I agree. One of the most cringe-worthy parts of this post is the author's multiple references to bond funds. Owning bond funds is not the same thing as owning bonds and every bond investor should know the difference.
Bond prices have an inverse relationship with interest rates. Bond prices fall when interest rates rise. When you own individual bonds, you cannot lose your principal if you hold to maturity unless the issuer defaults. Most bond funds do not hold bonds to maturity, so investors in bond funds have significant exposure to interest rate risk. This is especially true today given the interest rate environment.
There are other ways to address interest rate risk with bond funds, especially if you have a longer horizon. You can buy short-term bond funds, and there are even defined maturity funds. But you don't find any mention of those in the post. It's just bonds = bond funds.
It all comes back to your comment, "put the time in and you'll be rewarded over the long term." Even seemingly simple financial advice ("buy a bond fund!") is insufficient because it requires more time and effort to execute correctly than most people are willing to put in.
This is oft-cited difference between bonds and bond funds is a red herring when it comes to determining the proper investment of the two. The reason a single bond keeps you from losing your principal is because it has a declining duration, whereas bond funds generally have a fixed duration (more or less) since maturing bonds in the portfolio are usually reinvested into bonds of the same time to maturity.
You can simulate the behavior of a single bond by rolling your investments into shorter and shorter duration bond funds over time. The reason you would do this is if you have a known date for when you are going to need the principal. (This is the same justification you would use for buying an individual bond.) By controlling the duration via reinvestment into bond funds, you are diversifying away a majority of of the default risk (the major risk of owning bonds) while still being able to ensure your bonds are worth at least as much as your principal on a fixed date determined at the beginning of the investment.
As an aside, concern about the market price of a bond is usually a good example of focusing on the wrong thing. If a bond's price has declined because of increased default risk, this is obviously bad. But if a bond's price has declined because of increased interest rates, this means you will be able to re-invest the coupon at a larger yield, so depending on your investment goals (such as having a robust inflation adjusted income stream for retirement) this may not be strictly a bad thing.
> You can simulate the behavior of a single bond by rolling your investments into shorter and shorter duration bond funds over time.
As I noted, there are ways to address interest rate risk with bond funds, but you're ignoring the most important question in the context of this discussion: how many retail investors who put money into bond funds actually know about laddering strategies?
> But if a bond's price has declined because of increased interest rates, this means you will be able to re-invest the coupon at a larger yield...
This is true, but you have to wait until maturity unless you're willing to sell your bond at a loss. Despite the low interest rate environment, there are still a good number of retail investors buying exposure to long-dated bonds because they don't take the time to understand their investments. Many of these investors will either have to realize potentially painful losses or wait a long time before they have the opportunity to buy new bonds with higher yields.
I don't think you read the article I linked. Reducing the effective duration on the bond fund portion of your portfolio boils down to the same thing you'd do in any healthy portfolio: yearly rebalancing.
Also, the point is not to hedge 'interest rate risk' by just buying shorter duration funds, full stop. Interest rates do not pose a risk unless you had a set date to liquidate your investment. If you are not planning on liquidating your bonds then interest rates pose no risk, they just affect the growth of the income stream.
The point is, if you are concerned about getting your principal returned, decide upon how many years down the road you need it back. That is your initial duration. To maximize your return under that constraint, buy a fund at that duration. Then yearly rebalance with other shorter duration funds (while reinvesting coupons properly) to taper the net duration down over the course of the investment period. There you go, you've just simulated a single bond but now are no longer exposed to default risk.
Again: perpetuating the idea that 'getting your principal back' is a feature only found if you buy individual bonds directly is untrue and can result in terrible investment decisions. It presents a false dilemma between a 'secure principal' and diversification. Forgoing diversification in bonds is one of the most dangerous things you can do. More than any other asset class, bonds benefit immeasurably from diversification (and probably also active management) since default risk is the major risk the investor faces.
I don't think you understand the context of this discussion. As I explicitly stated, "there are other ways to address interest rate risk with bond funds." But this isn't a technical discussion about bond buying strategies. This is a discussion about high-level financial "advice" that was woefully inadequate for the intended audience (retail investors).
