I recently read an article in Smart Money magazine about retirement and the "viability of the 4% rule." It highlights varying opinions about a "safe" yearly withdrawal percentage from a retirement account. Of course, the long-standing guideline is 4%, yearly adjusted upward for inflation. So, a $1 million account would permit an initial draw of $40,000. The article cities research indicating that 1.8% ($18,000) might be safer. It also cites another study indicating that 7% would be reasonable for a bold investor with other income sources (like a standard pension).
Hmm. As I read the article, I was thinking: how about a portfolio that yields $87,000 a year, with no draw-down whatsoever? Don't tell me this is impossible, because I built it for a close friend, and you could build it right now. I think that beats a theoretical, hind-sight-inspired portfolio to pieces.
Here is a link to a spreadsheet with this portfolio:
https://docs.google.com/spreadsheet/ccc?key=0AmMlf3bsV3rFdFBVMGpSU2tqNUFOZVJPVjloNGF6T1E#gid=0
There are quite a few things to say about it.
1. It is not a classic Bodacious portfolio, as it was not built over 30 years, but rather done from 2008 to the present. But, the values in the portfolio are current, and you could buy most of these issues for the prices indicated. The amount invested is actually more than $1 million ($1.087 million to be exact), so the lower figure would lock in $87,000 per year.
2. The portfolio is poorly laddered, precisely because it was assembled over a shorter period, and more opportunistically (I grabbed things that looked particularly attractive at various times, as money became available for investment). So, the earliest maturities are two years out (Dean Witter) and a very small amount of money. The first serious redemptions begin in 2018, and are still modest. That is due entirely to my personal preference, which was to load up on long-term bonds, and thus lock in the huge yields I was seeing at the time (note the original cost of many bonds is exceptionally low, as they were purchased in 2008 and 2009). If you intended to buy a similar portfolio right now, you would probably want to buy more bonds with shorter maturities, and fewer long-term ones. Why? Well, if inflation kicked in, you would have a steady stream of money coming from redemptions to buy the higher yields. That would cushion the blow. This would mean modestly lower income now, but greater protection from future inflation. And that lower yield would still exceed the classic "safe" 4% drawdown.
3. This portfolio is NOT risk-free. All the bonds are investment-grade (with the exception of a split junk/investment rating on a small Sallie Mae position). The largest positions are in JP Morgan and Goldman Sachs. Again, this was deliberate. If the government was willing to hand these guys billions in 2008, then they have a de facto government guarantee. My thinking is much the same for Abbey PLC, which is a subsidiary of Banco Santander, the 11h largest bank in the world (sixth largest in Europe). I am making the same assumption here, that the bank is too big to fail, and therefore won't. In building this portfolio, I focused first on the risk of default. As long as these companies remain solvent, the portfolio will gush money. Still, each issue must be monitored steadily. A ratings downgrade to junk would probably require some action, even if losses are involved.
4. This portfolio is NOT particularly diversified. First, of course, it contains bonds, and only bonds. That's a no-no for standard experts. It is highly concentrated in bank and insurance stocks, also a no-no, as investment sectors go in and out of fashion. Values can, therefore, swing up and down rapidly. Remember, though, that such fluctuations are largely irrelevant to a Bodacious investor. We're in it for the long haul, and the bonds will all, eventually, mature at par.
5. Note the modest use of leverage in the portfolio. The present value (which would be the cost to purchase, of course) is a bit over $1.4 million, while the margin loan is just about $350,000. That is a margin percentage of 24%. Without margin, the yield on these bonds would be 6.9%; with margin, that jumps to 8.7%! Since the money arrives twice a year, that yield is actually closer to 9%. That's the power of margin rates at 1.25%.
So folks, tell me, please, why you would waste time and stomach acid with stocks when you can pull this kind of steady income from a Bodacious portfolio? Remember, experts debate the safety of a 4% draw, which assumes you are depleting your investment portfolio at a steady rate, with the goal of not running dry before you die. My friend's humble portfolio will do twice as well, without depletion! When she dies, there will be plenty left for her kids. Yes, of course, inflation might have its effect down the line, but inflation could damage a standard stock-based portfolio too. There is, at least, a clear way to deal with that future inflation, as discussed briefly above.
For a future blog, I'll prepare a few alternate Bodacious scenarios, which start with things you can buy now, and look forward with various assumptions.
'
Sunday, January 15, 2012
Wednesday, January 11, 2012
A Lump Sum Scenario
I've published another version of the spreadsheet, this time starting in 1982 with a start date of 1982, with a flat initial investment of $100,000.
Here is the link. https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdHZ2UzdsRUZ2cmRlS3dBUHNWSUVQWUE&output=html
1982 allows for a full investment cycle (30 years). It doesn't hurt that 1982 was a great year to start a bond portfolio (rates were historically high). Look and you'll wish you'd invested this way a long time ago.
Why did I choose 1982 for this lump-sum scenario? I ran it as a comparison to Charles Allmon Growth Investor 30-year results. He just retired, and Alan Abelson of Barron's praised him for beating the S&P 500 index yearly compounded return of 8.4% by 2/10ths of a point! He also praised the high cash levels and low volatility of Allmon's portfolio. Well, folks, my comparable bond $100,000 portfolio compounds over the same 30 years at 12.5% annually. It's in bonds! It gushes cash! Shouldn't Abelson be knocking at my door?
Why is the final yield figure of 7.86% so much lower than the 12.5 percent I just cited? Because it's an average yield, computed on a much larger average investment ($374,636). The average investment includes reinvested income. So, it's a matter of perspective. The first is a return on initial investment, the second a return on a weighted average investment.
Here is the link. https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdHZ2UzdsRUZ2cmRlS3dBUHNWSUVQWUE&output=html
1982 allows for a full investment cycle (30 years). It doesn't hurt that 1982 was a great year to start a bond portfolio (rates were historically high). Look and you'll wish you'd invested this way a long time ago.
