MONEY Ask the Expert

The Case for Investing in Bonds, Too

Q. I’m 52 and have had 100% of my savings in stocks since I began investing at age 25. Given my high risk tolerance and the fact that I expect that my pension and Social Security to cover a substantial portion of my expenses in retirement, why should I reduce my investment returns by investing in bonds? — Eric C.

A. If you’ve been putting your dough exclusively in stocks for the past 27 years, then you know firsthand how lucrative they can be over the long term. Since 1985, the year you began investing, stocks have gained an annualized 11%.

You no doubt also know how risky stocks can be over shorter periods. You’ve lived through the Crash of 1987 when the Dow Jones Industrial Average plummeted 508 points — nearly 23% — in a single day. And you’ve survived both the bear market of 2000-2002, which saw stock prices fall 49%, and the meltdown of 2007-2009, when stock values dropped almost 57% (a setback from which they still haven’t fully recovered).

I’m sure I also don’t have to tell you that bonds returned far less than stocks over the past 27 years and that their yields are especially low right now, with 10-year Treasury bonds yielding less than 2% and investment grade corporates paying only a half percentage point or so more.

Given your experience with stocks and the state of the bond market these days, I can understand why you equate keeping any of your savings in bonds as nothing more than an invitation to subpar returns.

But I think you need to revise your thinking. Here’s why:

You became an investor near the beginning of one of the greatest bull markets in history. The surge in stock prices that began in 1982 and with few interruptions continued through the end of 1999, showered investors with almost unprecedented rewards. It also included some truly phenomenal stretches, like the 10-year span from 1989 through 1998 when stocks gained a compounded 19% a year, almost double equities’ long-term annualized return since 1926. So I think it’s fair to say that this outsize performance has a lot to do with the way you feel about stocks.

Related: Investing: When to ‘Take Money off the Table’

What’s more, up to now you’ve viewed the risks and rewards of stock investing primarily through the lens of a relatively young person. Which means you’ve been much more likely to shrug off stocks’ periodic setbacks. They’re not as scary when you have decades to rebound from them.

But looking ahead, conditions may be quite different. While stocks are still likely to beat bonds over very long stretches, many analysts believe stocks won’t deliver anywhere near the same size gains they did in the go-go ’80s and ’90s, nor will they outperform bonds by as large a margin.

That’s certainly been true for the past 10 years with stocks gaining 7.3% vs. 6.3% for bonds. Some investment advisers, like PIMCO’s William Gross, are even forecasting extremely meager stock returns for the years ahead.

And while you may still think of yourself as quite the risk taker, I think you should allow for at least the possibility that a 50% decline in the value of your savings — and the retirement income it might produce — may be much more upsetting as you get closer to the end of your career than it was when you were starting out. I’m a bit older than you, but I’ve found I’m much more sensitive to stocks’ volatility myself.

As you weigh the issue of risk, you may also want to factor into your thinking recent research that suggests that the severity of downdrafts we’ve seen in stocks in the past may occur more frequently than we previously believed.

At any rate, I recommend that you at least consider scaling back your equity exposure. I’m not talking about a total retreat. Rather, I’m suggesting a stocks-bonds mix that allows for long-term growth, but won’t get hammered as much should the market tank during your home stretch to retirement — say, 70% stocks and 30% bonds. As you age, you would then gradually reduce your stock stake, dialing it back to 50% or so of your holdings by the time you retire and then eventually paring it down to between 20% and 30%.

If you expect that your pension and Social Security will cover most of your basic retirement living expenses, you’ll have more leeway in how much you’ll have to draw from your stock portfolio. That flexibility could allow you to be more aggressive and increase your stock percentage a bit. But I’d be wary of going higher than, say, 75% to 80% stocks today and 55% to 60% at retirement.

Related: Retirement Income: Five Steps to a Sound Plan

Many investors are particularly wary of making bonds part of their portfolio these days for fear they could suffer losses if interest rates rise. But the potential setbacks in bonds — especially those with short- to intermediate-term maturities — pale in comparison to the hits stocks have taken in the past and could take in the future. So despite any anxiety about interest rates rising, bonds are still a worthwhile way to reduce the overall risk level of a portfolio.

