Smart Advice for the HuffPost Investor

Are bonds really a necessary part of every investor's portfolio?

What is my prediction for the continuation of our aggressive foreign policy and how should investors adjust their portfolios to deal with it?

The markets are tanking, so what's wrong with a savings account in these volatile times?

I deal with these questions in this month's column.

If you would like your questions considered, please add a comment to this blog.

Question from Cognate:

Dan,

I don't understand the recommendation to include bonds in a long-term index fund portfolio (say 10 to 20 years before cashing anything in) and for someone who can tolerate occasional dramatic (say 30%) drops in one's net assets. The expectation is that even a 30% drop will recover over the life of the portfolio. Bonds prevent the possibility of a total loss (if the whole market crashes to zero) but they also prevent the high returns during the good years.

You are correct that bonds should not be included as a part of every investor's portfolio. Investors who can confidently state that they will not need to access a significant portion of their assets for ten years or more could consider a globally diversified portfolio consisting exclusively of low cost, stock index funds.

However, there are relatively few investors who fall into this category. And even some of those investors may not have the stomach to hold on when the market declines dramatically. For example, in 1973-1974, an all stock portfolio would have lost over 40% of its value. The markets did recover, but many investors panicked and incurred significant losses.

Here is the bottom line: Bonds reduce the long-term returns of an all equity portfolio, but holding them gives investors the staying power to wait out the inevitable downturns in the markets.

Question From January:

I read your advice with appreciation. Maybe that's because my modest mutual fund holdings are already diversified along the lines you suggest--with a bit more in international funds and a recent pull back into a somewhat higher percentage of bonds. All the talk about economic dislocation in the coming year spooks me. Isn't the goal to be able to sleep at night?

My question is, Are we committed economically as well as politically to our pursuit of the warfare state? Hence the chances of cutbacks in military spending, no matter who runs the nation, are unlikely?

Also, are our treasuries held by other countries always payable in dollars?

I could not agree with you more: the goal is to be able to sleep at night.

However, the way to get there is not by trying to predict the unpredictable. This strikes me as counter-productive. When our predictions go wrong, our anxiety will be increased.

There is a better way. Determine your tolerance for risk. You can do this by asking yourself these basic questions:

• Within how many years do you plan to withdraw at least 20% of your portfolio?


• What is the worst twelve-month unrealized percentage loss you would tolerate?

The answers to these questions will permit you to structure an appropriate asset allocation that will permit you to "sleep at night."

For example, risk adverse investors might consider a portfolio of low cost, passively managed mutual funds consisting of 65% bonds and 35% stocks. Properly structured, this portfolio has a very low volatility. Over the past 50 years, it has lost money only eight times, and its largest one year loss was 4%. Its 50 year average annualized return was 8.72%.

Similar portfolios can be structured for investors with a greater tolerance for risk.

Question From humanoid:

I have been investing in socially responsible funds for years now and am generally satisfied. However, after reading your advice, none of the funds I invest in were recommended by you. I checked their expense ratios and found them to be over 1%. Should I consider moving my money to other funds with lower expense ratios? The funds are no load and have low fees so I'm not sure if changing would be advantageous.

Also, I have some cash right now sitting in a savings account that pays 5.05%. I'm 56 years old, married, with no children at home. I have a 30 years mortgage and no other debt. Where is the best place financially to put my extra cash?

Everything else being equal, you would be well served by focusing on the funds with the lowest expense ratios. Lows fees correlate directly with higher returns. However, with socially responsible funds, you will want to be sure that the screens used to define what is "socially responsible" are the same for the funds you are considering.

If you have "extra cash", I am assuming that you mean you already have 6-12 months of living expenses in savings and are considering investing this cash.

For my views on how investors should determine their asset allocation and select appropriate investments, please see my blog entitled: "It's So Easy, Your Broker Could Do It!"

You are wise to consider investing your assets. A savings account that pays 5.05% is fine for holding cash you may need short term. However, when you consider the 3% historical rate of inflation, and the taxes (at ordinary income rates) on these earnings, you can see that you are barely breaking even, or possibly losing money in this account.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

Comments

[emerywood]

I wouldn't say holding bonds necessarily diminish one's total return. It all depends on when one buys bonds and what type of bonds. For instance, during the 80's when interest rate was at 15 % or higher and one was smart enough to have bought zero coupon bonds ( U.S. Treasuries ), he would have made a fortune when interest rate came back down to earth in the next 10 years.

[kingcityguru]

Invest in what China and India and Middle East need and want (the areas of the world with the fastest growing economies and populations) as their buying on the margins will drive prices.

