Wondering out loud about what to do next.
We’re still working out what to do with our 34% cash position, which we arrived at using this rule:
100 - [your age] = your stock allocation
although other advice may peg that allocation as lower by using the number 120, instead of a 100. I didn’t have to look far to find additional analysis regarding this formula. Either way you look at it, this rule is telling us that our non-stock allocation should fall within the range of 20% - 40%. What we have right now is 36% that is not invested in stocks, 2% of which is already invested in I-bonds. Sounds good, except it’s mostly in cash. The formula suggests that this portion not be invested in stocks, but aside from cash, that could also mean alternatives such as bonds and other potential investments.
So my question now is, what do we do with our remaining 34% cash?
We’re considering adjusting the allocation altogether and possibly take a little more risk but still fall within the range of 20% - 40%. We know that we would like to increase our international stock representation, which we will be doing. We also know that we will be entering into the world of REITs at some point, for that extra real estate hedge. What we’re left with though, is the question of whether bonds belong in our portfolio, and that is what I’d like to investigate here.
Do Bonds Belong In Our Portfolio Now?
Once upon a time, we had bonds.
While stocks tanked in early 2000, we had good representation in bonds which provided strong returns for a while. This part of our portfolio we subsequently shifted back to cash as we reacted more conservatively — thinking there would be better opportunities for these funds later on. We thought it would be best to accumulate and require this cash cushion after we took more risk in the business front and ended up with less job income in the last year. But it turns out that we may have miscalculated our reality somewhat causing us to play it more safely than we should have. With strong returns from the stock market and some stock option sales, our cash cushion has now grown a bit too large for our taste, yet we’re not willing to take an enormous amount of risk with it. As mentioned, one of our options is to review whether bonds are something to look into, to reduce risk in the long term. From cash to bonds, we’d be trading one form of risk (that of inflation risk) for another (that of slight volatility inherent in the bond market).
We wonder whether bonds are a good bet at this time. We have an inverted (or flat) yield curve, which shows that we would probably be better off picking shorter term bonds. If we get into bonds, we’d only put in 10% at most as we plan to redistribute our cash into REITs as well at some point. But if we consider 10% in mostly short term bonds, why even bother? Why not just remain in our trusty tax exempt money market fund which is now currently yielding 3.77%? This is a good deal because our taxable equivalent yield is around 6%, and we get this pretty much with no risk!
As you can see, we’re a bit confused as to what we should do.
Ultimately though, if we were to get into bonds now, it’s more for diversification purposes, in case those rates start to slip down the road. Are we sacrificing that safety and security for the opportunity to hedge? It seems like a wash if you compare short term bond yields to current cash account yields but these similarities may not last that long and it’s the future we’re not sure about. As people who have hardly ever owned bonds in our past lives, I’m not particularly sure if we’re going to gain much out of doing such a shift from cash to bonds these days, but convention is telling us to do it given we’re a bit longer in the tooth and we should practice some hedging.
Maybe it’s not really worth all the fuss. After all, we’re not talking about emerging market stocks here!
How about you? Would you move out of a fairly safe money market fund that yields an equivalent 6% taxable return and into an intermediate or short term bond fund? The answer we’ve arrived at for now is yes: again, we’re doing it for the sake of diversification and not to chase current rates.
Note: Last week, I wrote about how I’d handle a windfall with a contribution to Lazy Man and Money’s “Money Question” series. In that scenario, my approach to this windfall is different, as I’ve taken care of my primary goals and priorities already, such as ensuring I’ve properly dealt with existing funds as above.
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Well if you recall in the money question about how our portfolios look I am a big advocate of bonds provided they are the right kind and used for the right reasons. I currently hold about a 35% bond position (through a few mutual funds) and it is keeping up with and/or beating the S&P.
There are two reasons I like bonds. First, they produce steady income. This is good because this regular income can then be used to further enhance your portfolio by re-investing those proceeds. Unlike stock positions you aren’t relying on capital appreciation for growth so you can keep your principal in bonds relatively steady and that income that is generated is just like adding more money to your account.
The second is the downside protection/diversification which you mentioned. If you have a bond position that is yielding 5-6% and the equities are flat or even down you are reducing your losses and with the DCA of bond income you can potentially help boost your portfolio over the long term.
As long as your bond position doesn’t consist of strictly government or lower yielding AAA bonds they should have a positive effect on your returns. So if you go for slightly more risky bond holdings you should be able to see decent returns.
Of course that’s just me
Bonds always seem to be thought of as very conservative, safe and low-yielding investments used to reduce risk in a portfolio but there is a lot more out there.
Have you considered building a CD ladder too? My local (Georgia) credit union has CD rates for 1-3 year CDs with 5.25% APY. I (age 35) lean towards a higher stock % than you, but do have CDs too. The REITs are another good move I agree with as part of your non-stock holdings. I believe stocks will give you a better return with such a long time horizon still than bonds though.
Indexes that track commodities, currency carry trade also would be good non-stock classes to look at.
I’m not very confident in that taxable equivalent yield of 6% figure. I bet that calculator is using Marginal tax rates rather than effective tax rates. I know my effective tax rate is about half my marginal tax rate, and when I use the effective tax rate to compare yields, the munis are not nearly so attactive.
I’ll say more later…
FYI
http://www.fool.com/personal-finance/taxes/2007/03/02/your-tax-rate-marginal-vs-effective.aspx
For what it’s worth, I think dividing the fixed income part of your portfolio between cash and bonds in the best idea. While it is true, that money market funds yield more right now, for the 12 months ending 5/31, the Vanguard Total Bond Mkt Inx returned 6.59% and the American Century International bond fund returned close to 8%. So something is up with bonds.
This is may own target asset allocation:
10% Vanguard Money Market fund
10% Vanguard Total bond market index
10% American Century International Bond
8% Vanguard Inflation protected bonds
7% DB G10 Currency harvest fund (DBV)
40% Globally diversified equity funds
5% Timber REITs (RYN, PCL)
10% Precious metals ETFs (CEF and SLV)
Very interesting guys. I think I’m going to mull this over further and definitely get into the bond allocation soon, although the markets are a little roiled right now. I’m going to see about the riskier bond scenario as well, while international bond funds look appetizing too. If anything I’ll probably munch.
We also checked out currency hedging but so far haven’t decided to include it in our allocation; we thought instead to increase our foreign equity exposure figuring that it may deliver the same hedging effect for us. If you have further thoughts and details on this, I’d love to hear it!
Great Post! I would like to share an article with anyone interested in Options, or anyone confused by the difference in “Put†and “Call†Options.
The Daily Reckoning: Understanding Options
Take a look….Cheers!