"Paul Michael Brown" <pmb[at]his.com> wrote
- quote -

I think there's nothing wrong with probing how truly risk
tolerant a person is when trying to assist them. It's
probably a very good idea to do so.

But this point Tad and you are making seems to me to reject
the very important premise of Will's question: 'If a young
investor is truly highly risk tolerant... ' You both seem to
have gone off on a tangent: What if the young investor is
not truly highly risk tolerant, and here's why he may need
some second-guessing. Again, no problem with raising that
point. It's just not responsive to Will's question, IMO.

Will, I responded to your latest post responding to my post,
but the moderators are all powerful, and they're not getting
through. I think we've fallen off the same page, anyway. Or
perhaps we're having a minor semantical difference in how to
say to a young investor that 100% stocks is a very good
bet--but not a sure thing compared to holding some
bonds--for the long run.

Tad Borek (pithy and didactic as ever) recently opined:

- quote -

In my view, this is a key point. As others have noted elsewhere in this
thread many investors CLAIM to be "aggressive" or "risk tolerant," but
when the losses come they panic. I've noticed this among people I work
with who come to me for advice re investing strategy. Even though these
people are *extremely* well educated, and despite the fact they are
handsomely compensated, they have a remarkably low risk tolerance. I can't
count the number of times these people come to me and say they saw on TV
that equities had a bad day and they propose to move big wads 'o money
into low risk funds. As Tad explains, it's probably worth it to sacrifice
total return if having some money in bonds will help our hypothetical
young investor stay the course. After all, the whole idea behind saving
for the future is to INCREASE your confidence level. If you asset
allocation makes you crazy you need to change it. Finally, I'd note that
by having a bond position our 20-something investor learns a valuable
lesson regarding diversification and negative correlation. As he ages
he'll be comfortable with fixed income investing, which assumes a larger
role decades down the road.

- quote -

Another good point. I say to my younger colleagues: "If you are 100
percent positive that equities will always do better, why the heck are you
working here? If you're that smart you should quit to trade your own
account. And when you strike it rich, don't forget to invite me to visit
your villa on Sea Island."

Tad Borek wrote:

- quote -

Well, this is a good point. I wasn't thinking about the scenarios where
emergency expenditures occur that outstrip one's emergency fund.

-Will

Will Trice wrote:
- quote -

Well one difference is that short term bonds as an asset class are
different. Unlike the other asset classes in an "aggressive" long term
portfolio, they can't really drop in value much - there's no real
mechanism for that to happen. You can't say the same about the equity
asset classes or of REITs.

I've seen some chatter about "asset class correlations are increasing"
and someone who believed that to be an issue might rationally include
short-term bonds despite their lower expected returns. That way if The
Big Kahuna hits they have money to shift over. If your other 6 asset
classes are 0.75 correlated during a drop your rebalancing opportunities
will be kind of limited.

I guess this should be put in the "tactical" column, alongside buying
long bonds at 13%. If you really believed in the efficient frontier you
wouldn't second guess this kind of thing - you'd never say "hmmm, kind
of looks like a global asset bubble and I want some cash available to
throw into the ring if it all goes down at the same time."


- quote -

No, not at all - I'm leaving the statistical framework entirely with
that example. And it might not be 5%...my general point is that someone
might say "yeah, sure, Stocks for the Long Run, great, but what if it's
different by my first Roth withdrawal? wouldn't it be nice to at least
have $x to tap into from some short-term bonds?" They might even do
their risk analyses using a methodology other than 'efficient frontier'
(which most people have never heard of!).

The last thing I'd put in this category is "likelihood of tapping those
long-term funds early." You might be aggressive & expect a 30-year
holding period, then give birth to quintuplets, and need to tap that
Roth to fund their book tour (or at least, twins and an addition to the
house). As net worth increases, of course, this kind of consideration
gets less important because there truly are scenarios where you will
"never" tap the money early.

Sure this is breaking ranks from the EF kind of analysis but really - I
don't think many people invest in such a quantitative way, it's based on
much more subjective decisions.

-Tad

"Paul Michael Brown" <pmb[at]his.com> wrote in message
newsmb-1203061425160001[at]max1ka-81.his.com...
- quote -

Interesting oddities. Be careful about the capital gains, though - usually
a premium or discount is often amortized over the holding period and
considered (tax-exempt) interest.:
http://www.irs.gov/publications/p550/ch03.html#d0e7863 [amortize muni
premiums]
http://www.irs.gov/publications/p550/ch01.html#d0e2851 ["The discount on
municipal bonds generally is not taxable, but see ..."]
http://www.irs.gov/publications/p550/ch01.html#d0e2508 ["Original issue
discount on tax-exempt state or local government bonds is treated as
tax-exempt interest."]

