TLT Study - Inverting History

Discussion of the Bond portion of the Permanent Portfolio

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TLT Study - Inverting History

Post by Kbg » Fri Apr 26, 2019 6:13 pm

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Re: TLT Study - Inverting History

Post by europeanwizard » Sat Apr 27, 2019 1:42 am

Interesting... so even if interest rates would rise, we won't get the same performance from bonds -- due to the drag inherent in bonds.

Anyway, to counteract this, they say they do the following:
We take a different approach. Our portfolios are designed by “currentizing” historical bond returns. Things get a bit technical from here, but in a nutshell, we deconstruct each bond asset’s history into all of the constituent factors that drive returns. We assume that the largest driver of bond returns, the current yield, was never higher than it stands today. We leave all other return drivers untouched.

Below we show historical returns for long-term US Treasuries (TLT) in blue, versus returns that have been currentized based on where interest rates stand today (03/2019) in orange. The difference is stark, with annual returns cut in half, and a deep drawdown in the early 1980’s.

This currentizing process means that our asset allocations will slowly change over time based on where yields stand today. That’s okay. Sound buy and hold investing requires periodically rebalancing our portfolio. Those rebalances provide the opportunity to keep up with the optimal allocation. We can also adjust to the optimal allocation when we add funds (by buying assets that we’re under-allocated to) or withdraw funds (by selling assets that we’re over-allocated to).
So if I understand this correctly, whenever bonds with a higher coupon are available, they sell their lowest yielding bonds (at a loss I presume)? Or is this too simple?

Great link, thanks for posting!
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Re: TLT Study - Inverting History

Post by pmward » Sat Apr 27, 2019 9:10 am

Another article that I came across today looking at the issue of bond returns going forward: https://movement.capital/analyzing-bond ... ded4b883a5
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Re: TLT Study - Inverting History

Post by Kbg » Sat Apr 27, 2019 9:26 am

Bonds are the easiest of all assets to understand the returns on. You will get the nominal return stated if held to maturity, period. Duration will tell you what is going to happen to face value for interest rate change if you sell early. In the context of a PP, does one say I’m not being compensated adequately for the duration risk I’m taking or do I keep them for the original purpose laid out by HB (deflation protection)?

Given the above, I think a reasonable modification to the PP is to never roll to a lower interest rate bond and always roll to a higher rate bond if one is implementing via individual LTTs. There’s goodness to this tactic on a couple of levels that I’ll leave to the reader to discover.
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Re: TLT Study - Inverting History

Post by drumminj » Sat Apr 27, 2019 10:21 am

Kbg wrote:
Sat Apr 27, 2019 9:26 am
Given the above, I think a reasonable modification to the PP is to never roll to a lower interest rate bond and always roll to a higher rate bond if one is implementing via individual LTTs. There’s goodness to this tactic on a couple of levels that I’ll leave to the reader to discover.
And if one isn't available you hold? Shortening your avg time to maturity?
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Re: TLT Study - Inverting History

Post by sophie » Sat Apr 27, 2019 10:37 am

There's just one problem with the title of that piece. It's the phrase "in the era of rising rates".

If you know for a fact that rates are going to rise, and can predict exactly when it will happen, then the solution is obvious: get out of your long bond holdings just before the rise starts, and stay with short term instruments like T bills until the increase levels off. Then buy back in.

Do the authors know something I don't? The only reason I haven't done this myself is that I don't know that we're in an "era of rising rates", and there is no assurance that T bond rates won't go down. One day maybe they'll go up, but that could be 10 years from now for all I know.
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Re: TLT Study - Inverting History

Post by pmward » Sat Apr 27, 2019 12:23 pm

Also keep in mind, in regards to the PP, the idea is to rebalance over time. So if bonds are down in value and yields are going up, you will be purchasing more of them. That rebalance effect does tend to naturally claim more and more yield over time. So I think the PP will still work as intended. Just look at the 70's to mid 80s, in a rising rate environment the PP still performed in its natural historic range as a whole. The PP has also performed within its historic range as a whole when stocks and gold have been in severe bear markets, so I see no reason why it would not perform any different with bonds in a bear market. You can bet that gold would be performing well if/when this scenario takes place, as money will be looking for a new safe haven.