Why did I choose 1982 for this lump-sum scenario? I ran it as a comparison to Charles Allmon Growth Investor 30-year results. He just retired, and Alan Abelson of Barron's praised him for beating the S&P 500 index yearly compounded return of 8.4% by 2/10ths of a point! He also praised the high cash levels and low volatility of Allmon's portfolio. Well, folks, my comparable bond $100,000 portfolio compounds over the same 30 years at 12.5% annually. It's in bonds! It gushes cash! Shouldn't Abelson be knocking at my door?
Why is the final yield figure of 7.86% so much lower than the 12.5 percent I just cited? Because it's an average yield, computed on a much larger average investment ($374,636). The average investment includes reinvested income. So, it's a matter of perspective. The first is a return on initial investment, the second a return on a weighted average investment.
Monday, January 9, 2012
At the Finish Line
I want to talk about life-cycle investing, and the advice usually dealt out to people on the path to retirement. I think you all know the refrain: go heavily into stocks when young, and move gradually into more "stable" alternatives (bonds, annuities) when entering retirement. Even then, most experts recommend a heavy dose of stocks to make up for the ever-expanding life expectancy of the elderly. I think this advice is, by and large, crap.
Consider, first of all, the plight of someone nearing retirement who still has a hefty (50-70%) commitment to stocks. Since retirement is typically the point at which you begin drawing down assets, you are painfully exposed to volatility. Take the example of a targeted 4% draw-down (the most common percentage generally recommended) on a $1 million portfolio . You might enter retirement expecting to draw down $40,000 a year. In 2011's 3% ten-year bond world (the kind of "safe" bonds experts recommend), that would involve income of $15,000 on the 50% bond portion ($9,000 if 30%), and stock sales of $25,000 to $31,000. If, however, the stock market takes a plunge of 50% (think 2008-9), that portfolio is now worth only $750,000 to $650,000 (ignoring paper losses on bonds, as they will return to par eventually). In this extreme, but clearly possible scenario, your 4% draw-down shrinks to $30,000 (or $26,000). If you take out the planned-for $40,000, you'll erode an eroded asset base, making it ever harder to recover. Don't ever forget that stock swoons can be very long-lasting. The worst case was 1929 to 1955 for the DOW, an astonishing 26 years! To break even! More recently, 1966-83 (yeah, a couple of brief recoveries, followed by more swoons) and perhaps most relevant, 2000-2010. That's an entire decade, just completed, with no gain whatsoever. If you had been drawing down on your eroded assets throughout that decade, you might in in real pain by now.
If, however, you have followed the Bodacious Bond Plan, you will be mostly exposed to bonds at retirement, as you will have been throughout your investing career. So, what happens to you when prices plunge just as you retire? NOTHING! Repeat, NOTHING! For example, beginning the 2008-2009 period, a Bodacious $1 million portfolio was spinning off around 7% yearly (the average BAA bond yield of those two years), or $70,000 yearly. Sure, the market value of the bonds might have plummeted 25% to 35% (probably not 50%) at the worst moments, but income was unaffected. So, if you spent that money, all of it, what would have happened to your income going forward? NOTHING. Next year, you would have made that same $70,000, and bond prices would have recovered very nicely. By 2011, you would probably have been sitting on large capital gains, as BAA yields are now around 5%! And, all of this income would have been available without drawing down principal, i.e., selling bonds.
By the way. Did you notice the different draw-downs for the two portfolios? The generally recommended stock-based withdrawal mandates $40,000 per year; the Bodacious bond portfolio gushes $70,000. That is 75% more income from the beginning! The yearly stock draw-down involves selling stocks, perhaps at distressed prices. My model doesn't require any sales at all, unless you need more than $70,000 per year.
Yes, the stock draw-down usually posits increases along with inflation, so the $40,000 would go up, over time, to keep purchasing power stable. However, you could achieve much the same effect by spending 65% of the Bodacious income (in this case, $45,500), and reinvesting the difference at rates that usually compensate for inflation. Then you, too, could see inflation-adjusted retirement income. As for selling at a distress price? That will not happen (barring credit rating erosion, of course) if your bond portfolio is 30 years old. Why? Your oldest bonds will mature yearly, at par. Since your practice has been to buy at or below par, there is no loss whatsoever! The principal being returned is yours to spend or reinvest.
Here is how this reinvestment approach could work. The 35% you DON'T spend from the $70,000 interest stream will leave you with about $24,500 to reinvest. If rates have gone up to, say, 8% over the year,the will enable you to purchase bonds that will yield an additional $2000. Repeating for ten years will enable your income to go up by about 28%, even as value of the portfolio bounces up and down with the vagaries of the market. That translates into a inflation "rider" of nearly 2.5%, roughly the average over the past umpteen years. Note, this initial allowance of $45,500 is still 10.5% higher than the $40,000 recommended by the gurus. I have run many scenarios, with yearly rates ranging widely along the way. These variations don't seem to matter, as income goes up steadily. You might wince to see what high rates do to the market value of the portfolio, and rejoice prematurely when rates dip, but income maintains a steady upward trajectory.
Summing up (and repeating points made in earlier blogs):
With stocks, you have many enemies. 1. Stocks prices pogo up and down, often without rhyme or reason. As you near retirement, that volatility is very dangerous, as you might plan to sell soon. 2. Even stocks with a yield (dividends) aren't all that safe. A dividend is only as good as the most recent earnings statement. When tough times arrive, the dividend can be, and often is, slashed to the bone. To be fair, though, dividends often increase to compensate for the toll of inflation. 3. Fees can kill you, both with stock and bond funds. Take a management fee of 2% off the top, each and every year, and a nice 7% yearly return drops precipitously to 5%, before taxes and inflation. You'll be lucky to stay even. 4. Churn can kill you. Each time a professional buys and sells, transaction costs (direct, as in fees, and indirect at in bid/ask spreads) erode the value of the investment. 5. Death can kill you. By this, I mean that some stocks drop to zero, never to rise again. They don't appear in the indexes, but they do in your own returns. 6. For a stock to be a good investment, you must make two correct decisions: when to buy and when to sell. Botch either, and you're gonna feel it.
