Do I really need bonds?

[Ds2660]

Hello all,
First a little background.... I completed fellowship in 2013, began managing my own finances in mid 2014 after a bad but relatively minor experience with a financial planner. After reading The Intelligent Investor and several of Buffets passages, I am invested nearly entirely in S&P. I did not see the point in a bond fund as I am 36, am a long term investor, and have a high risk tolerance. I started a new job just over a year ago with a 3 year partnership track. All people historically hired by the group have made partner, and I am in the top 25% of producers.
I took a 70k pay cut in the first year of this new job but will more than make up for that in the next couple years. The group fully funds a 401k (36k from them, 18 from me), plus contributes 18k to a defined benefits plan. Eventually, I will be able to contribute up to an additional 54k to the DBP once I have 5 years of service with the group.
My question is, is it reasonable to have the DBP act as my bond portfolio? I plan on making the maximum contribution to the 401k, DBP, and having 75-100k to place into a taxable account after making partner, assuming income stays similar to what it currently is.

[The White Coat Investor]

It depends on how you react in the next bear market. Since you weren't investing in the last bear market, it's hard to say what you will do in the next one. It also depends on whether the future resembles the past (stocks generally outperform bonds over long periods of time, but there is no guarantee they will do so over your investing horizon.)

My DBP is about 50% bonds, so I wouldn't consider that as a bond substitute.  No idea what yours is invested in.

[mitochondria]

Having some of your retirement savings in a diversified bond fund will help you understand how these funds behave during different periods of the stock market/financial cycle.  The dividends that diversified bond funds yield are also pretty nice. My wife is also a physician and she is less aggressive than I am. At one point I had about 90% equity mutual funds and 10% bond funds (we where in our 30s/40s). She preferred 75-80% equities and 20% bonds. Her portfolio demonstrated "tighter" fluctuations and seemed to be take a stock market dive much better. This worked for her based on her risk tolerance.

After the housing market dive, she was pretty upset watching my portfolio get torched. After the market recovered, I rebalanced my portfolio to 80% equity/20% bonds.

One suggestion is to build up about 20-30% in bond funds. Based on your risk tolerance, wait for the next bear market and take advantage of the lower equity prices.  At that point, you can drift back towards the higher equity mutual fund portion you desire by unloading some bond funds.  Bear markets are buy markets!  This will work if you have a long time horizon and remain diversified in the equity mutual funds you choose.

I did not intentionally plan this myself, but during the years 2007-2009. My automatic retirement contributions were purchasing equity mutual fund shares at great prices.  My allocation at the time was 80% stocks and 20% bonds.  When the market recovered in the years following that period, buying all those shares during the down years seem to have an amplifying effect on the growth of my portfolio after that tough period.  There was no sophisticated analysis on my part. Just automatic contributions into a large diversified portfolio that recovered well with time.

[TheGipper]

You certainly do not NEED any bonds.

I personally would count your DB plan in your AA, as it is allocated.  For example, if it is invested 25/75 stock/bond, I would ignore the "guaranteed interest credit" and count my hypothetical DB account as invested 25/75.  Your DB plan will soon make up a significant portion of your retirement savings, so one could argue that you really don't "need" any more bonds and can be more aggressive with your other defined contribution retirement account allocation.

However, many have made persuasive arguments that a 10-30% allocation to intermediate or long duration bond funds will actually increase your risk adjusted returns (and maybe even your actual returns), over the long haul, especially if you combine them with other lower correlated equity funds.

Just look at this year.  Long term bonds crushed it against the predictions of all pundits.  Long/intermediate bonds IMO are a great diversifyer and hedge against deflation (or more practically a hedge against lower than expected inflation, ie the FED saying they will raise rates and then chickening out)

Bottom line is that there is a good argument to made for 10-20% intermediate or long term bonds even for a young accumulator in your scenario.

[artemis]

Far more people think they have a high risk tolerance than actually do.  It's a costly mistake to make.

[Ds2660]

Thanks, appreciate the input. The DBP is about 50% bonds. I agree with you mitochondria, in that bear markets are buy markets. I took that as a major point of Benjamin Graham with his Mr Market example, so I'm planning on leaning on that during the next bear market. It might not be easy, but that's why we have the plans made and in motion already! Set it and forget it automatic contributions are a way of life for me. While I haven't been through a true bear market, I did buy a fairly large amount of s&p when it plummeted last February and it seemed to me people were starting to panic. Again using Graham's and Buffett's analogy, the fund was on sale for a short time so I bought extra.