I think the main question I have with future bonds in the PP as a whole is the short term bonds. What does one do with these in a negative interest rate environment? Hold physical cash? Extend duration? Increase risk and go to all CD's and/or corporate short term debt? I probably would be inclined to do a bit of all the above. I'm not sure if Harry ever considered a negative interest rate environment in the PP.
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Re: TLT Study - Inverting History

Post by Kbg » Sat Apr 27, 2019 5:08 pm

Sophie,

The basic PP assumption is we do not know as we all are aware of. Hence my suggestion for those buying/rolling their own treasuries. For those using an ETF, rebalance.

Note...rolling up to higher interest rate LTT bonds is not likely to be able to make up a loss (in isolation).

STTs (or some other ST instrument) are always better than cash unless the nominal rate is actually negative. But again, what to do is not difficult at all. Go with the highest interest rate for a given length and risk level.
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Re: TLT Study - Inverting History

Post by mathjak107 » Sun Apr 28, 2019 4:48 am

once rates rise you will always be behind the curve .....

in it's simplest form take a treasury bond fund that is paying 5% and is 10 bucks a share and has a duration value of 5 , and you buy it...

if rates rise to 6% ,, the nav falls to 9.50 but you get an extra 1% interest , 6% instead of 5% for 5 years ... that extra 1% over 5 years makes you whole again , offsetting the 5% drop in nav but with a 5% return like the day you bought , that is 5% in a 6% world
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Re: TLT Study - Inverting History

Post by mathjak107 » Sun Apr 28, 2019 3:52 pm

MangoMan wrote:
Sun Apr 28, 2019 8:12 am
mathjak107 wrote:
Sun Apr 28, 2019 4:48 am
once rates rise you will always be behind the curve .....

in it's simplest form take a treasury bond fund that is paying 5% and is 10 bucks a share and has a duration value of 5 , and you buy it...

if rates rise to 6% ,, the nav falls to 9.50 but you get an extra 1% interest , 6% instead of 5% for 5 years ... that extra 1% over 5 years makes you whole again , offsetting the 5% drop in nav but with a 5% return like the day you bought , that is 5% in a 6% world
Except a 6% world didn't exist on the day you bought. So your point is moot if you want to invest in bonds. Or stocks for that matter; you can use the same erroneous logic. If you buy a stock fund today for $10 and the market drops 5% tomorrow, did you overpay for those shares? Because you now own $10 shares you could have bought for $9.50 if you had waited. Obviously, if you had known the market would drop 5% instead of going up, or that rates would rise 1% instead of going down, you would have just waited. But then your crystal ball must be better than mine.
all irrelevant ....it has nothing to do with crystal balls .. it is simple fact and math ...if you buy a bond or bond fund and rates rise even though your interest in a bond fund will rise over time in a rising rate you will always be behind the curve plain and simple ...my comment has nothing to do with predicting a thing ... this is exactly what the duration value of a fund tells us.

kbg understands exactly what i am saying . you can work towards getting the original interest rate you had the day you bought by staying in the fund for the duration but you as long as rates rise you will always be behind current.
Kbg wrote:
Sat Apr 27, 2019 5:08 pm
Sophie,

The basic PP assumption is we do not know as we all are aware of. Hence my suggestion for those buying/rolling their own treasuries. For those using an ETF, rebalance.

Note...rolling up to higher interest rate LTT bonds is not likely to be able to make up a loss (in isolation).

