Author Topic: Couple of questions about managing investment risk  (Read 1698 times)

mubington

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Couple of questions about managing investment risk
« on: December 28, 2017, 07:55:40 PM »
1. At present Iím managing my risk by varying cash to equity ratio. If I want to be risky I hold 80% equity and 20% cash. Or if I want to be safer I have 50/50. But I see vanguard life strategy or nutmeg have a fantastical blend of bonds and reits and all sorts.  Is restricting holdings to simply equity index and cash a valid way to achieve specific risk level? I have no idea what a bond is or how it hedges the market but is it gospel that I should just move to blended allocation anyway?

2. Iím late 30s targeting FI in 4 years. No assets except passive global index tracker equity. I feel like maybe I should diversify somehow. But on other hand, isnít global tracker about as diverse as you can get. vwrl presumably includes property holding companies and everything else under the sun, including investment companies that hold bonds, so is vwrl simply enough?

[sorry I double posted this in uk board but donít know how to delete]
« Last Edit: December 28, 2017, 07:59:43 PM by mubington »

inline five

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Re: Couple of questions about managing investment risk
« Reply #1 on: December 29, 2017, 05:54:05 PM »
Most people buy bonds because they tend to go up when equities go down and vice versa. When you rebalance you sell you bond holdings that have gone up and buy equities which have gone down. Holding cash means you'll miss out on those gains. For long term retirement planning I'd want at least 60/40 but probably more like 70/30 or even 80/20 if you plan to live off of it for 40 years. I'm not there yet but there is probably some data out there showing what ratio has the greatest risk based return.
« Last Edit: December 29, 2017, 05:55:45 PM by inline five »

ysette9

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Re: Couple of questions about managing investment risk
« Reply #2 on: December 29, 2017, 06:06:32 PM »
In order to properly have this discussion you first need to identify what risk or risks you are trying to mitigate. The risk of market fluctuations? If so, why? The bigger risk I think you need to be on the lookout for if you are going to FIRE and have a long retirement is the risk of outliving your stash.

Please let us know which risk you are concerned about because the strategy will vary greatly depending.

mubington

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Re: Couple of questions about managing investment risk
« Reply #3 on: December 31, 2017, 05:22:57 AM »
 
Most people buy bonds because they tend to go up when equities go down and vice versa. When you rebalance you sell you bond holdings that have gone up and buy equities which have gone down. Holding cash means you'll miss out on those gains. For long term retirement planning I'd want at least 60/40 but probably more like 70/30 or even 80/20 if you plan to live off of it for 40 years. I'm not there yet but there is probably some data out there showing what ratio has the greatest risk based return.

This what I don't understand. Are bonds are hedge against equity, or just a lower risk investment with less volatility and lower return? Looking at bond prices, they seem to have gone up with the market, so seem correlated, in which case what use are bonds as a hedge? 



mubington

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Re: Couple of questions about managing investment risk
« Reply #4 on: December 31, 2017, 05:55:54 AM »
In order to properly have this discussion you first need to identify what risk or risks you are trying to mitigate. The risk of market fluctuations? If so, why? The bigger risk I think you need to be on the lookout for if you are going to FIRE and have a long retirement is the risk of outliving your stash.

Please let us know which risk you are concerned about because the strategy will vary greatly depending.

I guess on reflection, I'm market timing to some degree. Just a gut sense I am perhaps overexposed to equity. I was 60/40 for quite a long time. And more recently with only 20% cash, I just feel a bit nervous.

I have no rational reason to derisk, other than general nervousness about being overexposed. I have safe business income for next 4 years, and probably longer after that, safe options to earn again if required. My expenses feel luxurious.

So i suppose I'm thinking I should convert part of the 80% to either bonds or cash. But any further sales would be taxed heavily this year,  so I was thinking it might be cheaper to convert 10% to cash, than say 20% to bonds and achieve same risk profile.