Bottom line: I’m all for maintaining reasonable exposure to stocks in the years leading up to and following retirement. But the key word is reasonable. Obviously, you have to decide what’s appropriate for you. But you’ll be a lot better off if your decision includes a realistic reassessment of your risk tolerance rather than simply going with what worked over the past 27 years.

MONEY

Investing: When to ‘Take Money off the Table’

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When it comes to investing your money, focus on creating and maintaining the mix of stocks and bonds that's right for you. Jupiterimages—www.jupiterimages.com

I think I get the idea of “taking money off the table” when it comes to investments. What I don’t understand is when you should do it and how much. Any advice? — Mark Tyner, New York, N.Y.

You hear this expression a lot around the investing world, usually when people are worried about a possible market setback.

For example, I recently saw a money manager on TV tell viewers it was time to “take some money off the table” because he thought that the stock market, which had gained roughly 10% the previous three months alone, was getting too pricey.

But like many concepts that pass for wisdom in the investing world — dollar-cost averaging being a prime example — this one doesn’t hold up very well when you really think about it.

Let’s say that you “take some money off the table” by selling $10,000 worth of stock from your investment portfolio. Unless you actually spend the proceeds of that sale on living expenses or whatever, you now have $10,000 in cash that has to go somewhere.

Whether you decide to put it in bonds, real estate, commodities, gold or an FDIC-insured savings account, it’s still part of your portfolio — and the return you earn or don’t earn on that money still counts as part of your portfolio’s overall performance.

So you haven’t really taken anything “off the table.” All you’ve done is move $10,000 to a different place on the table.

I don’t make this distinction to be coy or to engage in semantics. I do so because the phrase “taking money off the table” creates the false impression that it’s okay to view different parts of your portfolio in isolation.

But it’s not. You’ve got to look at the big picture because changes you make in one part of your portfolio necessarily affect the whole. And to truly understand the effect of any transaction, you’ve got to consider what that move means for your investment holdings overall — and how any move leaves your portfolio positioned for the future.

Related: Boost Retirement Income, Minimize the Risk

If you sell stock and put the proceeds into bonds, you’ve tilted your portfolio more toward the conservative end of the risk spectrum. Plow the proceeds into cash, and you’ve moved even more in that direction. More importantly, though, you’ve changed the balance of risk and reward in your portfolio. Essentially, you’re saying you’re willing to give up more potential gain in return for less volatility.

That’s fine, as long as your decision is consistent with your long-term goals and tolerance for risk. But from what I see, people who use the phrase “taking money off the table” aren’t talking about a long-term strategy. They’re reacting to something going on at the moment, such as a fear among investors that the economy will falter or the market will drop.

Combine that urge to react to short-term issues with the failure to appreciate how moves in one investment affect the portfolio in its entirety, and investors who think in terms of “taking money off the table” can very well end up undermining their long-term investing strategy.

To avoid that possibility, I recommend you simply settle on an overall mix of stocks and bonds that makes sense for your situation.

If you’re saving for a goal that’s decades away, you might keep 70% to 80% of your portfolio in stocks, even more if you’re okay with seeing the value of your holdings bounce around a lot in the short-term.

If you’re planning to tap your investments sooner, you’ll want to hold less in stocks.

Once you’ve chosen the right blend for you, stick with it except to rebalance periodically — say, once a year — to restore your portfolio to its target allocation. If stocks outperform bonds one year, you would sell some stocks and put the proceeds into bonds to get back to the right mix. This way, you’re not letting emotional reactions to market ups and downs dictate your investment strategy.

I can imagine that some readers are now saying, “Wait a minute. Isn’t rebalancing just another way of ‘taking money off the table?’” The answer is “no.”

Related: How Much Does Your Money Manager Cost You?

For one thing, rebalancing is systematic, not based on subjective notions of investments being overpriced or poised for a setback. There’s also no false sense that you’re removing money from the investment equation when you rebalance. It’s clear you’re taking money from one investment and putting it into another with the goal of maintaining a trade-off between risk and return in your overall portfolio.