With Bodacious bonds, you have some enemies too, but they're easier to recognize and combat. 1. Bond prices pogo up and down too. But as mentioned above, this is largely irrelevant, as income from the bonds is steady. 2. Bond interest is MUCH safer than a dividend. If a company can pay, it must. Most companies (particularly investment grade) do pay. If they don't, you still have a legal claim on that company's assets. You might get the money (and interest) back anyway. As to inflation, well, BAA bond payments won't increase, but they generally are issued at a yield substantially above the existing rate of inflation. 3. If you do it yourself (my hearty suggestion), there are NO fees! This is a huge advantage of managing your own portfolio. 4. There should be almost no churn in a Bodacious portfolio. You buy a 30-year BAA bond, and hold it to maturity. Next year, you do the same. As a small investor, you won't get the very best price, which is reserved for the big boys. However, you can get close, if you're patient and focus on small-size offerings. Typically they sell at a discount to large lots because the big boys can't be bothered. You will get the best price at maturity: par. 5. Death is a risk here too. You must watch the prices and ratings of the bonds in your portfolio. If an issue plummets below investment grade, sell it (even at a loss), or at least lighten up substantially. 6. For a bond to be a good investment, you need only make one correct decision: when to buy. The sale is built into the bond: maturity.
Consider, first of all, the plight of someone nearing retirement who still has a hefty (50-70%) commitment to stocks. Since retirement is typically the point at which you begin drawing down assets, you are painfully exposed to volatility. Take the example of a targeted 4% draw-down (the most common percentage generally recommended) on a $1 million portfolio . You might enter retirement expecting to draw down $40,000 a year. In 2011's 3% ten-year bond world (the kind of "safe" bonds experts recommend), that would involve income of $15,000 on the 50% bond portion ($9,000 if 30%), and stock sales of $25,000 to $31,000. If, however, the stock market takes a plunge of 50% (think 2008-9), that portfolio is now worth only $750,000 to $650,000 (ignoring paper losses on bonds, as they will return to par eventually). In this extreme, but clearly possible scenario, your 4% draw-down shrinks to $30,000 (or $26,000). If you take out the planned-for $40,000, you'll erode an eroded asset base, making it ever harder to recover. Don't ever forget that stock swoons can be very long-lasting. The worst case was 1929 to 1955 for the DOW, an astonishing 26 years! To break even! More recently, 1966-83 (yeah, a couple of brief recoveries, followed by more swoons) and perhaps most relevant, 2000-2010. That's an entire decade, just completed, with no gain whatsoever. If you had been drawing down on your eroded assets throughout that decade, you might in in real pain by now.
If, however, you have followed the Bodacious Bond Plan, you will be mostly exposed to bonds at retirement, as you will have been throughout your investing career. So, what happens to you when prices plunge just as you retire? NOTHING! Repeat, NOTHING! For example, beginning the 2008-2009 period, a Bodacious $1 million portfolio was spinning off around 7% yearly (the average BAA bond yield of those two years), or $70,000 yearly. Sure, the market value of the bonds might have plummeted 25% to 35% (probably not 50%) at the worst moments, but income was unaffected. So, if you spent that money, all of it, what would have happened to your income going forward? NOTHING. Next year, you would have made that same $70,000, and bond prices would have recovered very nicely. By 2011, you would probably have been sitting on large capital gains, as BAA yields are now around 5%! And, all of this income would have been available without drawing down principal, i.e., selling bonds.
By the way. Did you notice the different draw-downs for the two portfolios? The generally recommended stock-based withdrawal mandates $40,000 per year; the Bodacious bond portfolio gushes $70,000. That is 75% more income from the beginning! The yearly stock draw-down involves selling stocks, perhaps at distressed prices. My model doesn't require any sales at all, unless you need more than $70,000 per year.
Yes, the stock draw-down usually posits increases along with inflation, so the $40,000 would go up, over time, to keep purchasing power stable. However, you could achieve much the same effect by spending 65% of the Bodacious income (in this case, $45,500), and reinvesting the difference at rates that usually compensate for inflation. Then you, too, could see inflation-adjusted retirement income. As for selling at a distress price? That will not happen (barring credit rating erosion, of course) if your bond portfolio is 30 years old. Why? Your oldest bonds will mature yearly, at par. Since your practice has been to buy at or below par, there is no loss whatsoever! The principal being returned is yours to spend or reinvest.
Here is how this reinvestment approach could work. The 35% you DON'T spend from the $70,000 interest stream will leave you with about $24,500 to reinvest. If rates have gone up to, say, 8% over the year,the will enable you to purchase bonds that will yield an additional $2000. Repeating for ten years will enable your income to go up by about 28%, even as value of the portfolio bounces up and down with the vagaries of the market. That translates into a inflation "rider" of nearly 2.5%, roughly the average over the past umpteen years. Note, this initial allowance of $45,500 is still 10.5% higher than the $40,000 recommended by the gurus. I have run many scenarios, with yearly rates ranging widely along the way. These variations don't seem to matter, as income goes up steadily. You might wince to see what high rates do to the market value of the portfolio, and rejoice prematurely when rates dip, but income maintains a steady upward trajectory.