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Re: TLT Study - Inverting History

Post by boglerdude » Mon Apr 29, 2019 2:39 am

When and why are Japan's long term rates going to rise?
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Re: TLT Study - Inverting History

Post by pmward » Mon Apr 29, 2019 9:15 am

Kbg wrote:
Sat Apr 27, 2019 5:08 pm
STTs (or some other ST instrument) are always better than cash unless the nominal rate is actually negative. But again, what to do is not difficult at all. Go with the highest interest rate for a given length and risk level.
I think it does get a bit trickier than that if you look at the countries currency with negative rates. Most of them are negative up until about 10 years out. Since the whole point of the STT is safe money, I'm not sure if there is an appropriate "risk level" for that allocation in that environment. It would be a very hard decision to make, especially with any funds that need short term liquidity (emergency fund, big purchase savings, etc)
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Re: TLT Study - Inverting History

Post by Kbg » Mon Apr 29, 2019 2:40 pm

pmward wrote:
Mon Apr 29, 2019 9:15 am
Kbg wrote:
Sat Apr 27, 2019 5:08 pm
STTs (or some other ST instrument) are always better than cash unless the nominal rate is actually negative. But again, what to do is not difficult at all. Go with the highest interest rate for a given length and risk level.
I think it does get a bit trickier than that if you look at the countries currency with negative rates. Most of them are negative up until about 10 years out. Since the whole point of the STT is safe money, I'm not sure if there is an appropriate "risk level" for that allocation in that environment. It would be a very hard decision to make, especially with any funds that need short term liquidity (emergency fund, big purchase savings, etc)
It's not tricky at all, it's basic math. Using Germany as an example (I just pulled the 10 year rate as it was easy to find):

10yr bond:~-.6%
Inflation rate: 1.7%

Cost of holding 10 year German bond: -2.3% real
Cost of holding cash: -1.7% real

Correct answer: Hold cash

Let's assume the -.6 was a +.6 and it was a STT vs. 10 year bond. Thus, +.6 - 1.7 = -1.1 real.

Correct answer: Hold STTs

Assuming you do not believe you have an accurate crystal ball, the "correct" investment choice for cash and STTs is always an exercise in basic math that any elementary schooler can do.
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Re: TLT Study - Inverting History

Post by Kbg » Mon Apr 29, 2019 8:46 pm

MangoMan wrote:
Mon Apr 29, 2019 5:36 pm
Except STT aren't 10 years, they are 1-3 years (for PP purposes).
"Let's assume the -.6 was a +.6 and it was a STT vs. 10 year bond."
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Re: TLT Study - Inverting History

Post by stuper1 » Mon Apr 29, 2019 9:17 pm

Unless I'm missing something, it sounds like you're saying to hold STTs if they have a positive interest rate and hold cash otherwise. Does that mean physical cash? So I would sell my x hundred thousand dollars of STTs and turn it into greenbacks that I would put in my safe deposit box?
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Re: TLT Study - Inverting History

Post by sophie » Tue Apr 30, 2019 8:16 am

This is probably why European countries are going cashless:

https://www.verdict.co.uk/europe-cashless-society/

Anyway we just went through about 10 years of near zero returns on short term cash instruments, and there are plenty of threads out there on how to optimize. Savings bonds & fee-free bank savings accounts are your friends in a negative short term interest environment. But there's not likely to be a free lunch to partake of for too long, so you may not have much in the way of options. I expect many will turn to dividend stocks which is what happened here - but then if that's the case, it's hard to understand why European stocks haven't been doing well.

Optimizing long bonds is a different story. The US treasury market is too tight to allow for much in the way of arbitrage. When I last bought bonds, I checked yields and it actually worked out better to buy the bond with the lowest rate, because you get more of them for your money. But only slightly better, like a tenth of a percent difference.
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Re: TLT Study - Inverting History

Post by Kbg » Tue Apr 30, 2019 8:34 am

stuper1 wrote:
Mon Apr 29, 2019 9:17 pm
Unless I'm missing something, it sounds like you're saying to hold STTs if they have a positive interest rate and hold cash otherwise. Does that mean physical cash? So I would sell my x hundred thousand dollars of STTs and turn it into greenbacks that I would put in my safe deposit box?
No, I'm saying go with whatever ST instrument gives you the best risk equivalent real rate of return.

If we ever get to the point that banks charge you for holding your cash, yeah that's gonna be problematic in a negative interest rate environment. I have a hard time believing this would happen as they still need deposits to make loans and they can only make loans at a ratio to their reserves. Who knows though. As Meb Faber frequently says...the biggest surprise in my investing career is negative interest sovereigns.

