Across the Monevator comments and beyond, a cry has gone up: “Bonds are bad! Down with fixed income! Duration is for dummies! Stick your equity cushion where the sun don’t shine!”
It’s not hard to see where the hate comes from.
2022 has been a terrible year for bonds.
I don’t mean terrible ‘for bonds’ in the sense that bad years for bonds are less common than for shares, meaning you’re disappointed with, say, a minus 5% annual return.
It has not been a bad year for bonds like Oswald Mosley wasn’t that bad for a Nazi.
No, it’s been a bad year in the sense that some bonds and bond funds – those of lengthier duration – have done even worse than the risky US Nasdaq index – which itself has had a rotten year:
Clued-up investors know equity declines come with the territory. Fair enough.
However we own bonds mostly because we hope they’ll do better than shares when that happens.
That’s why 2022 stings so much. It’s not just that bonds have fallen a lot. It’s that they’ve fallen when shares are down too.
Bad for bonds is worse for LifeStrategy
Because long duration bonds have done so much worse than shares – especially US shares, juiced by currency gains for UK investors – we see surprising and ghastly results like this:
Source: Trustnet
The chart shows how Vanguard’s popular LifeStrategy funds have put in a Bizarro World performance this year.
- The supposedly lowest-risk LifeStrategy option – the 20/80 fund, with just 20% in shares and 80% in bonds – has done the worst.
- The best LifeStrategy fund to own in 2022 was 100% in shares.
This is the opposite of what we’ve come to expect from balanced funds like LifeStrategy.
And let’s be honest – it sucks.
It’s one thing to lose money in the hurly-burly of the stock market.
High risk, high reward, right?
It somehow feels far worse when your pension is battered by boring old bonds.
The trouble is the same unwelcome double act has done for both bonds and shares this year – high inflation and rising interest rates – with lofty starting valuations for both asset classes having a supporting role.
Hence in 2022 bonds and shares have moved down together.
So are the newly-converted bond-o-phobics right? Have bonds been unmasked as wolves in sheep’s clothing? Ripping your face off just when you could really use some comfy woolens?
Should we junk our bonds faster than Tories getting rid of a Prime Minister?
Not so fast.
Not such a bolt from the blue
The potential for bad years for bonds was always in the small print – and the history books.
Moreover the risk of a bad spell for bonds only rose as prices climbed and yields fell.
Of course, we human beings tend to think the opposite way. The longer something bad doesn’t happen, the more we dismiss the risk.
(This is also why every outdoor activity with children eventually ends in tears…)
And after a 40-year bull market for bonds – longer than many City careers – complacency was at an all-time high.
But the risks were still there, if you wanted to see them.
Way back in 2012 I explained how bonds looked more vulnerable as Central Banks lowered rates:
What makes bonds particularly risky at the moment is the low yields you get for holding them.
As we’ve seen, this increases duration, and so makes them much more vulnerable to interest rate shocks.
I held no government bonds myself, preferring cash. As I wrote then, gilts “gave me the willies”.
This was my stance for a decade. Seems a good call now – but the fact is until this year it was a losing trade to prefer cash over bonds for safety.
In my 2012 piece I also said I couldn’t imagine yields on a ten-year bond would go much lower than the prevailing 2%.
But they eventually went to near-zero, boosting returns for bond owners.
Moderation in all things. Even bonds…
My co-blogger The Accumulator has also flagged the issue many times before this annus horribilis:
- Why UK inflation-linked bonds might not protect you from inflation
- Negative yields on bonds: what do they mean?
- What the warning signs about the 60/40 portfolio are telling us
- Defensive asset allocation and model portfolios
- How much will you lose if bond prices fall?
Like me in 2012, he also suggested holding more cash as one response to very low yields. But being the grown-up in the room, The Accumulator also urged readers not to dump bonds entirely.
Instead he stressed you could choose lower duration bonds to make your portfolio less vulnerable to an interest rate shock.
Why didn’t we bail on bonds?
What none of our articles did was declare in 72pt bold font:
SELL YOUR BONDS – NEXT YEAR WILL BE TERRIBLE.
Indeed you’ll wait a long time to read an article like that on Monevator.
That’s not because we keep such secrets to ourselves. Rather it’s because we have no idea exactly when crashes of any kind will happen.
For The Accumulator, knowing your limits is a key plank of the passive way.
For me, a naughty active investor, it’s a perspective hard-won from years of trying to second-guess the market.
But this is not a cue for you to read a different website – let alone turn to TikTok – instead of sticking with us.
Because I don’t believe anyone can tell you exactly when to get in and out of markets, consistently.
Sure, you will find thousands of people making comically precise market predictions all over the Internet. Some of these people are quite popular. But that doesn’t mean they’re any good at it.
Everyone has a hunch now and then. And after a drink, I’ll tell you I think I do better than average.
For example here’s a bottom. And here’s a top.
I think I do okay, by the standards of a scurrilous game. But the fact is it’s hard to distinguish skill from luck – or more importantly to bank on it.
I don’t urge you to avoid making wholesale moves in and out of different asset classes (as opposed to judicious tweaks or re-balancing) not because I don’t trade my portfolio. But because I do.
Mugged by the market
Since 2010, some commentators – including me, as we’ve seen above – were saying bonds were over-priced and bound to crash when yields rose.
But as it turned out, bonds delivered solid returns for many years to come. Culminating in a final flourish in the 2020 Covid crash.
How many people held themselves – or their preferred pundits – accountable for getting those predictions of a bond crash wrong, year after year?
Of course you might argue it didn’t matter exactly when the bond crash happened. It’s been so deep you could have bailed on bonds in 2015, say, and still dodged a lot of pain.
True – but that statement is neck-deep in hindsight bias.
Once you’d sold your bonds, you had to put the money somewhere.
Maybe into low-to-zero yield cash?
It’s taken a crash of 2022 proportions for that bet to come good. There was no certainty it would.
Equities?
Sure, if you chose US or global equities then these have beaten bonds over the past decade.
But (a) you were and are always likely to get a higher return from equities than bonds, and (b) the risk is you don’t. Equities are far more volatile than bonds.
In some parallel universe, we saw a huge equity crash in 2016 that we’re only now limping out of. For the past six years in that alternate reality, even low-yield bonds did better than shares.
