Part of must-read guide: How to build an all-weather portfolio, step-by-step.
Step 8: Find low-cost ways to own your stock and bond allocations.
- Diversifying U.S. Treasury bonds isn’t as important as diversifying stocks.
- Low cost is the third important factor that determines success for bond investments: (1) time to maturity, (2) issuer credit quality, and (3) expenses and fees.
- Do-It-Yourselfers spend less.
“In Investing, You Get What You Don’t Pay For.”John C. Bogle
Five years ago, Samantha inherited $60,000 worth of high-tech stocks. She had an additional $40,000 in a savings account. She hired a financial advisor who replaced the stock with a mutual fund, put her savings in a bond fund, promised to keep her at this stock/bond ratio, and assured her that she will earn higher returns with their firm which will more than offset their fee which is 1% of her portfolio balance every year. The two funds have annual fees which were 0.4% and 0.3% which seemed small and she promptly forgot about.
That’s pretty typical. Many financial advisors charge fees of 1% (or more) of your portfolio balance each year to provide portfolio management services as well as ongoing financial planning advice. The question to consider is whether these services are needed and whether this is a fair way to pay for these services. It’s often less expensive to break the services out and pay for them separately.
To illustrate the cost of this service to Samantha, consider how her portfolio might grow with and without the all-inclusive professional services. We’ll assume stocks return 7% and bonds return 3% (both below historic averages). Her investment period is from age 30 to 70, and the firm keeps her balanced at 60% stocks and 40% bonds. The total value would be $491,000 after 40 years.
In contrast, she could set up an account at one of the mutual fund giants, choose an excellent balanced fund (60% / 40%) with an annual fee of 0.16%, and have an end value of $771,000. The difference of $280,000 went to her financial advisor’s firm!
That’s right! Now, there will be no way to make Samantha feel good when she learns this. Samantha takes all the risk, and her advisor would now own more than one-third of that total in exchange for their services. The question she really needs to ask herself is, “Did I get good value for what I paid this advisor?” For some the answer might be yes. But for many, I think this eye-opening reality is enough to help them understand that they can learn to take control of their finances and that this is one of the keys to achieving financial independence.
If you suspect that this book has a strong bias towards managing your own investments, you would be right! I think most people are smart enough and just need to be shown how, step-by-step. Yes, if Samantha (or you!) has something complicated that she needs advice on she should be happy to pay a fair price for that. But make that a separate and reasonable fee for that specific service.
How Much To Diversify Bonds?
Diversifying the highest quality bonds has neither the same importance nor benefits as diversifying stocks. The two main parameters you would consider diversifying are the credit quality of the issuer and the term of the bond.
With Treasury bonds, the most liquid investment in the world, trading costs are extremely low. And since there is no credit risk, you don’t need to use a mutual fund to diversify credit quality. Instead, you can buy individual Treasuries on your own, saving the expense ratio of a mutual fund. Or buy government insured CDs from a bank or credit union for the similar benefits. Smaller investments? Keep it simple. Just use a low-cost mutual fund, and get on with life!
Diversification of lower quality bonds would be important. But remember: The single biggest mistake bond investors make is reaching for yield after interest rates have declined. Don’t be tempted by high-yield bonds.
Is it important to diversify the term of the bonds? Not really. It is important to match the bond type and duration with the investment goal as we discussed earlier. You can accomplish this yourself with individual bonds or CDs, by a simple bond ladder, or with a constant duration bond fund.
Don’t try to time the market. Buy what you need now. As hard as it is to time the stock market, it’s even harder to time the bond market. Avoid speculating on interest rates. Decisions are too often made on where rates have been rather than where they are going. Instead, stick to the investment strategy that will best help you achieve your goals and objectives.
Earlier we discussed the pros and cons of international bonds, but they seem to cancel each other. So when in doubt, choose simplicity. Stick with U.S. bonds. John C. Bogle emphatically agrees, saying multiple times over his career: “When there are multiple solutions, choose the simplest one.”
The Importance of Low Cost
Low cost remains essential to success—basically, you get to keep what you don’t give away. “So if we pay nothing, we get everything.” That’s our goal—to keep what our investments earn.
Unlike stocks, where your return is tied to a company’s degree of success, the interest you receive for a bond (loaning your money) is largely uncoupled from that success. There is little value the manager for a fund of high-quality bonds can add—other than to attempt market timing.
It is hard for investors to keep costs (expense ratio) for bond funds less than stock funds, but the expected returns are certainly less so these costs take a bigger chunk. If your bond fund yields 2.5% right now, just 1% in fees or expenses cuts your return by 40%.
Consequently, owning individual federally-insured CDs or Treasuries can be a useful strategy. Very few CDs or individual Treasury bonds may be sufficient on your bond side, whereas owning so few individual stocks would be folly. It would for speculating, but not for investing.
