Buying things that you think will go down in value

[Reepekg]

It has been said around here that people get happy when their investments go down (in their wealth accumulation phase), because that means the stock market is on sale, etc. If one takes this to its logical conclusion, a 28 year old like me with an investment time horizon of forever should target buying things that have a gloomy outlook for the next 5-10 years. This assumes that one regularly invests during these down years.

Here is an example. A lot of people say don’t buy long term bonds because interest rates are historically very low and likely to go up. Let’s say I think that sounds like a reasonable prediction. I’m looking at BLV and thinking, this thing has to go down for a while when interest rates rise. It looks like it is already happening. I’m going to automate a $100/mo investment forever and smile when bonds are the hot thing again in like 20 years or when interest rates get slashed in the next economic crisis.

I suspect there is something fishy with this kind of long term strategy. It feels like market timing. Business cycle timing? Does missing out on high average yearly returns overwhelm potential benefit? Please poke holes and maybe I can learn something.

[Kazimieras]

I suspect there is something fishy with this kind of long term strategy. It feels like market timing. Business cycle timing? Does missing out on high average yearly returns overwhelm potential benefit? Please poke holes and maybe I can learn something.

Yes there is. There is a reason why people have been saying that bond prices will drop and that is because the Federal Reserve has the current prime lending rate at 0.25%. All that bonds are is an IOU that you give to the government, state, city/municipality or corporation. It is an agreed upon term where you give $1000 and they agree to pay you back the $1000 at the end of the bond, plus an agreed upon interest rate (in most cases this is a fixed rate). So when interest prices rise, people go - oh I could have this new bond which pays me more interest, so I'll buy that. Because of this, the old bond is now worth less money, since people can earn more elsewhere. This is so pronounced that you can actually calculate what the price of the bonds will be if the interest rate is changed.

The only time a long term bond would make sense to buy is if you firmly believe that interest rates will not go up over the period of that bond. That is unrealistic. Plus you are then holding the risk of the bond holder defaulting. Think that can't happen? Look at Detroit and its bond holders right now.

Since interest rates cannot become negative you will never profit" from the next time interest rates are slashed in the next economic crisis, since they can only drop 0.25% from where they are now! If you're seriously considering this, I would strongly advise you to immediately stop any plans you have, go and put the money in a vanguard ETF that follows an index like the Dow Jones and go read some books on the subject.

[KingCoin]

Since interest rates cannot become negative you will never profit" from the next time interest rates are slashed in the next economic crisis, since they can only drop 0.25% from where they are now! If you're seriously considering this, I would strongly advise you to immediately stop any plans you have, go and put the money in a vanguard ETF that follows an index like the Dow Jones and go read some books on the subject.

I suspect he's talking about longer dated bonds rather than 0.25% yielding short term t-bills, which are more similar to cash than bonds (at least in the context of an individual's portfolio).

Yes, reducing bond allocation in times of low interest rates is market timing pure and simple. As market timing goes, it's probably less of a sin than trying to time the stock market since rates do have a 0 bound. When 30yr rates hit 2.5%, you can reasonably conclude that your upside is severely capped, making them an poor risk proposition.

However, consider the situation now. 10yr rates are at 2.5%. Let's say you decide to allocate your bond money to cash, waiting for a better buying opportunity. Fast forward 5yrs. 5yr rates will have to be over 5% for you to break even. Even if you were "right", and 10yr rates have risen from 2.5% to 6%, your market timing has left you a loser if 5yr rates are at 4%. This is all a long winded way of saying there's a lot of opportunity cost in waiting around for a buying opportunity, and that opportunity may not even come. Just take a look at the interest rate picture in Japan for the last 20 years.

Your best bet, especially as an unsophisticated investor, is to develop an asset allocation policy and stick to it. Once you start trying to time the market, there's nothing stopping you from using similar reasoning to dump stocks at an inopportune time or double down on real estate in the midst of a bubble.

[dragoncar]

The relationship between bond price and interest rates is no linear.  If rates dropped to 0, you would make a killing.

[xocotl]

The relationship between bond price and interest rates is no linear.  If rates dropped to 0, you would make a killing.