Finally, people generally talk about taking money off the table when they have a gain or when an investment has recently soared. With rebalancing, it’s the relative proportions of the assets that dictate action. Thus, even if both stocks and bonds have a down year, you would still rebalance by selling some of the asset that performed better and plowing the proceeds into the one that did worse.

Bottom line: Forget about this notion of “taking money off the table.” It’s misleading and potentially harmful. Instead, focus on creating and maintaining the mix of stocks and bonds that’s right for you.

MONEY

Investment Advisers See Some Bright Spots

Nearly 60% of independent advisers think a double-dip recession is unlikely over the next six months, and more than 60% expect the S&P to increase in the same period, according to a survey released recently by Charles Schwab.

But don’t go betting the farm on these optimistic findings just yet. A look at the results from January’s survey of advisers shows that they aren’t necessarily the best augurs. In that earlier survey, 49% of advisers expected inflation to increase in the next six months (it hasn’t); 47% expected consumer spending to increase (it hasn’t); and 40% expected unemployment to increase (it hasn’t). Advisers did get some things right, though. In the January survey, 59% expected consumer savings to increase in the next six months (it did); and 46% thought the housing market would continue to soften (it has).

Schwab acknowledges that the survey has limited forecasting value. “We’re thinking [the study] is more like a national view of what’s going on,” says Bernie Clark, executive vice president for Charles Schwab Advisor Services. “It’s not a predictor as much as where we think that the trends are taking us.”

And what looks like the dominant trend these days? The biggest challenge facing advisers and their clients right now, Clark says, is what he calls the “uncertainty factor.” About half of advisers’ clients feel less optimistic about the economy than they did in 2009. Forty percent of advisers say their clients are less optimistic about their investment performance than they were six months ago, and 50% of advisers say their clients feel less confident they’ll be able to retire when they want to. Advisers report that 47% of clients are reducing expenses, and more than half are spending less on discretionary items.

Advisers have their own doubts, too. Seventy-one percent say it will be difficult to achieve their clients’ financial goals. That’s down from the 84% who held that opinion in early 2009, but up from the 58% who expressed these doubts earlier this year.

In any case, people are increasingly turning to independent advisers for help with financial planning. More than 9 in 10 advisers said they received new assets in the past six months.

For the record, the sector of the market that advisers think will perform the strongest over the next six months is information technology, cited by 47% of them. Of course, if you have your doubts about advisers’ predictive powers (see above), maybe you’d also like to know the sector in which they have the least confidence. And that’s consumer discretionary—the pick of only 9% of professionals. Check back in six months to judge their accuracy.

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MONEY

Your Midyear Tax Checkup, Day 2: Sell Investments Strategically

Having hit the midpoint of 2010, we’re doing a week-long spree of tax planning posts this week (check out the earlier one on figuring out if you’ll be square with Uncle Sam). As any tax pro knows, a little foresight can go a long way toward making your next April 15 a little more pleasant.

Today’s topic: Investing strategy.

If you sold an investment in ’07, ‘08, or early ‘09 for less than you bought it for — as many people did — you may still have capital losses that you’re carrying forward. If so, you also have a great opportunity to switch up your investments, rebalance your portfolio or simply liquidate into cash without incurring any taxes, says Rob Seltzer. You can apply losses to cancel out gains, which gives you an out: “If you want take some money off the table, you have a painless way of doing it,” he says. So take a look at your portfolio to see if there’s a need to change up or cash out.

But don’t forget too that up to $3000 of losses can be applied to ordinary income per year, and that can be worth a lot in terms of tax savings. So there’s no need to rush to use losses if you don’t have to. Besides, “Any losses carried over will be very valuable in future years, as the tax rates go up,” says Tustin, Calif. CPA Monica Rebella. That’s because the long-term capital gains rate is slated to increase to 20% for everyone in the 28% bracket or higher next year vs. 15% now for the 25% bracket and up.

In fact, because of the expected tax increase, Rebella notes she’s advising some retirement-age clients to liquidate more money than they ordinarily would this year, since it will be more costly for them in 2011. Now that’s foresight.

Tune in tomorrow for info on availing yourself of the most deductions you can.