If we actually got to such a situation then I think "real risk" vs. real returns would be the most logical driver as to what to do. Do I just pay the bank to hold my cash or do I store it physically somehow? Personally I'd rather have $100,000 in digital currency somewhere in multiple backed up locations than in physical cash in my home. (Note: I've probably been loose with my definition of cash. What I mean by cash is any form of money that is non-interest bearing. Thus, paper bills, precious metal coins that are legal tender, a debit card, no-interest checking account, pre-paid credit card or PayPal account...whatever.)

Cue gold fans here... :)
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Re: TLT Study - Inverting History

Post by pmward » Tue Apr 30, 2019 9:04 am

Kbg wrote:
Tue Apr 30, 2019 8:34 am
If we actually got to such a situation then I think "real risk" vs. real returns would be the most logical driver as to what to do.
The only question I have is how does one quantify "real risk"?
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Re: TLT Study - Inverting History

Post by Xan » Tue Apr 30, 2019 9:26 am

pmward wrote:
Tue Apr 30, 2019 9:04 am
Kbg wrote:
Tue Apr 30, 2019 8:34 am
If we actually got to such a situation then I think "real risk" vs. real returns would be the most logical driver as to what to do.
The only question I have is how does one quantify "real risk"?
I think it's the same debate we often have with gold: ETF vs big, obvious in-house safe vs hidden in-house safe vs deposit box. Not really a right answer, other than perhaps to diversify.
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Re: TLT Study - Inverting History

Post by Kbg » Tue Apr 30, 2019 7:51 pm

Yep. Let’s skip a rehash shall we. :-)
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Re: TLT Study - Inverting History

Post by Kevin K. » Sat May 04, 2019 9:54 am

pmward wrote:
Sat Apr 27, 2019 9:10 am
Another article that I came across today looking at the issue of bond returns going forward: https://movement.capital/analyzing-bond ... ded4b883a5
Thanks very much for posting this article.

Perhaps I'm drawing the wrong conclusion, but in reading this piece, the other article that the OP cited in starting this thread and other recent bond market analysis it seems pretty clear that with baseline Treasury interest rates so low and the yield curve inverted or close to it there's just not much incentive to hold T's with maturities much longer than a year or two. I understand and respect how the 30 year/STT barbell works in "normal" times, of course but with current 30 year rates at 2.93% (not even half a percent more than Tnotes) there's no way the long T's help in a flight-to-safety situation while any surge in interest rates would decimate them. Heck I don't even see any incentive to choose ITT's which would be the normal default choice (risk:reward sweet spot). I'm just not seeing a downside to keeping the entire bond allocation in STT's.
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Re: TLT Study - Inverting History

Post by pmward » Sat May 04, 2019 10:06 am

Kevin K. wrote:
Sat May 04, 2019 9:54 am
pmward wrote:
Sat Apr 27, 2019 9:10 am
Another article that I came across today looking at the issue of bond returns going forward: https://movement.capital/analyzing-bond ... ded4b883a5
Thanks very much for posting this article.

Perhaps I'm drawing the wrong conclusion, but in reading this piece, the other article that the OP cited in starting this thread and other recent bond market analysis it seems pretty clear that with baseline Treasury interest rates so low and the yield curve inverted or close to it there's just not much incentive to hold T's with maturities much longer than a year or two. I understand and respect how the 30 year/STT barbell works in "normal" times, of course but with current 30 year rates at 2.93% (not even half a percent more than Tnotes) there's no way the long T's help in a flight-to-safety situation while any surge in interest rates would decimate them. Heck I don't even see any incentive to choose ITT's which would be the normal default choice (risk:reward sweet spot). I'm just not seeing a downside to keeping the entire bond allocation in STT's.
Be careful. I literally just posted in another thread on this same subject. The fed is on record in their minutes discussing going negative on rates in the next downturn. There could very well be another decade or more left in the great bond bull market. Also, don't forget that if this doesn't happen and inflation and rates start to pick up a bit, gold, stocks, and short term treasuries would benefit. So any losses in long bonds would be made up and then some. There are still a lot of global deflationary headwinds at the moment, I sure as hell would not remove my hedge for that (long term treasuries) because there is a chance that long term treasuries will be *THE* asset over the next few years if these deflationary trends continue, and we get another recession forcing the Fed to go negative. Nobody knows nothing. Markets are not logical. Just because it seems like bond rates should go up, doesn't mean they will. And even if they do, you are hedged against it, and will be able to rebalance to claim more yield and buy more bonds for when the pendulum eventually does swing the other way again. The PP is not a speculators portfolio, where people buy and sell the assets based on where they hypothesize the future will go. The VP is for that. I like to hypothesize on these things for potential future VP bets, but I always make sure I am properly hedged in my PP and do not let my fears or opinions effect this part of my portfolio.
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Re: TLT Study - Inverting History

