Author Topic: Asset allocation - no bonds if you have debt?  (Read 5960 times)

FrugalFan

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Asset allocation - no bonds if you have debt?
« on: December 18, 2015, 01:18:21 PM »
I've read a lot about asset allocation over the last year (see links below). A lot of the advice makes sense. The post by Go Curry Cracker makes sense re: the risk of outliving your portfolio being an important issue for early retirees to consider. The post on Canadian Couch Potato (and the book, which I have also read) on only taking as much risk as you need to reach your goals also makes sense. My general idea had been to allocate 20% of our investments to bonds. But, I have just transferred a big chunk of cash from Edward Jones to an online brokerage and now that it is time to buy I am questioning my decision. A post I read last night from Millenial Moola made me wonder whether it makes sense to invest in bonds when we have mortgage debt. Maybe in today's low yield environment (and the likely reduced yield if/once interest rates increase), paying down our mortgage with 2.94% interest would be a better choice? A few other things to consider. Our employer pensions, which account for more than half our liquid NW, are more conservatively invested than our personal investment accounts. We also have a lot of cash (about 13% of our liquid NW).

http://www.gocurrycracker.com/path-100-equities/
http://canadiancouchpotato.com/2010/03/09/how-much-risk-do-you-need-to-take/
http://millennialmoola.com/2015/06/26/why-bonds-terrify-me-you-should-blame-the-fed-and-what-it-means-for-you/

GGNoob

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Re: Asset allocation - no bonds if you have debt?
« Reply #1 on: December 18, 2015, 01:29:14 PM »
For me personally...

Paying off the mortgage would probably be preferred to buying bonds, but buying stocks would be preferred to paying off the mortgage. Therefore, I buy stocks (index funds).

But I also have a pension and do some P2P lending so I do have fixed income.

Mighty-Dollar

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Re: Asset allocation - no bonds if you have debt?
« Reply #2 on: December 18, 2015, 06:27:40 PM »
Pay off debt. Then invest. Otherwise you are just gambling with borrowed money.

Financial.Velociraptor

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Re: Asset allocation - no bonds if you have debt?
« Reply #3 on: December 18, 2015, 06:40:07 PM »
It could be argued that you should increase your allocation to bonds if you have debt.  Your mortgage can be thought of as a 'short' position in the market as it is a liability rather than an asset.  So 250k mortgage needs 250k of bonds just to be at parity with respect to portfolio debt exposure. 

I think you are over thinking it though.  If you are indexer, just make your monthly contribution and let it bake for 3 decades...

Indexer

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Re: Asset allocation - no bonds if you have debt?
« Reply #4 on: December 18, 2015, 07:09:25 PM »
I would treat your mortgage and you investments as two different things. All these new strategies/thoughts around bonds like counting debt as negative bonds, or counting SS as part of your bond portfolio miss out on the real purpose of bonds.

When stocks go down, quality bonds tend to go up. They are a hedge, and they are a hedge that pays you regular income. A hedge that pays you to hedge is a beautiful thing.

Stocks normally earn a lot, but they can be very volatile. Adding bonds to a portfolio of stocks decreases the volatility while giving up some of the return, but not all of it. How much you need to tame your portfolio depends on your goals and your tolerance for risk. Your mortgage, SS, age, etc. shouldn't matter when figuring out your AA. They matter for other things of course. And just to clarify, your current age doesn't matter, but your time horizon and how long you expect to need the funds does. Since this is the MMM community I don't need to explain that a 30 year old might plan to retire in 5 years. ;)

If you have a long time frame and high tolerance for risk go 100% stocks. Have fun. If you can't stomach a 50% drop add bonds to tame the portfolio. If you need the money in 5 years add bonds to tame the portfolio. It really is that simple....


The mortgage really comes down to your interest rate VS desire to be debt free. If your interest rate is less than what you expect to reasonably earn in safer investments then you should invest. If it is more pay down the debt. My general rule of thumb. Debt interest rate <4%=invest. 4-5% it depends on whether you would rather be debt free or have a bigger portfolio. 6% or more = pay down the debt.
« Last Edit: December 18, 2015, 07:11:08 PM by Indexer »

dmn

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Re: Asset allocation - no bonds if you have debt?
« Reply #5 on: December 19, 2015, 06:19:59 AM »
I completely agree with the OP that the mortgage should be paid back first if its interest rate is higher than that of bonds with similar duration. In this situation, put as much in stocks as you feel comfortable with and pay back the mortgage with the safe part of your investment portfolio.