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MONEY

Vanguard Joins the ETF Price War

Now the ETF game is really getting interesting.

Vanguard announced it has removed trading fees on all 46 of its exchange-traded funds. In addition, the fund group lowered its commissions for buying or selling stocks or non-Vanguard ETFs to just $7 to $2, depending on the size of your account.

With these moves, Vanguard has trumped rivals Schwab and Fidelity, at least for now.

Schwab started the commission-free war last year by removing trading fees on eight of its own ETFs; it currently charges $8.95 a stock trade. Fidelity, which charges $7.95 a trade, recently waived fees on 25 iShares ETFs.

Vanguard is clearly determined to dominate. The firm, which took over its brokerage operations from Pershing last year, now manages some $100 billion in ETF assets and ranks as the third-largest ETF provider, behind iShares and State Street. That rapid growth has come about largely because Vanguard’s ETFs generally carry the lowest expense ratios of any fund family, an average of 0.18%.

That growth is likely to continue, since commission-free trading has eliminated one of the few reasons to avoid ETFs: For those who seek to make regular deposits, or simply rebalance, the cost of paying for trades can quickly outweigh the advantage of the lower expense ratios that ETFs may offer. And investors are also attracted by the generally (but not always) low fees and tax efficiency of ETFs, as well as as the ability to trade while the markets are in session.

Still, for longtime Vanguard investors, it’s surprising to see the fund family shift toward commission-free ETF trading. After all, Vanguard founder Jack Bogle has often complained that ETFs foster “short term speculation” — exactly the opposite of the patient, buy-and-hold investing approach he has long advocated.

But the move toward commission-free trading will ultimately benefit Vanguard’s mutual fund investors, says investment adviser Rick Ferri, head of Portfolio Solutions.

That’s because of the unique nature of Vanguard’s ETFs, which are share classes of existing mutual funds. This patented structure gives managers tremendous flexibility in buying and selling the portfolio’s stocks and bonds, which can improve tax efficiency and lower costs.

Ferri notes that the commission-free trades will help attract more assets and trading liquidity to Vanguard’s ETFs, some of which — its new bond ETFs, for example — still lack critical mass. So, odd as it may seem, if Vanguard sees an influx of day traders, who furiously churn their portfolios, that may eventually benefit its core group of buy-and hold investors.

UPDATE: A Vanguard spokesperson says that the fund group “will closely monitor trading of our ETFs, and if a client is engaged in excessive trading, we will reserve the right to reject further trades.”

Does all this mean you should rush out and buy Vanguard’s ETFs? Or swap your existing Vanguard mutual funds for their more glamorous ETF counterparts?

Not at all. You first have to look at your long-term goals and asset allocation strategy. In many cases, your mutual funds may give you access to asset classes that you can’t find in ETFs. Or the ETFs may be thinly traded or fail to track their indexes closely; that’s especially true for micro-cap and some types of emerging market stocks. And many bond funds have had trouble hewing to their indexes, particularly during the 2008 credit crunch.

Still, for your core portfolio, ETFs do offer great choices for tracking broad asset classes. And Vanguard, along with iShares and State Street, offers sound, low-cost options. [UPDATE: According to Vanguard, a switch from a Vanguard mutual fund to its ETF share class is not considered a taxable event.] The Money 70 funds, for example, include Vanguard Total Stock Market ETF and Vanguard Europe Pacific ETF VANGUARD TAX MANAG FTSE DEVELOPED MKTS ETF VEA -0.3528% , among others.

And if the price wars continue, the choices are likely to get even better.

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MONEY

The Market Boomed… and 401(k) Investors Sat on Their Hands

A new survey out today from Hewitt Associates finds that 401(k) investors haven’t been very busy lately. Just 16% of participants made any kind of fund transfer in 2009, vs. about 20% the year earlier. In other words, relatively few people noticed the 27%-return rally in the works and said to themselves, “Hey, I should jump back into stock funds.” That’s good… and it’s bad. And it’s an opportunity to make 401(k)s work better.

Why it’s good: Chasing hot-performing funds or sectors is a pretty-sure fire way to lower your return. But the majority of investors didn’t do that.