Or maybe there’s a universe where we’re still looking for a Covid vaccine, and the world is mired in a 1930s-style depression.
I don’t want to think about what our portfolios would look like in that reality. But I’m confident that bonds would be doing better than shares.
Investing: probably, likely, could, might, may, should
The trouble is we’re not good – as humans – in thinking about probabilities as a basket.
Something with a one in 50 chance of happening will happen, given enough throws of the dice.
Whereas people try to mentally transform risk like this:
Relatively lower risk = lower risk = low risk = no risk
That’s totally wrong. Bonds being relatively lower risk than shares never meant there was no risk.
It’s better to think of a diversified portfolio as a basket of relatively higher and lower risks, where something is definitely going to happen. But you don’t know what will happen in advance.
So 2022 should not be teaching you that bonds are bad, just because they’ve had a terrible year.
That would be like avoiding shares after the Dotcom bust of 2000, or never buying your own home after the early 1990s property crash.
The better lesson we should take from 2022 is very bad things can happen to our portfolios.
And that if a lot of things can happen, then some of them will.
This year it was bonds that blew up. But plenty of other historically rare but perfectly possible things are waiting to derail us in the future.
And in some of those situations, high-quality government bonds will be your best friends – especially now they have a meaningful yield again.
When you’ll be glad you own bonds
Here are a few plausible scenarios where you’d probably be glad you kept some bonds:
Deflation – Strictly a regime of falling prices, deflation tends to be associated with higher unemployment, lower economic growth, stagnant or falling wages, and weak or negative stock market returns. But the best paper assets – government bonds and cash – can hold their value as the rest of your portfolio tanks. If yields fall then bonds can give you a capital gain to offset losses elsewhere. Whereas cash is likely to be yielding nothing.
A big and prolonged equity market crash – I’m not talking about a wobble like late 2018 or early 2020. Even 2022 hasn’t been particularly painful compared to the worst stock market crashes of all-time. Rather, imagine if your shares drop 70% and stay down for years. Bonds will probably do much better, at least in nominal terms. (However some very bad bear markets for shares coincided with big inflation-adjusted declines for bonds. You’ve been warned!)
A short sharp meltdown – Think the Global Financial Crisis or another deadly pandemic. This overlaps a bit with the previous entry. But the distinction is that a meltdown or confidence ‘flash crash’ is short-lived. Bonds may give you speedy gains upfront. You can then re-balance into rebuilding your battered equity exposure for the long-term.
You’ve retired – If you quit work to live off a 20/80 portfolio, pregnant with bonds, I excuse you a hollow laugh. 2022 has been awful. But over longer spans of time, bond returns are much less volatile than shares. When you’ve no new money coming into your portfolio and less time to sit out the declines, that’s valuable.
We’ve written extensively about the role of bonds, so I won’t repeat it all here:
- Are bonds a good investment?
- Should you hold cash instead of bonds?
- A brief guide to the point of bonds
- Best bond funds and bond ETFs
Read those and our other articles about bonds for a reminder about the merits of this asset class.
And try to do so without wearing your blood-tinted glasses of 2022.
Yes the long-awaited bond crash has finally happened. But we’re probably through the worst. If anything, it’s less likely to happen again anytime soon. At least not to the same awful extent.
One very bad year doesn’t entirely destroy the logic of owning some bonds, no more than the sinking of the Titanic killed the need for global travel.
Better days ahead for bonds
As we’ve explained before, falling bond prices have a silver lining. When bond prices fall, yields rise. And that bodes well for future returns.
As of early October, Vanguard’s models suggested that between 30 June 2021 and 30 June 2022:
… projected 10-year annualised returns for UK aggregate bonds have risen from 0.6%-1.6% to 2.4%-3.4%, while return expectations for global bonds ex-UK (hedged) have increased from 0.5%-1.5% to 2.3%-3.3%.
Again, low returns had been baked-in. Now they look a lot better.
On a related note, the fund behemoth has also modeled how future expected returns from a 60/40 portfolio improved from the end of 2021 compared to late September 2022:
According to the latest forecasts from the Vanguard Capital Markets Model, the projected 10-year average annualised return for a 60/40 portfolio has increased considerably since the start of the year, from 3.3% to 6.8% – a rise of 350 basis points.
I will triple underline these are expected returns. They are not guarantees!
However the mathematics of fixed interest means that models can be more confident about future returns from bonds, compared to shares.
And those future returns look brighter.
If history is any guide it probably won’t be too long before even the battered 20/80 LifeStrategy fund is back in the black:
Again, you can’t be certain with a forecast. But at the least it shows you why I’m so wary of all the pessimism about bonds right now.
If anything, I’d be buying them. (In fact I am).
Bonds are not bad, but prices can be
I would be a hypocrite if I said you should always own bonds. I didn’t own them for a decade and perhaps in the future I’ll be out of them again.
But equally I’m not a supposedly passive investor now bailing on bonds after a very bad year.
If that’s you, then ask yourself:
- What do you know better than the multi-trillion dollar bond market?
- If the answer is ‘nothing’, then aren’t you just responding emotionally to recent losses?
This isn’t a call to excessively load up on long-duration bonds. Interest rates could go still higher. If they do then after a recent mini-recovery, bonds could decline once more.
There’s even an argument that bonds tend to move in long secular cycles. If that’s the case then we might be in for decades of rising yields and mediocre returns.
It’s also perfectly possible for bonds and equities to both keep doing badly for years – especially in real1 terms.
Again, no guarantees.
But let’s learn the right lessons from 2022. By all means diversify your lower-risk assets with cash and gold. Stick to intermediate or lower-duration bonds if you’re concerned about interest rate risk.
Or even be a naughty active investor like me. Own what you like, but be ready to sell on a whim!
(Just know you’ll probably do far worse for trying, and you’ll definitely be more stressed.)
But you should probably own some bonds
Frankly, if you’re someone who now thinks bonds are bad – full stop – then you’re probably the sort of person who most needs bonds in their portfolio.
Ideally tucked inside an all-in-one fund where you can’t see how the sausage is made. Because something is always doing badly in a well-diversified portfolio.
