When I wrote yesterday’s post I realized there is a fundamental flaw in the FIRE model. Yesterdays post had to do with changing the AA and moving the portfolio onto the efficient frontier, and it’s effect on portfolio success. By eliminating a class of stocks (global) and putting that money into bonds we saw an amazing change in the risk of the two portfolios, defined as % success. Why did this happen? How can selling stocks and buying bonds improve things so dramatically in terms of success?
You read the FIRE literature and all you read is the “magic of compounding”. Compounding has a specific mechanism. You take some “interest” add it to some principal, wait a year take some slightly larger “interest” add that to last years portfolio and the thing grows!
Here is $1000 over 10 years @ 7% interest. It nearly doubles to $2000 and every time you plunk $1000 into a 7% money machine for 10 years it will grow to $1976.15. There is a specific investment called a zero coupon bond that works exactly like this. If you buy a $1000 10 year 7% zero coup in 10 years you will get $1967.15 for your trouble. A bond is a contract that pays out in money and a low risk of failure. This is the magic of compounding! A mortgage works like this. You borrow $200K on a 15 year mortgage for a house and at the end of 15 years you have a piece of property you paid $360,000 for, (excluding tax write off etc.) The property may be worth more or less or equal to $360K, but that is independent of the loan. If you’re the mortgage lender you’re the recipient of the magic of compounding! A bond’s value can be directly calculated at any time and is fixed. There is a market in bonds, but if you just hold to maturity it is what it is. You’re bond at maturity becomes promised cash. Income on bonds are taxed as ordinary income unless the bond is a special deal like a Muni bond. The bond aspect of your portfolio uses the magic of compounding to inflate it’s value.
A stock is a piece of property. It’s like the house. You pays some money and gets some property and you owns he property. You don’t own money. What sets the value of your property is the market, so the value floats up and down on the market, but that value is not money unless you sell it. If the asset appreciates it’s called capital gain and if depreciates capital loss so it’s taxed in a completely different way indicating it is not using the magic of compounding to inflate it’s value. It’s using the market to set it’s price. Like the value of your house, you hope a stock goes up in value but there is no contract assuring that like with a bond. Stocks offer return based on profits. Basically you take a raw material or service add some value and sell it at a higher price, but that profitability rides on the waves of the economy. Generally economy good, profit good, economy bad, profit bad, but also stock price is based on management’s ability to execute and creative destruction, inflation, the cost of money, the cost of labor, the cost of logistics, aka the cost of commerce. So stocks are risky. There are a lot of variables and variables vary.
When you own a portfolio and you are not adding or extracting you basically own a fixed amount of property. This is an important concept. Regardless of the “value” of a share which is set by the market, if you own 1000 shares you own 1000 shares, same as if you own a house you own a house. This is why in a down market if you don’t sell there is a chance to recovery because the property stays constant. This is why I see little difference in Real Estate and stock investing. Real Estate throws off cash flow, stocks throw off dividends. Real estate can be leveraged so can stocks. Real estate can be depreciated stocks can be tax loss harvested. Real estate can be used as collateral for a loan so can stocks in several forms for example covered calls. The value of real estate is market and economy driven, same with stocks. Some difference like liquidity and carrying charges and efficiency and correlation but more alike than different from my perspective. There are some tax breaks in the law for real estate but without the breaks profits would/will get taxed as capital gains.
When you open a portfolio and start deflating it, now value is being drained from the portfolio. It is no longer a bobber floating on the economic waves but starts to loose value. If the economy is good the value is high and you can slice off a little and sell high. If the economy sucks you sell low, but sell you must because you need some hamburgers to eat. High or low the portfolio has converted some of its property into money. You may say dividends! dividends! When the portfolio was closed those dividends were being reinvested into more property, when open that value is coming out and dividends are still floating on the economy. They may last a while but eventually will falter in a down economy. This is not the magic of compounding. Let’s look at a couple graphs:
The magic of compounding!
You go SEE SEE the market goes up!! Except when it doesn’t You had to buy hamburgers in the years surrounding 1995 and 2003 and 2009 so sell low. Sell low = bad SOR. What’s the mean?
Not much magic here. Good old fashioned commerce with it’s concomitant risk and FED manipulation and money printing but no magic of compounding. The magic of this chart is you and your neighbor getting up every day and being productive. That’s the magic in stocks. American productivity and capitalism. So that’s why the 80/20 portfolio failed so much more than the 50/50 portfolio. It’s all been “magic” since 2009 but that trend line is calling for it’s pound of revision. In a balanced risk adjusted 50/50 portfolio half the assets are exposed to the compounding magic, in a 80/20 only 20% is exposed to the compounding magic. If you’re 80/20 you best be about protecting policies that encourage the magic of capitalism and productivity.
