Archives for September 2015

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Why Are Bonds a Useful Diversifier?

A reader writes in, asking:

“I graduated in May and immediately started contributing to the 401k at my new job. Fidelity runs the 401k. I am using the Spartan 500 Fund, the Spartan U.S. Bond Fund, and a small amount in the Total International Equity Fund.

I thought my portfolio was diversified. But the Spartan 500 fund went way down last month and the U.S. Bond fund barely went up at all. I’ve read that ‘bonds zig when stocks zag’ but that doesn’t seem to be working. Do you have any suggestions?”

The problem doesn’t appear to be with the portfolio. A portfolio of those 3 funds would be reasonably well diversified. The problem is that you’re expecting too much from your bond holdings.

Historically in the U.S., bonds have typically had a positive correlation to stocks. (See Figure 2 in this paper from Vanguard.) In addition, the correlation between stocks and bonds varies dramatically over time. (See Figure 1 in this article from Rick Ferri.)

In other words, the reason bonds are a successful diversifier is not that they have negative correlation to stocks and that you can expect bonds to rise reliably when stocks fall. Sometimes it works out that way, and it’s very convenient when it does. But you can’t count on it.

The primary reason that bonds work well as a diversifier is simply that they are less risky than stocks. That is, when stocks are falling, it’s entirely possible that bonds will be falling too. But as long as you’ve stayed away from very high-risk bonds (e.g., junk bonds or bonds with very long durations), it’s very unlikely that your bonds will fall as much as your stocks.

For example, the following chart (made using the Morningstar website), shows the returns of Vanguard Total Stock Market Index Fund (in blue) and Vanguard Total Bond Market Index Fund (in orange) over the last three months.

Screen Shot 2015-09-27 at 8.48.22 AM

As you can see, the stock fund fell quite noticeably around the middle of August. The bond fund didn’t shoot upward when the stock fund fell, but it didn’t decline precipitously either. That’s pretty much what you should be hoping for from a bond fund. It delivers boring, low-risk performance, even when stocks are performing poorly.

If you’re hoping that your bond holdings will reliably offset any stock losses that you experience, thereby allowing your portfolio to climb steadily upward without any bumps, you’re going to be disappointed.

Investing Blog Roundup: Should You Have Disability Insurance?

Disability insurance can be expensive. Unfortunately, a part of the reason it costs so much is that a significant portion of the people that buy policies end up receiving benefits. (Or, said differently, it’s not entirely unlikely that you’ll become disabled at some point during your career.)

This week, Jim Dahle asks when it makes sense to refrain from buying disability insurance. (The article is written with doctors as the intended audience, but the analysis applies to anybody.)

Investing Articles

Other Money-Related Articles

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Where, When, and How to Buy Mutual Funds

A reader writes in, asking:

“I am just getting into investing. It would be very helpful for folks like me, if you can write about where to buy, how to buy, when to sell and how to sell.

I have read few investment related books and searched online but could not find this kind of information. Most of them talk about what to buy. For example, from your site I understood what kind of funds to buy but I do not know where to buy them from, when to sell them and how often should I buy them, is there a good time to buy them as they too have price fluctuations like stocks.”

Where to Buy Mutual Funds

As far as where to buy different funds, I think it’s usually just a question of finding a place where you can buy them without having to pay commissions. For example, if you want to use Vanguard mutual funds, it usually makes sense to open an account at Vanguard and buy them there. Or if you want to use Fidelity’s “Spartan” index funds, Fidelity is probably the best place to do that.

With ETFs, there may be more options. For example, you could purchase Vanguard ETFs commission-free at Vanguard. But many of the most popular Vanguard ETFs are also available commission-free at TD Ameritrade.

In some cases, if there is a specific service that you want from a brokerage firm, and you know that it is only available at certain places (e.g., you’re looking for a firm that offers solo 401(k) accounts that allow both incoming rollovers and Roth contributions), it may make sense to use a firm with non-zero commissions. But you will usually know if you’re in such a situation.

When to Buy (or Sell) Mutual Funds

As far as when to buy and sell funds, there’s some disagreement on the matter. Personally, I follow a “strategic asset allocation” approach, which means that I do not adjust my asset allocation based on market valuations, predictions about interest rates, or anything of that nature. Instead, my portfolio only changes when a) something in my life changes such that I can afford more or less risk or b) a new product becomes available that allows me to meet my desired allocation with less work or lower expenses.

For people following such an approach, the question of when to buy and sell is very easy.

  • Buy when you have money to invest,
  • Sell when you need to take money out of the account (either to spend it or to satisfy required minimum distributions from a retirement account), and
  • At specific intervals (e.g,. once per year) buy and sell as necessary in order to rebalance (i.e., to bring your overall portfolio back to the desired allocation).**

In contrast, some investors prefer to use a “tactical asset allocation” approach, in which you shift your allocation in one direction or another based on various market conditions. Personally, however, I have never been convinced that such methods reliably result in anything other than an increased workload.

