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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.)

How Pensions and Social Security Affect Asset Allocation

A reader writes in, asking:

“I am a retired government employee, and I receive a pension to the tune of roughly $50,000 annually. I have a relatively low risk portfolio; it is a mix of stuff but roughly 20-25% is in stock with the rest in bonds or CDs. I recently met with an adviser who said that my pension is essentially a big bond so it’s a mistake to have such low risk holdings in my retirement accounts. This is the first time I’d heard of this idea before. What do you think?”

It is a very common idea for people to count their pension or Social Security income as a bond holding. Many financial advisors and writers suggest doing so. Industry luminary John Bogle suggests doing so as well.

Personally, I do not like the idea because:

  1. It is confusing to many people, and
  2. It encourages people to use higher-risk allocations in their portfolios as a result of their pension/Social Security income, when in many cases the correct approach is to do exactly the opposite.

Instead, I think it is easier and more helpful to think of a pension (or Social Security) as exactly what it is: income.

For example if you plan to spend $60,000 per year, and you have pension/Social Security income of $50,000 per year, then you only have to spend $10,000 per year from your portfolio. In other words, your pension/Social Security income allows you to use a withdrawal rate that is one-sixth the withdrawal rate you’d have to use if you didn’t have such income.

What this does is it allows you to choose from a broader range of asset allocation choices.

That is, you could say, “my pension satisfies my basic needs. Therefore, I can afford to shoot for the moon with my portfolio, taking a lot of risk in the hope of achieving very high spending or a large inheritance for my kids.” Or, just as reasonably, you could say, “my pension satisfies my basic needs. Therefore, I have no need to take risk in my portfolio at all. I’ll stick to very safe holdings like TIPS, I-Bonds, and CDs, so that I don’t mess up a good thing.”

Either approach can be perfectly reasonable, and the correct answer depends on your personal risk preferences.

It is a mistake, in my view, to say that a person should necessarily take on more risk in their portfolio as a result of having a large pension (or other safe source of income).

Should Spouses Make Asset Allocation Decisions Separately?

As we’ve discussed previously, it’s often possible to save on fund expenses and/or taxes by making investing decisions at the overall portfolio level rather than at the account level — making sure, for example, that your portfolio’s overall asset allocation is in line with your risk tolerance rather than trying to achieve a diversified allocation in each individual account.

I recently came across a discussion on the Bogleheads forum in which an investor asked whether, in cases in which the spouses in a married couple have very different ages, it makes sense to implement separate asset allocation plans for each of the spouses. That is, should the spouses’ respective accounts be looked at as separate portfolios?

In my opinion, no, a large difference in ages is not, in itself, a reason to break from the “it’s all one portfolio” concept.

What’s the Goal?

In most cases, when it comes to retirement savings, the primary goal is simply to provide a certain standard of living during retirement. And that’s the case whether we’re talking about his IRA, her IRA, their joint account, etc. And to the extent that a collection of accounts are all intended for the same financial goal, it makes sense to consider them as one overall portfolio intended to meet that goal.

Said differently, tax planning aside, with regard to retirement savings, it’s the overall portfolio value (rather than the value of a given account or a given holding) that matters. And, critically, that’s true:

  1. From the perspective of either spouse, and
  2. Regardless of the age of either spouse.

So decisions — whether asset allocation decisions, savings rate decisions, or spending rate decisions — should be made with regard to how they will affect the overall portfolio value.

Possible Exceptions

While the overwhelming majority of most married couples’ accumulated assets are devoted to the goal of financing spending in retirement, there certainly are cases in which a specific account is designated as the source of funds for some other specific goal. In such cases, I think those accounts should be treated separately for the purpose of making asset allocation decisions.

Example: Bob and Jane got married at age 60. Bob has three children from his prior marriage. Bob and Jane’s combined assets exceed the amount they expect to spend during their lifetime, so they have decided to treat their Roth IRAs as “bequest money.” They have agreed to list Bob’s children as the beneficiaries of Bob’s Roth IRA and Jane’s sister as the beneficiary of Jane’s Roth IRA.

Because Bob’s IRA and Jane’s IRA are intended for different goals rather than a combined “financing our spending in retirement” goal, it makes sense to make asset allocation decisions separately for each IRA.

