Exiting the PP

[melveyr]

Are the 5 year bonds held to maturity or do you roll them over? Is it a ladder?

I also have some reservations about the barbell. I think an intermediate term fund with the same duration as the barbell will offer higher expected returns with the same level of risk. However, I like that the barbell allows for more surgical placement of funds (for example holding LTT in tax deferred but using I-bonds and EE bonds as cash in taxable). Because of the free lunch aspects of EE/Ibonds and the tax advantages, I think the barbell can still make sense for me.

Additionally, if there was one change I would make to the PP it is a slightly lower gold weighting. Historically gold has had the highest covariance to the portfolio, indicating that the PP hasn't been balanced in the past and might continue to be gold heavy in the future. I think 10% is below the balanced weighting required, but perhaps balance isn't everything for you.

In summary, your portfolio seems very reasonable!

[MachineGhost]

I'm interested to hear your feedback on this change. I hope I won't be tarred and feathered for this blasphemy.

It makes sense to me.  It has essentially the same return and slightly more risk than the targeted risk parity PP I'm currently implementing.  It makes sense to shorten the duration of the LT bonds and preserve cash as an asset to head off a nasty interest-rate rising future.

[melveyr]

Also, just to make it clear.... Barbells do better in a rising rate environment than a bullet portfolio of the same duration. You might want to have a bullet bond portfolio for expected return reasons, but to do so because of fear of rising rates isn't quite appropriate.

http://en.wikipedia.org/wiki/Barbell_strategy

Note, this is assuming a parallel shift in interest rates (the shape of the curve not changing).

However, with the barbell portfolio you end up paying up for this privilege. This is why the sharpe ratio of bond returns decreases as you go out on the yield curve. I have gone back and forth on the bullet versus barbell debate about and what it means for the PP, and the barbell is still the winner in my mind because I can get above market rates for cash like instruments because of EE bonds and I-bonds and so I wanna grab that free lunch!

[dualstow]

After a little more than 4 years in the PP, I've decided to exit the PP and go with the following allocation:
60% 5-year Treasuries
10% Total Stock Market
10% Small Cap Value
10% Physical Gold
10% Cash (all I Bonds)

This kind of reminds me of Swedroe's Minimizing Fat Tails portfolio. Though not an exact match, it's got the 60% in 5-Year Treasurys and a very small allocation to stocks which includes small value.

I've been very interested in such a portfolio lately, although I do plan to stick with pp for the next twenty years, which is almost retirement age. Both your portfolio and the pp are attractive to me for the same reason. Though stocks are more "fun" and offer more potential upside, these portfolios look like they will suffer smaller drawdowns.

What I would like to know is, are you still in the accumulation stage, or are you "done"?

[Ad Orientem]

I think your portfolio is not unreasonable, which is to say it's not something that would keep me awake at night. That said I do think you are a tad light in inflation insurance. If you are only going to go with 10% gold I think you need some added currency diversification somewhere else. I would suggest just lumping all of your stock allocation into VT or alternatively 10% VTI and 10% VEU.

Edit: Typo

[MachineGhost]

MG, what allocation are you thinking of with your target risk parity approach?  And I can't remember, would the portfolio weights adjust with the moving average of risk (volatility)?

Stocks: 18.81%
Bonds: 33.65%
Gold: 6.45%
5yr Ladder: 39.39%

The weights should not adjust unless we have another 1981 or 2007-style deflation that triggers new lows.  With a portfolio this fixed income heavy, it doesn't pay to reduce the bond's duration as the return will be lowered at a higher rate than the risk is reduced.  I guesstimate the effective duration is about 20 years if you can just average both ends of the barbell to get it.

In reality, I will be using I-Bonds in place of the ladder and reducing the duration of the bonds to under 5 years until I see some hard proof I can time the ins and outs of LTs.  I assume we're all aware that the biggest bubble in history is gong on in bonds right now.

