Author and investment advisor William Bernstein wrote a thoughtful WSJ piece on bonds, which I think is useful for the DIY investor. The overall theme is that you should take minimal risks with the bonds in your portfolio. Taken in isolation, some types of bonds are likely to provide higher long-term returns than others. However, you should consider how they fit into your entire portfolio. Historically, it has been more efficient to take your risk with stocks and use your bonds for their stability. Bonds become the “dry powder” you can use to buy more stocks after a crash (rebalance!).

I found myself breaking down the article into three main categories. The types of bonds he recommends most, the ones he considers acceptable, and the rest which should be avoided. These are my short notes; read the article for the supporting arguments.

PREFER

• Individual US Treasury bonds, manually laddered.
• US Treasury bond mutual funds, for smaller balances.
• Top-yielding FDIC-Insured Certificates of Deposit, manually laddered.
• Short-term or intermediate-term, higher-quality municipal-bond funds, for large taxable balances.

OKAY

• “Total bond index” mutual funds, as they consist mainly of high-grade, government-backed bonds.
• US Treasury bond mutual funds for larger balances.

AVOID

• All corporate bonds, but especially avoid lower-grade and/or longer-term corporate bonds.
• Lower-grade and/or longer-term municipal bonds.

I would point out that inflation-protected bonds (TIPs) are not mentioned directly, I guess because they aren’t directly comparable to these nominal bonds. Either that, or he just considered them to be the same as traditional Treasuries. He talks about TIPs a lot elsewhere (including his books), so a little specific advice would have been helpful.

My other opinion is that running your own bond ladder is quite doable but only the most DIY of DIY investors would do it better than a low-cost bond fund. I own individual TIPS and it’s not hard but not a ton of fun either to keep track of auction dates and avoid cash drag. Vanguard charges only 0.12% annually for their short-term government bond ETF (VGSH) and Admiral fund equivalent. $12 a year per $10,000. $120 a year for $100,000. I’d rather just pay that unless I had millions or I had a lot more free time. However, if you’re already paying a financial advisor, I would let them manage an individual bond ladder as part of their fee.

One of the decisions a DIY investor needs to make is how much international stock exposure to add to their portfolio. Recently, the US stock market has had much higher returns than non-US stocks overall, including Emerging Markets. But this Vanguard article reminds us of the diversification benefits of adding international stocks. Somewhere between 20% and 50% is the historical sweet spot:

Vanguard says 60/40 is best. Over the past year or so, Vanguard has shifted their “ideal” stock asset allocation to 60% US and 40% international. This is the breakdown used for their Target Retirement 20XX funds, their LifeStrategy funds, and also their 529 College Savings Age-Based portfolios. Part of their justification is that the expense ratios for their international funds has dropped as well.

World market cap weighting is at 52/48. What do the global capital markets have to say? The world market cap weighting has shifted to 52% US and 48% non-US, as tracked by the Vanguard Total World Stock ETF (VT). VT tracks the FTSE Global All Cap Index which is a free-float-adjusted, market-capitalization-weighted index.

I like simplicity and symmetry, so I am sticking with 50/50. I’m just one amateur, but I feel the trend is towards a market-cap weighting. 50/50 isn’t all that far from 60/40, especially because my overall asset allocation will soon by 60% stocks and 40% bonds. 50/50 is also really easy to rebalance and makes my portfolio looks nice and symmetrical.

Want some support to own international stocks? If the recent poor performance of international stocks has you down, Research Affiliates recently updated their Expected Returns Chart (mentioned previously) and it shows Developed European, Developed Asian, and Emerging Market stocks having a much better outlook than US stocks:

They use a mix of different historical valuation techniques to make these forecasts, so they aren’t just pulled out of thin air.

Want some support to NOT own international stocks?
While it is hard to argue against the historical diversification benefit of owning some international stocks, I don’t know if it is absolutely necessary. If you bought big chunk of the S&P 500, and a smaller chunk of US Treasuries, and ignored it for 30-40 years, you’d probably come out pretty happy. Some big names would agree:

• Jack Bogle (if you didn’t know, the Founder of Vanguard!) says you don’t need international stocks.
• Warren Buffett’s advised portfolio for his wife’s trustee upon his death… includes no international stocks. It is simply 90% in a low S&P 500 index fund and 10% in short-term government bonds.

One argument is that many US companies already make a huge chunk of their money from their international operations anyway.

So there you have it. I hope you are sufficiently confused. 🙂

I’m catching up on some reading. James Picerno of The Capital Spectator did some backtesting of simple portfolio rebalancing where once a year you go back to your target asset allocation. Does it matter if you rebalance at the end of every year, or just pick any random date once a year? His test portfolio was a globally diversified portfolio made up 60% stocks and 40% bonds (11 different funds).

