Bonds Can Help When Your Portfolio Is Too Volatile

If you have the ability to precisely estimate what your liabilities are gonna be in the future, it can be really good, because what are you doing? Basically, you're taking risk off the table, to Wes' point, you're aligning the liabilities and the asset. Those things move in lockstep. I know how much money I'm gonna have down the road, right? The problem when you move over to the individual or the wealth space is try estimating your future liabilities with that type of precision, right? I mean, you used the boat example, right? I don't know what a boat's gonna cost 10 years from now. That's really tough, it's really tough to know. I mean, think about college expenses. You plan for college and you save for college. But telling me right now what my kids are gonna spend or I'm gonna have to spend on college 10 years from now, I don't really have any precision around that. So, trying to perfectly match up the liability with the assets today, it's more of a challenging thing to do I think when you move into kind of the personal wealth space. What I can tell you is it'll be more expensive than what you're saving for. Thanks, Gochnour, I appreciate that. Welcome to "The Informed Investor," where we break down the latest financial headlines, bringing in research and insights to help you separate the news from the noise. Are bonds boring? No way, they are awesome. I'm Mark Gochnour, joined today by Jake DeKinder and Dr. Wes Crill. You love bonds. I love bonds. No, I'm not kidding, I really do. I find 'em really interesting. I think there's so much more precision around 'em. I think there's so many more, I'll say use cases for the different types of bonds that are out there. I truly, I really do love bonds. I can't tell if it's the allergy medicine or you guys are just very funny today. This gonna be a great show. You sounded a little stuffed up. Yeah, you know, the pollen hits this time of year in Austin and apparently I'm more sensitive than the average person. And the longer you stay in Austin, I feel like, it gets worse. I never had allergies until I moved here and it still gets me a little bit too. Yeah, I don't have it too bad so lucky. You reminded me. I can tell our bond joke. Right, so if we have anybody out there in the audience that's ever gonna come to a Dimensional conference, pretend you haven't heard this joke before. All right, you ready for the joke? Let it rip. I know what's coming. This is, I think this is Dave Pleck our Global Head of Fixed Income where I first heard this. Okay. All right. What is the difference between a bond and a man? Difference between a bond and a man? And I'm sure the audience is just sweating bullets trying to think through this thing, right? Would you like to do the reveal? Put your answer in the comments? Do you wanna do the reveal? A bond eventually matures. Yes. I mean that's a classic. There's another part to it too though. Didn't this come from an Uber driver when we were, or a version of this. Well we were, I think we we're in Portland. I think we were in Portland. We were gonna the airport and the Uber driver was asking what we do and we mentioned this joke and what'd you say? Some version of there's less interest in both over time. We're like, that's a good answer. That's a way better answer. That's a great answer. That's funny. All right, bonds though. I liked what you said there, they're incredibly important. They can become complex but they meet a whole variety of needs for investors and that's what we're gonna talk about here. The different way to think about your needs and where bonds can come into play a role in that. So let me start with some headlines here. First one, why cash is still king for short term goals. Just because you're over 50, this applies to me, not you guys, so you probably don't need to listen to this. Got a few more years. Just because you're over 50 doesn't mean you have to invest in bonds. And bonds pay in good and bad times. I'm gonna come to that one a little bit later, but reaction to the headlines. Jake? Cash is king. Always has been, probably always will be. I always keep cash in my wallet. Yeah, I mean look that's probably comment around last couple of years. You get a rise in interest rates, short term rates are up, cash is a little bit more attractive. We've heard it in terms of cash and money markets and short term vehicles as well. So that's probably where that headline's coming from. That second one on paying good and bad times. I think that sets up the idea that you can manage risk with fixed income. And I think that's really where the interesting part is when it comes to bonds is the different kinds of risks. You know, risk is not the same to you know, maybe two different people. And so the kind of asset you would use to manage the uncertainty around those risks can be very, you know, very different. I love where you went there with that headline because that's what I was thinking too, like bonds pay, I don't necessarily mean they have the highest yield or payment, it's just they're achieving the goal of what you want from a bond over that time. And think through some of the things here. You think about stocks, like that's easy, right? That's the growth, the portfolio over longer periods of time, growth of wealth. What's the role of bonds? Depends, right? It could be for expected return, it could be to manage inflation, it could be I need short term cash for something. It could be I have a payment I gotta make in 10 years and it could get complex to say okay, how do I think about my bond allocation depending on all these different goals. So which one do you guys wanna start with? I