[melveyr]

MG, what allocation are you thinking of with your target risk parity approach?  And I can't remember, would the portfolio weights adjust with the moving average of risk (volatility)?

Stocks: 18.81%
Bonds: 33.65%
Gold: 6.45%
5yr Ladder: 39.39%

The weights should not adjust unless we have another 1981 or 2007-style deflation that triggers new lows.  With a portfolio this fixed income heavy, it doesn't pay to reduce the bond's duration as the return will be lowered at a higher rate than the risk is reduced.

In reality, I will be using I-Bonds in place of the ladder and reducing the duration of the bonds to under 5 years until I see some hard proof I can time the ins and outs of LTs.  I assume we're all aware that the biggest bubble in history is gong on in bonds right now.

How are you generating these weights? From a risk parity perspective it looks extremely light in gold. Also are you going for equal risk contribution between "asset classes" or between economic environments?

[MachineGhost]

How are you generating these weights? From a risk parity perspective it looks extremely light in gold. Also are you going for equal risk contribution between "asset classes" or between economic environments?

Well, I'm reducing the risk parity portfolio by 65% to get to my risk target.  I'd say I'm going for equal risk between the asset classes, not the environments.  If I was to do it by environments, I would do it by their past occurences, not risk.

[Reub]

So then are you saying that the PP doesn't work?

And was HB wrong when he said that timing was impossible?

[Reub]

In this article, Gary Shilling warns of future deflation:

http://www.bloomberg.com/news/2013-03-2 ... ation.html

Is anyone certain that he is wrong?

[Pointedstick]

Sounds like basically a bet against deflation or serious inflation. I sympathize and have anti-deflationary worries myself, but I don't think it's the right time to sell the bonds if you're nervous about rising rates. The Fed has made itself pretty clear about suppressing rates until unemployment is much lower, and I don't see a real recovery underway. When rates start to rise, I think it'll be pretty obvious.

[MachineGhost]

Here's what I know about timing.  Do not listen to any human being.  Listen to the math.  Only math is the language of the universe and is objective.

Nate Silver proved this.  Twice.

[Tyler]

But when the math consists solely of poorly-fit regressions of past human decisions, even equations are unpredictable. The stock market is a psychological human construction and not a law of nature.

[moda0306]

Also, just to make it clear.... Barbells do better in a rising rate environment than a bullet portfolio of the same duration. You might want to have a bullet bond portfolio for expected return reasons, but to do so because of fear of rising rates isn't quite appropriate.

http://en.wikipedia.org/wiki/Barbell_strategy

Note, this is assuming a parallel shift in interest rates (the shape of the curve not changing).

However, with the barbell portfolio you end up paying up for this privilege. This is why the sharpe ratio of bond returns decreases as you go out on the yield curve. I have gone back and forth on the bullet versus barbell debate about and what it means for the PP, and the barbell is still the winner in my mind because I can get above market rates for cash like instruments because of EE bonds and I-bonds and so I wanna grab that free lunch!

The tie breaker for me on all this is the fact that the yield curve is so steep. With 30 year bonds yielding 2.4% higher than 5-year bonds, and 5 year bonds about .7% higher than t-bills, a barbell strategy fits my biases best.

I get where Desert is coming from, but I personally would be much more apt to simply reduce my long bond allocation but go longer an do a barbell rather than invest in a lot of these mid-term bonds with yields much closer to 1 month rates than 30-year rates.

In a flat curve environment, I'd be much more attracted to a shorter average duration and bullet strategy.

[Tyler]

BTW, your portfolio seems well thought out, Desert.  I can't fault you for being concerned about rising rates.

Personally, I like the PP/VP distinction for forcing me into quantifying my confidence in my ability to time the market. The more confident I am, the larger the percentage I put in my VP. For the record, I'm currently at 0% in the VP. .

But I can see having a bit of VP cash and stocks at some point when rates really do start to rise again. Whatever helps you sleep at night.