I do not think that adding bonds has additional value for volatility reduction, as your total portfolio value includes the value of your house, your mortgage, your stocks and your bonds. The volatility of your net worth is identical no matter whether you have bonds or a smaller mortgage. It is just your brokerage account which will show more fluctuations if you do not own bonds, but the value of your house equity will fluctuate less by an equivalent amount (due to less mortgage leverage). The only real effect is the difference in interest rates, and paying down higher-interest debt guarantees a higher safe return than buying bonds.
« Last Edit: December 19, 2015, 06:22:01 AM by dmn »

Tyler

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Re: Asset allocation - no bonds if you have debt?
« Reply #6 on: December 20, 2015, 11:40:46 AM »
Optimizing portfolio performance is more sophisticated than simply selecting several top-returning individual assets. Volatility, sequence of returns, and correlations can affect your ultimate compound returns in unexpected ways, and sometimes adding a lower-paying but uncorrelated asset to a portfolio can result in higher overall returns in the long run. That's what makes bonds such an important ingredient in most asset allocation recipes.

I also think many people don't really understand how bonds work.  The total return is not just in the interest payments but also in the price movements, and rebalancing can work in your favor even with zero-coupon bonds (volatile bonds that pay no interest). Interest is only half the equation.

Put those things together, and automatically assuming that buying bonds is a bad deal simply because the bond interest is lower than your mortgage rate isn't necessarily true. It's more complicated than that.

I personally believe the asset allocation for your investments should be evaluated separately from your mortgage. Sure your investment portfolio and home equity both count towards your net worth, but they're very different types of assets and mixing them up short-changes their individual characteristics.  If your mortgage rate is high, then I see that as a good reason to refinance or pay it down but not necessarily to change portfolios from something that works for you financially and emotionally. IMHO, choose your home and AA wisely based on their own individual merits.

mizchief

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Re: Asset allocation - no bonds if you have debt?
« Reply #7 on: December 20, 2015, 01:25:10 PM »
"A few other things to consider. Our employer pensions, which account for more than half our liquid NW, are more conservatively invested than our personal investment accounts. We also have a lot of cash (about 13% of our liquid NW). "

I think it makes sense to consider asset allocation across all of your investments.  Your employer pensions are invested more conservatively?  Does this mean they hold a greater percentage of bonds or fixed-income assets?   Your asset allocation should consider the total percentage of bonds across all of your holdings, regardless of where they are held?  You could think of cash similarly to bonds too. 

So what is your total (bond + liquid cash)/personal investments + employer accounts?   Is that a good number for you and the risk you can live with?  That caculation will help you decide what to do with the new Ed Jones money, whether to buy more bonds (or hold cash) or buy more equities.

Kaspian

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Re: Asset allocation - no bonds if you have debt?
« Reply #8 on: December 22, 2015, 01:12:34 PM »
My general idea had been to allocate 20% of our investments to bonds.

Do this, write it down, and ignore everything else.  Your risk tolerance being in line with who you really are as a person (and investor) is the single most important factor to your portfolio succeeding.  There are people out there who think they are braver than you with asset allocation but will fail miserably on the battlefield. 

AdrianC

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Re: Asset allocation - no bonds if you have debt?
« Reply #9 on: December 22, 2015, 06:48:46 PM »
Are you buying bonds because you think they are a good investment? Or is it to steady the portfolio when the bad times come?

For me, when my stocks went down 40% in 2008 it gave me enormous comfort knowing the house was paid for and we had FDIC insured cash in the bank. I don't think a different financial asset, such as bonds, would have helped so much.

Kaspian

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Re: Asset allocation - no bonds if you have debt?
« Reply #10 on: December 23, 2015, 12:26:40 PM »
I don't think a different financial asset, such as bonds, would have helped so much.

Actually, umm... They would have.  In 2008 US Bonds were the best performing asset class in the world.  They increased in value 32% that year.  Rebalancing at the end of the year would have moved a massive (!) chunk of money into equities, which had done -21% over the same period, allowing you to sell the first high to buy the other low.   The same thing would have occurred again in 2011.  Why not take advantage of this diversification class?


AdrianC

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Re: Asset allocation - no bonds if you have debt?
« Reply #11 on: December 23, 2015, 09:29:14 PM »
I don't think a different financial asset, such as bonds, would have helped so much.

Actually, umm... They would have.  In 2008 US Bonds were the best performing asset class in the world.  They increased in value 32% that year.  Rebalancing at the end of the year would have moved a massive (!) chunk of money into equities, which had done -21% over the same period, allowing you to sell the first high to buy the other low.   The same thing would have occurred again in 2011.  Why not take advantage of this diversification class?