But I think I misunderstand bonds as a hedge.



ysette9

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Re: Couple of questions about managing investment risk
« Reply #5 on: December 31, 2017, 12:44:36 PM »
Okay, so good job with the recognition about market timing. Please do some reading on that to convince yourself what a bad idea it is. Maybe Bogle’s book, A Random Walk down Wallstreet, Bogleheads wiki, the Vanguard white paper on market timing, this blog and forum, and other resources. Market timing does not work and you need to understand this and internalize it enough to not doubt your strategy when people around you do differently or you hear the squawking heads on television or something.

Next, what happens when the market takes a downturn? I say “when” and not “if” because it is inevitable. What do you do? If you are smart and wise and follow your investment policy statement (read up on them in the Bogleheads wiki) then you know that the correct response is to do nothing. You say you have safe income for the next four years so if the market dumps tomorrow, your best move is to buy more stocks while they are on sale if you can afford to do so.

If you are scared of your balance dipping during the inevitable market fluctuations, you need to ask yourself why. If you can’t make peace with the fact that the returns you get from stocks come with volatility then you need an asset allocation better suits to your risk profile. Remember that there is no free lunch: either you learn to hold on to the rollercoaster ride of the market or you work longer and save more to buy yourself a lower-return, more predictable ride.

ysette9

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Re: Couple of questions about managing investment risk
« Reply #6 on: December 31, 2017, 12:47:26 PM »
To answer your question about bonds, they do provide less constitute and less return and they are also supposed to move in the opposite direction of stocks. Bonds produce income which can be good if you need income (retirement) but should be managed appropriately while in your accumulation phase. Meaning  , if you have them, put them in a tax-advantaged account so you aren’t paying income taxes on them.

SwordGuy

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Re: Couple of questions about managing investment risk
« Reply #7 on: December 31, 2017, 04:49:01 PM »
Bonds and Bond Funds are not the same.

I'll start with bonds.

A bond is a debt, much like a mortgage.   If you buy a bond, you are buying a debt, just like a bank buys a debt when it issues a mortgage.  The bond comes with terms.   The terms include how long before the money has to be repaid in full and how much interest it will pay in the meantime.   Assuming the bond issuer does not go bankrupt, your money is in a safe place with a known return on investment.

Example:  You buy a bond for $10,000.   It pays 4% over 10 years.   Every year you would receive $400 in interest and at the end of ten years, you would have your $10,000 back.   At that time, you could buy another bond at whatever the prevailing interest rate is.

What if you need some money back before 10 years go by?  One way would be to set up a bond ladder.   Buy bonds at different term lengths at staggered intervals.  This could be called a bond ladder.  That way, after it's set up, every few months a bond would be maturing and you would have cash available.     If you didn't need the cash at that time, you would buy another bond.

That's why bonds, PURCHASED IN THIS MANNER, would tend to mitigate the volatility of the stock market.

I hope that makes sense.

But what happens if you need money from a particular bond, RIGHT NOW, even though it has not matured?

Well, let's go back to that 4% interest rate bond.   If I wanted to sell you a "used" bond that paid 4% interest, but you could buy a "new" bond that paid 6%, you probably wouldn't be interested in my bond.  Conversely, if new bonds only paid 2%, my 4% bond would be much more interesting, right?   So, when I sell a bond early, I'm going to sell it for more or less than I paid for it depending on the current bond rate compared to the bond's interest rate.   I would have to sell my used bond at a discount if new interest rates were higher than my bond and I could sell at a surplus if new rates are lower.

Now, the best way to avoid the problem of having to sell a bond at a discount is not to need the money before the bond matures. :)  That's what a stache is for! :)


Now, let's talk about bond funds.   What's a bond fund?  It's like a mutual fund of stocks, except it's composed of bonds instead of stocks.

Why invest in a bond fund instead of individual bonds?

Individual bonds don't come in small dollar increments.   The dollar values are much higher, so it's harder for someone starting out to buy an individual bond in full.   It's the same reason why mutual funds of stocks allow you to own partial shares of stocks.   

Second, how many high dollar value bonds can you afford to buy?   If you are like most folks, not that many.  That means your bond savings are more subject to bankruptcy risk, just like buying a portfolio of just 10 stocks is riskier than buying an index of thousands of stocks.