How Should Annuitizing Affect Asset Allocation?

A reader writes in, asking:

“If I buy a lifetime annuity after retiring, should that money come out of my bond allocation, stock allocation, or equally from all of my holdings?”

Any of those approaches can make perfect sense, depending on the situation. In short, after annuitizing, you should ask exactly the same questions you would have asked before annuitizing in order to set your asset allocation:

  • How much risk can I afford to take?
  • How much risk do I want to take?

In other words, just like always, you want to figure out what risk level is appropriate for you, then choose an asset allocation that meets that risk level. Once you know the allocation that you want to have after you’ve purchased the annuity, it will be easy to figure out which holdings to sell in order to meet that allocation.

If you were comfortable with your risk level before annuitizing, it’s likely that it makes sense for the annuity to come from the bond allocation. But that won’t always be the case. After all, for many people, the whole point of annuitizing is that they want to reduce the level of risk in their portfolio.

Example #1: Shortly after she retires, Glenda buys an inflation-adjusted lifetime annuity. Between the annuity and her Social Security benefits, she has about $30,000 of safe annual income — enough to satisfy her basic needs, given that she owns her home and has paid off her mortgage. She would like to be able to spend more than $30,000 per year, but she knows she can get by on that amount, if she has to.

Because Glenda can afford to take on a good deal of risk with the rest of her portfolio, because she has always been fairly comfortable with volatility, and because she wants to shoot for high returns, Glenda decides to use a high stock allocation with the remainder of her portfolio. (That is, she uses bond holdings to fund the annuity purchase.)

Example #2: Glenda’s twin sister Gail is in the exact same position as Glenda, but she has always been less comfortable with seeing the value of her holdings bounce around. So, despite having a high economic tolerance for risk, Gail decides to use the same conservative allocation for her portfolio after annuitizing that she used prior to annuitizing — that is, she uses both stock and bond holdings to fund the annuity purchase — thereby resulting in an overall reduction of risk, given that she has transferred a significant portion of her wealth from stocks to fixed income (i.e., the annuity).

Example #3: Tom found himself unintentionally retired at age 62. He held off on claiming Social Security all the way until age 70, but because of a modest earnings history, he still only receives about $15,000 of Social Security per year. He also purchased a fixed lifetime annuity that pays another $8,000 per year. While Tom would have liked to be able to lock in a higher amount of safe income, he felt that he couldn’t afford to allocate any more money to an annuity because doing so would have left him with very little in the way of liquid assets.

Because Tom has a level of safe income that doesn’t quite meet his needs, and because he doesn’t have a very large remaining portfolio, Tom has a low economic risk tolerance. That is, regardless of his emotional comfort level with volatility, Tom cannot afford to take on a great deal of risk with the non-annuitized portion of his portfolio — meaning the annuity should probably come out of his stock holdings or a combination of his stock and bond holdings.

Is Your Allocation a Good Fit for Your Risk Tolerance?

Over the last few days, I’ve gotten several questions from readers about:

  • The loss that Vanguard’s TIPS fund has experienced so far this year, and
  • The losses that stocks have experienced so far this month.

For reference, as of this writing, Vanguard’s Inflation-Protected Securities Fund has incurred a year-to-date loss of 8.67%. And, according to Morningstar, Vanguard’s Total Stock Market Index Fund has incurred a loss of 4.53% over the last month, and Vanguard’s Total International Stock Index Fund has incurred a loss of 9.42% over the last month.

Intermediate-Term TIPS and Short-Term Losses

The idea of the intermediate-term TIPS fund is that, over the long term, it should roughly keep pace with inflation. The fund is not intended to protect against short-term losses. And with an average duration of 8.5 years, there’s no way to avoid experiencing several short-term losses over an extended holding period.

As a reminder, when interest rates move, a bond’s price will move (in the opposite direction) by an amount roughly equal to its duration, multiplied by the change in interest rates for similar bonds. Given the 8.5-year average duration for Vanguard’s Inflation-Protected Securities Fund, interest rates on intermediate-term TIPS barely have to move by 1% for the fund to experience the kind of loss it has experienced this year. In other words, this is no big deal.