Other oddities:
- Muni bond fund distributions of interest are usually taxed on a pro-rated
basis - the percentage of the income coming from out-of-state bonds are
subject to state income tax. However, some states (e.g. Calif., N.J., N.Y.)
require over 50% of the income to be state-tax-exempt before they will allow
you to exempt any of the income from state taxation.
- Muni bonds from U.S. territories and possessions are exempt from taxation
in all 50 states; this includes areas like Puerto Rico, the US Virgin
Islands, Guam, etc. There is one mutual fund I know of designed to take
advantage of this fact: Franklin Double Tax-Free Income Fund
http://www.franklin-templeton.com/re...fundNumber=123

--
Mark Freeland
nNeEwTs[at]sonic.net

TB wrote:
- quote -

Absolutely, again I should have added the caveat that I was writing
about investing for long-term goals, not short-term goals.

- quote -

Yep, I can definitely agree here. When interest rates are that high,
locking them in doesn't seem to be a bad move. So I should add yet
another caveat to my original post: when interest rates are low (of
course, then one has to define "low"...).

- quote -

This is why I described our hypothetical investor as "truly highly risk
tolerant". I know such people exist.

- quote -

This is just standard asset allocation with rebalancing when you have
bonds, isn't it? I assume that you would have to do this anyway to get
the full benefit of bonds in the first place.

- quote -

Yes it is rational, but as you said subjective. And I'm not sure that
your math works. Does a 95% confidence level really translate into 95%
of funds in an asset? What happens if I use this logic for 3 asset
classes? What about 4 or 5? 10?

-Will

Elle wrote:

- quote -

This was one of my points.

- quote -

I can't agree more, I've made this assertion in this group in the past.

- quote -

But this is a gross prediction, not a prediction on the order of market
timing.

- quote -

I can certainly agree with this. But I would think that it would be
imprudent for anyone to optimize their portfolio based on the assumption
that bonds will outperform stocks in the long run. Given that, is it
helpful to have anything in bonds over the long haul? Let's say for
example that you have 20% in bonds. If somehow stocks perform equally
with bonds over the long haul, then no harm done. Heck, you could have
been 100% in either and gotten the same result. Maybe stocks do a
little worse than bonds. Then there's not much difference between
having 20% bonds or going all equity. But what if stocks severely
underrun bonds over the long haul. Well then you're probably screwed
anyway because only the bond portion of your portfolio made any money.
Given the unlikelihood of this last scenario occurring, it seems than
100% equities is the right answer for the long haul (given that the
investor is truly risk-tolerant).

-Will

John wrote:

- quote -

Numbers never lie, only those who quote them...

- quote -

You are right, of course. I should have had the caveat that I was
limiting my remarks to stocks vs. bonds.

-Will

Will Trice wrote:
- quote -



Most people overestimate their level of risk tolerance; they figure that
out when everything is going down. A young person can afford to be
totally wiped out because he has a long tome to recover -- but he might
not be able to sleep at nights if he invests 100% in stocks and the
market goes crazy with wild up-and-down (more a little more down than
up) swings.

You have to look at the risk level of the portfolio as a whole. If a
good piece of your money is in bonds, chugging along at a nice safe 5%,
you can be more aggressive with your equities investments.

When interest rates are falling, long-term bonds can have impressive
capital gains.

Bob

Will Trice wrote:
- quote -

Will,
Sure there are arguments for bonds for anyone...

Forgetting about the efficient frontier for a moment, think in practical
terms: even the youngest and most risk-tolerant investor has some
relatively short-term needs for cash. New car, big vacation, down
payment on a home, grad school tuition, binge at Armani, whatever. It's
perfectly rational to park a bunch of money in say a short-term bond
fund that you can tap into at any time to fund these things. "A bunch"
could easily be 20% of this younger person's net worth. It insulates you
from even a big drop in the stock market...you can ride through it
without selling, even if it takes years to unwind.

But let's say we're talking about just one part of this young investor's
investments, a long-term part - like a Roth IRA for a 25 year old, say.
Bonds?

