More on Dave Ramsey and investing

[disneysteve]

On a few recent podcasts, Dave has talked about investing and I've heard a little more detail about his thinking. He is almost entirely opposed to investing in bonds of any type regardless of your age. The explanation he gave was that if you look at the look term track record of the stock market and chart volatility and do the same for the bond market, the volatility graphs are very similar. Bonds are less volatile but not significantly so according to Dave. His thinking is that people buy bonds to get a safer, more stable, investment and that isn't really the case. And on top of that, the return is lower than stocks (we all agree on that point of course). So if you aren't getting less volatility and you're getting lower returns, why bother?

About the only time he recommends an investment that involves bonds his when he talks about Growth and Income or Balanced mutual funds which will hold a portion of their portfolio in bonds.

I'm certainly not agreeing with him or promoting his plan (100% stocks all the time for everyone) but I thought it was interesting to hear his reasoning. Thoughts?

[dczech09]

Dave is correct when he says that bonds and stocks are fairly similar in terms of risk. At least based on standard deviation analysis, they are very close.

However, bonds have two types of risk: default risk and interest rate risk. Both types of risk are easy to understand and easy to counter, which Dave does not really spend any time discussing.

Default risk
What it is: the risk that the borrower will default on their obligation
How to manage it: stick to high rated bonds with low risk of default. Avoid junk bonds (unless you are a speculator).

Interest rate risk
What it is: the risk that your bonds will fluctuate in value based on prevailing market interest rates. Rates go up, bond values go down. Rates go down, bond values go up.
How to manage it: don't buy and sell bonds. Simply buy and hold bonds until maturity. This will make it so that your return is the bond's interest/coupon rate. The only time you face interest rate risk is if you buy on the secondary market (as opposed to the primary market) and sell in the secondary market before maturity.

With this being said...
Dave is a huge promoter of mutual fund investing, and I think most of us here agree with him that mutual funds are very beneficial to the average investor.

The problem with bond mutual funds is that investors have no control when the manager buys or sells bonds. In other words, their exposure to interest rate risk is completely at the mercy of what the mutual funds manager sells. And in this day and age where mutual funds managers are often scared into making rash decisions (consider all the mutual fund managers who sold off during the financial meltdown), it becomes VERY risky to get involved with bond mutual funds.

Ultimately, I believe this is where Dave's mind is. It is a little too complicated to explain to everyday folk who do not necessarily understand the market place as well as someone who has studied finance in college.

[disneysteve]

Simply buy and hold bonds until maturity.

it becomes VERY risky to get involved with bond mutual funds.

Ultimately, I believe this is where Dave's mind is. It is a little too complicated to explain to everyday folk who do not necessarily understand the market place as well as someone who has studied finance in college.

I think that's true. The other problem is that putting together a diversified portfolio of individual bonds isn't cheap. You can't get started with a couple thousand dollars like you can with a mutual fund. Personally, I invest in a bond fund. I know all of the reasons I shouldn't and I'm probably at the point now where I should transition into buying individual bonds. In fact, I think I'll start a thread on that very topic to get some tips and advice.

[Petunia 100]

On a few recent podcasts, Dave has talked about investing and I've heard a little more detail about his thinking. He is almost entirely opposed to investing in bonds of any type regardless of your age. The explanation he gave was that if you look at the look term track record of the stock market and chart volatility and do the same for the bond market, the volatility graphs are very similar. Bonds are less volatile but not significantly so according to Dave. His thinking is that people buy bonds to get a safer, more stable, investment and that isn't really the case. And on top of that, the return is lower than stocks (we all agree on that point of course). So if you aren't getting less volatility and you're getting lower returns, why bother?

About the only time he recommends an investment that involves bonds his when he talks about Growth and Income or Balanced mutual funds which will hold a portion of their portfolio in bonds.

I'm certainly not agreeing with him or promoting his plan (100% stocks all the time for everyone) but I thought it was interesting to hear his reasoning. Thoughts?

I think we can't simply ignore correlation. Since stocks and bonds have a low correlation, owning both reduces the volatility of the entire portfolio.

There is the re-balancing bonus, too. There is ample evidence that holding different asset classes and re-balancing regularly improves total returns. It stands to reason that if I am 100% stocks and the market tanks, I do not have the ability to buy more stocks at those new, lower prices. If on the other hand I had a portion of my money in bonds, I have an awesome buying opportunity.