Even though the relationship is non-linear, rates don't have that much left to fall. The slope may be steep, but the total gain if rates drop to zero is not that impressive. By my quick back-of-the-envelope calculations, your gain if you hold a 10yr note and rates drop from 2.5% to 0% is about 28% (assuming a zero coupon bond; for treasuries, which have coupons, the duration of the bond would be shorter than the maturity, giving you slightly less upside potential). Now, for a 30 yr zero coupon bond @ 3.63% yield you do have more like 197% potential upside if 30 yr rates somehow dropped to 0%. For some reason I can't picture that happening though, not to mention the fact that you're taking on massive downside risk if you buy 30 yr bonds right now...

[Marmot]

Yes there is. There is a reason why people have been saying that bond prices will drop and that is because the Federal Reserve has the current prime lending rate at 0.25%. All that bonds are is an IOU that you give to the government, state, city/municipality or corporation. It is an agreed upon term where you give $1000 and they agree to pay you back the $1000 at the end of the bond, plus an agreed upon interest rate (in most cases this is a fixed rate). So when interest prices rise, people go - oh I could have this new bond which pays me more interest, so I'll buy that. Because of this, the old bond is now worth less money, since people can earn more elsewhere. This is so pronounced that you can actually calculate what the price of the bonds will be if the interest rate is changed.

Great explanation. Just want to elaborate on the bolded text in the excerpt from your post. The old bond is worth less if you want to sell it early; if you hold it to maturity, you'll still get same $1000 back at end and the same promised fixed coupon payment. There is of course still an opportunity cost to doing this. My advice to those that really want to own bonds right now; don't buy anything with more than  7 years til maturity (and try not to pay a premium). Avoid bond funds, unless they have very low average maturity. I do not currently own any bonds for reasons that Kazimieras stated; though I am only 29.

[dragoncar]

The relationship between bond price and interest rates is no linear.  If rates dropped to 0, you would make a killing.

Even though the relationship is non-linear, rates don't have that much left to fall. The slope may be steep, but the total gain if rates drop to zero is not that impressive. By my quick back-of-the-envelope calculations, your gain if you hold a 10yr note and rates drop from 2.5% to 0% is about 28% (assuming a zero coupon bond; for treasuries, which have coupons, the duration of the bond would be shorter than the maturity, giving you slightly less upside potential). Now, for a 30 yr zero coupon bond @ 3.63% yield you do have more like 197% potential upside if 30 yr rates somehow dropped to 0%. For some reason I can't picture that happening though, not to mention the fact that you're taking on massive downside risk if you buy 30 yr bonds right now...

Gold point -  my statement was  biased because I hold the longest duration bonds I can get my hands on

[fiveoclockshadow]

Since interest rates cannot become negative you will never profit" from the next time interest rates are slashed in the next economic crisis, since they can only drop 0.25% from where they are now!

Not true at all.  Deflation.  Or extended periods of no inflation.  Both exist, ignore them at your own peril.

Can't happen?  Let's see how what was the second largest economy in the world did in the past couple of decades.

Interest rates in Japan:



Looks awful.  What about inflation:



Hmmm... OK, so those bonds at least held their real value over time.

Ah, but what fool would keep money in bonds that yield nearly zero percent?  You are sure to lose your money!  So in 2000 the Japanese investor should buy stocks! Now, now, NOW!!!!



Ah, poop.  That didn't turn out well at all.

Don't think of bonds being near zero percent as an indication to buy stocks.  The correct answer is you don't know, so diversify.  Heck, stocks are still quite expensive by most historical measures.  Yields are low and risk premium is low.  Not clear at all they are a wise investment either.

Don't get confident about things you should have no real confidence in.  First and most important rule of long term investing.  And know your history, lest you be doomed to repeat it.

Best of luck!

[Kazimieras]

Thanks for the expansion Marmot,  that is an important bit to add.

ficeocolockshadow, those are two of the three possibilities of the US economy. If things go into deflation - well I don't want to imagine that. It would be even more interesting to see this happen given the high levels of QE Bernanke is feeding into the system. If things stay the same, with the cheap credit out there, equities will likely continue to outperform bonds, just due to their nature.

It is important to consider the bond market right now has been horribly distorted by the Feds, who have deliberately been pushing down long-term yields (thank you operation twist). I personally avoid bonds for now (I'm 30, and don't see an upside to them and have opted for other ways to diversify) but will tout them as part of a well balanced portfolio.