The above reasons show bond funds are a good deal for those who can't safely (or at all) afford to invest in individual bonds.

The problem is that you're bond holdings are mixed up with other people.  If they haven't managed their affairs well, they will need to sell some bonds.  If a lot of them have to do that, the bonds that are maturing in the fund will not be enough to cover the fund's need for cash to hand back to fund holders.   So bonds will have to be sold before they mature.  If current interest rates are lower than the bonds they sell, the bonds will be sold at a discount.   Since you own some of those bonds, you'll take a loss on those bonds even if you didn't sell any out of your account.   

That's why bond funds follow the stock market more than individual bonds do.

I hope that helps out.   It took a long time before I understood this, a lot of the explanations I were just a mishmash of partial information.





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Re: Couple of questions about managing investment risk
« Reply #8 on: January 01, 2018, 05:13:37 AM »
Bonds and Bond Funds are not the same.

I'll start with bonds.

A bond is a debt, much like a mortgage.   If you buy a bond, you are buying a debt, just like a bank buys a debt when it issues a mortgage.  The bond comes with terms.   The terms include how long before the money has to be repaid in full and how much interest it will pay in the meantime.   Assuming the bond issuer does not go bankrupt, your money is in a safe place with a known return on investment.

Example:  You buy a bond for $10,000.   It pays 4% over 10 years.   Every year you would receive $400 in interest and at the end of ten years, you would have your $10,000 back.   At that time, you could buy another bond at whatever the prevailing interest rate is.

What if you need some money back before 10 years go by?  One way would be to set up a bond ladder.   Buy bonds at different term lengths at staggered intervals.  This could be called a bond ladder.  That way, after it's set up, every few months a bond would be maturing and you would have cash available.     If you didn't need the cash at that time, you would buy another bond.

That's why bonds, PURCHASED IN THIS MANNER, would tend to mitigate the volatility of the stock market.

I hope that makes sense.

But what happens if you need money from a particular bond, RIGHT NOW, even though it has not matured?

Well, let's go back to that 4% interest rate bond.   If I wanted to sell you a "used" bond that paid 4% interest, but you could buy a "new" bond that paid 6%, you probably wouldn't be interested in my bond.  Conversely, if new bonds only paid 2%, my 4% bond would be much more interesting, right?   So, when I sell a bond early, I'm going to sell it for more or less than I paid for it depending on the current bond rate compared to the bond's interest rate.   I would have to sell my used bond at a discount if new interest rates were higher than my bond and I could sell at a surplus if new rates are lower.

Now, the best way to avoid the problem of having to sell a bond at a discount is not to need the money before the bond matures. :)  That's what a stache is for! :)


Now, let's talk about bond funds.   What's a bond fund?  It's like a mutual fund of stocks, except it's composed of bonds instead of stocks.

Why invest in a bond fund instead of individual bonds?

Individual bonds don't come in small dollar increments.   The dollar values are much higher, so it's harder for someone starting out to buy an individual bond in full.   It's the same reason why mutual funds of stocks allow you to own partial shares of stocks.   

Second, how many high dollar value bonds can you afford to buy?   If you are like most folks, not that many.  That means your bond savings are more subject to bankruptcy risk, just like buying a portfolio of just 10 stocks is riskier than buying an index of thousands of stocks.

The above reasons show bond funds are a good deal for those who can't safely (or at all) afford to invest in individual bonds.

The problem is that you're bond holdings are mixed up with other people.  If they haven't managed their affairs well, they will need to sell some bonds.  If a lot of them have to do that, the bonds that are maturing in the fund will not be enough to cover the fund's need for cash to hand back to fund holders.   So bonds will have to be sold before they mature.  If current interest rates are lower than the bonds they sell, the bonds will be sold at a discount.   Since you own some of those bonds, you'll take a loss on those bonds even if you didn't sell any out of your account.   

That's why bond funds follow the stock market more than individual bonds do.

I hope that helps out.   It took a long time before I understood this, a lot of the explanations I were just a mishmash of partial information.



This was fantastically written! in fact I am going to copy and give to my kids! :-p

And to OP, like anything, there are good and bad bonds!