Or, stated differently, if an 8.67% loss over a few months is a big deal for you, then perhaps this fund is not a good fit for your risk tolerance. For example, you may want to instead consider Vanguard’s new Short-Term Inflation-Protected Securities Fund, which has an average duration of just 2.5 years.

Another thing to remember is that, except in the case of a default, the price of any given bond will move toward its par value as the bond approaches maturity (because its value will, naturally, be its par value when the bond reaches maturity). So if you plan to hold a bond fund for a long enough period of time (longer than the fund’s average duration, as it turns out), an increase in rates is not a problem. In fact, it works out to your advantage, because the new bonds that the fund buys will have higher yields.

Stocks Go Down Sometimes.

With regard to the losses incurred by domestic and international stocks this month, the “this is no big deal” message is even stronger. A loss of less than 10% (and less than 5% for domestic stocks!) is the sort of thing you need to be very comfortable with if you’re going to have money in stocks.

Quite in fact, you need to be OK with the idea of a loss that is a) five-times the size that we’ve seen over the last month and b) coupled with truly terrible headlines of some sort (e.g., the  U.S. going to war with somebody). Of course, you don’t have to relish the idea of a 50% market decline. But you need to know that it could happen. And you need a financial plan that won’t be ruined if it does happen.

If you’re an investor who is new to the stock market and this is your first time experiencing anything other than the superstar returns that stocks have had over the last few years, there are two reasonable ways to respond to this recent decline:

  1. You could come to terms with the fact that this sort of thing is normal, and carry on with your plan, or
  2. You could decide that your chosen allocation is too risky for your actual risk tolerance, scale back your stock allocation, and count it as a relatively inexpensive lesson (less expensive, that is, than waiting until a full-scale bear market to learn the lesson).

Observing how you feel in the face of real-life losses is the best way to assess your risk tolerance. If a risk tolerance questionnaire told you that you have a high risk tolerance, yet you find that you’re very worried when actual losses come along, the questionnaire was probably wrong.

Getting Crafty with Two-Fund Portfolios

After the recent article explaining that, yes, my wife and I still use Vanguard’s LifeStrategy Growth fund for our retirement savings, and, yes, we’re happy with it, a number of readers wrote in to ask about other ways to build a simple portfolio or to share their own methods of doing so.

Two-Fund Portfolios Using Total World Stock ETF

Several readers wrote in to say that they like the idea of a simple portfolio, but are not especially enamored with the Total Bond Market Index Fund that is included in Vanguard’s funds-of-funds. One reader wanted to shift toward corporate bonds in order to get the slightly higher yields. Another wanted to shift in precisely the opposite direction, using exclusively Treasury bonds. Still other readers said they wanted to stick to short-duration bonds in order to minimize interest rate risk.

Any of these desired allocations could be satisfied while still keeping things very simple by crafting a two-fund portfolio consisting of Vanguard’s Total World Stock ETF and the bond fund of your choosing. (While I don’t usually have a strong opinion on the mutual-fund-vs-ETF question, I think with Vanguard’s Total World Stock fund it makes sense to use the ETF, given that there is no Admiral Shares version of the traditional index fund.)

LifeStrategy Plus Tilt

A few readers wrote in to say that they like to keep things simple, but they also like the idea of tilting toward a specific category of stocks (either REITs or small-cap/value stocks), so they’ve created two-fund portfolios consisting of a LifeStrategy fund plus Vanguard’s Small-Cap Value Index Fund or a LifeStrategy fund combined with Vanguard’s REIT Index Fund.

Personally, I think it’s very neat that so many different diversified portfolios can be created using just two mutual funds. That said, as usual, a list of caveats applies:

  • Funds-of-funds (such as the LifeStrategy funds) are tax-inefficient, which is relevant if some of your assets are in taxable brokerage accounts.
  • Even Vanguard’s funds-of-funds have slightly higher expense ratios than the expense ratios you could have if you built a portfolio using the underlying funds.
  • Depending on how happy you are spending time in Excel, once you’ve moved beyond a portfolio that automatically rebalances itself, two funds might not be a heck of a lot easier than three, four, or even more funds.
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