And I do like the great point that was brought up that there is more than one market out there. I am from Canada and personally, while I love my country, most of my investment money is not in it. There are better opportunities elsewhere that earn more, and I've made a healthy killing the past couple years.

[fiveoclockshadow]

ficeocolockshadow, those are two of the three possibilities of the US economy. If things go into deflation - well I don't want to imagine that. It would be even more interesting to see this happen given the high levels of QE Bernanke is feeding into the system. If things stay the same, with the cheap credit out there, equities will likely continue to outperform bonds, just due to their nature.

It is almost certain equities will outperform bonds in the long run.  If you've got a long time horizon until withdrawal, a high tolerance for risk and good future human capital (i.e. you can still work) then zero or nearly zero bonds is a perfectly valid choice for a portfolio.  If you are in a different place in your life it would be a pretty dumb choice.  I was just pointing out the pitfalls of trying to time allocation changes based on market data, not claiming bonds will outperform stocks in the long run.  They really can't.  It sounds like you've got a very sensible reason to hold few bonds - young, working and risk tolerant.

It is easy to build a convincing narrative around whatever fundamentals exist in the market - particularly when something atypical (e.g. heavy handed QE) is going on.  But that is dangerous as such narratives have routinely failed in the past and alternative narratives that are equally valid predict the opposite.  For example, if there are extreme levels of QE in the market and yet the economy is barely plugging along that is the sign of a very weak and unstable economy.  Bonds might have low yield but the economy is ready to tank as soon as QE is removed.  Equities have run up to nearly the same levels as before the crash yet the economic outlook is no better than back then - arguably worse (Eurozone much worse off, China which has been driving global economy looks set to tumble, US legislative branch dis-functional) - so why not expect another big crash and seek the safety of bonds?  Equally compelling narrative - so which is correct?  No one really knows, so decide your bond/equity allocation based on your risk/return requirements and stick with it - regardless of what the Fed does.

[zunachy]

It has been said around here that people get happy when their investments go down (in their wealth accumulation phase), because that means the stock market is on sale, etc. If one takes this to its logical conclusion, a 28 year old like me with an investment time horizon of forever should target buying things that have a gloomy outlook for the next 5-10 years. This assumes that one regularly invests during these down years.

Here is an example. A lot of people say don’t buy long term bonds because interest rates are historically very low and likely to go up. Let’s say I think that sounds like a reasonable prediction. I’m looking at BLV and thinking, this thing has to go down for a while when interest rates rise. It looks like it is already happening. I’m going to automate a $100/mo investment forever and smile when bonds are the hot thing again in like 20 years or when interest rates get slashed in the next economic crisis.

I suspect there is something fishy with this kind of long term strategy. It feels like market timing. Business cycle timing? Does missing out on high average yearly returns overwhelm potential benefit? Please poke holes and maybe I can learn something.

Hi, I think you are misinterpreting the strategy.

The reason people think that bonds will have a gloomy outlook for the next 5 to 10 years is because they are very expensive now.  Whether or not their price will go up or down depends on interest rates which in large part depends on the economy and fed policy.

Now,  if

a) you think that bonds are fairly priced now,
b) you think that value of bonds will be higher in 10 years or so
c) but meanwhile, say in the next 5 years, bond prices will go down (interest rates will go up)
d) and you plan on saving and buying during those five years

Then you will get a positive return. 

The main question to answer is -- will whatever it is you plan on buying be worth more at point B than at point A -- if yes, then every lower purchase you make at point(s) C is just gravy.


Personally, I would not try this with bonds now.  They are just too expensive. It is entirely possible that in 10 years the rate on ten year treasuries will be lower than it is now -- say 1% as it is in Japan, and hence point B will be worth more than point A (plus the C gravy) -- but I doubt it.  If interest do go down -- then the economy will be worse.  In effect you are better against America.

Where this strategy works wonders, in my opinion, is in stocks of individual companies. 

I don't believe I can time the market -- but I also don't  also believe in EMH.  If I see a company I really like selling for a good price, I buy it.  If next month I see it selling for a better price I buy more of it.  In the end the returns are huge.  I have done this with two companies for periods of years -- prices were dropping until they were not -- and in the process of doing this again now with another company.  If the price of the current company that I am buying will continue to go down, and the actual business continues to improve I will be very happy.