mean if you were to ask someone, okay, what is, what is the primary risk you might be trying to manage? If you just ask someone on the street, they're probably gonna say volatility. And so I think a lot of times fixed income becomes synonymous with tailoring portfolio volatility and so that's one of the common uses, not the only one, but that does sort of set up okay. What kinds of fixed income would be useful from managing portfolio volatility? I would agree with that. I think that's probably a big question that we get and a big thing we see from financial professionals is is you've got X risk over here with sort of the equities and X volatility. How do you partner that with fixed income to really think about the overall volatility of the allocation? And that's an important part too. You know, sometimes people would be like, well this type of investment or this fund or this whatever has this volatility or this standard deviation, and always be careful at looking at something in isolation. You really wanna think about how they play together. That's a Markowitz takeaway, right? You know you never wanna look at things in isolation, you wanna look at what they do in the aggregate of the portfolio. That's actually an important concept when you think about the different types of fixed income that would be suitable for tailoring portfolio volatility. It also depends on what else is in the portfolio. Like if you're an equity heavy investor, you might be able to take, you know, different positions when it comes to duration or credit quality or fixed income than if it's very fixed income heavy in light on equities. I like that point there and I think people sometimes don't realize that, that if you are in that 80%, 70% equity right? I mean that's gonna drive the volatility and so you may have the ability to put a fixed income vehicle or fixed income allocation in there that maybe does have a little bit more term or credit or a higher expected return even though it may be a little bit more volatile, 'cause the equity's gonna drive that volatility. When volatility, you're talking standard deviation. Yeah, I was just gonna comment on that. So you know when we talk about standard deviation, so standard deviation is commonly used as a risk measurement tool but it kind of matters what you're taking the standard deviation of. Now in this case we're talking about standard deviation of you know, account balance of the price of these assets. Some of the other examples we might comment on, you might be concerned with taking the standard deviation of something else. So it's always the volatility but the volatility of what? In this case portfolio stability. That sets up, okay, what kind of fixed income would you want there? Well what types of fixed income have lower volatility? Well that you know might lead you towards something that's shorter in duration. So nearer term maturity in terms of the bonds or higher credit quality, whether it's you know, government bonds or higher tiers of credit quality. Well another good way to look about it is kind of like what may be that a kind of expected draw down, right? Because what is another reason that people use fixed income? It's because I have maybe shorter term spending needs. We see this all the time from a financial planning standpoint. So yes it is the volatility, how does it play with the equities? But you also have to think about, hey if things get a little bit choppy, am I gonna have this because I've got short term spending needs. So we had a conference recently with financial professionals and there's a question in there I'll get your thoughts on I guess the two parts to this. The one question, well the question was there was a, I looked at a portfolio, one portfolio had a standard deviation of it was like 15.1 and one was 15.3. And if I was like, okay, so though 15.1 has less risk. Well, one, it's kind of the same number. So that's one, so I'll come to you. I got a two part question. One is how would you think about then that idea of a standard deviation, let's call it 15 for a portfolio but then two, if you went to an investor and said hey do you want a 15.3 or a 14.8? Like I don't know what you're talking about, I just need some money when there's tough times and I want some return, like I don't know. Right, so. I think to your point, it's hard to look at a standard deviation number and have that be meaningful to you. Sometimes we'll use things like okay, what's been the worst draw down? In the case of fixed income we might look at, okay what happens in months where the stock market is down? What happens to your fixed income? And I think that's something that differentiates higher quality fixed income as you see that on average it's been up when the stock market was down. I think sometimes that's more meaningful than just calling out the standard deviation. All right, let's go back to your comment you made there. You know like short term cash, I really want to have something there in tough time periods in the market where I know I've got my cash. That's reasonable. Like I look at my folks, they always had a pretty hefty amount to very short term, very high quality and in their mind it was, hey no matter what happens, like I've got 10 years of spending I don't even have to worry about. And that's what made them comfortable and I think for them that was probably the right answer. Maybe somebody else, it's a different amount in the way they think about that. But how do you think about then just the bucket of just pure stability and safety? Well that's part of tailoring overall portfolio volatility. So you have your growth assets, you have like your stocks or whatever you're trying to