I don’t mean this unkindly. The opposite. I know it’s been a rotten year.
However I’m worried some people are going to load up on equities, only to sell out at the bottom when the next deep stock market crash comes and they have no safety cushion at all.
Shares are riskier than bonds. Not this year, but most years.
And there are pros and cons for every asset class.
You think bonds are bad? That’s a shame, because they haven’t looked this good for ages.
Never say never again
- Inflation-adjusted. [↩]
I know I shouldn’t do this
But, but, but, gold 😉
I have never held bonds, because I regard my DB pension as doing that job. And I don’t understand them. But if this is so beaten up….is it time to buy a smidge 😉 I could even buy it in say 50:50 VGLS and pretend I’m not doing the bond thing, plus get a tilt to value away from the US tech.
OK I’ll crawl back into my active hole. I think this is aimed at passivistas, not mustelids.
I was lucky to dodge this bullet, selling our bonds after the 2020 Covid crash and holding more cash and equities instead. I did not predict the 2022 crash, it was more a case of comparing the relative risks and rewards from holding bonds versus cash. I think pointed out some of the arguments here. Exceptionally unlikely performance was required from bonds in order to match the returns on cash deposits, plus the fact that cash had zero downside risk. It just did not seem logical to continue to hold bonds.
I would endorse buying them now as part of a portfolio, but I will largely stick to cash as it better suits our drawdown strategy. I did buy some short dated gilts a few weeks ago, but intend to hold them to maturity, so very similar to term deposits. Our strategy is to spend from cash, topping up from dividends and occasionally from equity disposals after good performance. Essentially our investment horizon for bonds/cash is short and we keep the risk in the equities portfolio, which is held with a long term view. This does mean we miss out on the long term rebalancing bonus from something like a 60/40 portfolio, but all-in equities should deliver more over the long term, offsetting the loss of rebalancing bonus.
Love this by the way: “The longer something bad doesn’t happen, the more we dismiss the risk.”
Brilliant and so true.
@ermine — I mention gold in the article as part of a more diversified non-equity basket. But be aware that the long-term return from gold is around zero, versus 1.5-2% for UK government bonds. Holding gold in place of government bonds would have been costly, historically. (I own some, but it’s no substitute. It’s additional IMHO).
@Naeclue — Cheers! Yes, I remember your tweaks being documented over the years. It worked out very well for you. 🙂
I wonder if the erosion of CGT exemption in today’s budget will further tip us to certain direct gilt holding?
(Have a bunch of loose thoughts on how the CGT might impact the role of GIA’s in drawdown or rebalancing when we get to the budget article).
So in terms of your ‘you should be buying-i am’ comment
If you’re like me currently 100% equities , decent amount of cash (1.5 years spending- probably too much) adding a decent amount every month/ year and am comfortable with the volatility, and if my portfolio stays down for a long time . Age 42 not planning on retiring for 10 years at least
Would you sell equities to buy bonds atm? Or just start buying bonds out of cash?
I’ve always understood bonds are there if you’re going to cut and run at the first sniff of a crash. And that if yields on the ‘lower risk’ bonds have risen then by definition the expected returns for higher risk assets have also risen as investors will always demand a premium for said risk .
Have I understood correctly ?
Bonds are certainly looking more attractive and I have been adding to iShares TIPs, a real return of around 1.7% is not unattractive…..
From someone who has always had a heavy equity concentration I find myself with 30% bonds !
I like the article stressing the fact that a good decision can have a poor outcome, we all have had good results from poor choices and need to realise we were lucky , I’d rather have good decisions then poor decisions , whatever the outcome, over time those good decisions work out more often then not.
Very timely article and many thanks for the previous ones on this site pointing out the risk in fact high risk of long term bonds in a low interest environment. I moved my pension based on the articles showing value small company equity and gold work well in a balanced portfolio. My default pension was loaded up on gilts and the move was timely. Now i am thinking about a bit of a tweak to gilts.
@FBA – as another expat here – I’ve been buying bond funds with cash. Like you I have about 2 years in cash, feels way too much and with the shocking inflation figures, need a plan B which is VBND and VGOV in equal proportions, but only up to 10% of my pf. I also have (Singapore) short term T-bills, as a cash/fixed deposit substitute, until I can formulate a better plan. Haven’t looked at gold or any metals since I don’t understand their safe haven status or loyal following (sorry ermine).
As an ancient retiree (now 76) rtd 18 years I had made my pile and entered retirement with 3 index funds only-simple,cheap and easy to understand
The portfolio had 65% Bonds-a Vanguard Global Bond Index Fund hedged to the Pound ie a conservative portfolio
It’s done the job for me through many ups and downs over the years
No doubt will manage this current crisis too
Not had to change anything,rebalance or sell-Asset Allocation remains the same
Portfolio went down 12% but now 10% down ie going the right way
Investors forget the tremendous years we have had -there will always be highs and lows-that’s investing for you
Lucky to retire when I did probably but take some personal responsibility for having saved a lot and lived frugally
Can do nothing about the luck but the other 2 factors are under the investors direct control
So far so good!
xxd09
The wider point here is that a portfolio of only stocks and conventional bonds lacks diversification. That’s not hindsight, it’s clear from first principles when you map out what happens across the 4 quadrants of deflation/inflation vs. growth/recession. During stagflation, “passive” herd portfolios like 60/40(/0/0/0/0/0) get hammered.
Remember those crazy times of QE infinity when yields on anything slightly more creditworthy than Argentina were zero or negative. Cash often had better yield than bonds. Even gold.
Sticking with only bonds was quite the active bet on the deflation-forever scenario.
Just on the whole “Why didn’t we bail on bonds?” / please don’t hunt us down and deploy piano wire on us as revenge for your bonds tanking aspect of the piece,
don’t worry – I don’t blame you at all, infact, I have been half saved from blundering into too many bonds as a cautious type by ingesting what has been written here.
It has been quite noticeable that in comment threads up to I think autumn 2020 the general folk advice here was roughly “just buy VWRL & VAGP”. Then, suddenly and silently, the agg worship vanished (bar @xxdo9).
Bogleheads were ahead of you in saying “just use VWRL&cash” at that point while Slow&S. ploughed on to the bond cliff, but I do really
appreciate the detailed explanations of bond behaviour you’ve done lately.