How to Buy Mutual Funds

As far as how to buy, with traditional open-end mutual funds, there’s nothing to it really. You simply log into your account and place a buy order. With ETFs, there are some additional considerations with regard to what type of order to place (e.g. market order, limit order, etc.) and what time of day to place a trade. (See this paper from Vanguard for a more thorough explanation.) But those considerations can be sidestepped completely, if you desire to do so, simply by using traditional open-end mutual funds.

**If your portfolio includes taxable brokerage accounts, there may also be tax-related reasons to buy and sell funds (e.g., tax-loss harvesting or tax-gain harvesting).

Investing Blog Roundup: Anxiety about Interest Rates

For the last few years, two of the most common questions I’ve received are a) when will the Federal Reserve raise interest rates and b) what should investors do about it?

As Allan Roth points out this week, the market is already pricing in expectations about the Fed’s actions. As with stocks, you have to know something the market doesn’t know in order to reliably beat a buy/hold/rebalance strategy.

Investing Articles

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Why I (Still) Like All-in-One Mutual Funds

A reader writes in, asking:

“You haven’t written about how you feel about the LifeStrategy funds in light of current market events. Are you still using one? Are you happy with it?”

The short answer is that:

  • Yes, we’re still using the Vanguard LifeStrategy Growth Fund for all of our retirement savings,
  • Yes, we’re still super happy with it, and
  • Neither my investment strategy nor investment tactics change as a result of market conditions, so that’s not really playing a role (in either direction) regarding my level of satisfaction.

All-in-One Funds Are Low-Stress, Low-Maintenance

One of the primary reasons I’ve enjoyed using the LifeStrategy fund is that it is a very low-hassle way to invest. When I sign into the Vanguard site to make a contribution, I don’t have to spend any time figuring out how much to buy (or sell) of each fund in order to maintain our desired overall allocation across accounts. Nor am I spending any time or energy considering adjustments to our asset allocation. All I’m doing is entering the amount of the contribution I want to make, confirming the transaction, and signing out.

If you use an all-in-one fund, you will want to make a point of staying informed about changes made to the fund (for example, Vanguard recently increased the international allocations in their all-in-one funds), because it’s possible that the fund company could change the underlying allocation in such a way that it’s no longer appropriate for your needs. But, at least with Vanguard, such changes don’t happen especially often, so the amount of work (and thought) involved is minimal.

All-in-One Funds Help Reduce the Likelihood of Mistakes

A second reason I like using an all-in-one fund is that it reduces the likelihood that I’ll tinker with our portfolio in a way that will ultimately be detrimental to performance.

Morningstar research has consistently shown that investors tend to underperform the funds that they use, because they switch between funds at the wrong times. (This is generally the result of buying immediately after a period of good performance and selling after a period of poor performance.) Interestingly, in research from earlier this year*, Morningstar found that investors in target-date funds have actually had better performance than the funds themselves over the 10-year period ending 12/31/2014.

But They’re Not for Everyone

Despite the benefits mentioned above, all-in-one funds have their limitations. Last time I gave an update on using the LifeStrategy fund, I wrote the following, which I still think is true.

All-in-one funds are not a perfect fit for everybody. There are plenty of reasons why any given investor might be better off taking the DIY-allocation approach. For example:

  • The fund-of-funds structure is tax-inefficient, which is relevant if you have assets in a taxable brokerage account.
  • Some people will not be able to find an all-in-one fund with an asset allocation that suits their needs (e.g., because they need to underweight U.S. stocks in their IRA in order to make up for the fact that they’re overweighting U.S. stocks in their 401(k) because their retirement plan’s only decent choice is a U.S. stock fund).
  • Some people will prefer to implement a strategy that “tilts” the portfolio in some way (most commonly toward small-cap value stocks or REITs).
  • Some people don’t mind the modest work involved in managing a portfolio, are completely confident they will not do any detrimental tinkering, and want to take advantage of the slightly lower costs of individual index funds or ETFs.

*A free Morningstar account is required to view the article.

Investing Blog Roundup: ETF Pricing Problems

The vast majority of the time, the market price of an ETF very closely tracks the collective market price of the fund’s underlying assets. So many investors were, naturally, quite surprised recently when the market prices of several ETFs suddenly deviated (for a short while) significantly from the per-share value of the underlying assets.

This week Michael Kitces has a great explanation of the mechanism that usually keeps the market prices on track, an explanation of how that broke down, and some suggestions for how best to avoid such negative situations when trading ETFs.

Other Financial Planning-Related Articles

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