Post by Kevin K. » Sat May 04, 2019 7:48 pm

A couple of quotes from Jazon Zweig's synopsis of William Bernstein's "Deep Risk" (the best analysis of the PP I've read) come to mind:

"Deflation, the persistent drop in the value of assets, is extremely rare in modern history, Mr. Bernstein says. It has hit Japan but almost nowhere else in the past century, thanks to central banks that print money to drive up prices. The best insurance against deflation is long-term government bonds. Diversifying your portfolio into international stocks also helps, since deflation often doesn’t hit all nations at once.

While bonds protect you from deflation, they expose you to inflation — far and away the likeliest source of deep risk. Mr. Bernstein notes that inflation can destroy at least 80% of the purchasing power of a bond portfolio over periods as long as 40 years.
That is deep risk at its deepest — a hole so profound most investors can’t get out of it in a lifetime. That happened in, among other places, France, Italy and Japan from 1940 through 1979, Mr. Bernstein says.
The best insurance against inflation, he says, is a globally diversified stock portfolio with an extra pinch of gold-mining and natural-resource companies. Treasury inflation-protected securities, U.S. bonds whose value rises with the cost of living, also can help."

Bernstein points out that not all of the events the PP is designed to protect against are equally likely to occur (or equally devastating if they do) so allocating equal parts of the portfolio to each threat doesn't make sense. Tyler's Golden Butterfly is, it seems to me, a sensible way to tilt towards prosperity while diversifying the stocks in a simple way. On the bond side, from playing around endlessly on Portfolio Charts and looking at actual returns during market panics I see little advantage to the PP barbell over holding almost entirely ITT's with perhaps a year or two in STT's or a Treasury MM account.

Remember that Browne recommended gold as an inflation hedge when it isn't that at all (that's what the stocks are for). I still believe in including it in the portfolio for the reasons that Tyler mentions but I think that Tyler and Desert have shown that intelligently tweaking the PP in light of the many changes in the markets that have occurred since Mr. Browne gifting us with the PP can work well. Browne was a genius but "paper" gold, 30 year treasuries yielding less than short term and a government so dysfunctional it's willing to make treasury defaults into a political football probably weren't visible in his crystal ball.
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Re: TLT Study - Inverting History

Post by pmward » Sat May 04, 2019 8:05 pm

Kevin K. wrote:
Sat May 04, 2019 7:48 pm
A couple of quotes from Jazon Zweig's synopsis of William Bernstein's "Deep Risk" (the best analysis of the PP I've read) come to mind:

"Deflation, the persistent drop in the value of assets, is extremely rare in modern history, Mr. Bernstein says. It has hit Japan but almost nowhere else in the past century, thanks to central banks that print money to drive up prices. The best insurance against deflation is long-term government bonds. Diversifying your portfolio into international stocks also helps, since deflation often doesn’t hit all nations at once.

While bonds protect you from deflation, they expose you to inflation — far and away the likeliest source of deep risk. Mr. Bernstein notes that inflation can destroy at least 80% of the purchasing power of a bond portfolio over periods as long as 40 years.
That is deep risk at its deepest — a hole so profound most investors can’t get out of it in a lifetime. That happened in, among other places, France, Italy and Japan from 1940 through 1979, Mr. Bernstein says.
The best insurance against inflation, he says, is a globally diversified stock portfolio with an extra pinch of gold-mining and natural-resource companies. Treasury inflation-protected securities, U.S. bonds whose value rises with the cost of living, also can help."