You're right that there are arguments for going all-stock and to me one
of the hardest to refute is rooted in Finance 101/cost-of-capital.
Companies borrow (selling bonds) to fund projects that earn profits
(which are manifested to shareholders in share prices and dividend
payments). Bondholders get only the benefit of the company's borrowing
cost, and assumedly the company wouldn't borrow if it didn't expect a
positive IRR from the project - meaning, something higher than that cost
of capital. So saying that equities will lose to bonds over the long run
suggests that collectively, publicly traded companies will, to use a
W'ism, misunderestimate their capital projects. Possible, I guess, but
doesn't seem too likely, at least not over the long term.

Then again if long-bond rates ever got to 13% again it would be hard for
me not to think of locking in that return for part of a long-term
portfolio. Sure, it would mean that we were in the middle of
hyper-inflation and that the long-term inflation expectations were very
high. But 30 years is a long time and as we've seen, the unwinding of
high bond rates leads to very high bond returns. Of course this is more
of a "tactical" argument for bonds and hardly applies when the rates are
where they are now.

Going back to the efficient-frontier there's still an argument for bonds
for the 25 year old's Roth. If you run the numbers adding in say 10% or
even 20% to bonds doesn't really lower the long-term returns all that
much, but does reduce volatility noticeably. The math might suggest that
it's not worth it (the returns do look a bit lower) but there is this
notion of "keeping the faith" and if that monthly statement drops just a
little less, perhaps it's going to keep this guy invested instead of
bailing out. This is a subjective thing but there does seem to be an
unfortunate human tendency towards selling after things drop "enough" -
which of course is just the opposite of what you should be doing.

Also, having those bonds there provides a source of cash for
rebalancing. If you were concerned about a major drop in one of the
asset classes you invest in and especially, if you were concerned about
a period where investments were closely correlated (eg small & large US
stocks, small & large foreign stocks, and REITs all dipping at the same
time) you might rationally keep money in short-term bonds so you have a
source of funds to invest after the drop should those dips happen. One
issue with the "efficient frontier" is that it's always moving around a
bit and some of it breaks down should asset class correlations increase.

The last argument I'd phrase this way: are you 100% confident that stock
returns are going to beat bond returns between now and when you take out
your first dollar? I'm not 100% confident of much and if you're 95%
confident, perhaps you put 5% into bonds. It's a subjective thing but
economically rational right?

-Tad

"Will Trice" <wwtrice[at]paragondynamics.com> wrote
- quote -

When the market (or a particular stock or a bond) is
"overvalued" is a best guess. But so too is the optimum
allocation of stocks and bonds.

Both best guesses rely on past data, averages, and an
assumption that market parameters behave stochastically. In
fact, there is no assurance that past averages will repeat
in the future, even for the long-term, and we don't know how
much of human-driven market behavior is stochastic.

- quote -

Just my opinion, but I don't feel the above is precise
enough to be useful. I favor citations like the following:

"According to Jeremy Siegel's Stocks for the Long Run, for
every rolling five-year investing period from 1802 to 2002
(i.e., 1802-1807, 1803-1808, etc.), stocks outperformed
bonds 80% of the time. Stocks beat bonds for 90% of the
rolling 10-year periods, and essentially 100% of the rolling
30-year periods. For holding periods of 17 years or more,
stocks have always beaten inflation, a claim bonds can't
make." http://www.fool.com/retirement/retirement01.htm

My point being that, sure, we have a lot of past data, but I
won't go around assuming what another person's time horizon
is; or where we are in an arguable market cycle; or that
market behavior is stochastic and therefore someone with a
ten-year time period has a 90% probability of doing better
in 100% stocks than in X% stocks and (100-X)% bonds; or that
the last 50 years is all that much like the early 1800s,
when it comes to stocks and bonds.

- quote -

But your plan also tries to predict: It assumes that, say,
the next ten years has a 90% probability of producing stock
performance that is superior to bond performance.

If you want to say stocks /appear/ to be the better bet,
based on x, y, and z, then FWIW, that's fine, AFAIC. But to
insist they are the best bet isn't true to reality, in my
opinion.

Will,

Numbers can lie.

I agree that it can be hard to market time and get it right enough
times to make the position come out ahead of staying 100% in equities.
What I do not like about the argument is there are other investments
that do better than 100% stock. So, how far does one go to determine a
strategy before you get to the conclusion that there is no absolute
best answer? It could easily be argued that real estate will provide
better growth and better income (plus tax benefits and the safe use of
leverage). Even if you are an all cash RE investor you will be
producing returns close to the stock market so any use of leverage
should push RE a head of equities.