To highlight this, I used the author's lack of distinction between bonds and bond funds and the most simple difference between how they function as employed by your average retail investor. You're obviously free to go off on a wild tangent detailing in more depth the way that bond funds can be used, but ironically you're only proving my original point: this is not nearly as simple as the OP's advice ("buy a bond fund!") and requires an investment of time and effort that exceeds what the vast majority of people are willing to put in.
I don't think bonds are really a good investment for most people. They basically have the same edge case volatility as stocks(1) without the upside. If you have a diversified portfolio the worst stock market crashes where only an issue if you used leverage.
(1)As in if the issuers fail you get nothing.
PS: Granted if bonds where still paying 10+% that would be another story, but after taxes there only slightly ahead of inflation.
Getting the same return on a bond investment as a stock investment is not the goal. Diversification into fixed income reduces risk (specifically volatility) which is important when you need the money at a predicted date. See this link, provided elsewhere in this thread:
Sorry to ding, but "I don't think bonds are a good investment for most people" is exactly the type of MattCuttsian financial generalization I'm trying to discourage in my little corner of this thread.
Bonds are paying way less than stocks. If you think there a good idea feel free to defend them but consider this:
First off most methods of diversifying bonds (bond funds) add interest rate risks so there not predictable returns. Which means you can buy specific bonds. A 1 year T-Bill pays under 1% before taxes which is hardly worth the hassle for most people. To get better returns in the short term your stuck with increased risks. Sure, longer term bonds have higher returns but not all that high and your still stuck with inflation risks.
As to the classic advice of sticking 50% of your portfolio into bonds your basically getting negative risk adjusted returns. If you want liquidity just hold cash it's safer and more flexible. As to being an inflation hedge I don't see how we can have less inflation in the future.
PS: There are edge cases, but as long as interest rates are this low their fairly rare.
Edit: I do agree it's a good idea to keep some liquidity, but nothing is wrong with just holding some cash.
Because clearly individual small time investors make the majority of all investments... Err, wait no. Sure, there is also a huge market for elemental fluorine that does not mean it's something you want in your house.
Don't get me wrong there generally small risk adjusted net gain in any portfolio if you spend the effort picking the correct set of bonds. The problem is there a far more complex financial instrument than stocks which makes them really easy to mess up. Add to that the current returns and it's just a poor bet for most people.
Also, I note you in no way actually defended them. In there defense a condo association saving up for known long term repairs are basically an ideal bond invester.
PS: A 1/10 th percent gain on 50 billion is worth a lot of effort a 1% percent gain on 50k is not worth much.
Matt Cutts bought federal tax-free and California muni (also tax free for him) bonds. The point of my speaking up was pointing out how odd, narrow, and narrowly-specific his recommendations are. You've now added your voice to the chorus. Your recommendations are also -- narrow and a little odd.
If you're a Googler with a 3% Cali muni, that's equivalent to a taxable 6.07% yield. Beats cash.
Long term capital gains is 15% not 50+%. Also, California bonds are far from a risk free investment which is why they pay more than 1%. Remember a 5+ year bond can have negative real returns if inflation increases.
EX: People have paid 50 k for a 30 year T bill, waited 5 years and sold that for less than 50k. The important thing to remember in such situations is just because you did not sell the bond does not mean you did not lose money.
Muni bond interest is interest dividend income; has nothing to do with capital gains or AMT or whatever else you Googled. I lived in California and received 1099-DIV -- have you?
For a Googler making a big salary, that's 39.6% Federal plus 11% California state. Matt didn't say this in his post, you obviously don't know what you're talking about in your comment, and we've once again proven why giving investment advice on the internet is stupid.
It's either so general to be obvious, or so specific to an individual that it risks misleading people in similar (but not similar enough) scenarios. Matt did the world no favors with his post and you're not doing much with your comments.
"Muni bond interest is interest dividend income" that's completely irrelevant. It's easy to get a bond whose payout is treated as capital gains and thus taxed at 15% + state tax. As to AMT, it's relevent specificly because Muni bond's can increase your taxes if your under the AMT. Muni bond's can also increase your taxes if your getting money from SS.