6 Replies to “SOR”
I’m curious on how this principle changes when discussing bond investing as part of a bond mutual fund vs an individual bond.
Your example makes sense with an individual bond which you can hold until maturity and get cash value. For me it gets a little hazy when you own a collection of bonds in a bond fund. Say the intermediate term vanguard bond fund. With this fund so they hold individual funds in maturity or do they trade them out and pick up new ones when it falls out of the required time horizon for that particular bond?
Bonds are a little different than bond funds. You can evaluate a bond down to a bp. You can know exactly the value of what you own. A bond is a loan, a precisely specified contract. Own a bond you’re a loaner, own a stock you’re an owner. There still is a market in bonds however. Let’s say you buy a $1000 10 year treasury at 3%. If you hold it for 10 years you will get $1300 – taxes. That’s the contract. Tomorrow the treasury issues a 10 year with 3.5% yield. That contract is worth $1350 – taxes (which are slightly more due to progressivity). You can precisely evaluate what to buy and given the two you would buy the 3.5% contract, more bang for same buck. Let’s say you need to sell your 3% contract. It’s not worthless it’s just worth less. To sell the 3% you need to offer your contact at a discount, and so you do. The discounting is a market mechanism and your contract is worth what someone will pay you, same as a stock deal or a real estate deal or a William DeVane “what’s in your safe” GOLD! deal, but the value of the bond is precise and the market is pretty efficient so you will probably get a little less than expected but you get out of the contract. Let’s say instead of 3% the next day bond is 2.5%. Now your contract is at a premium and you can sell at a gain. This is why bond price moves opposite to interest in a market. There are all kind of bond mutual funds. Managed funds try to discover and arbitrage pricing anomalies to maximize profit and charge you a management fee. There are all kinds of different issues you can buy like corporate debt treasury junk foreign mortgages combinations and these issues carry different risk of default. In addition bonds can be levered with derivatives like credit default swaps and “insurance”. If the risk is mis-priced you get 2008. Claimed AAA paper that’s actually BBB You can’t “own” a McMansion and 2 new cars, and a boat, and 1st and second mortgages and student loan debt on a cabbies salary. Fanny and Freddy thanks to Barney Frank and sub prime lending were throwing money at bad risk and guess what it failed. So that kind of explains risk in bonds. A similar thing happened in 1978 when Carter signed legislation that unhooked S&L interest from prime and suddenly S&L’s became credit card companies and inflation went out of control. There were other causes IMHO like a rapid expansion of money due to “woman’s liberation” meaning the women all went to work but none the less the point is bonds carry risk apart from the razor logic of the calculations.
Bond funds typically do not hold the bonds to maturity. Active funds look for highest yield and are like active mutual stock funds. Index funds seek to follow an index and as such are cheap to manage. Funds capture both interest and market action and are diversified across risk classes. You can choose a fund based on it’s risk reward characteristic same as a stock. VBMFX has an expected return of 4.74 and a SD of 3.39. I did an analysis of 10 year treasuries and over the past 20 years average (to 2018) and return was 3.9%. If you’re WR is 4%, 4.74% (VBMFX) pays your WR plus an excess 0.74% at quite low risk compared to stocks. The risk of VTSMX is 15.24. Also bond funds are liquid, so you can move value in and out and can re-balance your AA or change your risk profile at will. They have an effective 0% correlation with stocks most the time. This past year as interest went up bonds went down as well as stocks, but that distortion IMHO is due to the FED easy money policy. VBMFX is down 2.98% ytd, VTSMX down almost 8% ytd, VGTSX down 17.21% ytd. That’s the “three” of the BH3 which one do you want to sell to buy your hamburgers for next year?
This is why stocks have become unstable. When the FED had it’s boot on the interest rate forcing it low, stocks became the only game in town despite their high risk. Stock prices became inflated as evidenced by the regression to the mean chart. People got used to the risk but have not suffered its vengeance in the past 9 years. Bonds also became inflated since interest was held low and as interest goes low bond price goes high, so we have both asset classes inflated and both will regress to the mean. As bond prices regress yield will improve. As interest rates go up, bonds will become a more attractive deal and stocks will get sold down, regressing to the mean as people move their money to higher yield lower volatility bonds. Bonds are less risky so their value loss will be smaller going forward and their return will increase so even in regression to the mean bonds are a relatively safer way to buy hamburgers. The S&P in real terms over the past 18 years has returned a growth of only 3.5%/yr and a 2% dividend at a 15% volatility. The volatility is what creams you because of SORR. You are forced to sell low to buy your hamburgers to live on. A bond fund with it’s far lower volatility paid 4.74% and in excess of the 4% WR. If you’re 80 years old and having your 4% WR needs covered what deal sounds better to you, the high risk deal or the low risk deal? The high risk deal failed 13 times, the low risk deal failed basically once. The high risk deal was 100% out of money at year 27 on the 10% SOR curve. The low risk deal had more money in the bank at 30 years than when you started on the same SOR curve. This calculation was done using VBMFX as the bond.