actually grow your account balance 'cause most people are gonna need that. If you're saving for the future, you're probably not gonna be able to get there, satisfy your goals in the future on low risk assets alone. But then what do you do to kind of minimize the ups and downs? And I think that's why you're gonna want that bucket of fixed income. And especially if you think you have some needs that are gonna be near term, you probably don't want those in risky assets. You're gonna want those in something that's closer to cash in terms of its return volatility. Well it's also, remember people ask all the time, what's the appropriate allocation? What's the best allocation? I mean really it's the one that helps you achieve your goals and allows you to sleep at night, right? So for your parents, like you know, nobody can say, hey here's the exact amount you want to have in fixed income. Yes, you can model out spending needs. Yes, you can do all of those things but you're gonna settle on some number that says for whatever reason this is what I believe allows me to sleep at night and feel good. So that if there is a market downturn, that's the appropriate one for it. So it doesn't mean you don't look at all of sort of this data and spending needs and try to do the best that you can, but at the end of the day, if it's not taking you off track from your goals, if you want to tell me that you want to be 60% in bonds or 50% or 40% and that's makes you comfortable, it's a good allocation. Just go about it the right way and put the right type of fixed income in it. Yeah, the right allocation is the one you can live with. Completely. Yep and even within that allocation to bonds, it can get a whole bunch of different types of bonds depending on the needs. And so what, you talk about let's say T bills, you know, one month treasury bills and you think, well they're essentially riskless to the extent there may be a default with the government. It depends how you define risk, how you're measuring it. That's exactly where I was going with that is there could be a big risk in owning, right? If you are concerned with preserving your purchasing power. So I mean you're gonna take inflation to account, T-bills could become riskier because historically, you know, in high inflation periods T-bills have have had negative real returns. And by real I mean you know, net of inflation. And so that could mean that when you're thinking about consuming in the future, you actually could be losing purchasing power if you're in that. It might look risk free in terms of return volatility when you're thinking about gross of inflation but net of inflation it could actually be riskier. Well let's look over the last 30 years. I mean recently we got a spike up in inflation, I'll give you that right? But if you look over the last 30 years, inflation's been relatively low and relatively stable about two and a half percent if you look at USCPI, right? If you take that 30 year period and say well I wasn't invested, what would've happened to my purchasing power over time? It would've been roughly cut in half. So even when you have low inflation, relatively stable inflation, you still have to consider it. And it's a great point both of you make around T-bills. Yeah, you're trading off basically one risk for another. It's an incredibly important consideration managing inflation. So what are some options for investors if that is something they're concerned about? And let's make it clear too, Wes, give us a thought on we say unexpected inflation, right, because expected inflation is already priced into a bond. Yeah, that's good point. Expand on that a little bit. You know, I mean clearly like asset prices are gonna take into account the market's expectations for inflation and so the return demanded by market participants, which effectively guides the price, is going to have to at least start there, right? We see periods of time where the inflation expectations can be much different than what we actually get. I mean you can see the inflation expectations usually using, for example, inflation swap rates. You can see what is the market expecting inflation to be and then you get actual inflation, which again is gonna be based on things that were unexpected. So class examples coming out of COVID where you had, you know, supply chains trying to reassemble themselves and you had a run up in prices that would only have been expected if you knew we were gonna have a global pandemic and knew exactly what the fallout was gonna be. And so that's why investors might wanna go one step further and actually hedge unexpected changes in consumer prices. And you know, there's a lot of types of fixed income where you can do that. Where you can get inflation protection that effectively pays you for unexpected inflation. Well, but also be really clear on what is it you're trying to accomplish. And if you, if you want to perfectly hedge unexpected inflation, there's great ways to do it. But I think 2022 is a good example where you had some tip strategies, right? Which is a treasury inflation protected security where you say I can take that risk of unexpected inflation off the table. Well Wes kind of commented on this, there's still real rate risk. You look at a lot of those strategies and they're down in 2022. So an investor gets to the end of 2022 and it's like, hey, what the heck happened, right? Inflation was up, I thought I was protected. Be like yeah but your goal was to hedge unexpected inflation and you did that. So at the end of the year don't be disappointed 'cause the value was down because maybe you didn't clearly define what your goal was. Exactly, the goal of protecting against