Summing up (and repeating points made in earlier blogs):
With stocks, you have many enemies. 1. Stocks prices pogo up and down, often without rhyme or reason. As you near retirement, that volatility is very dangerous, as you might plan to sell soon. 2. Even stocks with a yield (dividends) aren't all that safe. A dividend is only as good as the most recent earnings statement. When tough times arrive, the dividend can be, and often is, slashed to the bone. To be fair, though, dividends often increase to compensate for the toll of inflation. 3. Fees can kill you, both with stock and bond funds. Take a management fee of 2% off the top, each and every year, and a nice 7% yearly return drops precipitously to 5%, before taxes and inflation. You'll be lucky to stay even. 4. Churn can kill you. Each time a professional buys and sells, transaction costs (direct, as in fees, and indirect at in bid/ask spreads) erode the value of the investment. 5. Death can kill you. By this, I mean that some stocks drop to zero, never to rise again. They don't appear in the indexes, but they do in your own returns. 6. For a stock to be a good investment, you must make two correct decisions: when to buy and when to sell. Botch either, and you're gonna feel it.
With Bodacious bonds, you have some enemies too, but they're easier to recognize and combat. 1. Bond prices pogo up and down too. But as mentioned above, this is largely irrelevant, as income from the bonds is steady. 2. Bond interest is MUCH safer than a dividend. If a company can pay, it must. Most companies (particularly investment grade) do pay. If they don't, you still have a legal claim on that company's assets. You might get the money (and interest) back anyway. As to inflation, well, BAA bond payments won't increase, but they generally are issued at a yield substantially above the existing rate of inflation. 3. If you do it yourself (my hearty suggestion), there are NO fees! This is a huge advantage of managing your own portfolio. 4. There should be almost no churn in a Bodacious portfolio. You buy a 30-year BAA bond, and hold it to maturity. Next year, you do the same. As a small investor, you won't get the very best price, which is reserved for the big boys. However, you can get close, if you're patient and focus on small-size offerings. Typically they sell at a discount to large lots because the big boys can't be bothered. You will get the best price at maturity: par. 5. Death is a risk here too. You must watch the prices and ratings of the bonds in your portfolio. If an issue plummets below investment grade, sell it (even at a loss), or at least lighten up substantially. 6. For a bond to be a good investment, you need only make one correct decision: when to buy. The sale is built into the bond: maturity.
Thursday, December 1, 2011
Why Is This Important?
The spreadsheet shows wonderful long-term increases over very long periods of time. This is, by itself, not amazing. You'll find many stock scenarios that look far better, turning the theoretical 1947 investor into a multimillionaire. So, why isn't America awash in multimillionaires? There are several reasons, but the main one is that the widely published figures are bogus.
I think that stock yields are vastly overstated over time. First, they gloss over management fees, which reduce final results hugely. Almost all actively managed funds consistently under-perform their benchmarks for this reason alone. Second is portfolio churn. "Bad" investments are constantly being sold in favor of "good" new ones. Each time, a layer of transaction costs (buy-sell spreads, broker fees) erodes results. Third, taxes are ignored, even though many investors must pay them. Fourth, the weak, lame, crooked and incompetent are undercounted, as they usually go bankrupt and disappear from the averages. This also applies to fund families. Typically, an investment giant will launch a flock of new funds, and eventually merge the failures into the winners. The former's crummy results are no longer visible in the family's "stellar" long-term results. Factor all this in, and a long term return on a stock portfolio will easily fall to 7% annually, or less.
Now look at the Bodacious Bond Machine again. How does its 7.65% compounded return fare relative to the flaws discuss in the previous paragraph?
Fees: there are none. You run the portfolio; you don't collect a fee from yourself.
Portfolio churn: there is very little. Bonds are bought and held until maturity. Of course, bonds will, after 30 years, be retired and force reinvestment of the funds returned to you. I wouldn't call that churn, though.
Taxes: they are are typically higher on interest than on capital gains or dividends. This is a negative for a bond portfolio, but taxes can be deferred or eliminated through a tax-deferred or post-tax (Roth IRA) plan.
Fallout: this is a real issue for bonds too. Occasionally, a company defaults on its bonds, causing severe losses. However, the plan's focus on investment-grade bonds reduces this risk considerably. For example, since 1981, the average default rate for BBB- bonds (the lowest investment grade) has been .28% (see http://en.wikipedia.org/wiki/Bond_credit_rating). That drops to .16% for BBB+ bonds. In both cases, there are many years when the average rate is 0%, as defaults tend to be cyclical, associated with recessions.
Note, that this default rate would not necessarily be fully realized. Your could, for example, sell a given issue once it is downgraded to junk. For most companies, the road to default is gradual. Companies on the brink (Albertson's, Sears, Lucent, Sprint, Clear Channel, MBIA) have been declining for many years. Selling them as they turn into junk would have caused losses, but a limited portion of the investment. Even if the bond defaulted entirely, there might still be a return of capital once the company is reorganized or liquidated. One clear implication of default rates is that your bond portfolio should be diversified, both over time and company type. The first is accomplished by regular yearly purchases, achieving an automatic ladder of new bonds and ones nearing maturity. The second is your responsibility. Pick carefully, and widely.
Summary:
Can you see why this is so important? Do you now get why the case for bonds is so compelling? If a realistic expectation for a long-term stock investment is really only in the 7-8% realm, and I believe it is, then you'd be nuts to pursue that return with stocks when it is freely available with bonds. Instead of sweating bullets every time the market swoons, you can relax in the sure knowledge that your bonds will recover. Paper losses are irrelevant! A stock that drops 50% in value overnight might come back from the dead, but the bond will make the return journey for certain (barring default, of course).
So, again, why are there so few multimillionaires, either from stock or bond investing? The major reason is psychology. It's rare for anyone to really follow a plan. Psychology swings investors back and forth like a pendulum. They panic when the market has punished them, and swing to exuberance when it's soared. Since you CAN'T predict tops or bottoms, the only way to take advantage of them is to be steady. Over time, a regular investment will capture peaks (typically when bond prices are low), and keep from going overboard when prices are high (and yields low).