As an aside, it seems there has been a bit of career change talk on the forum lately. I remember reading some good advice (from Work Less Live More, I think) to never make huge life decisions right when you switch or walk away from a career.  Making big decisions (moving, relationships, money) while you're clearly stressed and in mental transition can too easily become knee-jerk reactions that you regret later. Take a few months to decompress and avoid pressuring yourself to figure everything out up-front.

[sophie]

After a little more than 4 years in the PP, I've decided to exit the PP and go with the following allocation:
60% 5-year Treasuries
10% Total Stock Market
10% Small Cap Value
10% Physical Gold
10% Cash (all I Bonds)

I agree with pointedstick and moda:  there's not much protection against deflation.  It looks like you're betting that the Federal Reserve will change course in the near future.  It might, but it's still a bet.  Regarding serious inflation, this portfolio might do ok even with the small gold allocation, because the yields on cash and lowest rungs of the treasury ladder will increase in lock step and the top rungs of the ladder won't lose too much.  You might try back-testing this during the late 1970s.

I was also wondering how you'd rebalance.  With those 10% allocations you'd probably make it an annual event rather than use bands.  The I-bonds, gold, and 5-year ladder would all be a bit awkward to manage, should you be rebalancing out of them before retirement.

[Kshartle]

Real rates on 5 year treasuries and cash are solidly negative. You're basically surrendering purchasing power without a fight to the counterfeiters to avoid volatility. Holding this for the long-term will be a big loser. Bernanke has promised to keep rates low and not pay attention to inflation. In fact, the stated policy is now inflation rather than stable prices. Take him at his word. Every day the financial media is trying to convince the population that inflation is good.

As far as people thinking this is not sufficient protection against deflation....well I disagree vehemently. That's all this is. Deflation is the best possible scenario for you here. Ohhh sure in nominal terms you might lose a few percent....maybe 10 or even 20. But if that's the case you'll still be in a great position to pick up stocks at rock-bottom prices. You might be able to buy corporate bonds paying high interest rates also. So even though the total amount of dollars might decrease the purchasing power would be up substantially. This is all provided the government makes good on its promises to bondholders. Unless they slash the budget by a trillion or more they can't do it without inflating. I think they will eventually be forced to cut the budget but we'll see.

This is fine if you've got about 5-7 years left to live and you are drawing down your assets to live on without much intention of passing anything on. If you've got any kind of medium time horizon well.....why on Earth would you put so much money into essentially negative yeilding assets?

[MachineGhost]

Kshartle raises a good point.  It would be more robust to construct a lower volatility portfolio by focusing on real returns rather than nominal.

[Kshartle]

Inflation is the big wildcard. The whole idea of investing is to guard your purchasing power and maybe grow it if you can handle more fluctuation. ST bonds just aren't doing that right now. I really wish they were but they aren't. I remember getting my paychecks from little Ceasars in the 90s and buying 2 year CDs paying 6%!!!!

6 freakin percent! I was a teenager and I thought this was the greatest concept in the world.

The Central bank is ruining lives. It's transferring the wealth of anyone holding paper to the bankers, the politicians and welfare leeches. That's why I'm all in on Gold and stocks. But I'm only 34 and earning the most money in my life. No kids no mortgage and no wife, girlfriend makes plenty and we save 3-4k a month at least. So I have the luxury of not caring about short term market movements. I know everyone isn't in the same position. I imagine in 20 years I'll be making moves to smooth it out a little more.

[dualstow]

...
I'm all in on Gold and stocks.
..
I know everyone isn't in the same position.

Eesh, you can say that again. I was nearly 100% in stocks at 34, but nowadays I'd take Desert's portfolio, including "surrendering purchasing power without a fight to the counterfeiters" over all stocks or all stocks/gold for sure.

[Kshartle]

It's not that volitile. It's much less than either of them separately. Especially in this money-printing environment. Bernanke is trying his best to keep the dollars flowing to me.

