Desert Portfolio Question

[sophie]

I thought the Desert Portfolio is going for an average of 5 year bonds, so one proposed strategy was to buy and maintain a 10 year Treasury or CD ladder - nice idea, since it gives you effectively some cash assets and also an ER of zero for 60% of the portfolio. Agree that 7-10 years is too long for "intermediate".

It's a nice portfolio. The main worry is that you'd have 60% of the portfolio devoted to an asset that will often provide zero or negative real returns, especially after taxes (the bonds aren't intended to provide capital gains, unlike the PP's long bond allocation). This has been the case since 2008, and also occurred in the 1970s. If stocks aren't picking up the slack, 10% gold isn't enough - you need closer to 20%.

[Jeffreyalan]

I think what I am struggling with are the "risk" factors. Now that we are a one-income family, we can less afford to take financial hits. But we also need to make our money grow as much as possible. That is the dilemma. Should I just put our money in the local bank money market account, earn 2.35% and call it a day? Or should I place the funds in the Desert Portfolio and theoretically earn more than that but also put our funds at market or ETF/Counterparty risk?

Jeffrey, the only way to answer that is to ask what is the time when you think you're going to spend this money, and for most people there are multiple periods when the money will be used... house, car, college, retirement, etc.

If you have something coming up in the next 10 years, I would not put money into Desert. Look at the Long Term returns chart at
https://portfoliocharts.com/portfolio/desert-portfolio/

You could have dead money for a decade.

Good lord, where do you get 2.35% at a local bank money market? Marcus online pays 2.05%, Ally online is 2.0%.

I would say the need for the money is indeterminable. In theory I don't need it right now or for anything in the foreseeable future. However, if something unexpected happened (I lose my job for example) then all bets are off.

My bank is Bay State Savings Bank and they have a MM savings for 2.35% currently.

[Kbg]

Intermediate is normally understood to be 6-10. A pure 10 would require significant time managing bonds.

[sophie]

Tyler's site has it listed as "intermediate bonds", although true Desert initially said "10 years". Desert - which is it??

[Kbg]

Sophie,

On your chart/discussion on bonds losing to inflation. Not quite true, what treasuries do is lag inflation. If you look at the annual return profile of any treasury you can see this is clearly the case. Investors do not normally lend their governments money for free and they expect inflation+ a bit as a minimum. And as you know, bonds are across the board repriced when interest rates change.

Cash does lose money to inflation, treasuries usually do not as a normal rule of thumb if you stick to 10 years or less. The longer you go out the weaker the connection is, but it’s still there. Dumber than dirt is holding actual cash, one should always hold an interest bearing instrument. (Immediate emergency funds excepted).

I think funds like BIL or SHY are brilliant replacements for cash.

Now if one looks at the data you will see the above is not always true for periods of time because it takes a while for equilibriums to be re-established, but the large majority of time it is.

[sophie]

What was not quite true?

If anything pops out of that chart I posted, it's that the relationship between 10 year treasury yields and inflation is not at all straightforward. Your blanket statement that treasuries reliably lag inflation doesn't really capture it.

I posted it to explain my main concern with the Desert Portfolio's large bond allocation, as good as it is otherwise. It may backtest well but it's still a vulnerabilty, if there's a long period where the 10 year treasury is not providing a positive real return, and stocks can't pick up the slack. It's a theoretical worry that may well not pan out, so don't take it as a condemnation of the portfolio.

[D1984]

What was not quite true?

If anything pops out of that chart I posted, it's that the relationship between 10 year treasury yields and inflation is not at all straightforward. Your blanket statement that treasuries reliably lag inflation doesn't really capture it.

I posted it to explain my main concern with the Desert Portfolio's large bond allocation, as good as it is otherwise. It may backtest well but it's still a vulnerabilty, if there's a long period where the 10 year treasury is not providing a positive real return, and stocks can't pick up the slack. It's a theoretical worry that may well not pan out, so don't take it as a condemnation of the portfolio.