So, can YOU follow a plan? Probably not; most people can't. I do think, though, that my plan is far easier to follow than one based on stocks. The main reason is cash. You can see it arrive, on schedule, twice a year, every year. You can then take that cash, reinvest it, and watch even more come in, on schedule, twice a year, every year. This is very comforting. It might be enough to keep you on track, year in, year out.
My next blog will start with specific ways to implement the PLAN. Eventually, I'll also talk about a forbidden topic: bond timing.
I think that stock yields are vastly overstated over time. First, they gloss over management fees, which reduce final results hugely. Almost all actively managed funds consistently under-perform their benchmarks for this reason alone. Second is portfolio churn. "Bad" investments are constantly being sold in favor of "good" new ones. Each time, a layer of transaction costs (buy-sell spreads, broker fees) erodes results. Third, taxes are ignored, even though many investors must pay them. Fourth, the weak, lame, crooked and incompetent are undercounted, as they usually go bankrupt and disappear from the averages. This also applies to fund families. Typically, an investment giant will launch a flock of new funds, and eventually merge the failures into the winners. The former's crummy results are no longer visible in the family's "stellar" long-term results. Factor all this in, and a long term return on a stock portfolio will easily fall to 7% annually, or less.
Now look at the Bodacious Bond Machine again. How does its 7.65% compounded return fare relative to the flaws discuss in the previous paragraph?
Fees: there are none. You run the portfolio; you don't collect a fee from yourself.
Portfolio churn: there is very little. Bonds are bought and held until maturity. Of course, bonds will, after 30 years, be retired and force reinvestment of the funds returned to you. I wouldn't call that churn, though.
Taxes: they are are typically higher on interest than on capital gains or dividends. This is a negative for a bond portfolio, but taxes can be deferred or eliminated through a tax-deferred or post-tax (Roth IRA) plan.
Fallout: this is a real issue for bonds too. Occasionally, a company defaults on its bonds, causing severe losses. However, the plan's focus on investment-grade bonds reduces this risk considerably. For example, since 1981, the average default rate for BBB- bonds (the lowest investment grade) has been .28% (see http://en.wikipedia.org/wiki/Bond_credit_rating). That drops to .16% for BBB+ bonds. In both cases, there are many years when the average rate is 0%, as defaults tend to be cyclical, associated with recessions.
Note, that this default rate would not necessarily be fully realized. Your could, for example, sell a given issue once it is downgraded to junk. For most companies, the road to default is gradual. Companies on the brink (Albertson's, Sears, Lucent, Sprint, Clear Channel, MBIA) have been declining for many years. Selling them as they turn into junk would have caused losses, but a limited portion of the investment. Even if the bond defaulted entirely, there might still be a return of capital once the company is reorganized or liquidated. One clear implication of default rates is that your bond portfolio should be diversified, both over time and company type. The first is accomplished by regular yearly purchases, achieving an automatic ladder of new bonds and ones nearing maturity. The second is your responsibility. Pick carefully, and widely.
Summary:
Can you see why this is so important? Do you now get why the case for bonds is so compelling? If a realistic expectation for a long-term stock investment is really only in the 7-8% realm, and I believe it is, then you'd be nuts to pursue that return with stocks when it is freely available with bonds. Instead of sweating bullets every time the market swoons, you can relax in the sure knowledge that your bonds will recover. Paper losses are irrelevant! A stock that drops 50% in value overnight might come back from the dead, but the bond will make the return journey for certain (barring default, of course).
So, again, why are there so few multimillionaires, either from stock or bond investing? The major reason is psychology. It's rare for anyone to really follow a plan. Psychology swings investors back and forth like a pendulum. They panic when the market has punished them, and swing to exuberance when it's soared. Since you CAN'T predict tops or bottoms, the only way to take advantage of them is to be steady. Over time, a regular investment will capture peaks (typically when bond prices are low), and keep from going overboard when prices are high (and yields low).
So, can YOU follow a plan? Probably not; most people can't. I do think, though, that my plan is far easier to follow than one based on stocks. The main reason is cash. You can see it arrive, on schedule, twice a year, every year. You can then take that cash, reinvest it, and watch even more come in, on schedule, twice a year, every year. This is very comforting. It might be enough to keep you on track, year in, year out.
My next blog will start with specific ways to implement the PLAN. Eventually, I'll also talk about a forbidden topic: bond timing.
How It Works.
Again, here is the link to the spreadsheet:
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The most difficult task I faced in creating the spreadsheet was how to calculate average returns over time. Simplistic calculations yielded extreme distortions. For example, dividing the net portfolio increase by the total net investment at the end of a long time series greatly understates returns compared to inflation. This is because the cumulative effects of inflation over, say, 40 years are compared to final returns mostly generated far more recently. I finally hit upon a weighting system. This is a factor that combines the BAA interest rate for a given year with the dollar total invested that year. Dividing the sum of those factors by the total amount invested over a period of time yields an average return for that same time period. This average return can then be applied to the final portfolio value to calculate a weighted total investment. This weighted investment is the amount of money that would, compounded by the average interest rate over a time period, yield the final portfolio value.
Typically, a high interest rate will generate a far larger factor than a low one. Also, that high interest rate, toward the end of the series, will create a higher factor than the same interest rate early on (typically less money being invested earlier). The advantage of the factor is that high interest years have greater weight, as do years with high dollar investments. Years with high interest rates AND high dollar investments weigh the most. Note also that investments as long as 30 years in the past are still relevant, as the BAA yield is a 30 year yield. Bonds purchased in 1985, for example, would still be generating interest today.