Why it’s bad: As Hewitt notes, the numbers also mean that the majority of investors didn’t move to rebalance their portfolios. That means that as the value of the stocks in their portfolio grew, they were more exposed to equities (as a percentage of their overall portfolio) at the end of the year than they were at the beginning. Trimming back on stocks to get back to your original asset allocation can help reduce risk, and it gives your portfolio a slight (and smart) contrarian tilt, because it forces you to sell what’s hot and buy what’s not.

How to make 401(k)s better: If employers and policymakers want people to get more out of their 401(k)s, investors who underreact aren’t as big a problem as investors who overreact. It’s hard to convince someone who thinks that frequent trading is helping his return that he’s wrong about that — although he probably is. But for most investors, it seems, inertia plays a huge role in their investment decisions (or, more precisely, their non-decisions). That suggests that you can do a lot of good just by nudging people into low-cost, well-diversified investments at the very beginning.

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Angry Schwab Bond-Fund Customers Win in Court

Charles Schwab lost a big court decision last week in a case that has significance for investors in mutual funds. A federal judge ruled that Schwab violated the law when its YieldPlus ultra-short bond fund failed to get shareholder approval before loading up on mortgage-backed securities. When the market for those securities collapsed, the fund lost 36% — a nasty surprise for investors who believed that YieldPlus was a safe alternative to cash. Left to decide is the amount of damages the investors should receive; lawyers say California investors alone lost about $170 million, the rest about $800 million.

I myself looked into YieldPlus while reporting a recent story for MONEY about Charles Schwab. Most observers I talked to believed that the fund’s losses represented an isolated mistake — a big, bad mistake to be sure — rather than evidence of a corrupted corporate culture. But the YieldPlus debacle did strike me as a particularly problematic episode for Schwab, which built a wildly successful discount brokerage based on the philosophy of not telling its investors what to buy. As the company delves deeper into helping its customers design their portfolios and invest smartly for retirement, it becomes ever more challenging for Schwab to provide advice that’s free of conflict. Once a firm creates its own mutual funds, such as YieldPlus, an obvious question is raised about the incentives employees have to sell those funds instead of others.

Let’s review the arguments of this surprisingly underpublicized case:

During the 2000s, according to the complaint at the center of the recent case, Schwab marketed YieldPlus as offering “good returns with low principal risk,” listing the fund as an option for investors’ cash allocation in their portfolios. Yet, the plaintiffs claim, YieldPlus loaded up on mortgage-backed securities that were much riskier than its marketing materials conveyed, allocating as much as half of its assets to MBSs in early 2008. The complaint further alleges that Schwab trained its customer representatives to recommend customers transfer assets to YieldPlus from money market funds, and that Schwab’s compensation structure made it financially beneficial for them to do so. (The company’s compensation system paid more for assets held in mutual funds than in CDs, for example.) Schwab, in court documents, denies that it took on more risk than allowed and denies that it misrepresented anything to investors. The company also rejects the allegation that it trained reps to upsell customers into the fund and had any incentive to do so. For the company itself, YieldPlus brought in roughly $76 million in fees for the four years leading up to the collapse.

In any case, Schwab customers piled into YieldPlus, pushing its assets past $13 billion in 2007 — just in time to see the fund tank, along with the MBS market, in 2007 and 2008.

A key allegation in the lawsuit is that YieldPlus’s big bet on the MBS market violated a policy preventing it from investing 25% or more of its assets “in an industry or group of industries” unless shareholders voted to allow it. That’s led the parties in the case to argue over such issues as the definition of a “single industry,” Schwab’s obligations to notify investors, and the necessity of getting shareholder approval for the change in policy.

But in a decision issued last week, U.S. District Judge William Alsup sided with investors against Schwab, ruling that the fund’s MBS investments represented a reversal of the fund’s diversification policy that needed a shareholder vote for approval. “This is not a disclosure question,” the judge wrote. “It is a governance question.” Alsup also ruled April 8 against certain trustees of YieldPlus and YieldPlus’ former manager, Kim Daifotis, who had attempted to get various counts against them thrown out.