You sure about your data? Bonds were the best performing asset class in 2008. They did not increase in value by 32%.

bdbrooks

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Re: Asset allocation - no bonds if you have debt?
« Reply #12 on: December 24, 2015, 10:06:47 AM »
Actually, umm... They would have.  In 2008 US Bonds were the best performing asset class in the world.  They increased in value 32% that year.  Rebalancing at the end of the year would have moved a massive (!) chunk of money into equities, which had done -21% over the same period, allowing you to sell the first high to buy the other low.   The same thing would have occurred again in 2011.  Why not take advantage of this diversification class?

I'm pretty sure you are referencing TLT (30 year US government debt). It was the most aggressive bond holding you could have at the time. It only would have worked out like you said if you rebalanced right as TLT was spiking. If you had rebalanced in June while the market was still severely depressed, TLT was worth about 25% less than if you rebalanced at the end of the year. So even your strategy that is aided by hindsight bias was still subject to a certain level of being able to time it right.

Another important point is that interest rates are different now. Before the crisis, rates (30 year treasury rates) were around 4.5% mark and plummeted to 2.6%. We are currently right around 3%. If stocks crashed again, rates would have to drop to around 1% to provide the same kind of rebalancing opportunity. That is bordering on impossibly low for 30 year rates. Implied in that would mean that investors are expecting a combined 1% for their return AND INFLATION. If inflation is over 1% the next 30 years, then they will come out with negative real returns. I personally don't think that will happen. It is worthwhile to look at how the "standard" 60/40 portfolio did in the 40's, 50's, and 60's. Interest rates started low and rose over that time period. The 60/40 portfolio lowered volatility, but at a huge expense of returns. That is very different from the last 30 years where it greatly reduced volatility and only marginally affected returns.

Finally, your statistic that equities were down 21% is just wrong. Depending on the different equity classes they were down 28-53%. Note that US government bonds are not shown on the attached table and they performed considerably better than AGG (US corporate bond etf based on Barclays aggregate index).

RichMoose

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Re: Asset allocation - no bonds if you have debt?
« Reply #13 on: December 26, 2015, 09:26:51 AM »
You should look at your portfolio as a whole. This includes your personal investments plus your pensions. Come up with an acceptable asset allocation that suits your timeline and risk comfort. For most people this will be somewhere between 60/40 to 90/10. If your pensions are Defined Benefit plans, count the whole pension as a bond.

Ignore the mortgage thing. This is debt, not part of your portfolio.

Hope this helps. :)

FrugalFan

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Re: Asset allocation - no bonds if you have debt?
« Reply #14 on: December 26, 2015, 11:49:45 AM »
Thanks to everyone who responded. Yeah, I think sometimes I just look for an excuse to pay off our mortgage faster, even if it does not make sense financially. It would be so nice to have the extra cash flow and one less big expense to worry about, but it is only temporary, and we could always sell off some investments to pay it off at some point if we really want to.

Tuxedo, we have a hybrid pension (with aspects of both defined benefits and defined contribution). I think our rough plan for now would be for DH to keep working in some capacity until at least 55 so that he is eligible for his pension (which has a minimum guaranteed benefit), and I will likely stop working earlier and cash out my pension and invest it. So I will look at our pension investments and make a decision based on our entire investments asset allocation (ignoring cash that is being saved for other things and other aspects of net worth).

Mighty-Dollar

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Re: Asset allocation - no bonds if you have debt?
« Reply #15 on: December 26, 2015, 11:27:58 PM »
Never replace bonds with anything. You want to be 100% stocks? Not good. Have you heard the phrase, when stocks fall money runs to the safety of bonds? That's why you own bonds.
This site is helpful is determining bond / stock allocation ratio. Test out a few allocations until you find a sweet spot...
http://www.vanguard.com/nesteggcalculator

AdrianC

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Re: Asset allocation - no bonds if you have debt?
« Reply #16 on: December 31, 2015, 06:23:43 AM »
Never replace bonds with anything. You want to be 100% stocks? Not good. Have you heard the phrase, when stocks fall money runs to the safety of bonds? That's why you own bonds.
This site is helpful is determining bond / stock allocation ratio. Test out a few allocations until you find a sweet spot...
http://www.vanguard.com/nesteggcalculator

Love that Vanguard site. Thanks for posting.

It is using historical data, of course. It's not projecting from where we are now, with a fully valued stock market and record low bond rates. Bonds will be a good investment again one day. I'm not putting money into bonds right now, though.

Back to the OP - you don't need an excuse to pay off the mortgage faster. It's not a black/white case of makes sense/does not make sense. Under certain circumstances not guaranteed, you might be slightly better off keeping the mortgage and investing the extra money in stocks (not bonds). Weigh that against the absolutely guaranteed return of not paying mortgage interest and the unquantifiable benefit of being completely debt-free. It's a great feeling that lasts.