unexpected inflation was met. You just happen to have some losses from real changes in real rates and I think that'll cut a lot of people by surprise. Yeah, Around that. So what are a couple solutions there as you think through then, well I do want protection against unexpected inflation, but maybe I don't want as much duration or long maturities. Yeah, I mean there's a lot of different solutions that would be inflation protected. Obviously the most obvious one being, you know, tips or treasury inflation protected securities are issued by the government that, you know, give you that. Now going back to your duration comment about the real rate risk, you know those tend to have longer durations and so you're gonna have more volatility than you would for like one month treasury bills. So there's ways you can get synthetic inflation protection where you can overlay that on different fixed income asset classes, whether it's corporate bonds or muni bonds. But same idea as you're gonna get compensation for unexpected changes in consumer prices. Now they can cut both ways. If and if inflation in actuality ends up being less than the expectation, then you're gonna end up having a negative return from that. Hey Wes, sometimes you hear about this idea of LDI or liability driven investing. You know, maybe walk us through what that is and then you know where that can come in to be part of your strategy for for bonds. Yeah, it's another kinda risk. So you know, we've been talking about okay, uncertainty around the value of your invested assets, the uncertainty around inflation, whether it might be the uncertainty around being able to afford future liabilities. I often use a classic example of like, okay, let's say I wanna buy a boat 10 years from now. Let's say I don't know how much boats go. Let's say it's a hundred thousand dollars. Well I know to a high degree of certainty what the cost is of that liability today. How do I know that? Well it's how much money I have to set aside in something that is basically riskless. So if I buy a 10 year treasury, we're gonna take the inflation component out of this, say the price is gonna say $10,000. I know precisely how much money I need to set aside in say 10 year US treasuries based on current interest rates. And that expresses the value of that liability. So what liability driven investing is about is you have a portfolio of assets whose price is along with the price of that liability. So I already expressed the price of that liability using interest rates, which means there's interest rate sensitivity. And so if I align the so-called duration of my portfolio of assets with a duration of that liability, what that means is yes, both of 'em are gonna change in price as interest rates move, but they're gonna be moving together. And I think that's a really key component because this is a different kind of standard deviation you're gonna measure. It's not the standard deviation of the portfolio value that matters, it's the standard deviation of what I can draw off of my portfolio in the future. And that's just gonna be a different set of assets. Yeah, I mean you see it maybe a little bit more in the institutional space. I mean you've seen it with pension funds over time. You've seen it with insurance. I mean if you have the ability to precisely estimate what your liabilities are gonna be in the future, it can be really good. 'Cause what are you doing? Basically you're taking risk off the table. To Wes' point, you're aligning the liabilities and the asset. Those things move in lockstep. I know how much money I'm gonna have down the road, right. The problem when you move over to the individual or the wealth space is try estimating your future liabilities with that type of precision, right? I mean you use the boat example, right? I mean I don't know what a boat's gonna cost 10 years from now, right? That's really tough to, it's really tough to know. I mean think about college expenses. You plan for college and you save for college, but telling me right now what my kids are gonna spend or I'm gonna have to spend on college 10 years from now, I don't really have any precision around that. So trying to perfectly match up the liability with the assets today, it's more of a challenging thing to do I think when you move into kind of the personal wealth space. What I can tell you is it'll be more expensive than what you're saving for. Thanks Gochnour, I appreciate that. But I think this, you know, you go back to, okay, what is the low risk asset that you would use here? We already mentioned one example of how t-bills can actually be riskier than you might otherwise think. In the case of inflation, they're also risky when you talk about long dated liabilities because you know, yes they have low return volatility, but because they're being rolled over every single month, I have no idea what the interest rate is gonna be one year from now, five years from now, 10 years from now. And so I can't project, if I'm using T-bills, what I'm gonna be able to afford in the future. Depending on the path of interest rates, I could be very underfunded for my future goals. I could be overfunded, which is almost as bad because then you have the opportunity costs of I saved too much money here, I could have been using it for something else. Yeah and it, this starts to me kind of getting that conversation around bond ladders, which we hear about or buying individual bonds. So I mean, shoot, we get this question all the time at conferences, don't we? Oh yeah, yeah, about, hey I can just go buy a bond ladder, I can get a targeted duration using bond ladders. But you know, just be careful. It's very expensive for an individual