Anyway, your really a perfect example of someone that bought bonds without actually really understanding them or their tax implications that well. Sure, it worked out well for you, but when giving advice it's really important to understand the big picture. Not just, hey it worked for me and your probably in exactly the same situation aka let’s assume without saying that everyone lives in California.
tacos, I tried to point people to Scott Adams' financial advice for people in regular situations. People who have done well in a startup are often in California, so I wanted to make sure that I mentioned the tax advantages of municipal bonds.
You've mentioned my limited experience but other than Schwab vs. Vanguard for donor-advised funds, what would you do differently? Of course people have to do their own research, but limited experience is no reason not to share information and ideas.
Matt, I appreciate you reaching out. Especially since you're a long-established contributor to the world of tech using your real name and I'm using a week-old moniker representing a Mexican food product. Some history:
I'm somewhat bedazzled by Reddit's /r/personalfinance group. It's a weird mix of debt support group, FICO score obsessive-compulsives, bots posting FAQ entries, and what appears to be 14 year olds who watch that guy who yells on the finance channel instead of doing their algebra homework repeating the same boilerplate advice over and over regardless of what the panicked, desperate OP declares is his unique financial situation and needs.
Between that, pg's insane essay yesterday on "being mean", and a discussion with a knucklehead here last week who didn't understand dilution or liquidity, your post caught me at an odd time.
My first problem with your post is that it lacks context. It goes from "gee shucks here's some dumb shit I did" to vague recommendations straight out of elementary school economics to "choose a credit union -- but not the one I chose" to suddenly talking about donor-assisted charity funds and maintaining your own mini-index fund by purchasing 75 stocks. You also use the phrase "sunshine tax" referring to weather just to make sure it's a big ol' swirl of mixed metaphors.
As someone who's only previously read your stuff when you're outlining guidelines (and teasing vague hints) of how not to piss off Googlebot, it's a little weird.
It's the same problem /r/personalfinance faces. It's not clear how old you are, where you live, what your marital/child situation is, what your health is, what your parent's health is, what your values are, or just how fucking rich you are. I don't blame you for not saying it and I don't want to know. But without that, you're a talking head spouting finance with no track record and no background, and you're saying nothing that I haven't heard from that blonde lady with the fancy haircut or the Reddit finance bot.
It's the blogger's curse, one I find myself asking whenever I start clicking around the web: why did you write this post, who the hell are you, and why should I take you seriously?
You lost your shirt on Cisco, you nearly lost it all with unsecured notes, and now you're giving me advice about securities? Um, ok. Paul Graham's doing his Dale-Carnegie-On-A-Bumper-Sticker schtick, I guess why not?
Context aside, some specifics relating to your article:
1. You are probably a bad stock picker
Should read "I am a bad stock picker." Overlaps with "just buy an index." Also, for support you link to an article written by someone who was banned for life from the securities industry.
2. No one cares about your money as much as you do
No one cares about your health as much as you do either. That doesn't mean you shouldn't visit a doctor when there's a lump in your ballsack. The world isn't melting and there are trustworthy financial organizations. Though I'd sure love to know why Google Finance sucks so hard. Financial news is a bot-filled hellhole, and given its highly keyworded nature with ticker symbols included, Google still insists on showing me blurbs from an Oregon utility (Portland General electric company) instead of GE, the 9th largest corporation on the planet. Nice scripts, dude. Reminds me of the time Google Translate autodetected Gesundheit as Spanish.
3. Wall Street is not your friend
This is a "hard won" lesson for you? How exactly were you maimed by the lack of regulation on Wall Street? You weren't even holding securities and you still made out okay. Also... capitalism? Zero sum? This is news? Sounds like rhetoric to me.
4. Think about working for equity vs. salary
Series A pinch, plenty of signs of a bubble ready to burst, interest rates ready to rise and suck the dumb money out of the Valley, energy prices in turmoil, housing still weak, and you're suggesting people dive into a startup in lieu of salary ("versus") in December, 2014 in order to retire? Let's meet back in 5 years and see how that worked out, deal?
5. Prefer index funds
Fascinating. 50/50 stock/bond split you say? And a plug for Vanguard LifeStrategy? Did you really just say "diversify but watch out for fees"in 339 words and slip a brand in? What is this, BuzzFeed? And... "Prefer"? Why? Versus what? And did you just link to that shitty site run by the guy banned for life from the securities industry again? Yes, yes you did.