I think you could maybe write more spelling out the bond recovery dynamics: LS20 is down 13% with a 6% expected return? well that’s 2025 for nominal recovery and about 2029 for inflation-adjusted recovery.
And the only way those bonds usefully deliver is when rates get cut.
Could the world really jump straight back to 0% rates if shares drop 30% next year with inflation still up around 10%?
I noticed one commentator adding Intermediate US bonds recently, but
most still seem to be staying short or doing direct gilts for the now.
Would be interested in a piece from The Acc on how the current situation affects the ‘bonds-first’ strategy from the Living Off Your Money guide, that if I recall correctly he’s using to finance his retirement.
Interesting I use Lifestrategy 60 and 80 as my two benchmarks to track my unitised performance. One the last few years, with a lower equity allocation (approx. 50%) I have landed between the two in terms of performance. I only hold a small % of gov bonds and these are mainly short duration, but recently have been thinking about whether this might be a good time to switch the allocation to intermediate gilts (or global gov bonds).
I would also add there are more than two asset classes 😉
@FBA
@mr_jetlag
If you are sitting on so much cash and are sure you don’t need some of it urgently, why not just go for the simplest possible strategy of buying a single short duration bond? GB00B7Z53659 yields 3.3% until maturity in September next year, that’s likely thousands of pounds considering your cash pile. Not sure about your broker, but I can buy similar local bonds for a flat 5€ fee.
Meany- thanks for the mention
Over my reasonably long investment journey I have always been looking for an alternative to bonds
Never found it yet-alternatives are expensive and difficult for an amateur to understand-bonds are bad enough!
I still keep looking
I also have never market timed since my youth -had fun then and learned my lesson ie don’t!
Only keep a cash stash for 2 years living expenses-(cash instant ISAs are a worthwhile new arrival in an era of rising interest rates )
Those two facts ie no worthwhile alternatives and no market timing mean that I just stay the course -boring ,counterintuitive but seems to have worked in my case over the long term- all becoming a bit academic now for me
xxd09
@ Sparschwein – I think that’s a really good point that stagflation is the achilles heel of a straightforward equity-bonds portfolio.
The strength of that portfolio is it’s really simple to implement if investing isn’t something you want to think much about. It’ll do the job for you, most of the time, but there’ll be speed bumps along the way.
But the other side of the deal is: it’s best if you invest on auto-pilot for 20-40 years and don’t pay much attention when the world is going to hell.
60/40 equity/bonds works if you don’t pay attention to its weaknesses *and* don’t pay attention when those weaknesses materialise.
It’s the worst of both worlds if you don’t pay attention to the small print but *do* pay attention when the 60/40’s weaknesses are most apparent.
That moment won’t last.
Years from now this won’t matter. Right now it matters a lot.
@ Meany – don’t understand why people would turn to individual gilts right now as a solution to this. Unless it’s individual linkers. There are cases when individual nominal gilts make sense but they’re very specific. I get the sense the reaction you’re spotting is to do with the notion that bond funds are broken?
@ Scott – currently I’m in my cash bridge phase so no need to sell. The current situation wouldn’t change anything though. If both asset classes are down I’d still rather sell bonds. I’ll ponder more though, see if I have anything useful to say. And you have just sparked another idea for an article!
@ Ermine – the time to tilt to gold was before all this kicked off! GBP gold prices are bid up right now. They’re not far from all time highs. The weak pound has boosted them too. I agree with you that gold has a role to play in a decumulator’s portfolio. But a big move now risks ‘buy high, sell low’ disappointment.
@ Fatbritabroad – I just updated the Monevator expected returns table:
https://monevator.com/passive-expected-returns/
If you look at the frozen Vanguard and BlackRock returns (published in May and June) vs the updated Research Affiliates and Monevator returns (ours are based on the Gordon Equation) then you can see expected returns are up across the board.
You’re right that theory expects the equity risk premium to rise when the yield of the so-called riskless asset rises. It doesn’t suggest that bonds don’t have a role to play though.
Every time I look at historical returns I see the same thing:
100% equities outstrips other portfolios over longer timeframes. But that masks the chance of a big shock torpedoing your personal performance over a shorter timeframe i.e. the chance that you hit a bad sequence of returns AKA “are unlucky.”
You get superior risk-adjusted returns (not superior absolute returns) on average when bonds are in the mix. 20% – 40% bonds typically.
Personally I want some cash, some linkers, some gold in my mix too and knock back conventional bonds to get them.
I’d rather hold cash than short bonds. For my conventional bond allocation, it’s intermediate government bonds for me so I don’t weep into my hands next time equities take a proper kicking.
The best place to be in 22 would have been cash – preferably in USD! The dollars strength is food for thought in terms of an accessible diversification (on top of the usual bonds, cash, gold) given negative correlation to recent declines. No guarantees of course but would be an interesting study to run on past data. I guess with a 50/50 split you will get half the relative currency gain or loss.
@xxd09 I went into drawdown in July and I’m trying desperately to find ways to preserve the small amount of pension savings I’ve build up. I’ve followed your posts here and on the Citywire forum with great interest. Re the Vanguard Global Bond Index you hold. I charted up Vanguard Global Bond Index Fund GBP Hedged Dist (think this is your fund?) on the Fidelity website and over the past 10 years the resulting graph says it turned £1000 into £1070.34, so a return of about 7 per cent over that decade. Which can’t be much more than an instant access savings account. And over this past horrible year it’s turned that £1000 into £865. There really don’t seem that many attractive options out there right now!
@Calculus, yes USD cash would have been good, but the way I see it is that I have significant exposure already in my equities portfolio. I draw and spend in GBP and most of the things I spend on are priced in GBP, so I don’t want the value of my cash savings varying in value due to exchange rate fluctuations. I want my cash savings to be as risk free as I can possibly make them. Inflation risk is bad enough.
Mike -thanks for reply
I hold bonds primarily to reduce the volatility of my portfolio
Secondarily there may be some growth -in fact just under 3% pa since fund inception in 2009
This bond fund done both jobs for me
Equities of course do the heavy lifting (growth) but they are very volatile hence the bond holding
Anomalous behaviour of bonds this year ie falling as well as equities is unfortunate and unusual-the stockmarket market does these unexpected things!