General Guidance For Selecting Bonds
- Use bond funds (or a recurring ladder) for future needs that don’t have a calendar date. This will generally become most of your bond investments.
- Use individual bonds or non-recurring ladders for specific obligations. Generally prefer CDs, and US Treasuries to keep costs down. Diversification helps very little here.
- Check a fund’s duration. Keep the duration shorter than when you will need this money.
- Stick to short- or intermediate-term for the best risk/reward. An exception might be longer-term TIPS. .
- Stick to the highest quality bond funds or individual bonds rated AAA or AA. Don’t chase performance. Risk is better rewarded in the stock market.
- Split your bond investments between TIPS and nominal bonds to hedge for unexpected inflation.
- Deferring taxes is very valuable. Bonds are “inefficient” in that they get taxed at a higher rate than stock investments. Hold taxable bonds in tax-advantaged accounts like IRAs and 401(k) accounts, at least when interest payments are significant.
- Use index funds for liquidity, low cost and diversification.
- Staying with U.S.-only is fine.
- Be wary about buying individual bonds because of cost and liquidity. An exception is buying new issues of U.S. Treasuries, both nominal bonds and TIPS.
- Plan to reinvest your interest earned. This allows the power of compounding to work on your behalf.
- Don’t try to time the market.
Five Low-Cost Strategies You Can Do Yourself
#1 Low-Cost Mutual Funds: The easiest winning strategy for simple long-term investing in intermediate-term highest quality bonds is a low-cost bond index mutual fund. The annual cost (ER) for both these is only 0.10% for investments over $10,000.
FIBIX Fidelity Spartan Intermediate Treasuries Fund (cost = 0.20%)
VFITX Vanguard Intermediate Treasuries Mutual fund (cost 0.20%)
#2 Low-Cost ETFs: If your transactions are long-term and infrequent, then you can consider an ETF fund if you don’t have good low-cost mutual fund choices. For examples:
AGG iShares Total Bond Market Index Fund ETF (cost = 0.08%)
BND Vanguard Total Bond Market Index Fund ETF (cost = 0.08%)
#3 Opportunistic CDs and I bonds: Earlier we showed that if you are willing to put in the time and effort, you can actively mine long-term CDs with above-market yields and attractive withdrawal penalties. Also true for Inflation Savings Bonds (I Bonds).
#4 Opportunistic TIPS: The yield for TIPS varies between roughly -1% and +3%, so one strategy for those who insist on watching the market is to convert the bond holdings to TIPS when their real yield exceeds, say, 2%. Is this market timing (which is bad)? You decide. To me it is not speculating on the future, but rather locking in attractive rates the same way homeowners do when mortgage interest rates fall very low.
#5 Individual Bonds for Lowest Cost
Building your own fund only makes sense to me if you are using Treasuries and your goal is lowest possible costs. For some perspective, consider owning $100,000 in Fidelity Spartan Intermediate Term Treasury Fund. The expense ratio for this is currently 0.1%, which means you pay only $100 per year. I think that’s a bargain for most people! But suppose the bond portion of your portfolio is bigger, or your expense ratio (operating cost) is higher? I, for one, have a hard time paying hundreds or thousands of dollars each and every year for something I can easily learn to buy and own for free!
Treasuries (includes TIPS) are attractive because they can often be purchased and held without a sales commission and annual fees, and they don’t need diversification because most consider U.S. Treasury bonds to be free of credit risk.
Earlier, we made the case for CDs. Some people use DepositAccounts.com to find CDs with attractive rates and are careful to observe the FDIC limits of $250,000 per account. Note that while the market where bonds can be traded is extremely efficient, there is quite a lot of variety in CD rates. This is because big institutional money cannot participate, and also because banks use these rates as a promotion to capture new customers. Until recently, I didn’t own any CDs because: (1) I don’t like the extra research and complexity of working with multiple institutions, and (2) they lack the liquidity of bond funds. But I certainly know people who do use this to their advantage. Just make sure you understand the penalty if you liquidate early—it’s typically at least a few months of interest.
Individual corporate bonds are another animal. Their costs are expensive and not transparent and diversification becomes a necessity. Mutual funds and ETFs are definitely the preferred way to own even the highest quality corporate bonds. Institutional investors have the upper hand. There is no organized “bond market” so access is one advantage they have. They can also trade at preferred rates/prices. If you are tempted to own corporate bonds funds, you must do additional homework so that you know exactly what bonds are owned by the fund and the costs of the fund.
This chapter introduced the third of the three important factors that characterize bond investments: term, quality, and costs.
One of your biggest costs is hard to recognize because it isn’t going to be listed on your account statement—but you don’t need to be a genius to recognize that ordinary tax brackets will take a huge bite out of what your investments earn. You need to be a little tax savvy.
Next is STEP 9. Taxes matter. Learn how and when to use tax-advantaged accounts.