To put this in other words, the weighted investment calculation converts the many yearly investments into a lump-sum equivalent. This would be a single initial investment that would yield the same long-term results. The advantage of weighted investment is that the cumulative effects of compounded interest and compounded inflation can be seen side by side. The very good news is that inflation's effect diminishes steadily over time. This is, perhaps, counter-intuitive, but actually makes good sense. Inflation compounds at a far lower rate (2.5% or so yearly) than the bonds income does (7.65% or so).
The base spreadsheet assumes a steady injection of inflation-adjusted funds every year. In most time series, the predictable spread of the BAA yield over inflation quickly brings the portfolio into the black. Every single time series has positive results for 10, 20, and 30 year periods. By 20 years, nearly every time series outperforms inflation robustly.
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The most difficult task I faced in creating the spreadsheet was how to calculate average returns over time. Simplistic calculations yielded extreme distortions. For example, dividing the net portfolio increase by the total net investment at the end of a long time series greatly understates returns compared to inflation. This is because the cumulative effects of inflation over, say, 40 years are compared to final returns mostly generated far more recently. I finally hit upon a weighting system. This is a factor that combines the BAA interest rate for a given year with the dollar total invested that year. Dividing the sum of those factors by the total amount invested over a period of time yields an average return for that same time period. This average return can then be applied to the final portfolio value to calculate a weighted total investment. This weighted investment is the amount of money that would, compounded by the average interest rate over a time period, yield the final portfolio value.
Typically, a high interest rate will generate a far larger factor than a low one. Also, that high interest rate, toward the end of the series, will create a higher factor than the same interest rate early on (typically less money being invested earlier). The advantage of the factor is that high interest years have greater weight, as do years with high dollar investments. Years with high interest rates AND high dollar investments weigh the most. Note also that investments as long as 30 years in the past are still relevant, as the BAA yield is a 30 year yield. Bonds purchased in 1985, for example, would still be generating interest today.
To put this in other words, the weighted investment calculation converts the many yearly investments into a lump-sum equivalent. This would be a single initial investment that would yield the same long-term results. The advantage of weighted investment is that the cumulative effects of compounded interest and compounded inflation can be seen side by side. The very good news is that inflation's effect diminishes steadily over time. This is, perhaps, counter-intuitive, but actually makes good sense. Inflation compounds at a far lower rate (2.5% or so yearly) than the bonds income does (7.65% or so).
The base spreadsheet assumes a steady injection of inflation-adjusted funds every year. In most time series, the predictable spread of the BAA yield over inflation quickly brings the portfolio into the black. Every single time series has positive results for 10, 20, and 30 year periods. By 20 years, nearly every time series outperforms inflation robustly.
Tuesday, November 15, 2011
THE PLAN!
Now, about that spreadsheet!
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The spreadsheet demonstrates the results of following a bond investing plan. I believe it yields consistent results over time, and avoids most of the huge losses that periodically plague the world of stocks. I think it is fairly simple, yet produces eye-popping results.
The spreadsheet has four inputs: a starting year, investment amount, lump sum indicator (is this a one-time investment, or a regular investment adjusted yearly for inflation?), and a tax rate. All the scenarios depicted here assume a regular investment amount, with no allowance for taxes. I'll discuss a lump-sum scenario in a later post.
You might be amazed to learn that the plan is simplicity itself: start with a base investment amount, and use it to buy BAA 30-year bonds every year. Each year, increase that base amount by the prior year's inflation rate, to ensure that the same purchasing amount is invested each year. Also, reinvest the prior year's interest. Ignore the ups and downs of the stock market, and ignore periodic panics about inflation, war and pestilence. Repeat every year for MANY years (a minimum of 20, preferably 30 or more). You'll love the results!
Don't take this too literally. "BAA 30-year bond" is a guideline. You might buy bonds with a lower or higher rating (as long as they're investment-grade). You might buy bonds with shorter or longer maturities, depending on what looks favorable when you're ready to buy. Over time, you want a mix of maturities and industries, but buying every year will tend to smooth things out
The spreadsheet demonstrates results for every initial year from 1947 to the present. For each such year, 10, 20, 30 and max (whatever the end year is) results are shown. The benchmark is inflation. To determine how well a time series has done, an inflation "toll" is subtracted from the portfolio's end value. The difference is an after-inflation return. What is striking about the results is that very few years show a negative return relative to inflation. The worst is the earliest start year, 1947. It starts out with nine straight years in which inflation is higher than the bond returns. This is largely due to the fact that inflation 1947 was over 14%, and over 8% in 1948, while BAA yields were slightly over 3%. This anomaly was due to the end of rationing in World War II. However, this same series shows a final portfolio figure of nearly $4.75 million, even after adjusting for inflation! All this from a total investment of $302,000 over 65 years (1000 inflation adjusted dollars every year).
While 1947 shows huge returns, so do more recent time series. 1980 was a terrific time to start (a little over 30 years). A total of $65,000 becomes $463,000 by 2011. But 1990 wasn't bad either. It turns $30,000 into $100,000. And 2000? $14,000 becomes $27,000. In fact, EVERY time series beats inflation by the 10-year mark! By 20 years, every time series outperforms inflation by a large amount.
How could this be? The magic lies in two factors: the power of compounded interest (an amazing thing) and the fact that the BAA yield was higher than inflation in all but 5 of the 65 years covered by the spreadsheet. That excess yield compounds to produce stunning results. Now, is this potential growth unique to bonds? Not at all. Most stock-return charts will show similar, or even better results. The difference is that bonds are far less volatile, far more predictable, and ultimately, far safer than stocks. Given the choice, in my opinion, you should always opt for the safer investment that still meets your investment needs. That is, hands down, the bond option.