Whatever Schwab’s culpability, says Morningstar’s managing director Don Phillips, there’s no question that YieldPlus is a “big, ugly black eye” on Schwab’s image of a good citizen — one that looks out for investors and not its own pockets. “People,” he says, “expect more of Schwab.”

No less a sage than Vanguard founder Jack Bogle called me this week to talk about the ruling, calling YieldPlus a classic example of a firm “reaching for yield” to produce results that help it sell the fund. It’s one of the classic sins of mutual fund companies he battles against. “The message over and over again,” he says, “is, ‘Go the straight and narrow.’”

To me, the lesson is that there are pitfalls to Schwab’s decade-long effort to become more than a simple hub for transactions. When you recommend an investment, sometimes you’re wrong, besmirching both your regulatory record and your image. John Kador, who wrote a mostly-glowing book about Charles Schwab and who now blogs about apologies, says he thinks Schwab erred in not apologizing to customers quickly and taking responsibility for their losses. But, he says, Schwab is trying to do the right thing in figuring out how to provide the most conflict-free advice possible to its customers. Keep this in mind, though: Just because advice is unbiased doesn’t mean it’s good.

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MONEY

A Dangerous Omen Looms for Bonds

One of the key questions faced by investors today, a year after the markets were at their worst, is how safe it is to go back in the water. Given that bonds have turned out to be a better bet than stocks over the past 20 years — and given the steep decline and perhaps shaky rebound in the equity markets — is it time to reassess the primacy of stocks in our portfolios? Will we be better off with the security and steadiness of bonds?

A great answer to that question came last week from Charles Schwab chief investment strategist Liz Ann Sonders.

Presenting her outlook on the economy and the markets to a group in New York City, Sonders spotlighted what appears to be a powerful contrarian indicator — that is, measure of how the investing herd is zigging in the market, giving a wise and brave investor a roadmap of where to zag.

The contrarian indicator in this case is a monthly asset allocation survey run by the American Association of Individual Investors, a nonprofit focused on investor education. Since November 1987, AAII has been asking its members for snapshots of how their own investments are distributed — how much of their wealth is in stocks (and stock funds), bonds (and bond funds) and cash (or cash equivalents, such as money-market funds).

In that historical record are some fascinating tidbits. Looking back in the archives (accessible with an AAII membership priced at $29 a year), Sonders found that the time at which investors devoted the the highest share of their portfolio to stocks was in early 2000, when AAII respondents had more than three-quarters of their money in stock.



You remember what else happened around then, right? The S&P 500 Index shot past 1,500 — only to begin a two-and-a-half-year slide down to 800. The Nasdaq’s slide from its giddy, early-2000 heights was even more devastating.

When did cash hit its peak allocation in the AAII survey? That would be last March, Sonders learned, when people had 45% of their wealth in the green stuff.



Has cash proved to be a good place to have your money since then? No, it hasn’t. The the average money-market yield over the past year, according to Lipper, has been less than one-tenth of one percentage point. In contrast, the exchange-traded fund based on the Barclays Capital Aggregate Bond Index returned 8% over the past twelve months. The total return of the S&P was 37%.

So when did bonds reach their high-water mark in the AAII survey? Last summer, when fixed-income investments amounted to 25% of portfolios.



Hmm. And what do allocations look like right now? As far as bonds go, there’s little change.



Notice, Sonders said last week, that the current allocation to fixed-income, at 24%, is still very near the category peak hit last summer. “I think this has implications,” she said.

Moreover, said Sonders, following the previous two times in recent financial history when bonds outperformed stocks over a two-decade period, the next five years “hugely” favored stocks over bonds.

Will the AAII continue its predictive streak as a contrarian indicator? We’ll find out in a few years.

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MONEY

More Money Friday Roundup: ETF Hazards & When Not to Tip

Personal finance from around the Web:

  • Exchange-traded funds are all the rage these days, but are they right for you? Here’s a primer on perks and pitfalls of ETFs. [USA Today]
  • If your teenager is more worried about the latest Twilight movie than her latest bank statement, she might need some credit guidance. Here are some tips to help your teen become credit savvy before the balances accumulate. [Wise Bread]

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