Bernstein points out that not all of the events the PP is designed to protect against are equally likely to occur (or equally devastating if they do) so allocating equal parts of the portfolio to each threat doesn't make sense. Tyler's Golden Butterfly is, it seems to me, a sensible way to tilt towards prosperity while diversifying the stocks in a simple way. On the bond side, from playing around endlessly on Portfolio Charts and looking at actual returns during market panics I see little advantage to the PP barbell over holding almost entirely ITT's with perhaps a year or two in STT's or a Treasury MM account.

Remember that Browne recommended gold as an inflation hedge when it isn't that at all (that's what the stocks are for). I still believe in including it in the portfolio for the reasons that Tyler mentions but I think that Tyler and Desert have shown that intelligently tweaking the PP in light of the many changes in the markets that have occurred since Mr. Browne gifting us with the PP can work well. Browne was a genius but "paper" gold, 30 year treasuries yielding less than short term and a government so dysfunctional it's willing to make treasury defaults into a political football probably weren't visible in his crystal ball.
Eh I don't agree with a lot of this.

First, deflation happened in 2008 here, it's happening currently in the EU and Japan, and we are still having some deflationary forces at play here (which is why growth and inflation have both been anemic over the last decade). It would be foolish to pass judgement on the likelihood of deflation, especially since it is the current global trend, and our population is going to continue to exhibit deflationary pressures for at least the next few years to decade while the boomers retire and millennials come of age. And since it's a global trend... good luck with international diversification helping you here. International diversification benefits become less and less as global economies over time become more and more integrated. Did global diversification help in the deflation of 2008? Nope, even though the deflation started in the U.S. international diversification actually hurt you, as the international stocks (especially emerging markets) dropped more than the U.S. and have recovered slower.

Bonds do expose you to inflation risk... but it's only 25% of your portfolio. The other 75% would benefit from an uptick in inflation. I don't disagree with the fact that over long periods 10 year treasuries tend to perform similar to the barbell, but I still think the barbell has benefits in the shorter term (with intermediate you expose 50% of your holdings to inflation risk, and LTT's provide a bit more oomph in a deflation) and is more flexible as the cash holdings give you some optionality (treasury bills, short term treasury notes, I-bonds, corporate short term debt, CD's, TIPS, etc).

As for gold and inflation... we all know that gold is not correlated to "inflation", gold is correlated to fear. Aside from periods of fear gold marches to the beat of it's own drum, sometimes going up and sometimes going down. But in times of fear (like high inflation) gold will shoot up and can be counted on.

Stocks are *NOT* an inflation hedge. Slightly increasing inflation within the normal ranges is good for stocks. Fast increasing or high inflation is not. Look at the 70s in the U.S. as an inflation adjusted chart to see how bad of a beating stocks took that decade. A nominal chart hides the true destruction. Also, see any country ever that went into a hyperinflation, stocks lose substantial money in real after inflation terms when inflation is high and/or increasing fast.

Modifying the PP is ok if your intentions are good. The principles matter much more than the exact 4x25 weighting’s. Desert swapped the barbell for intermediate (simply for simplicity is my understanding) and then did approximate risk parity on the weightings. Tyler in the golden butterfly did a PP with a 20% built in VP in a passive SCV tilt. I think these are fine, but their decisions to make these changes were not based on fear, greed, or what they expected the short to medium term trends in the market to be.
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Re: TLT Study - Inverting History

Post by Kevin K. » Sun May 05, 2019 9:18 am

Thanks for the wise perspective pmward! I really appreciate your thoughtful comments.

This article from just 4 days ago from Schwab supports what you and others here are saying about the dangers of going to only short duration bonds. They're not proposing barbells or ladders that go out to 30 years but I can see why a barbell of STT's and ~7 year bonds would be appealing.

https://www.schwab.com/resource-center/ ... ve-is-flat
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