Seems to have caught many of the pundits out let alone amateur investors like me!
Obviously factors like how much money saved,rate of drawdown etc affect an individual investors personal situation
Stockmarket collapses are however normal and must be expected
Your asset allocation should allow for this eventuality A 10-12% drop in portfolio value as I have recently experienced is not unusual
I do sympathise with an investor going into drawdown in a stockmarket downturn-it is perhaps the worst scenario one could envision
The stockmarket will recover in time but too higher level of withdrawals at this moment could cause a portfolio damage from which it will have serious difficulty recovering
Many investors have 2-5 years of living expenses in cash equivalents for this eventuality on which they can draw/live giving the stockmarket time to recover
xxd09
@Naeclue, Yes see what you mean, Perhaps useful for a further out/ accumulation strategy where the reserve asset is for rebalancing.
@Mike – I think, unless you need the cash, if you’re 15% down in Vanguard Global Bond Index Fund, you have to hang on in there and not sell. Wait for the higher yields to work their magic rather than lock in the loss. But I feel for you.
If you’re just illustrating the point about losses, I think investors really need to do their homework and find the Duration of any bond fund they buy. That information, and how to use it, should be front and centre on all websites. Which it isn’t, it took three websites for me to find it for Vanguard Global Bond Index Fund (It’s a smidge under 7, fwiw, so should take about 13/14 years to recover your losses, assuming interest rates remain constant.)
@Brod – completely agree on your point about duration.
Going a step further, I find it useful to actually look at the underlying bonds in a fund. The market value, face value and coupon information for bonds in something like VGOV (on their ‘professional’ page) helps demystify the difference between a fund like that and an individual gilt.
What’s the line in The Big Short? Older investor guy to Burry: ‘You read them? Nobody reads them’
Just had a look at the Vanguard gilts ETF VGOV. It has an effective yield to maturity of 3.6%. That is much better than 12 months ago when it would have been less than 1%. An investment growing at 3.6% will eventually overtake one growing at 1% – this is a basic feature of exponential growth. So anyone holding VGOV and experiencing the capital loss over the last year is ok provided they are still accumulating and several years away from needing to take an income. Anyone accumulating with a long time horizon should eventually do well out of the fall in bond prices.
I think it is trickier if you are decumulating, or getting close to it. Again selling out of bonds may not be the answer. Nobody really knows though. If you were drawing down at 3% or lower a year ago then you can probably just carry on with the plan. If drawing more than that then your punt didn’t come off and it is probably advisable to do some belt tightening.
There have been big falls in gilt prices in the past (when looked at in real terms) that would have worked out just fine in the long run for decumulators, but also times when it would have been better to switch to cash or shorter dated bonds after the falls. The early 70s was brutal, with gilts down in real terms 3 years on the trot between 1972 and 1974. Decumulators would have been better off switching to cash/short dated gilts after the 1972 fall. Cash/short dated did not do well either, but the much lower volatility helped decumulators.
The right answer may well be to diversify as @TA has done. Intermediate gilts + linkers + cash + gold, rebalanced annually. I would really need to hold my nose to buy gold, but historically it has proven useful at times. I have no plans at present to go back into intermediate gilts, but might be interested in linkers maturing between 4 and 6 years which I would hold to maturity. Unfortunately these are showing negative real yields again, but still might be worthwhile if inflation remains high.
@Brod no I didn’t buy that Vanguard bond fund myself. I got out of bonds about a year ago. Since then though I have managed to lose plenty of money on plenty of other investments!
@Mike – ah, that’s good. Though I think the phrase is “got lots of life experience”.
The weak pound has made my portfolio look great. When (if?) that reverses, not so good. I’m 2% down in Sterling (thank you Gold) but I’m 16% own in USD. In Euros about 5% or so. Pick your poison.
And what’s the phrase about diversification? If you don’t hate something, you’re not properly diversified?
I’ve been underweight on bonds for years, and have used substitutes (yes, I know not the same thing) such as global infrastructure, and what bonds I had where split four ways into gilts/corporate and long/short duration.
I’m now in divestment in SIPPs but still accumulation in ISAs. I find my rebalancing (to free up or invest cash) means that I’m selling equities in SIPPs and buying bonds in ISAs, which is fine. I tend to do “sell only” rebalancing in SIPPs and “buy only” in ISAs unless things are madly out of kilter.
I invested cash in ISAs (from dividends on ETFs) during the real bad hair days of the BoE bail out of gilts – blood on the streets, even if your own, etc.
Thanks for the comments
@mr_jetlag not actually an ex pat. Livingnand working in the uk just a name i used once on a travel review and decided to keep it . I really must get a different online handle as it just confuses people!
@ Fatbritabroad – I like it! It’s a great image.
Thanks for this discussion and insight!
As an actual Brit abroad (unlike @FBA) access to many overseas funds/investments is a little tricky – not impossible, but not easy, particularly with regard to taxation. I did have an international gilt fund (Vanguard) in my ISA years ago – but sold the entire stocks and bonds ISA as it’s treated as totally taxable here in NZ.
I’ve not got gilts in my portfolio – NZ gilts have never been competitive with cash or corporate bonds but even they are currently at 3-3.5% over 1-4 years – so a lot better than in the recent past. I do have NZ corporate bonds instead as part of my portfolio – although not quite the same range as local shares, yet I worry about the diversification. At least none of them are “junk” rated. On the other hand, I invested in an Air NZ Corporate bond at 6%+ last month – and Air NZ is half owned by the NZ Government sooo…..
@Mike – I too went in to draw-down in July so the latest financial news has me wondering if this was a good plan or a good time to start decumulation with around only (!) 2.5-3 years expenses in cash until my state pension kicks in……and gives my stocks and corporate bonds portfolio time to recover.
And NZ has inflation (like the rest of the world) has headed northwards this year – currently at 7.2% annually for the last quarter – slightly offset by interest rates in 1 year term deposits at up to 5%.
Ah well, the local supermarkets have Christmas clubs that give bonuses of 5-6% which has been a world beating return on a few $K cash over the past few years, and at least means we won’t starve next year….