The potential for zero real bond returns is an issue; I would also be concerned about the stock allocation in the Desert Portfolio; it is from all one country and is cap-weighted so it is tilted towards the largest stocks (which could very well end up being the most overpriced ones...think of US large-cap in the late 1990s). What happens if that one country (the United States in this case) has poor equity market returns over the next 10-15 years like happened from 2000 to late 2012; IIRC that is how long it to the market just to get back to even counting reinvested dividends but not even considering inflation from 2000 to 2012 (which would have made it take even longer to get back to even)? This isn't even the worst example of what could happen; what if we get 26 years of 0.41% per year real returns like Switzerland had from year-end 1961 to year-end 1987? Or basically 0% overall real returns like France had from early 1962 to the end of 1987? Or almost 0% real return like Italy had from mid-1996 to today? Or even negative real returns like Japan or Taiwan from 1989 or 1990 to today (granted, we aren't nearly as overvalued as by measures like CAPE, PE, PB, Tobin's Q, Buffet Ratio, P/FCF, etc as those last two countries were but we are still in pretty rich valuation territory....the "bad case" scenario for a portfolio like this is richly valued stocks and richly valued bonds....which we do kind of happen to have at the moment)?

Why not substitute some of that TSM for an equal weighted S&P 500 Index or an S&P 400 Midcap index, and while one is at it, would adding even a little international exposure (GDP-weighted and not cap-weighted so as to avoid bubbles like Japan in the late 80s) in lieu of some of the US exposure hurt either?

Finally, as for the bonds...if one is worried about a long period where the 10-year Treasury is providing little or zero (or negative) real returns why not go half intermediate TIPS and half regular ITTs? We have good synthetic TIPS data back to 1954 if needed.

Again, these are just some potentially helpful suggestions, so Desert, please don't take this as a dig on the portfolio personally; any portfolio that is heavy in US stocks and nominal bonds (say, a 30/70, or 20/80, or Wellesley, or the "original" Larry FTM portfolio) would also not come out too well in a scenario like the one I mentioned above

[Phorteun]

I would also be concerned about the stock allocation in the Desert Portfolio; it is from all one country and is cap-weighted so it is tilted towards the largest stocks (which could very well end up being the most overpriced ones...think of US large-cap in the late 1990s). What happens if that one country (the United States in this case) has poor equity market returns over the next 10-15 years like happened from 2000 to late 2012; IIRC that is how long it to the market just to get back to even counting reinvested dividends but not even considering inflation from 2000 to 2012 (which would have made it take even longer to get back to even)? This isn't even the worst example of what could happen; what if we get 26 years of 0.41% per year real returns like Switzerland had from year-end 1961 to year-end 1987? Or basically 0% overall real returns like France had from early 1962 to the end of 1987? Or almost 0% real return like Italy had from mid-1996 to today? Or even negative real returns like Japan or Taiwan from 1989 or 1990 to today (granted, we aren't nearly as overvalued as by measures like CAPE, PE, PB, Tobin's Q, Buffet Ratio, P/FCF, etc as those last two countries were but we are still in pretty rich valuation territory....the "bad case" scenario for a portfolio like this is richly valued stocks and richly valued bonds....which we do kind of happen to have at the moment)?

Why not substitute some of that TSM for an equal weighted S&P 500 Index or an S&P 400 Midcap index, and while one is at it, would adding even a little international exposure (GDP-weighted and not cap-weighted so as to avoid bubbles like Japan in the late 80s) in lieu of some of the US exposure hurt either?

If I'm not mistaken Desert once flirted with a more diverse split of the 30% Stock allocation, making it:

10% TSM
10% SCV
10% EM

Someone can find the quote, or maybe Desert himself could give his two cents!

[Xan]

Good lord, where do you get 2.35% at a local bank money market? Marcus online pays 2.05%, Ally online is 2.0%.

A couple of days ago Marcus cranked it up to 2.25%.

[Kbg]

I think there is a difference between how assets behave under different economic environments and and how assets will perform going forward. Bond rates in a portfolio lag rate increases and decreases. (I just refined my statement as the earlier was not precise.) They clearly do with the caveat that the lag is increased for longer term bond issues. It's in the data.

With regard to under performing, as has been noted numerous times on the board and it is also in the data, there is almost no substantial difference between an intermediate bullet and a barbell of cash and LTTs. The PP has a full 50% of it's portfolio in a barbell...so by way of comparing apples to apples the only thing we are debating is a 10% allocation to interest bearing instruments. Same for stocks and gold in both ports.

So if we want to have a discussion about if both the PP and the Desert should have more stocks or gold that is a legit debate (and of course we know that topic has reams about it written elsewhere).

Of note...the Desert has 5% more stocks than the PP...so perhaps we are now just down to a gold allocation...

In short...if you are going to take on the Desert for too much in treasuries, you have to levy the same criticism against the PP.

The fact is none of us know what economic conditions we are going to have going forward, the PP will probably do better during high inflation. I don't think that is really debatable. However, if we don't have those conditions then gold is normally a boat anchor on performance.

