Archives for June 2017

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Stop Reading This Blog.

Admittedly I don’t mean for the headline to apply to every reader. But I don’t mean for it to be just “clickbait” either. I genuinely mean that some of you would be better off unsubscribing from this blog/newsletter.

That probably requires a bit of an explanation.

When I started writing this blog in 2008, the whole idea (i.e., “oblivious” investing) was that:

  1. Most people should stop reading/watching financial news, because such sources of information talk constantly about things that have no real significance to a long-term investor, and
  2. Most people shouldn’t check their investments very often, because doing so can cause unnecessary stress about short-term fluctuations.

What I’m coming to realize, however, is that there’s a group of people who would be well served by discontinuing their intake of even “good” sources of investing information (e.g., this blog, the Bogleheads forum, etc.).

Specifically, based on correspondence with readers, I’m coming to realize that there are some people (quite a lot, actually) who find themselves second-guessing their own investment decisions whenever they’re confronted with a conflicting suggestion from a credible source. This personal characteristic combined with frequent intake of investment information can lead to a problematic situation.

In short, if:

  1. You’re already at a point where you know enough to create and manage a low-cost, diversified portfolio that’s roughly suitable for your risk tolerance, and
  2. Reading about investing is making it harder to manage that portfolio (because it makes you constantly doubt your choices)

…then additional reading might be doing more harm than good. (Plus, reading has a cost in that it’s taking up your time.) Of course, the above two points are an evaluation that only you can make. But it’s worth thinking about at least.

One of the most important lessons in investing is that there is no “perfect” portfolio, but there are many “perfectly fine” portfolios. Once you are confident that you have a “perfectly fine” portfolio, just stick with the plan and let the portfolio do what it is meant to do.

Pick Your Own Asset Allocation

A reader writes in (regarding last month’s article about “total market” investing):

“Your article made me feel much more comfortable with my market-cap weighted portfolio!

However, after reading your email, a news story came out about Wealthfront. Burton Malkiel has written extensively about the merits of market-cap weightings. He and Charlie Ellis helped me build my simple portfolio!

However, it just came out that Malkiel is ignoring his own advice, and has decided to add smart beta ETFs to Wealthfront portfolios. This is a crushing blow. It seems more and more of my favorite investing authors are abandoning the plain vanilla portfolios they have written about for decades, and instead are embracing momentum, value, and small stock overweights in hopes of beating the market.

I am trying very hard to keep it simple and stay the course. But it seems we are losing members of the plain vanilla club every day! Losing Malkiel and Ellis was not fun for me to read about this morning.”

Firstly, advisory firms (including robo-advisors) have an incentive to make their portfolios look smart/complicated. If it’s a simple total market portfolio, people might wonder: why not just handle it on their own? Or why not just use a less expensive target-date fund?

The more important point, however, is that there are no clubs or teams here. It doesn’t work to weigh the names on one side of an asset allocation debate against the names on the other side.

Ultimately you have to weigh the evidence and arguments on each side of the debate and then decide for yourself.

If you decide based on the names on each side, it will always be a struggle to stick with the plan, because on any asset allocation debate there will be experts — credible ones — who disagree with you, regardless of which side of the debate you’re on. And they’ll have convincing-sounding arguments and data backing them up.

For instance on the topic of bonds, several parties I respect greatly have made different arguments.

Personally I would find it impossible to weigh the credibility of one of those parties against the credibility of the others.

In addition, if you decide based on names, you always have to revisit your portfolio decisions whenever a) an expert changes opinion or b) you encounter a new expert with an opinion on the matter.

Conversely, once you’ve made the decision for yourself, you can put it out of your mind and move on with your life.

Reading a new expert opinion or reading about an expert changing their opinion should be roughly as impactful as reading a list of “Top 10 Cities for [People of Your Generation]” in a magazine. Even if your town isn’t on the list, you don’t consider moving. You’ve already made an informed decision, so the writer’s opinion has no impact on where you choose to live.

In short, with any asset allocation decision, regardless of what you end up choosing, the goal is to take your time with the decision, so that ultimately it’s your decision, and you can be confident/content regardless of who agrees or disagrees with you.

Don’t Forget About Disability Insurance

A fundamental principle of financial planning is that insurance comes first. If you don’t have the proper insurance, you can do everything else exactly right — save a large percentage of your income, invest that savings wisely, engage in excellent tax planning, etc. — and still end up financially ruined if you find yourself on the unlucky side of a large uninsured risk.

Of course, you don’t need every type of insurance. For example, if there is nobody else who is financially dependent upon you — as would be the case for many people with no children — you most likely have no need for life insurance.

But if you have a job, there’s a good chance you are dependent upon the income from that job — and therefore have a significant need for disability insurance.

A 2014 “actuarial note” from the SSA estimated that, for a person who reached age 20 in 2013, there is only a 6.5% chance of dying prior to full retirement age but a 27% chance of becoming disabled prior to full retirement age.

