- In asset allocation, what is the importance
of short-term bond vs money market in the context of risk/return ratio?
-
A: Most investors are familiar with the concept of the
yield curve: in normal times, the longer the duration of a bond, the higher its yield
should be. But, most investors haven't considered that while the yield moves up nicely
from one day to about two years, there isn't much more yield gain between the two-year and
thirty-year points! Even a large change in interest rates will have no impact on the value
of a 30-day Treasury bill, but a very small change in interest rates will send the value
of a 20-year Treasury bond gyrating. So, risk increases dramatically as a bond's duration
increases.
When interest rates rise, long term bonds tank. But short-term bonds
hold their ground, and actually yield more as they are re-invested! The shorter the
duration of the bonds, the less they give up in capital value, and the sooner they recover
to par. After two years, we don't get much in the way of additional yield or return, but
risk keeps goes up rapidly. So, two years appears to be about an optimum point during most
market conditions.
Bottom line: If we are willing to extend our durations to
about 1-2 years, then we can pick up about 1% in yield without exposing ourselves to much
in the way of additional risk. After that, risk rises too fast to be attractive.
Can I reduce the risk for given return in a
portfolio without investing in any bond?
from Sundar
Q: Can I reduce the risk for given return in a
portfolio without investing in any bond but in various equities (large, small, growth,
value, international, emerging, and reits) and money market funds in the ratio of 80/20 or
75/25?
I would like to maintain the portfolio even during retirement
without any bond funds but money market (20 or 25%) marked for required annual withdrawal
for 3 to 5 years ahead and readjust the portfolio periodically. Is there any potential
danger or pitfall?
A: In the old days, retirees were urged to
invest in reits, bonds, convertible bonds, and utilities. These investments were
considered "safer". That was before Modern Portfolio Theory demonstrated
that by mixing equities with high risk but low correlation to one another the resulting
portfolio would contain less risk than a "safer" portfolio while generating a
higher return. So, attempts to tailor portfolios by selecting "safe" assets do
not result in optimum performance.
You can use either short term bonds, money market funds, or CDs for
the portion of the portfolio that will store value for future income withdrawals. As
previously discussed, I believe that short term bonds perform very well in this role.
Whatever you use in this function, have enough to provide for several year's withdrawals.
Then re-balance as required.
I generally advise retirees to have from five to seven year's income
needs in these very liquid assets. So, if you were going to withdraw about 6% per year, I
would think that a 70/30 or 60/40 mix would be appropriate. Of course, if you are going to
withdraw less, than the proportion of equities could be higher.
The risk is that in a sustained market decline, you won't have
enough liquid assets to wait it out. Then you will be forced to sell your equities while
they are down. In the very worst case, the fund will begin to self liquidate.
How can I assure myself high rates of returns
on my mutual funds?
from Robert
Q: How can I assure
myself the returns for mutual funds that are so frequently quoted (i.e., 12%, 20%, etc.)?
How can I know if these rates will stay steady for the next 20 years to build a large
profit/savings?
Also, why are there so many types of mutual funds? It's kind
of confusing for me.
A: Several hundred years of history and
data indicate that markets have positive expectations. There were active grain futures
markets in Amsterdam one hundred years before Columbus sailed! And, the data is available
today for us to study.
Markets and segments of markets work very well to reward investors
for making capital available. Higher risks are associated with higher returns. If we
examine the additional return that a market segment generates over and above the risk free
rate of return, we can identify the market segment's risk premium. In real terms that risk
premium has been shown to be remarkably stable over time. For instance, there is no reason
to believe that small domestic value stocks will suddenly begin to return less than
quality corporate bonds.
Of course, we are talking about longer periods of time. In any one
year period, just about anything can happen. But over ten or more year periods, the
results sort themselves out pretty reliably.
So, it's a pretty good guess that markets will continue to reward
investors for the risks that they accept. Nobody can guarantee that that will happen, but
there seem to be strong economic reasons for the trend to continue. If you are a
capitalists, you have to believe that it will. If you believe that, one of the best ways
for you to profit from the system is to purchase equity mutual funds.
There are many different markets, and many market segments in the
world. Moreover, there are different strategies used by investors to attempt to
maximize their profits in each segment. So, different funds allow investors to mix
markets, market segments, and strategies to form the portfolios that they believe meet
their needs.
Finally, there are lots of fund companies, and over 8500 non money
market funds trying to distinguish themselves to investors. So, creative fund labels
sometimes appear for marketing purposes. For instance, there may not be a lot of
difference between a growth and income fund, a balanced fund, an asset allocation fund, or
an equity income fund. So, if you are confused, you can bet you are not alone!
What funds are suitable for young adults?
from Evelyn
Q: I am 18 (adult in Florida) and looking for
a mutual fund that might have some programs for young adults. I've heard of the Stein Roe
Young Investor Fund but have not really been able to explore other options. Please help me
look for a mutual fund which is suitable for me.
A: Of all the factors that investors should
consider, age is one of the least important. First determine your objectives, time
horizon, and risk tolerance. This will go a long way toward helping you zero in on
suitable funds.
Next, look at sales loads, operating expenses, diversification,
style, investment techniques, track record, returns, management, minimum purchase amounts,
availability at the various discount brokerages, and other features.
Incidentally, the Stein Roe
Young Investor Fund is a growth fund whose chief claim to fame is that if you make
automatic investments, you can open an account with just $100. This may be an important
feature to many young investors. But you pay for the feature. Returns have been decent,
but expenses are 1.5% per year, a little on the pricey side.
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