[Pointedstick]

As far as people thinking this is not sufficient protection against deflation....well I disagree vehemently. That's all this is. Deflation is the best possible scenario for you here. Ohhh sure in nominal terms you might lose a few percent....maybe 10 or even 20. But if that's the case you'll still be in a great position to pick up stocks at rock-bottom prices.

There is a little voice in my head constantly saying the same thing and I'm not sure whether it's a genius or a gambler. Or maybe both.

I really agree with you that deflation is a good thing as a consumer. Your dollars rise in purchasing power! It's even better if you're also out of debt. But deflation is ruinous to the stock market, and business in general. If it's a quick period of deflation, then yes, you have the opportunity to buy stocks at a nice discount if you're a shrewd market timer or your stocks fall far enough to hit a rebalance band. But what if the deflation persists stubbornly for years?

Stock- and gold-heavy portfolios in Japan--the best modern example of serious long-term deflation--have been utterly devastated. The stock market has lost 75% of its value since 1990. Gold priced in Yen lost 50% from 1984 to 2004, and was flat or losing for 14 years starting in 1990. A stock and gold heavy portfolio like yours would have been just ruined, year after year after year.

[Kshartle]

Everyone is worried about some Japanese style long-term stock market decline. First off, the Japanse market went up about 300% in six years or so. A lot of the decline was just reversing the prior gains. The US market hit an all-time high back in 2000 (inflation adjusted). So we haven't done anything for 13 years already. If you're worried about stock duldrums for decades then take the less risky approach and diversify globally. I know we've been through this time and time again on the board. I've still never heard a logical reason why you'd restrict yourself to the stocks of one country but hey, if you want that risk you can have it.

I am heavily invested abroad. It's pretty much all in Vanguard ETFs. On the other side I've got gold and half as much silver. It's all ETFs (I know, shame on me. I've really, really got to change this). I made a sizble move into GDX at $42 per share and doubled down in the high $36s. I'm hoping the bottom is in but either way these stocks seem ridiculously low.

Outperform the PP? Depends on what you mean. No question it will be about twice the volitility. I'm 99% certain the long-term return will be much higher. The inflation protection means I sleep well at night. Deflation is not scary to me. Let it crash. We have too much business and economic activity being driven by inflation. It would be good to fix the economy rather than go from bubble to bubble. I welcome it and know we'll have it at some point. The government will probably just come in and dump more cash on us though so the drops will be temporary. Deflation would not hurt bad except that the government will enforce wage and price controls and effectively ban a lot of activity that can't be sustained at higher prices.

Stocks and precious metals and I say bring on the deflation. Bernanke has sworn to resist it so it must be good for us.

[Ad Orientem]

I am an advocate of having some international exposure in stocks.  It adds insurance for both deflation and inflation since both tend to be currency specific events. But aside from that I am pretty much just doing the old 4x25% thing. I just split the stocks between VTI and VEU.

[iwealth]

Also, just to make it clear.... Barbells do better in a rising rate environment than a bullet portfolio of the same duration. You might want to have a bullet bond portfolio for expected return reasons, but to do so because of fear of rising rates isn't quite appropriate.

http://en.wikipedia.org/wiki/Barbell_strategy

Note, this is assuming a parallel shift in interest rates (the shape of the curve not changing).

However, with the barbell portfolio you end up paying up for this privilege. This is why the sharpe ratio of bond returns decreases as you go out on the yield curve. I have gone back and forth on the bullet versus barbell debate about and what it means for the PP, and the barbell is still the winner in my mind because I can get above market rates for cash like instruments because of EE bonds and I-bonds and so I wanna grab that free lunch!

Melveyr,

I think I've seen you mention this before and I just want to confirm. For someone with limited tax-deferred space, assuming overall duration of bond holdings is the most important factor (notwithstanding the barbell vs. bullet debate), would one benefit from using zero coupon bonds (EDV) in tax deferred space and balance out the duration using either cash or short term-treasuries in taxable?