6. Prefer credit unions over banks
"Wall Street is like [sic] carnival sideshow designed to separate you from your money." Really, dude? Half the credit unions in the US have less than $20 million in assets. Call me weird but I'd like my bank to be worth more money than I am. Deposit a couple six figure checks and you'll learn fast where service comes from at even the shittiest Bank of America branch. They'll give you more than lollipops. And, bonus: they can afford to make an Android app. Credit unions are great, except when they suck. Check yours, read the fine print, then consider that getting direct deposit to the bank that has ATMs everywhere might work out just the same on fees and better interest rates on savings to boot. And with an Android app!
7. Prefer Vanguard over almost anyone else
"I consider them one of the only companies on your side in the financial world." What an odd endorsement. Have you exhaustively researched the other discount brokers and their services? E-trade for individual 401ks? Schwab for low-deposit requirements across the board, extensive checking/banking options (varies by state)? Chase/Wells Fargo for HSAs? A not insane recommendation would be "use Vanguard as a baseline, they're tough to beat." And maybe keep your financial industry ethical intuition to yourself?
8. You probably don’t need a “assets under management” financial advisor
Another dubious section but CLEARLY should refer to the need for a tax advisor and/or estate planner. Two posts upthread I'm arguing with a guy who doesn't know how interest is taxed. Nobody gets this shit right and .25-.5% for a few years (especially when you're starting out) might be worth it. As for your well-earned phobia about outsiders touching your money, perhaps we could compromise? Trust but verify, perhaps? And maybe "don't get your advice on the internet" -- oops, isn't that pretty much what Scott Adams says in your first paragraph?
9. Consider municipal bonds
No discussion of risk. No discussion of how to compute effective tax rate.
--
I realize this is harsh but I just don't understand why you woke up with a belly full of turkey and decided to become Suze Ortman. If you wanted to provide anecdotes and share mistakes you made, go for it. But when you turned the corner into being "an authority" on such a huge, complex beast that affects everyone in incredibly subtle, different ways -- you lost me.
7Figures2Commas, of course I know the difference between a single bond vs. a bond index fund. I clipped coupons off a bond my grandfather gave me as a kid.
The interest rate environment at this moment is interesting with QE coming to an end, but I'm trying to give advice that will work well long-term.
You might know the difference between a bond and a bond fund, but there's nothing in your post that highlights the distinction for the readers who don't. As an example, you state:
> I’d also recommend investing in a bond index fund. Bonds tend to do well when stocks do poorly, and vice versa, so investing in both will tend to reduce your risk.
Notwithstanding the fact that "bonds tend to do well when stocks do poorly" is a vast oversimplifcation[1], "I’d also recommend investing in a bond index fund" is far too general a statement to be considered actionable advice.
This is not actionable advice either:
> But there is a simple trick to minimize your taxes: buy municipal bonds for the state where you live. For example, Vanguard offers municipal bond funds for many states, including a bond fund for California.
Vanguard offers multiple bond funds for California (there's an intermediate-term and long-term). Which one are you referring to, and why?
If you followed the title of your post ("Nine hard-won lessons about money and investing") and didn't package your own lessons as "advice" (your words, not mine) for everyone else, I think folks would have responded less critically to it. Instead, you ironically dissed financial advisors while providing "advice" far less detailed and actionable than one could expect from even the most mediocre or inexperienced of financial advisors.
Bond prices have an inverse relationship with interest rates. Bond prices fall when interest rates rise. When you own individual bonds, you cannot lose your principal if you hold to maturity unless the issuer defaults. Most bond funds do not hold bonds to maturity, so investors in bond funds have significant exposure to interest rate risk. This is especially true today given the interest rate environment.
There are other ways to address interest rate risk with bond funds, especially if you have a longer horizon. You can buy short-term bond funds, and there are even defined maturity funds. But you don't find any mention of those in the post. It's just bonds = bond funds.
It all comes back to your comment, "put the time in and you'll be rewarded over the long term." Even seemingly simple financial advice ("buy a bond fund!") is insufficient because it requires more time and effort to execute correctly than most people are willing to put in.