And the above estimate uses the SSA’s definition of disabled, which states that you must be unable “to do any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months.” There are plenty of people who incur injury or illness that meaningfully reduces their income yet who do not qualify for Social Security disability benefits.

In addition to being difficult to qualify for, Social Security disability isn’t particularly generous in terms of amount paid. You can get an estimate of what your Social Security disability benefits would be (if you became disabled right now) by signing into your online account. The average monthly Social Security disability benefit is $1,172. That’s a heck of a lot better than nothing, but even with other forms of government assistance, we’re talking about a serious financial struggle in most cases.

So how many people actually have private disability insurance? Last year an article by Stuart Heckman in the Journal of Financial Planning looked at the 2013 Survey of Consumer Finances from the Federal Reserve Board to answer that question (and many other related questions). Heckman found that only 30% of households had private disability insurance (i.e., insurance beyond that provided by Social Security). Interestingly, he also found that people who use a financial planner are not significantly more likely to own disability insurance.

My overall point here is just to provide a basic reminder: don’t forget to consider disability insurance. Do you have it? If not, should you?

If you do end up shopping for disability insurance, you should know that there’s a lot of variation from one policy to another. This Bogleheads wiki article provides a brief explanation of the most important considerations.

What Happens to Bonds in a Stock Market Crash?

A reader writes in, asking:

“I have one friend who is paying 1% to have her assets managed for her. When I looked at the portfolio the advisor had her in, it seemed riskier than one might like given that she hopes to retire one year from now. I encouraged her to ask him, ‘If the market were to crash tomorrow and drop by half, will that change my plan to retire?’

I want to give a simple example and wanted to check something with you first. Let’s say she has $1,000,000, half in stocks and half in bonds. So if the market were to drop by half, then she would wake up tomorrow having lost $250,000, right?

So my question is, when assessing risk tolerance, is it sensible to assume the bonds will hold steady?”

The “if the stock market fell by half and bonds stayed level” scenario is one that I use myself, as I think it provides a very rough but quick and useful metric of how reasonable a person’s overall allocation is.

So, yes, I definitely think it’s sensible to consider such a scenario.

However, I wouldn’t say that it’s a good idea to put oneself in a real-life situation where you’re 100% reliant on bonds not falling when stocks fall. Because they could. On the other hand, they could increase in value while the stock market falls, thereby offsetting the loss somewhat.

In short, what happens with the bond holdings depends on a) the immediate cause of the stock market decline and b) the type(s) of bonds in question.

For instance, it may be instructive to look at what happened with the last big market decline in late 2008. The chart below (made using the Morningstar website) plots four different mutual funds from 1/1/2008-12/31/2010.

Mutual Fund Chart

  • The blue line is Vanguard Total Stock Market Index Fund (VTSMX),
  • Green is Vanguard High-Yield Corporate Fund (VWEHX),
  • Yellow is Vanguard Intermediate-Term Investment-Grade Fund (VFICX), and
  • Orange is Vanguard Intermediate-Term Treasury Fund (VFITX).

The stock fund obviously falls by quite a bit in late 2008.

The high-yield corporate bond fund (green) falls right along with it, though not as much. This is more or less what you’d expect, as a situation in which businesses suddenly look more risky is a situation in which people might not want to hold bonds from the riskiest businesses (i.e., high-yield bonds).

The investment-grade corporate fund (yellow) also falls, though not as much as the high-yield fund. Essentially, you have the same thing going on with investment-grade corporate bonds as with high-yield bonds, but investment-grade bonds are from less risky companies, so people aren’t running from them as much as they are from the riskier choices.

The intermediate term treasury fund (orange) goes up over the period in question, as people “flee to safety” — pushing up prices for the safest bonds (and pushing their interest rates down).

So that’s how different types of bonds behaved in one particular stock market decline scenario. But other scenarios can have different results.

For instance, the following chart shows the same four mutual funds from 1/1/2000-12/31/2003. In the dot-com crash, all three bond funds did just fine — even the high-yield fund had only minor bumps. And that’s about what you’d expect given that most businesses weren’t particularly in danger of failing to pay their obligations.

Dot Com Crash Chart

Alternatively, one could imagine various scenarios in which the market decides not that “U.S. businesses look much riskier than they did a month ago,” but rather that “the United States looks much riskier than it did a month ago.” In such a scenario, it seems likely that the investors who choose to “flee to safety” would not flee to Treasury bonds — and some would even flee away from Treasury bonds. So we would see a case in which Treasury bonds would fall (to some extent) while stocks and corporate bonds fall as well.

So, to summarize, yes I think it’s often helpful to think about a scenario in which stocks fall by half and bonds go nowhere. But it’s also a good idea to think about and prepare for other scenarios. (And in general, diversification is the tool to prepare for such scenarios.)

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