(I can’t believe I puled this one out and only about 1000 words! Explaining bonds is a bit hard)
Investors stress that we can’t “time the market.” Although that is true, there is also a pattern of “reversion to the mean.” When greed is strong and P/Es run high we know it won’t last forever.
I would be concerned about starting my retirement right now because of the potentially devastating effects of SOR risk. A big decline at the start of retirement can be disastrous.
We actually “time the market ” all the time. If you have a big wad to invest and you dollar cost average you are timing the market, but what you are really doing is changing the AA from less risk to more risk. This is why waiting to invest is a bad idea. If you have money put it in. You can’t make money if your’re not invested. If you lower your WR in retirement in a down market you are timing the market. When you re-balance every year or so you are timing the market in a mechanical way. If one asset goes up you “sell some high” and store some of the excess value for a future time when the market is down so you can “buy low”. The mechanical nature of the system keeps “you” from making a mistake. The process also keeps your risk constant. I’m not passing judgement on timing just pointing out we do it all the time, and even include timing in our plans all the while denying being a market timer. Personally standing there and letting the market clean your clock when you can reduce your risk I think is silly. There are ways to stay fully invested without suffering the full onslaught of a down turn but you can’t do it shooting from the hip, or selling out low. It requires a specific plan.
I came up with a system to protect yourself if you retire into a down market and that is to have your portfolio have 2 pieces, one an insurance piece and one the portfolio in the main. I wrote a post on XRAY’s site about it. The upshot is you have a pot of money that does not bear market risk, that you can substitute for portfolio SORR. It turns out you really need only 1 small pot of insurance money to cover you in early retirement. If you don’t use it then convert it into your late in life, “lifeboat” I’m actually doing this while I’m Roth converting. I’m living on cash from stocks I sold near the market peak. This closes my portfolio to SOR for the next 5 years while I spend down the cash and do my Roth conversion. I’m also timing SS and allowing it to max out while living on my cash. At 70 my cash stash will expire and SS will start, so I’m living the “nightmare scenario” in a relative pocket of safety. In addition I’ve reduced my AA to something closer to 50/50 for the next several years. The real academic studies (not the bogglehead bla bla bla) which I have read have shown portfolio longevity is affected by what I call epochs, periods where you achieve specific portfolio milestones based on longevity and not based on slavishly maximizing profit without equal consideration of risk. The recommendation is to reduce the AA to 50/50 in the 10 year period peri-retirement, 5 years before and 5 years after. 5 years before preserves portfolio value as you glide into retirement if you happen to hit a bad SOR. 5 years after retirement you are closer to death so your portfolio needs to provide for 5 less years of income, reducing your risk of failure. The older you get the less likely it is a portfolio mistake will have time enough to manifest in a way to take you out, which is why early SOR is the real killer. Your mistake has a long time to manifest.
If you look at the analysis from this article, you see the benefit of risk adjusting the portfolio as you open it to withdrawal. With the Monte Carlo calculator you can actually add the worst SOR first, up to like 10 years and see how bad times affect longevity in a quantitative way. It dramatically might change one’s thinking about what actually IS FI and RE and how some simple changes, done some years before dramatically changes the “sleep well at night” aspect of retirement. The key is to allow interest to accumulate, which takes years, and do things like tax loss harvesting when expedient which takes proper timing. When I sold my stock for “to live on money” I saved $120K in cap gain taxes, from tax loss harvesting I did back in late 80’s, 2000 and 2009. $120K tax saving is a free year of retirement.
People tend to use Future Value calculators as their projection tool and that’s woefully inadequate IMHO. It completely misses SORR. Monte Carlo does not. It’s also about budgeting correctly as well and living within one’s means but FIRE types are used to that. Here is my article on epochs
Whoa. I am getting used to your responses being more thorough than many folks full post.
I have structured 4 portfolios.
1) Retirement portfolio- no/ minimal market, longevity or inflation risk
2) Estate Portfolio- holds investments for a 20 year old and all passed on with zero taxation.
3) Risk Portfolio- This is my 60/40 portfolio likely forever in my Medical Corporation.
4) Taxable Portfolio- a Personal portfolio to spend all dividends NOW.
Plan is to build a broad market index portfolio large enough that I can live off the dividends like any cultish dividend growth investor. ?
These responses are the purview of a low volume non commercial blog, plus they are things I want to point to. Add tax loss harvesting and your plan = perfection MB HNY