to go buy individual bonds, right? You need some institutional buying power to get execution on some of that. Yeah and for anyone who's not familiar with that concept, so we talk about a bond ladder, it's basically okay, if I have five years, I might have bonds that are maturing, you know, one year, two years, three years, four years, five. So I have this continuous sort of flow of cash. But that also means that you're foregoing the opportunity to pursue higher expected returns in that scenario. Because the highest expected return is not gonna be sort of an equally weighted average of one, two, three, four, and five year maturities. It might be somewhere in between. Clearly it's gonna be a behavioral element here because if you, we know the bonds are changing price as interest rates change, but if you're not selling them before maturity, you don't see it. So there is sort of the comfort of knowing you're gonna get exactly whatever that maturity payment is. Well the cost too as an individual, I mean going out and buying an individual stock on an exchange, I mean obviously you have to consider bid as spreads, all of those things, transaction costs, right? But if you want to go out and buy individual bonds in not large quantities, in odd lots, in smaller dollar amounts, all of these things, what we know is, is that when you trade in the institutional space like we do here at Dimensional and what we do there versus trying to do that as an individual or even a financial professional, a financial advisor, it's a lot tougher to get good prices for that stuff. Especially in corporates and Munis completely around, by the way you mentioned Munis, so you, that's another option. You might have somebody that's, you know, tax sensitive investor and Munis can be a good way to think about, you know, avoiding some of the taxes with that income. Yet another use for fixed income, yeah. Okay, so a lot of uses we just talked about there. I mean it can get complex very quickly depending what the needs are. So how does somebody try to put all this stuff together? Like to me it just goes back to most investors probably need some financial professional help. Absolutely. To make sense of this. I think people under, I mean maybe it's, they feel this way, but I think people are more comfortable with the stock market in general than the bond market. But do understand that, man, there's a lot of use cases, there's a lot of interesting things you can do with bonds, a lot of different goals that you might be able to establish with that. So to your point, to understand it, maybe getting with a financial professional to say, here's my goals, here's what I'm trying to do. What's the best way to go about it? Can be a good route. All right, so I'm gonna go back to the headline that we read earlier just to sort of come back to assessing or the bonds you're using, delivering and meeting the need, the goals of what you have. So bonds pay in good and bad times. And again, we talked about this earlier, but when I'm talking about pay, I'm saying meeting the goals, depending on what it is. If it's inflation protection and you are using tips to protect against unexpected inflation, yeah you have some real risk, your value of your bond may go down, but that's okay because you're protecting against what your goal was. All right, so I'm not the most creative person here, but I'm gonna try something. I have an analogy. I'm ready for it. You ready for this one? Can't wait. All right, so Jake, you know you play tennis as well. I play tennis and so let's just say we got our tennis shoes. I don't play tennis. You don't do. You don't golf either? I don't have the temperament for it, I used to. Yeah, so you're not very good in this example then. Okay, so Jake. Say it to me. I got you, bring it on. Let's talk, all right. So we play tennis, we like golf, we like to hike. And so we got hiking shoes, we got tennis shoes, we got golf shoes, we got probably just shoes to wear around. We got probably dress shoes. I have cowboy boots on right now. I got boots just not on today. All right, but they surve a purpose, right? So when we're playing tennis, we're not wearing cowboy boots, right? Or we're not bummed that I've got golf shoes I'm not using today when I'm playing tennis. And so I equate that with the bonds, right? So let's just say, hey, I am in cash but I'm not earning the 6% I could on this longer term bond. That's okay because it's a different goal. So don't stress about, hey, I'm not getting that kind of return when I'm getting this return because it's meeting my stability goal. Or I might lose money on a tips bond. That's okay because I'm getting protection against unexpected inflation. That's really good. Does that make sense? Sure, that works for me. You could be the judge. That's way better than my analogy, which I used to use too to dissuade people from buying like the whole, the entirety of the bond market. Is I say, when you go shopping for pants, you get just your size in the pants. You don't buy every single pair of pants there in different sizes. I like yours better. All right. Hey, one question we get as it applies to bonds is, how you gonna forecast interest rates? Tell me what interest rates are gonna be. We get that with stocks too. Hey, can I predict what's gonna happen in stocks going forward? So that is going to be a future topic on the "Informative Investor." Is there any way to be able to time markets into the future and stocks or any way you can time interest rates. So stay tuned for that future episode. Thanks for joining us today and be sure to go into the survey and give us some thoughts on future topics. Thanks everybody, have a great day.