[Petunia 100]

Dave is correct when he says that bonds and stocks are fairly similar in terms of risk. At least based on standard deviation analysis, they are very close.

However, bonds have two types of risk: default risk and interest rate risk. Both types of risk are easy to understand and easy to counter, which Dave does not really spend any time discussing.

Default risk
What it is: the risk that the borrower will default on their obligation
How to manage it: stick to high rated bonds with low risk of default. Avoid junk bonds (unless you are a speculator).

Interest rate risk
What it is: the risk that your bonds will fluctuate in value based on prevailing market interest rates. Rates go up, bond values go down. Rates go down, bond values go up.
How to manage it: don't buy and sell bonds. Simply buy and hold bonds until maturity. This will make it so that your return is the bond's interest/coupon rate. The only time you face interest rate risk is if you buy on the secondary market (as opposed to the primary market) and sell in the secondary market before maturity.

With this being said...
Dave is a huge promoter of mutual fund investing, and I think most of us here agree with him that mutual funds are very beneficial to the average investor.

The problem with bond mutual funds is that investors have no control when the manager buys or sells bonds. In other words, their exposure to interest rate risk is completely at the mercy of what the mutual funds manager sells. And in this day and age where mutual funds managers are often scared into making rash decisions (consider all the mutual fund managers who sold off during the financial meltdown), it becomes VERY risky to get involved with bond mutual funds.

Ultimately, I believe this is where Dave's mind is. It is a little too complicated to explain to everyday folk who do not necessarily understand the market place as well as someone who has studied finance in college.

Management risk can be eliminated by choosing index funds/etfs.

[Strevlac]

The volatility of bonds is nowhere close to the volatility of stocks! Where in the world are you getting that info??

Also, it doesn't matter what bonds a fund manager sells. Proceeds from bond sales can be reinvested in new bonds at exactly the same yield as if the manager never sold in the first place. The coupon rate is irrelevant for short term trades. If the proceeds are not reinvested and instead distributed to those redeeming shares then those folks take the hit for bailing. Not the people still in the fund.

Yields for bonds are not attractive right now and there is interest rate risk, I get that. But interest rate risk does not = risk of permanent losses. As bond fund holders we WANT interest rates to go up. It is to every fundholders long-term benefit that they do. It is painful in the short term but that is investing.

[disneysteve]

I think we can't simply ignore correlation. Since stocks and bonds have a low correlation, owning both reduces the volatility of the entire portfolio.

I realized that he didn't mention this at all. He made no mention of the fact that stocks and bonds tend to move in opposite directions.

The volatility of bonds is nowhere close to the volatility of stocks! Where in the world are you getting that info??

This is what Dave Ramsey was saying - that the volatility of stocks and bonds aren't that different when you chart them out.

Not saying I agree. Just sharing his info.

I'd love to actually see the volatility charts he's talking about.

[disneysteve]

http://www.ritholtz.com/blog/2013/06/sbg/

Here's a chart with 50-year returns for stocks, bonds, and gold.

[corn18]

The interest on municipal bonds are federal tax free and sometimes state and local tax free. That can be beneficial if the yields are higher on muni's and you are in a higher tax bracket. At 31% effective tax, a muni bond @ 5% yields the same as a taxable investment at 7.24%.

[kork13]

I think we can't simply ignore correlation. Since stocks and bonds have a low correlation, owning both reduces the volatility of the entire portfolio.

I realized that he didn't mention this at all. He made no mention of the fact that stocks and bonds tend to move in opposite directions.

It's not simply that they tend to move in opposite directions (which would indicate a strong negative correlation, and thus a good hedge), but they simply don't move in concert with each other AT ALL. Right now, most all assets are at relative highs -- stocks, bonds, precious metals, etc. Other times, stocks & bonds truly do appear to move opposite each other. That just means that they really aren't correlated much at all, and they move independently of each other. THIS is the benefit that bonds bring to your portfolio, exactly as Petunia brought up. By investing in two mostly-uncorrelated asset classes, you reduce overall volatility risk.

Secondly, Mr. Ramsey has a tendency to vastly over-simplify an issue. Yes, bonds sometimes can have high volatility at times, depending on a variety of factors--type/class, rating, yield, and most especially, market conditions (to name a few). However, the overall price volatility of bonds is nowhere near that of stocks, as demonstrated by the chart that DS posted. Yes, there is definite volatility. However, the extent of those swings in price are lower than in stocks.