@FBA – it IS a great handle. I’ve been using mine since the MSN/hotmail glory days (1997)…
@niwax I’m heavy cash since I liquidated some assets as part of a move to Asia. this was at the tail end of last year and things have not been conducive to redeploying capital since then. I was lucky in a way that 50% of it was converted to SGD before the 20% plunge in sterling, so that’s some fx gains banked.
I’m in the “maybe one more year” phase of FI shepherding my old firm through its next transaction, so not drawing down but want to be ready for when that happens. In addition to the 50/50 split I mentioned, I am constructing a short duration ladder from SG Tbills (4% for the 6mo, sorry ISIN escapes me rn). So a definite tilt into fixed income for me from a previous VWRP+Chill stance.
nb: someone should list a bond fund under CHILL for all the bogleheads out there…
@TA – 60/40 is basically all-in on duration and had a boost from ever falling interest rates over the past few decades. So performance looks great when going by recent history.
Now we’re past a turning point and we *might* return to the deflationary times that favour 60/40 – or not. We could get growth & continued inflation. We could get a decade of stagflation. Nobody knows for sure, and certainly I don’t.
What I’m quite confident in is that the probability of stagflation is non-negligible (say, 10%) and the impact is high. So risk being probability x impact, it’s something I wanted to mitigate.
The big question is, how. There are probably smarter ways of doing this, what I settled on, for lack of better alternatives: a chunk of short & medium non-hedged TIPS, 10% in gold, a few % in other easily investable precious metals and 7% in commodity stocks (instead of commodity futures which are very complicated and probably not suitable as long-term investment).
@Sparschwein. Completely agree with your points. The equity-bond portfolio provides no hedge in the stagflation quadrant. Assuming you have no view on assets or their returns (i.e. genuinely passive), that is 25% of scenarios. Not good.
This means the equity-bond index portfolio is very sub-optimal as the correct passive portfolio. For most retail investors trying to hedge retirement, if assets are A and liabilities are L, we can think of them as being short a continuous digital knockout option with strike A-L = 0. If at any point the barrier is struck, the portfolio failed. The objective is to minimize the risk of failure, not to maximize the value of A-L. Long-term, the equity-bond portflio has a large positive mean expectation value of A-L. Unfortunately, this is totally wasted, since it’s not sold to buy downside protection against A-L >0 (i.e. when there is no problem to hedge anymore!) but it’s deeply short convexity near the barrier A-L=0. It’s most vulnerable exactly when you most clearly need it. Stagflation is an example where that is most apparent.
Frankly, the equity-bond portoflio has no risk management in it’s approach. There is no stop-loss, no rebalance to counter rising barrier risk. It’s just far too late when the portfolio is down 30%. “Do not sell” is just not a risk management strategy.
Great article and great comments, particularly Naeclue, Sparschewin and ZX (Sorry a dis-interested observer).
Understand what you are invested in. 60:40 has worked so well over the last decade and then not this year significantly due to the trajectory of interest rates. Duration…….
In a discounted cash flow formula if the risk free rate of return declines, the present value increases. increase interest rates and the reverse is true hence portfolio rises and falls all else being equal. When interest rates are zero the relative impact is materially greater due to convexity as others have described better than me.
Bonds are a lot better value than they were last year. So are equities. The fact either has declined doesn’t necessarily matter if you had correctly assessed whether a year ago the likelihood is that what you had would cover your future liabilities. The issue is if a year ago you’d bought bonds with a YTM at circa 1% thinking simply yup, that’s part of a portfolio that will sustain the fabled 4% SWR then that’s an issue. But the clue is kind of in the 1 and the 4!
I also hold Gold and unhedged medium duration $TIPS for the reasons Sparschewin outlines. I’m sure there are better options and I suspect that I’ve not got enough in those two buckets. But it’s enough for a no. years expenditure were things to go badly wrong. Both look relatively speaking a better investment than a month ago as the £ has appreciated against the $.
I’ve made plenty of investing mistakes in my lifetime but last year took out a substantial 5 year fix at 0.95% having otherwise been un-leveraged. Sat on the cash – Naeclue I was influenced by your comment on a forum, which said – margin loans are low but so are the expected returns……Anyway have bulldozed the lot into short dated gilts therefore creating some risk free yield carry or credit card stoozing writ large. Tax free as well therefore creating a slight poke in the eye for the continued f*ckupperry of our society and its governance.
Apologies if this is unsuitable/not the right article to ask. Feel free to delete
An Irish domiciled gilt ETF, like IGLT or VGOV, when it comes to tax return would income be foreign interest or foreign dividends?
My HL tax cert bundles it with all other equity type ETFs under ‘foreign income’ but the tax return makes a distinction between the two. My googling hasn’t really helped..
@ Rhino – it’s interest. Any fund more than 60% invested in bonds counts income as interest.
Thanks TA, much appreciated.
Just picking up on ZX’s comment above. Just because a scenario has been placed in a quadrant doesn’t mean it’s got a 25% chance of occurring? Or am I missing the point?
Currently pondering best plan of action re fixed income. For those that have been smashed and are no paying attention what is best plan moving forward. I’m sure I can prefer it together from the myriad of bonds articles here. Basically how to move forward from a simple vgov, IGLT setup. In a way that doesn’t totally crystallise losses..
@Rhino – I think the assumption that each scenario has equal probability is as good as any. Short of having a department of macro wonks who do sophisticated analyses and then get it wrong anyway. What matters is that the probability is *non-negligible* because the impact is high and that’s certain.
Fwiw I’m adding back some long USTs because we are off the zero-% boundary and they can conceivably work in a deflationary bust again.
Un-hedged because USD moves tend to make USTs double effective when stocks drop. Currency hedging seems counterproductive here, particularly against GBP that predictably tanks during crises like an EM currency.
On the subject of portfolio construction / risk management, I was interested to read Cullen Roche has reached similar views as to some of those shared on this thread and in comments past:
https://www.pragcap.com/do-we-implement-portfolio-construction-completely-backwards/
@TI I think most of us subconsciously chase/hope for better than expected returns, rather than simply being content to cover our liabilities in the least risky fashion. That said, until the latter stages of accumulation, many of us have only a vague idea what those liabilities will be and, ultimately, none of us knows when cometh the hour.