As a result, Americans need to discover commodity investing and commoodity stocks and put away the techs that can't make a buck.
Buy nuclear and oil producing stocks as well as some golds.

[JeremiahJones]

If bonds help you sleep at night, by all means buy bonds --- secure in the knowledge that your loss over time will at least be fairly predictable. Being long bonds is a bet on stable or falling interest rates --- and interest rates are already fairly low by historical standards. ... Inflation may be necessary to foster the illusion of ever-growing wages and profits, but it's death for longterm bondholders. Had you bought a 100-year, $1000 treasury in 1914, your returned principal in 2014 would be worth maybe $30 --- and possibly much less if Helicopter Ben Bernanke is forced to keep cranking up the money supply (M3 growth is currently estimated at 10-13%). You could buy TIPs, but then your bet is that the government will accurately report the rate of inflation. Yeah, right. ... Consider instead investing in dividend-paying stocks: your "principal" is indexed to the real world rate of inflation and unlike bonds, the payout rate should increase over time.

[SisterAnn]

Studies have shown that you do better with 40% bonds, in the long run, if you can get a decent rate of interest of at least 5%. I have a link to one study, I can find, if anyone is interested. It shows the difference over several periods, of different ratios of bonds and funds or stocks.

If the market went down 50% today, your bond balance would remain the same and the first of each month you get an interest 'pay check'. It is like having little minions working as you sleep. I can invest the interest in funds or accumulate them to earn more interest.

The money market interest can go down, but interest on bonds is locked in.

You also have the money to buy the market at the bottom, if you want to.

I made a lot of money on the face value of bonds yesterday. I have lost money at other times, when the face value goes down.

I am more into income preservation, that is why I like bonds, but I realize I am bearly beating inflation. I can't stand to be outdone and I feel outdone when I lose in the market. I always have an escape door, in this case it is bonds.

When the market goes down, those bonds are shining stars in my portfolio.

I can see the other side, if you stay fully invested and know when to get out, then you can do better totally in funds. I tried that and missed a lot of money because it would keep going up after I sold, by the time I got back in, the market went down.

My 401k limits selling, too, which doesn't help. It doesn't have foreign bonds or gold in it or I would buy those, too.

[SisterAnn]

I couldn't find the old study I have read about bonds. One I found recommends bonds at a 9% interest rate after retirement, saying that you would do better over the long run with that, instead of market investments. That goes without saying, but there isn't such a critter. To get 5% bond interest, you don't get pure treasury bonds, so they probably are risky.

There isn't a really safe place to go at this time. I have some dividend funds and they go down a lot when the market goes down. Property is going down and probably interest rates will go down next week.

Looking back over my portfolio, it does show I would have been better off being totally invested in the market.

My biggest problem is remembering how much we lost when the bubble busted and DH and I stayed fully invested.

Being in bonds, even if I don't beat inflation, is better than losing half my principal when the market goes down, like we did during the bubble era loss.

It all depends on how well the market does.

My husband and I are considering cashing out our 401k and buying ETFs so we can get out of the market when we want to. Once we pay our 401k regular taxes, then we would only pay the capital gains rate on any new profits. It all depends on whether we can use the 10 year averaging to cash out. There is a lot to consider. You pay commissions on ETFs, so you couldn't do a lot of selling and buying. Buying stocks and getting the certificate for them may be the best way to go. There are no charges until you sell except on your dividends.

[Overd0g]

I would advise Huffpo readers to not be investors. After all, property is theft, money corrupts, and capitalists (and by associate capital itself) is evil.

[KRANKY]

Bonds are OK, for the investor that has enough loose cash and a Looooooooooong time horizon.
They are ideal for the richest and the youngest. Everyone else is SOL, unless you consider giving your worthless grandkids a trust fund a worthwhile investment.

For those more intrepid, and self centered; consider ETF's that short...in order to balance and hedge other long positions.

If you already have millions, go ahead and buy bonds. Why would you even consider risky stocks?
Bill Gates does not invest, he takes the sure bet with bonds. Course, he can afford it.

If you are not Bill Gates, why would you take his low risk route?

[frost]

.

it should be noted that as important as how you handle your money is..

handling your entire investment should include your income potential through your labor or service..

please continue your education and grow your skill-set as part of your "investment portfolio".. either through college or more specialized training.. life must be treated as an opportunity to increase our earnings potential through our own wisdom which only comes from improved job skills..

okay so now i've said that..

this economy is weakening fast and we need to insure that our investments are safe and also portable as well.. my suggestion would be foreign currency that has some stability right now.. the euro perhaps... balanced with some stocks that have a reasonable percentage of foreign ownership.. Chinese possibly..

what say you..
.