Here, again, are a few cautions. The spreadsheet is a back-tested artifact. It takes advantage of hind-sight. The assumptions it makes are not guaranteed to work going forward. Most of its spectacular returns are due to that huge spike in interest rates in the late 1970's and early 1980's. Critically, it presumes that you don't have to pay taxes along the way (or that you pay them from outside the portfolio). Most of the excess return comes from the regular reinvestment of income. Remove some of that for taxes, and the results drop drastically.
The huge advantage of a plan oriented to bonds is that losses can be pretty much ignored. Repeat: your "losses" don't matter! Those terrible drops of 1979-81 were on paper only. They had NO effect on income, which continued unbroken, and increased very nicely in subsequent years due to the giant yields locked in along the way. You don't need to worry because there is a "correct", predictable end price for a bond. It is par. What happens in the meantime is irrelevant, as the price will end, upon maturity, at 100 cents on the dollar. The only thing that can hurt you along the way is a default (very very bad), or a margin call (so don't overuse margin).
The advantage of a "system" is that you have far fewer tough choices to make. Each year, you're going to buy BAA bonds, 30 years out. Yes, you have to decide which bonds, and when to buy during the year. I'll have some more suggestions about these lesser issues in a later blog.
https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The spreadsheet demonstrates the results of following a bond investing plan. I believe it yields consistent results over time, and avoids most of the huge losses that periodically plague the world of stocks. I think it is fairly simple, yet produces eye-popping results.
The spreadsheet has four inputs: a starting year, investment amount, lump sum indicator (is this a one-time investment, or a regular investment adjusted yearly for inflation?), and a tax rate. All the scenarios depicted here assume a regular investment amount, with no allowance for taxes. I'll discuss a lump-sum scenario in a later post.
You might be amazed to learn that the plan is simplicity itself: start with a base investment amount, and use it to buy BAA 30-year bonds every year. Each year, increase that base amount by the prior year's inflation rate, to ensure that the same purchasing amount is invested each year. Also, reinvest the prior year's interest. Ignore the ups and downs of the stock market, and ignore periodic panics about inflation, war and pestilence. Repeat every year for MANY years (a minimum of 20, preferably 30 or more). You'll love the results!
Don't take this too literally. "BAA 30-year bond" is a guideline. You might buy bonds with a lower or higher rating (as long as they're investment-grade). You might buy bonds with shorter or longer maturities, depending on what looks favorable when you're ready to buy. Over time, you want a mix of maturities and industries, but buying every year will tend to smooth things out
The spreadsheet demonstrates results for every initial year from 1947 to the present. For each such year, 10, 20, 30 and max (whatever the end year is) results are shown. The benchmark is inflation. To determine how well a time series has done, an inflation "toll" is subtracted from the portfolio's end value. The difference is an after-inflation return. What is striking about the results is that very few years show a negative return relative to inflation. The worst is the earliest start year, 1947. It starts out with nine straight years in which inflation is higher than the bond returns. This is largely due to the fact that inflation 1947 was over 14%, and over 8% in 1948, while BAA yields were slightly over 3%. This anomaly was due to the end of rationing in World War II. However, this same series shows a final portfolio figure of nearly $4.75 million, even after adjusting for inflation! All this from a total investment of $302,000 over 65 years (1000 inflation adjusted dollars every year).
While 1947 shows huge returns, so do more recent time series. 1980 was a terrific time to start (a little over 30 years). A total of $65,000 becomes $463,000 by 2011. But 1990 wasn't bad either. It turns $30,000 into $100,000. And 2000? $14,000 becomes $27,000. In fact, EVERY time series beats inflation by the 10-year mark! By 20 years, every time series outperforms inflation by a large amount.
How could this be? The magic lies in two factors: the power of compounded interest (an amazing thing) and the fact that the BAA yield was higher than inflation in all but 5 of the 65 years covered by the spreadsheet. That excess yield compounds to produce stunning results. Now, is this potential growth unique to bonds? Not at all. Most stock-return charts will show similar, or even better results. The difference is that bonds are far less volatile, far more predictable, and ultimately, far safer than stocks. Given the choice, in my opinion, you should always opt for the safer investment that still meets your investment needs. That is, hands down, the bond option.
Here, again, are a few cautions. The spreadsheet is a back-tested artifact. It takes advantage of hind-sight. The assumptions it makes are not guaranteed to work going forward. Most of its spectacular returns are due to that huge spike in interest rates in the late 1970's and early 1980's. Critically, it presumes that you don't have to pay taxes along the way (or that you pay them from outside the portfolio). Most of the excess return comes from the regular reinvestment of income. Remove some of that for taxes, and the results drop drastically.
The huge advantage of a plan oriented to bonds is that losses can be pretty much ignored. Repeat: your "losses" don't matter! Those terrible drops of 1979-81 were on paper only. They had NO effect on income, which continued unbroken, and increased very nicely in subsequent years due to the giant yields locked in along the way. You don't need to worry because there is a "correct", predictable end price for a bond. It is par. What happens in the meantime is irrelevant, as the price will end, upon maturity, at 100 cents on the dollar. The only thing that can hurt you along the way is a default (very very bad), or a margin call (so don't overuse margin).
The advantage of a "system" is that you have far fewer tough choices to make. Each year, you're going to buy BAA bonds, 30 years out. Yes, you have to decide which bonds, and when to buy during the year. I'll have some more suggestions about these lesser issues in a later blog.
So take a look at the spreadsheet. Then, you can kick the tires and mock the assumptions.
The Plan: Introduction
I have referred several times to a spreadsheet I built over the last couple of years. It begins with bond yield and inflation data from 1946 to 2010. Bond yield data is taken from the Moody's Seasoned BAA yield series. It represents "average" yields, by year, for corporate bonds of good, but not prime quality. These bonds have a very low default rate, yet yield considerably more than the very top investment groups (AAA, AA and A). Their rates have varied a great deal over the years, going from lows of 3.21% to 16%. A key factor is that these rates are usually higher than the prime rate (the rate charged "prime" customers for short-term borrowing) for any given year, and usually beat inflation. Why are the seasoned BAA rates higher than other bonds? It's very simple: they are long-term rates. As the website says: "Moody's tries to include bonds with remaining maturities as close as possible to 30 years."