[LivingAlmostLarge]

I think it's just a good way to diversify your portfolio. Something he never mentions is the risk of investing 100% in stocks. I liked the intelligent investor by william bernstein. http://www.efficientfrontier.com/

It shows different portfolios and what happens when it is diversified but not.

[feh]

I think Dave Ramsey should stick to the topic of debt reduction.

I will make one other comment - too many folks, when putting together their portfolio, think about X% equities and 100-X% bonds. In fact, folks should be thinking about X% equities and 100-X% fixed income, of which bonds can be a portion of. Other such components of fixed income are cash, CDs, etc.

It's important to match your bond fund choices with your time horizon. If I needed money in 2 years, I would not invest it in an intermediate term bond fund. That just doesn't make sense. For time horizons of less than 5 years, as of today, CDs are probably the better choice, as the interest rates are similar and you don't have interest rate risks w/ CDs.

That being said, 30% of our portfolio is fixed income, and of that 30%, 75% is in intermediate term (ie. average duration of 5-6 years) bond funds. I won't be accessing that money for 12 years. I am hoping for interest rates to rise.

[dczech09]

The volatility of bonds is nowhere close to the volatility of stocks! Where in the world are you getting that info??

Also, it doesn't matter what bonds a fund manager sells. Proceeds from bond sales can be reinvested in new bonds at exactly the same yield as if the manager never sold in the first place. The coupon rate is irrelevant for short term trades. If the proceeds are not reinvested and instead distributed to those redeeming shares then those folks take the hit for bailing. Not the people still in the fund.

I read an article in the WSJ a while back that talked about a study of stocks, bonds, and gold. The article was ultimately bashing gold, but also pointed out that stocks and bonds having virtually the same standard deviation in returns over a long period of time. I wish I could remember what article it was, but I think I may have to do a little analysis myself- it would be very interesting!

I understand that stocks are more volatile than bonds, especially emerging markets and international stock. However short-term volatility and long-term risk are two different things.

And yes it does matter what/when a mutual fund manager sells. If they sell when interest rates are higher than the coupon rate on their existing portfolio, they get less in proceeds which means less can be purchased to replenish their bond position.

What I was getting at is that interest rate risk is virtually neutralized by long-term investors. Just as you pointed out that the coupon rate is irrelevant to short-term investors, which is true.

I am not a bond investor myself (I invest in stocks and real estate). However, I know the basics about bonds and know how to use the basics to ascertain other insights.

[Strevlac]

And yes it does matter what/when a mutual fund manager sells. If they sell when interest rates are higher than the coupon rate on their existing portfolio, they get less in proceeds which means less can be purchased to replenish their bond position.

Technically true but this isn't a permanent loss. That's what I'm trying to say. Bond fund turnover doesn't really matter when it comes to changing interest rates (it matters for trading costs/spreads but that's a different conversation).

Example:

$1,000 bond
2% coupon
10 year maturity
At the end of ten years you will have $1,200.

Interest rates rise 1% in year five, the NAV of your existing bond drops 5%. You sell your bond at a loss and buy a new bond. Your new bond will be yielding 3%. At the end of year ten, including your $50 loss, you have $1,200:

2%
1,000.00
1 20.00 1,020.00
2 20.00 1,040.00
3 20.00 1,060.00
4 20.00 1,080.00
5 20.00 1,100.00
6 20.00 1,120.00
7 20.00 1,140.00
8 20.00 1,160.00
9 20.00 1,180.00
10 20.00 1,200.00

Swap in year 5:
3%
1,000.00
1 20.00 1,020.00
2 20.00 1,040.00
3 20.00 1,060.00
4 20.00 1,080.00
5 (50.00) 20.00 1,050.00
6 30.00 1,080.00
7 30.00 1,110.00
8 30.00 1,140.00
9 30.00 1,170.00
10 30.00 1,200.00

[krantcents]

Investing is a very personal choice! Generalized advice can be very misleading. There are a variety of ways to stabilize your investments during times of volatility and bonds may or may not be a good choice. In my particular case, the fixed income portion of my portfolio is satisfied by a pension and Social Security. Bonds do not make sense for me.