[Halsey]

frost...just yesterday Warren Buffet said the chinese market is, in his opinion, tremendously over-valued and sold his stake (after a gain of 76%) in Petro=china..he's a pretty smart guy..so I too now discourage my clients from chasing the Yuan..we don't even really know it's value..and the chinese barely allow any float.. you can, again using ETS's...put a small percentage in foreign currancies..via FXE, FXY, FXC, and FXA, etc... what Dan never mentions is getting into non-correlatives...managed futures...in most cases,one does have to have a certain net worth,but there is one mutual fund that follows the DDI index...yes..it hAS fees..but still allows for that exposure..

to the woman who wants to get a higher rate of return, but stay fairly liquid..sounds like she has enough to put a bit in auction rate securities..MARS...yesterday..I bought some for a client paying 5.65%...AAA rated..28 day maturity..yes..the rate will probably go down..but the principal remains safe...

sometimes..one NEEDS a trustworthy broker to find these gems...

[peaceandfreedom]

Dan--

In your column someone asked:

My question is, Are we committed economically as well as politically to our pursuit of the warfare state? Hence the chances of cutbacks in military spending, no matter who runs the nation, are unlikely?

And it ties in with my questions.

1. I'd like to know, given the national debt, continued government deficit spending and borrowing, and the continuing mortgage and RE woes, if you feel that there is a deep recession or even a depression looming on the horizon?

2. If either of those scenarios are a possibility, what are the best ways for average income individuals to protect their assets so as to emerge in good financial shape?

3. Can you provide any info on how the wealthy have historically weathered these downturns?

4. Do you indeed feel that we are in a war economy that will last--and this is not a political question, but one that goes straight to what investments would earn the greatest return over that time.

Thank You

[miguelpakalns]

Mr. Solin --

I am a 26-yr-old 401(k) investor currently saving money to open a prospective online trading account, in which I had planned either to: A. Buy-and-hold equities of low-debt companies with strong earnings growth and positive cash flow, or B. Buy socially responsible Funds, or most likely C. Both.

My 401(k) does not meet your standards. I currently hold about 60% emerging markets (FEMKX, reduced contributions from 50 to 33 a few months back but the % remains at ~60 due to NAV growth), 30% domestic (Fid Contrafund FCNTX and FDSCX) and roughly 10% junk bonds (FAGIX).

As you can see, I am an investor willing to gamble, and so far it has payed off very handsomedly (FEMKX!! ; Began buying FAGIX when it was 8.60-8.70 two months ago, saw it was generic junk corporate debt with few direct ties to mortgages or subprime and I figured it was being panic-sold, now it's back toward NAV 9.00 plus the monthly dividend).

Would your advice be for me to switch my 401(k) to Index Funds, and take my gambles with the online trading instead? To switch everything to Index Funds?

I hate to admit it, but advice to dump my YTD-28% earning portfolio for 8-11% earners will not please me nor most investors my age, even if I/we know it is "the most sound" advice (with young colleagues we snicker about "index investors").

Should I jump out of Emerging Markets before the "inevitable" crash? (note again, I felt "bubble" in June/July and started cutting back contributions, but FEMKX keeps on chugging with only the occasional blip)

Any special advice for online buy-and-hold investing? Or is the recommendation Index Funds uber alles?

Trying to make sense of all this, much appreciated,
Miguel Pakalns

[Shagnasty]

Your response to Cognate regarding bonds might be misconstrued. I believe you mean to recommend no-load mutual funds with low expense ratios. However, "exclusively of low cost, stock index funds." could easily be interpreteded to mean small-cap stocks, which I am sure you did not intend.
Carry on.

[dansolin]

You are correct. My recommendation would be for two low-cost stock index funds: A domestic stock index fund that has as its benchmark the Wilshire 5000, like the Vanguard Total Stock Market Index Fund (VTSMX) and a broad international index fund like the Vanguard Total International Stock Index Fund (VGTSX). 70% of this portfolio should be allocated to the domestic fund and 30% to the international fund.

[Chris]

Does Vanguard pay you to promote their funds? I tihnk this is am important question since you are givign out financial advice and constantly mention Vanguard.

Also most finaical advisors disclose their holdings. So are you invested in any of the funds you name?

All of this goes toward bias and is important for all people to know when reading your columns.