Here’s a chart of his results:

His comments:

The basic message: rebalancing is a valuable tool for generating superior risk-adjusted performance. But it seems that tapping into this value-added service doesn’t require a lot of intellectual firepower for a standard asset allocation strategy. Letting a monkey choose the rebalancing dates over a period of years works as well if not better than automatically rebalancing at the end of each year.

My version: Rebalancing helps you maintain your desired risk profile, and it may even improve your risk-adjusted returns (it did in the last decade). Get the benefit with minimal fuss by rebalancing once a year. It doesn’t really matter what day, just make sure to do it once a year. However, I find it easier to stick with the same one every year so you can put it on your calendar. (First business day after Christmas, July 1st, your birthday, etc.)

I’ve been investing in tax-exempt municipal bonds for a few years now. I made the change due to a combination of reasons. For one thing, I started running out of room in my tax-deferred accounts for US Treasury bonds, TIPS bonds, and REITs. Second, I believe that buying muni bonds through a Vanguard actively-managed mutual fund gives me a diversified mix of high-quality bonds. Third, the effective after-tax yields on muni bonds can be very attractive when compared to US Treasury bond yields. In many time periods, muni yields have been as high as Treasury yields, even before any tax considerations. This was very rare pre-2008 financial crisis, with the historical average being a 80% ratio.

Here are a few charts that track the relationship between the yields on US Treasury and Investment-grade municipal bonds. Notice that the ratio of Muni-to-Treasury has kept close to 100% in the last few years. I’ve tried to dig up enough to cover a continuous timeline, but let me know if you have a better graph.

Source: Wealthmanagement.com

Source: Financial-Planning.com

Source: ValueWalk.com

Although it can be tempting to use these charts as timing tools, I try to focus on the overall picture. Due to the tax-exempt advantage, I am happy as long as the muni rates are roughly the same as Treasury rates.

As of September 9, 2015, the SEC yield of Vanguard Intermediate-Term Tax-Exempt Investors Shares (VWITX) was 1.78% while the SEC yield of Vanguard Intermediate-Term Treasury Investor Shares (VFITX) was 1.43%. Both are hardly exciting and the muni fund is considered a little more risky (how much riskier is quite difficult to quantify), but for my own portfolio I think the higher yield is worth it especially considering the muni interest is exempt from federal income taxes.

Muni bonds are a somewhat different from other asset classes because they are owned mostly by individuals as opposed to institutions. Based on Morningstar investor returns, us individuals haven’t shown any superior skill at market timing their buys.

However, the performance gap is similar to that of the Vanguard Treasury fund of similar duration. So perhaps that gap is just due to the effect of natural cashflow timing (i.e. regular investments over time) rather than failed attempts at chasing performance.

Updated 2020. How many e-mails have you gotten regarding “recent market volatility”? The advice is almost always the same, think long-term. Feeling some fear and uncertainty is normal. During extreme times, a phrase often heard will be “I’m just going to take some money off the table until things calm down. Why risk it?”

What happens when you play it safe? Here’s a 2015 chart from FiveThirtyEight.com comparing the results of a “cautious, play-it-safe” investor and the “do-nothing” investor:

Imagine two people who each invested $1,000 in the S&P 500 at the beginning of 1980. The first one buys once and never sells. The second one is slightly more cautious: He sells any time the market loses 5 percent in a week, and buys back in once it rebounds 3 percent from wherever it bottoms out. At the end of last week, the first investor’s holdings would be worth $18,635. The second investor would have just $10,613.

This is interesting, because they let you (sort of) pick the temporary bottom. But as you can see, you miss the huge gains. Perhaps the key is that you waited to sell until the market dropped first. If you wait until that sharp drop, then it’s probably already too late.

Remember, the only two possibilities for the stock market are all-time high or a drawdown. The highs you don’t really feel. The drawdowns are quite painful. Here’s a continuously updated chart from Doug Short illustrating the drawdowns since 2009. Lots of painful drawdowns, but during that time the market is up over 200%.

This is also why financial advisors tell you to create an investment policy statement. That’s where you write down ahead of time “If [this] happens to my portfolio, I will do [action or lack of action] because [reason].” Then when the drop actually happens, you break out that piece of paper to remind yourself what the calm, rational version of yourself would have done.

I would also add that this is why I don’t support the “100% in stocks” argument that I hear 10X more often after a long bull market. With time and pain, I have come to appreciate the warm fuzzies that come from owning a nice chunk of safe, liquid bonds.