Archives for October 2020

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Investing Blog Roundup: Expected and Unexpected Returns

On Monday we discussed the expected return from the Vanguard Total Bond Market Index Fund.

This week I came across an article from esteemed economist Kenneth French discussing the expected and unexpected returns of Facebook, Amazon, Apple, Netflix, and Alphabet (i.e., Google).

A key point about expected returns is that, except for a few specific types of investments (e.g., Treasury bonds that we intend to hold to maturity), we don’t actually expect to get the expected return. That is, we will almost always get more or less than the expected return (i.e., there will be some level of positive or negative unexpected return — we just don’t know how much).

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*After the account fraud scandal and auto insurance scandal, I don’t understand why anybody still trusts this company with their money.

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Will a Total Bond Fund Keep Up With Inflation?

In reply to the previous article about fixed-income options in a low-yield environment, a reader wrote in with the following question:

“Would Vanguard’s Total Bond Market fund (or the equivalent) be expected to match inflation over time?”

For a bond (or bond fund), the best estimate for its expected return is its yield. Right now, the SEC yield for Vanguard Total Bond Market Index Fund is 1.19% You can find this on either the “Overview” or “Price & Performance” tab on the fund’s page on the Vanguard site.

But there are two important points of note here.

First point of note: that’s the expected return over the fund’s average duration. We can click over to the “Portfolio & Management” tab to find the fund’s average duration: 6.5 years. So what we’re seeing here is that the fund’s expected return over the next 6.5 years is 1.19%.

For periods shorter or longer than 6.5 years, there’s a greater degree of uncertainty about what the actual return will be.

For shorter periods, 1.19% is still probably the best expected return estimate, but the actual return is going to be primarily affected by price movements (i.e., whether the bonds’ prices move up or down as a result of interest rate changes). See any of the following articles for a discussion of how bond prices respond to changes in interest rates:

For longer periods, 1.19% is (again) likely the best guess, but we (again) have a lower degree of certainty. In this case, a major cause of the uncertainty is that, as we look at longer and longer periods, we simply don’t know what bonds are going to be in the fund’s portfolio. For example, imagine that we were concerned with the expected return over the next 20 years. Given the fund’s average effective maturity of 8.5 years, most of the bonds currently held by the fund will have matured before the 20-year period is even halfway over. In other words, the return earned by the fund over the next 20 years will be hugely affected by the yields on bonds that it hasn’t even bought yet — and which haven’t even been issued yet. And since those bonds don’t even exist yet, we have absolutely no way to know what their yields will be.

Second point of note: because this is a nominal bond fund, the 1.19% figure is a nominal yield (i.e., before inflation) and therefore a nominal expected return.

A good way to get a rough estimate of the market’s expectation for inflation over a given period is to find the difference in yields between TIPS and nominal Treasury bond for the period in question. For example, since our expected return is for a 6.5-year period, we could look at the yields for 7-year TIPS and 7-year Treasuries. Right now, the yield on 7-year TIPS is -1.10%, and the yield on 7-year Treasuries is 0.55%. That’s a difference of 1.65%, which tells us that the market is expecting inflation of roughly 1.65% over the next seven years.

So, in summary, with an expected nominal return of 1.19% over the next 6.5 years and expected inflation of roughly 1.65% over the next 7 years, we can say that the expected return for Vanguard Total Bond Market Index Fund is about 0.46% below inflation over the next 6.5 years.

But that’s just an expected return. The actual nominal return could be meaningfully different from the 1.19% figure. Or inflation could be meaningfully different from the 1.65% figure. And as discussed above, for periods shorter or longer than 6.5 years, there’s an even greater degree of uncertainty.

Investing Blog Roundup: Open Social Security Widow(er) Update

A quick announcement about the Open Social Security calculator: it now has full functionality for widow/widower scenarios (including mother/father benefits as applicable).

To be clear, the calculator has always accounted for survivor benefits, but it was not built to provide guidance to people who are already widows/widowers at the time they are using the calculator.

When I first created the calculator, my line of thinking was that such wasn’t necessary because the analysis for a surviving spouse is usually very straightforward. In fact, in the absence of complicating factors, there are only two options worth considering, as compared to the 96 options for a single person to consider or 9,216 options for a married couple.

But of course, that’s “in the absence of complicating factors.” And in real life, complicating factors do apply in many cases. (The earnings test is the complicating factor most likely to dramatically affect the analysis for a widow/widower.)

So, as of last week, the calculator now provides guidance for widows/widowers, with all of the same features as in other cases.

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My new Social Security calculator (beta): Open Social Security