The bond hand wringing honestly bothers me a bit because it does not take all US economic history into account. We all know about the 30 year bond bull market starting in the early 80s. However, if we go back to 1929 and equate 2008 with it, then we could just as well have low interest rates for 30 more years (1929- early 60s). And then there is Japan...in short assuming inflation is not a good assumption (nor is assuming deflation).

[Jeffreyalan]

I think funds like BIL or SHY are brilliant replacements for cash.

How do you feel about the safety of ETFS that hold Treasuries? I am contemplating keeping a stash of cash there and sucking up the .15 expense ratio instead of having to managing a 1-2 year treasury ladder.

[Kevin K.]

I think funds like BIL or SHY are brilliant replacements for cash.

How do you feel about the safety of ETFS that hold Treasuries? I am contemplating keeping a stash of cash there and sucking up the .15 expense ratio instead of having to managing a 1-2 year treasury ladder.

Vanguard Federal Money Market fund has a current yield of 2.31% and an expense ratio of .11%. That'd be my first choice if I didn't want to do what I've been doing, which is buying 6 and 12 month Treasuries for no fee and just reinvesting when they come due.

William Bernstein and others categorically say there's no reason to ever pay a dime for Treasury bond funds of any duration but I'm not quite that cheap and understand the desire for convenience.

Vis-a-vis the various iterations of the Desert Portfolio, "intermediate" in Treasuries means 5 years, not 10 and that has been the historical sweet spot for risk/return. I understand the logic of the PP barbell but historically 5 year treasuries have offered as good or better a return with far less volatility. And there is no way I would own long treasuries in a rising-rate environment in which the starting point is negative real returns and with Treasuries constantly flirting with inverted yield curves. I'm keeping my entire bond allocation in 6-12 month Treasuries and have been for nearly a year and a half now. ~2.5% positive returns have made the simultaneous tanking of all other asset classes much easier to deal with.

If you can set aside the self-promotion and irritating ads this now 6 year old article by Todd Tresidder does an excellent job of showing just how dangerous bonds can be in a low interest rate/high volatility environment. Larry Swedroe sounds much the same warning in the just-published updated version of his book "Avoiding Black Swans."

https://financialmentor.com/investment- ... ubble/9064

[Kbg]

I think funds like BIL or SHY are brilliant replacements for cash.

How do you feel about the safety of ETFS that hold Treasuries? I am contemplating keeping a stash of cash there and sucking up the .15 expense ratio instead of having to managing a 1-2 year treasury ladder.

VGSH is .07%. And I think Schwabs is cheaper. That’s pretty cheap for the convenience. I have both treasury funds and a treasury direct account and while I like TD and use it, the fact is you can only buy in $100 increments and you buy at a discount and get full face value back. So for example you buy for 97.50 get 100 back and if you roll then you have 2.50 that you can’t do anything with.

If you go with one of the big ETF companies I wouldn’t have any concerns safety wise and as mentioned it becomes cost vs hassle factor.

For me I like the etf version in a brokerage that reinvests dividends with fractional shares...but I would not argue against TD at all. Really it’s a matter of preference and cost for convenience.

[Jeffreyalan]

I think funds like BIL or SHY are brilliant replacements for cash.

How do you feel about the safety of ETFS that hold Treasuries? I am contemplating keeping a stash of cash there and sucking up the .15 expense ratio instead of having to managing a 1-2 year treasury ladder.

VGSH is .07.

If you go with one of the big ETF companies I wouldn’t have any concerns safety wise and as mentioned it becomes cost vs hassle factor.

I was looking at shorter duration ETFs like BIL or GBIL. I understand the mechanisms behind ETFS but still have some nervousness (probably unfounded) about putting a huge chunk of my savings into them.

[Kbg]

How do you feel about the safety of ETFS that hold Treasuries? I am contemplating keeping a stash of cash there and sucking up the .15 expense ratio instead of having to managing a 1-2 year treasury ladder.

VGSH is .07.

If you go with one of the big ETF companies I wouldn’t have any concerns safety wise and as mentioned it becomes cost vs hassle factor.

I was looking at shorter duration ETFs like BIL or GBIL. I understand the mechanisms behind ETFS but still have some nervousness (probably unfounded) about putting a huge chunk of my savings into them.

While they are not very fun or interesting to read, I recommend reading the full prospectuses of the ETF s you are considering. I would be cautious about going too short in duration with a fund. At least with the data I have and on Mornignstar, BIL lost a small percent for six years in a row as fees were higher than interest received and SHV basically returned nothing.

If you are nervous about treasury ETFs then go with CDs at a bank where you have FDIC insurance backing.