grow our portfolio and maybe end up with a bunch more money later in life, it would be nice, and then we could pass the gift of FIRE on to our now 7 year old daughter when we die. I guess as our daughter is growing up, we'll have to think about that question more. I wouldn't want to do it if it might really screw her up somehow. I've known more than one person who grew up expecting to come into big money later in life, and it seemed to not be a real good thing for them. I've been thinking of posting a new thread to see what other Mustachians are planning on doing with their stashes after they die. Maybe there's a thread like that already. I guess I should search first.

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Re: "Why You Shouldn't Substitute Stocks for Bonds"
« Reply #45 on: December 13, 2015, 09:49:06 AM »
People commenting here seem to forget bonds have plenty of risk.  Long-term, decades of investing, a collection of stocks are not that risky.  Long-term, bonds are quite risky.

From a recent book I read:

"Always focus on “real returns” – after inflation has been accounted for.
The best times for investing have historically been when fear is rampant.
Expect negative returns on equities will occur for 2 to 3 calendar years out of every 10.
Studies indicate government bond yields go through cycles lasting about 60 years: 30 years for the uptrend and 30 years on the other side.  If the theory holds true, yields have “virtually no room to move further downward, thus no capital gain opportunities remain”.  This means some sort of 70/30 portfolio split (equities/bonds) is a better bet for the foreseeable future.
“Actuaries estimate that real returns on bonds over the next 25 years will average between 1 and 1.6 per cent depending upon the term of the bond”."