[litovskyassetmanagement]

Ds2660 wrote:

Hello all,
First a little background…. I completed fellowship in 2013, began managing my own finances in mid 2014 after a bad but relatively minor experience with a financial planner. After reading The Intelligent Investor and several of Buffets passages, I am invested nearly entirely in S&P. I did not see the point in a bond fund as I am 36, am a long term investor, and have a high risk tolerance. I started a new job just over a year ago with a 3 year partnership track. All people historically hired by the group have made partner, and I am in the top 25% of producers.
I took a 70k pay cut in the first year of this new job but will more than make up for that in the next couple years. The group fully funds a 401k (36k from them, 18 from me), plus contributes 18k to a defined benefits plan. Eventually, I will be able to contribute up to an additional 54k to the DBP once I have 5 years of service with the group.
My question is, is it reasonable to have the DBP act as my bond portfolio? I plan on making the maximum contribution to the 401k, DBP, and having 75-100k to place into a taxable account after making partner, assuming income stays similar to what it currently is.

Click to expand...

Yes indeed.  When you have a paired plan, your CB plan should be included into your overall portfolio allocation, and you can adjust your 401k allocation to compensate if the bond allocation in your CB plan is very high.  However, you need to know exactly what it would invest in.  Some investment managers constantly shuffle their allocation, and in that case you have no idea what you have.  If your plan is 100% bonds, that makes things easy, especially if the plan holds specific funds that you can identify.  It would be best to find out what your CB plan's allocation is, how it changes (if at all) and exact investments in the plan.  Then I would use that information to adjust your 401k plan allocation.  Presumably, your 401k will be significantly better funded at least initially, until your CB contribution catches up.  I find that this 'de-risking' is a natural process that makes good sense, as you do want to lower your stock exposure over time without selling anything.  Because presumably your 401k performance over time might be higher than your CB plan's performance, even when you start contributing significantly more into your CB plan, you would still be able to have some control over your stock/bond allocation, and you can rebalance your portfolio by rebalancing each one separately (while considering both portfolios as one) with the incoming contributions. Also, another thing to make sure is that you are not hit with asset-based fees on your DB plan contributions - that's a common problem with group CB plans.

[East coast]

Wise folks know what they don't know - in your case, that would be your true risk tolerance.

[VagabondMD]

artemis wrote:

Far more people think they have a high risk tolerance than actually do.  It’s a costly mistake to make.

Click to expand...

So true! I learned about my risk tolerance in the 2000-2 bear market (when I was 90% in stocks) and in the 2008 bear market (when I was 75% in stocks). I was much more comfortable in 2008, despite experiencing larger paper losses, than I was in 2000-2002. At 60% in stocks, and with a greater degree of diversification than previously (real estate, alt investments, etc.), I expect that I will weather the next bear market even better.

You do not know how you will react in a bear market until you experience one.

[litovskyassetmanagement]

Vagabond MD wrote:

artemis wrote:

Far more people think they have a high risk tolerance than actually do.  It’s a costly mistake to make.

Click to expand…

So true! I learned about my risk tolerance in the 2000-2 bear market (when I was 90% in stocks) and in the 2008 bear market (when I was 75% in stocks). I was much more comfortable in 2008, despite experiencing larger paper losses, than I was in 2000-2002. At 60% in stocks, and with a greater degree of diversification than previously (real estate, alt investments, etc.), I expect that I will weather the next bear market even better.

You do not know how you will react in a bear market until you experience one.

Click to expand...

Unfortunately, 2000 and 2008 bear markets couldn't have been more different, so what worked in 2000 failed miserably in 2008.  I wrote this a while back, but there is a chart that shows how a 50:50 portfolio behaved during the two crashes, and this is exactly the reason why anyone investing in the market should understand the nature of risk (and why it has nothing to do with risk tolerance):

http://www.dentaltown.com/Dentaltown/Blogs.aspx?action=VIEWPOST&b=143&bp=716

In 2000, diversification worked well, but in 2008 it didn't work at all.  The only way to protect one's portfolio was to have less exposure to stocks.

The second post talks about correlation and diversification:

http://www.dentaltown.com/Dentaltown/Blogs.aspx?action=VIEWPOST&b=143&bp=719

One thing to understand is that correlation changes ALL the time, so at any one point it does not matter whether you are diversified or not, but rather, whether you are exposed to high risk assets or not (and to what degree). To the above I should add Wade Pfau's drawdown charts showing that we can not afford to make mistakes (and make assumptions that this time would be just like last time as far as the duration of the drawdowns).

So for someone who makes large contributions to retirement and after-tax accounts, risk should be decreasing over time, and the starting point does not have to be 'all in' (in fact, starting at 50:50 might be a good idea).  The less you are exposed to the markets, the less you need to worry about crashes, but some exposure is necessary, and % in stocks depends on how long your horizon and the amount you will be accumulating over time. It has nothing to do with risk tolerance, but rather with controlling your exposure to a risky asset (and that's what risk management is all about).

While during accumulation you have an opportunity to buy low, the game is totally different in distribution when you have no income to reinvest and very little tolerance for prolonged drawdowns.  Also, once your portfolio gets to be in the millions, your contribution amount might not be enough to make a big difference during drawdowns, so that's another factor to consider (and why de-risking over time is a good idea).  That's why CB plans are great for that as they force you to allocate more towards bonds over time.