To support your point about a 100% stock position, Peter Lynch said to
say 100% in stock and sell 5% a year rather than switch to fixed income
investments. Others will say that 4% might be the right number. Peter's
point is the greater growth will more than compensate for the
volatility risks.

Will Trice wrote:
- quote -

Elle wrote:
- quote -

I would contend that most (or all) investors are incapable of accurately
deciding if the market is overvalued (my definition of overvalued being
that the equities market is going to move downwards within the short
term - otherwise who cares if it is overvalued?).

- quote -

But over the long term staying 100% in stocks beats staying less than
100% in stocks and it is not likely that an investor can predict when
s/he is entering a period (short-term) when bonds will beat stocks. So
shouldn't the risk-tolerant investor not bother trying to predict those
periods and just stay invested in equities?

-Will

"Will Trice" <wwtrice[at]paragondynamics.com> wrote
- quote -

I agree with the first sentence just about word for word.
Then I
would elaborate as follows: "For the active investor, when
the market is overvalued, put more in [high grade] bonds
(including money markets), and vice-versa. By contrast, the
passive investor definitionally might be said to be more
risk averse, so he or she should have some fixed income in
his or her portfolio at all times."

"Overvalued" of course is subjective.

- quote -

I don't agree with this. Bonds can improve returns. Not
always, but at times.

- quote -

I realize these curves are sophisticated mathematical models
that take no small amount of computational power and
historical data to generate. But they do rest on many
assumptions. ISTM their worth, insofar as specificity is
concerned, is not much. They're guidelines that assume the
future will tend to generally resemble the past.

I think it's more accurate to say that, for some time
periods, adding bonds reduces returns; for others, it
improves returns.

Paul Michael Brown wrote:
- quote -

Do most people think this is true? The whole point of adding bonds is
to reduce volatility, but if you look at efficient frontier curves,
adding bonds also reduces long-term returns. If your hypothetical young
investor is truely highly risk tolerant, why have bonds (that investor
would not seem to be interested in reducing volatility, and would be
interested in maximizing return)? Even if one can make a successful
argument for bonds in this case, 20% seems really high, doesn't it?

-Will

- quote -

The general rule is that munibond interest is always exempt from federal
taxation, and exempt from taxation in the state of issuance. If you're
willing to pay the state income tax you can buy bonds from any state you
like.

But there are exceptions. For example, some "private activity bond"
interest is subject to the AMT. And in the District of Columbia, munibond
interest is exempt from state tax regardless of the state of issuance.
Ditto for Alaska. There may also be capital gains or losses that affect
your taxes.

For more than you ever wanted to know about the tax aspects of munibond
investing, see:

http://www.investinginbonds.com/learnmore.asp

Good site for other bond related stuff, by the way. Although skewed toward
investors who buy individual bonds.

"Bucky" <uw_badgers[at]email.com> writes:

- quote -

I agree with that and never said otherwise. I only said that someone
who consumes the interest is going to have a personal RoR that is
less than the YTM.

--
Rich Carreiro rlcarr[at]animato.arlington.ma.us

"Paul Michael Brown" <pmb[at]his.com> wrote
- quote -

I am still a little concerned about rising interest rates
lowering the prinicipal value of one's investment in
intermediate to long term bond funds. But that could be hair
splitting at this point. Media reports say the Federal
Reserve Board is (understandably, AFAIC) cooling its jets.

I can stomach an intermediate term fund a lot better if one
intends to hold it for the long term. NAV may decline around
10%, worst case? But who really cares 20 years from now,
since the yield will pay that back and then some, etc.? I'm
just messing with the charts at finance.yahoo and Vanguard
and some intermediate term, high grade funds, unfortunately
going back only about 15 years.

Vanguard's total bond market index fund (VBMFX) and seems to
offer serious competition to any other total bond market
index fund.

Good words on this subject from you as well...

Yahoo Finance has some very good reading and it's free. Also, I would
recommend doing your bond buying with an online broker if you don't
want to pay higher transaction fees. Schwab, Vanguard and many more
have excellent bond sites.

Cogent as ever, Elle wrote:

- quote -

For the fixed income novice I think bond funds are the best bet. I like
the bond funds that track the total U.S. bond market. All the big
companies offer them. You get professional management, excellent
diversification and low fees.

- quote -

Another reason I like bond funds for all but the most sophisticated and
diligent investor.

- quote -

Another excellent point from Elle. Even the youngest and most
risk-tolerant investor should have *some* fixed income in his portfolio.
Doesn't have to be much, and it doesn't have to be fancy. Say 20 percent
in a total bond market index fund.