I think this is the point ZX/A Disinterested Observer has been making both here and elsewhere (Fire v London).
@Martin T — I don’t really want to import debate from other blogs onto this one, but just to take the recent FireVLondon post comments, I don’t except the criticism.
We don’t “convince everyone to maxmize total returns” at all, @TA’s articles have always stressed a broad asset mix and we’ve taken in fact endless criticism over the years for including or not including this or that asset in suggested passive portfolios, rather than going, say, 100% long equities, which is of course what ‘maximises total returns’.
The argument about matching portfolios to future liabilities is more germane and more interesting, and fairer. We don’t spend a vast share of our time on this.
And given all the different situations and futures of people, is it realistic to think that, say, a 60/40 portfolio (again, just using this for shorthand, see @TA’s articles about what that ’40’ comprises), adjusted up or down a bit for risk tolerance, just happens to be optimal for every one of ‘the masses’?
No, it is certain it won’t be.
However the issue is once you deviate from this you get into thorny territory very quickly.
Data and experience suggests most people are not good at counter-cyclically adjusting their asset exposure (except through simple rules like rebalancing), forecasting asset class returns, or doing any kind of complicated maths on their current portfolio exposure (in terms of volatility / VaR etc) and their expected returns.
Moreover they do not have access to many of the financial products that have been suggested in these debates (invite-only macro hedge funds for example) nor do they have very high salaries that enable them to dial down risk to the lowest level to maximize *some future liability* matching.
Let’s not forget that your ‘future liabilities’ to an extent write themselves, because the lifestyle you find yourself living will in part be determined by the returns you achieve.
Most of this future spending is not, for example, a year’s worth of known school feels in 2035 — rather it is “can we afford to go to Malta or instead Madagascar for our 25th wedding anniversary?”
As I’ve said many times the liability matching discussion is all super-fascinating, very valid as an approach for those who are in a position to enact it, and food for thought in comment discussions for the rest of us.
But with respect to our articles/mission, we aspire to broad strategies that take a majority of people away from toiling around in the dark — perhaps picking 3-5 random / active funds when they join a new job and are asked where they want to invest their pension and never thinking of it again, punting on crypto or growth stocks once or twice in a lifetime as a fad, and putting money in a cash ISA now and then when they have a couple of good years in a row and see some cash piling up.
That is the reality of the typical UK investor/reader. Not rocket scientist quants applying industry-grade risk tools and maths to portfolios of inaccessible hedge funds.
We have spent our years here trying to convert those typical people into regular and disciplined savers/investors in diversified portfolios that will do pretty well while dialing down the risk of blowing up / bailing out, over long periods of time.
If someone has a problem with that, too, then you can’t please everyone, but I believe it’s a pragmatic and realistic sweet spot. I’ve learned a lot from certain posters’ comments over the years and I think it seeps into @TA’s thinking also. That’s all to the good. But I don’t believe there’s any reason to throw the baby out with the bathwater here.
Of course if an individual wants to do more / go deeper / has money for alternatives or even financial advice then that’s entirely their choice and I applaud them for it. My own investing is deeply bonkers and the antithesis to @TA’s approach, and I am no hypocrite! 😉
My recent disagreement with Monevator (one of a quite a few) is really in the definition of a passive portfolio. Monevator equates passive with index tracking.
My definition is that the passive benchmark portfolio is the portfolio which meets the long term objectives (typically future liabilities) whilst minimising the risk of failure and not taking a macroeconomic view on asset classes or markets.
That was the definition taught to me over 25 years ago when I started. Somehow over that period, passive seems to have now been equated with index tracking. I feel that loses two key criterion. You are not meant to take a view on whether bonds or equity valuations are good or bad. Or whether we get deflationary growth or stagflation.
You also are meant to hold the portfolio that meets the objectives whilst minimising risk of failure. You cannot do that if you only look to optimise the asset side and totally ignore the liability side. This is the problem with the MPT/EMH equity-bond approach. It’s essentially a very long term horizon view but ignores liabilities and path dependence. In most scenarios it ends up generating too much in the way of assets but at the expense of a higher risk of failure over the shorter term. It’s clearly suboptimal (technically it’s most short convexity near the barrier you need to protect). How you protect that barrier is debatable. I use long convexity macro funds but you could annuitize, hold cash, buy downside puts, sell risk reversals etc. They all come down to essentially selling some upside to protect downside. Bonds do that very well in some scenarios but can make it actually worse in others.
I don’t see any complexity in my view. Or rather what I see is people trying to solve a very complex problem with something way too simple. It’s another gripe with a Monevator but it’s exactly this constant desire for simple solutions to complex problems that has gave us Brexit and Trump. I hate it and it seems to totally pervade society.
Frankly it’s really difficult when people such as Monevator agree with people who can equate macroeconomic theories such as EMH or RWH with something like the laws of thermodynamics. EMH and RWH aren’t even consistent with each other yet passive types point to them (at the same time!) as supporting their extreme views. They are just toy models not fundamental physical laws. Such an equivalence makes my blood boil.
@ ZX – the term ‘passive investing’ is simply a common cultural label for a set of practices designed to help ordinary people look after their investments.
It was also known as ‘index investing’ (my very first articles on Monevator referred to it as index investing) but passive investing won out.
Are you also petitioning Warren Buffett, William Sharpe, William Bernstein, The Bogleheads, and many other of the leading voices who advocate for ‘passive investing’?
The fact is that this movement was championed by public-spirited members of the American wealth management industry aghast by the way ordinary people were exploited by their own industry. It’s done a huge amount of good and enabled a lot of people to invest for the better. People who’ve done their best to self-educate themselves. I’m sorry you think that the desire to find workable solutions – even if imperfect – is wrong or dangerous.
If you see a better way then I’m all for it. Set up your own public channel and explain to people how you can help. I’ll be there reading / watching / listening to every post and trying to learn as much as you can teach.
But let’s not waste time arguing about labels. What’s important is the body of knowledge behind the label. So set yours out.
When I got into this some years ago I noticed that the “passive” concept often gets overextended to the point that it becomes unhelpful. Because passive *stock market* investing is good (I agree), passive-anything must be good.