Why are long-term rates so much higher? They reflect a perception of risk. The farther out a maturity is, the more things can go wrong. Rates can rise, eroding the value of the bonds. Inflation will also do its erosion. Finally, there is credit risk: the possibility that the financial health of the issuing company will deteriorate to the point that the bond defaults. All of these possibilities lead investors to expect, and demand, higher rates of return for long-term bonds. There is also a perceptual problem most investors have with these bonds: thirty years is "too long". Older folks think they'll die first; younger ones dislike thinking about how they'll look in the mirror in thirty years. Either way, that endless prospect discourages investors.
I believe, though, that BAA type bonds represent the absolute sweet spot in the investing world. Sure, if you're old, you may be dead before these bonds mature. But in the meantime, you'll be collecting those fat interest payments. And will your spouse, children, or grandchildren, refuse the money? Furthermore, if you need cash in the meantime, there is a ready resale market for most large-cap bond issues. The price you get on a resale may vary greatly, depending on present interest rates (either up or down), supply and demand, and the ever-present fear factor. All these make it a very good idea to make your initial bond purchases at a discount to par. That shields you on the downside, and builds a predictable upside into the transaction (if you hold the bond to maturity). It will, after all, return the exact same amount as the original buyer paid upon issuance (par).
My ideal scenario, reflected in my spreadsheet, is to build a long-term bond portfolio steadily, year after year. A predictable amount should be added to the portfolio regularly, and interest income should be reinvested steadily. This latter requirement means that the bonds should be held in a tax-deferred vehicle like a traditional IRA, Roth IRA or 401 K plan. Since taxes are paid on the latter two only upon withdrawal, and the Roth is funded with post-tax money, everything compounds tax-free. That's huge, as you will see.
Why not wait for those magic moments when bonds have reached a cyclical peak, and then pounce? Well, there are two problems with that. First, those moments of peak yields are also moments of extreme terror. In 1982, and 2009, people were running AWAY from bonds, not towards them. In 1982 they were panicked about rates (16% and higher) exploding upward. In 2009 they feared the entire financial universe was about to crash. Second, it's hard to recognize a peak until it's past. Once it's past, you regret missing it, and stew instead of acting. The brave souls who grabbed for peak and near-peak yields were richly rewarded, but they spent many sleepless nights until things went their way. I was one of them, because I was following a plan (albeit a newly conceived one).
Psychologically speaking, brave investing is a non-starter for the huge majority of investors. Fear overwhelms greed at the precise wrong moment. It's easy to be intrepid when you've just reached new highs in your portfolio; it's exceptionally difficult to jump in when you've just taken ferocious losses. So, how can you overcome your own inner demons? The only way I know is to have that plan, and stick with it through thick and thin. Put it on autopilot as much as possible.
My next blog will demonstrate the results of following a plan.
Why are long-term rates so much higher? They reflect a perception of risk. The farther out a maturity is, the more things can go wrong. Rates can rise, eroding the value of the bonds. Inflation will also do its erosion. Finally, there is credit risk: the possibility that the financial health of the issuing company will deteriorate to the point that the bond defaults. All of these possibilities lead investors to expect, and demand, higher rates of return for long-term bonds. There is also a perceptual problem most investors have with these bonds: thirty years is "too long". Older folks think they'll die first; younger ones dislike thinking about how they'll look in the mirror in thirty years. Either way, that endless prospect discourages investors.
I believe, though, that BAA type bonds represent the absolute sweet spot in the investing world. Sure, if you're old, you may be dead before these bonds mature. But in the meantime, you'll be collecting those fat interest payments. And will your spouse, children, or grandchildren, refuse the money? Furthermore, if you need cash in the meantime, there is a ready resale market for most large-cap bond issues. The price you get on a resale may vary greatly, depending on present interest rates (either up or down), supply and demand, and the ever-present fear factor. All these make it a very good idea to make your initial bond purchases at a discount to par. That shields you on the downside, and builds a predictable upside into the transaction (if you hold the bond to maturity). It will, after all, return the exact same amount as the original buyer paid upon issuance (par).
My ideal scenario, reflected in my spreadsheet, is to build a long-term bond portfolio steadily, year after year. A predictable amount should be added to the portfolio regularly, and interest income should be reinvested steadily. This latter requirement means that the bonds should be held in a tax-deferred vehicle like a traditional IRA, Roth IRA or 401 K plan. Since taxes are paid on the latter two only upon withdrawal, and the Roth is funded with post-tax money, everything compounds tax-free. That's huge, as you will see.
Why not wait for those magic moments when bonds have reached a cyclical peak, and then pounce? Well, there are two problems with that. First, those moments of peak yields are also moments of extreme terror. In 1982, and 2009, people were running AWAY from bonds, not towards them. In 1982 they were panicked about rates (16% and higher) exploding upward. In 2009 they feared the entire financial universe was about to crash. Second, it's hard to recognize a peak until it's past. Once it's past, you regret missing it, and stew instead of acting. The brave souls who grabbed for peak and near-peak yields were richly rewarded, but they spent many sleepless nights until things went their way. I was one of them, because I was following a plan (albeit a newly conceived one).
Psychologically speaking, brave investing is a non-starter for the huge majority of investors. Fear overwhelms greed at the precise wrong moment. It's easy to be intrepid when you've just reached new highs in your portfolio; it's exceptionally difficult to jump in when you've just taken ferocious losses. So, how can you overcome your own inner demons? The only way I know is to have that plan, and stick with it through thick and thin. Put it on autopilot as much as possible.
My next blog will demonstrate the results of following a plan.
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