It gets tenuous with other asset classes. Do I want to “own the bond market”? Bonds have a certain job and I want those kinds that can do the job, not those that add risk (corporate, EM, junk, CDOs…). Active bond funds tend to load up on this stuff (often without DIY investors realising), so index funds are still good here, “owning the market” isn’t.
At the portfolio level, the “passive” concept becomes entirely unhelpful. Or shall I say ideology, because for much of the “passive” investing community 60 stocks/40 bonds became The One True Passive Portfolio from which thou shalt not deviate. This is a general observation. Monevator was actually very helpful when looking how to diversify the defensive part.
Once people accept that asset allocation is complicated and inevitably involves difficult *active* choices, we can have an adult discussion and start improving. The received wisdom from 40 years ago doesn’t cut it anymore. Especially in risk management, and this was as true before it became obvious with the return of inflation.
I do believe we need to add some advanced instruments. I dabbled in shorts and VIX futures but frankly I don’t have the know-how to make it work. Much kudos await someone who can make such strategies that @ZXSpectrum mentioned accessible to interested DIY investors.
@TA. There is a rather big difference between you and I. It’s that I’m regulated by the FCA, SEC, CFTC and you are not. Anything I say that then goes wrong can come back to hit me in a court of law. I could not say “do not sell” when something is down 30% because if it then went down another 30%, I’d get sued by some clueless retail investor. Since they always blame everyone but themselves.
Meanwhile, you can give out what is functionally the same investment advice, but then hide behind the idea it’s just for educational or entertainment purposes. It’s not just you. It’s TEA or the “ValueInvestor” or any or many financial blogs. Some of these even get paid for that.
@ZXSpectrum48k I have a lot of sympathy with some of your opinions on this and specifically I think you make a good point about short term failure risk and some of the potential answers for a “barrier”. I was not personally comfortable with the Monevator definition of the changes that needed to be made to the 40, to “fix” the 60-40 portfolio.
But I think you are being ‘harsh” on Monevator and @TA and @TI with some of your criticism. The site has done a lot to promote people to think about their finances and specifically financial independence, communicating on complex subject in a way that makes them easy to consume. I don’t believe they have ever claimed to advise and if they are, from the comments threads a lot of their readers are not taking it as such. Aren’t we are all here for diverse opinions and to learn from each other?
With regards to the differences between the financial industry and finance blogs, that position might let you take the high ground, but in my opinion the finance industries quality of advice is woeful and the regulation toothless.
The finance industry would want to take £20-30k+ in fees out of my portfolio every year to “manage it” for this they are not prepared to agree any targets or benchmarks that they will exceed. The advice would still leave me with all the risk. The’ll just take my money, because I’m obviously a “clueless” retail investor as far as they are concerned.
Personally I’d rather take my own chances through self education and blogs like Monevator.
As an example of what I mean by regulation, my wife was taking advice from an “advisor” through her previous employers scheme, the advisor marketed themselves as “impartial”, they were restricted not independent.I found 15 mistakes in their “advice” including comparing two projections one of which was inflation adjusted the other wasn’t! It was just awful. We complained to the company and were immediately offer £250 and agreed they needed to review their compliance processes. I said I wanted to them to write to all ex employees who had received advice and describe themselves properly as impartial and correct their processes, they would not do this just £250. The FOS agreed with the complaint, but said because we had not been financially disadvantaged they would not do anymore, the FCA would not engage on the specifics, the compliance manager and advisor are still working for the firm.
You suggest that retail investor can sue, but I suspect this would have just lined a lawyers pocket. We were only not out of pocket because we realised the advice was not worth the paper it was written on.
@Matthew. I’m being harsh because they were harsh on me. TI supported someone (Naclue) who made the equivalence between passive investing and the laws of thermodynamics. Utter rubbish.
Moreover, he basically said I was lying about the performance of macro hedge funds. What is wrong with this sort of performance? https://www.eurekahedge.com/Indices/IndexView/Eurekahedge/481/Eurekahedge-Macro-Hedge-Fund-Index. We’re talking about consistent returns over the last 20-30 years, without a single 10% drawdown and 4x the Sharpe ratio of assets like bonds or equities. Yes, it’s not possible to replicate a macro hedge fund index easily but that’s not what I argued. I argued, that in aggregate, they performed very well. The data is clearly there to support that.
I’m a fan of Monevator but it seems that no counter-argument is allowed to this idea that investing solely in index trackers on a buy and hold basis is the only way to go. There is no room for “diverse opinions” any more. Even when supported with actual data.
It might work for some but it takes an awful lot of risk and there are other alternatives. For most people the ideal passive portfolio is an annuity. Yet, it seems now that instead you are told that a 60:40 portfolio is somehow “more passive”. I don’t see that is true at all.
From Monevator perspective, a fund with fixed term liabilities holding 100% equity trackers would be passive. Yet if it held 100% actively managed bond funds it would be active. That’s totally bizarre, as buying equity trackers is a far larger deviation in risk terms from their liability structure than buying actively managed bond funds. Their concept really ignores the liability profile completely.
As for HNW retail they are known for being highly litigious. When I setup a hedge fund (with others) over a decade ago, I was warned to move all my assets into my partners name, despite being inside an LLP. HNW retail would try to pierce the veil of the LLP and go for your personal wealth. They could never win. That was clear but that wasn’t their aim. Their aim was to threaten you with millions in costs going through the courts and to drag you to an early settlement to avoid that risk. That is the game retail plays. Hence I never touch them with a bargepole. They are clueless about what they invest in and you dare not ever make a loss.
@ZXSpectrum48k #47
I read this article which talks of mimicking for DIY investors the Eurekahedge long volatility index using 50% gold & 50% JPY / AUD a simple combination which represent safe-haven instruments and closely replicated the performance of the CBOE Eurekahedge Long Volatility Hedge Fund Index.
https://insights.finominal.com/research-60-40-portfolios-without-bonds/?mc_cid=98a180c4fc&mc_eid=7ac1089c53
I am not a trader just a simple DIY investor trying to learn and improve investment decisions. Using ii platform does anyone understand/know how to implement the JPY/AUD component ? Just cash in 25% of each currency pair or… ?
Best in advance
MrBatch