Cash, TIPS, Retirement, and ... Rachel Fox?

1. Reader Question

If you are investing for retirement that will start in the next ~5 years, and believe that interest rates will rise significantly in the next 0-3 years, would it be better for the "bond" portion of your portfolio to:
1) Keep money in short-term TIPS bond funds (i.e. VIPSX) until rates rise, and then shift to a long term TIPS bond fund (i.e. TIP)
2) Keep money in a cash equivalent until rates rise, and then buy a long term TIPS bond fund
3) Keep money in long term TIPS bond fund before and after rates rise, or
4) A better option?
Thank you for your time and help.

My Reply

If you are absolutely sure that the rates will rise significantly in the next couple of years, then there is no question that the best place to be is cash and maybe I-Bonds.

TIPS provide inflation protection but inflation is not synonymous with interest rates. If inflation does not rise but nominal interest rates do rise, then TIPS might be the hardest hit securities in fixed income space (when looking at different securities of same maturity) because like nominal treasuries their yields are most depressed and have furthest to go to get back to normal. This is the most likely scenario for the next few years in my opinion. Shorter TIPS will probably weather this period better than longer ones, but no TIPS will be immune.

If (expectation of) inflation does rise -- with or without increases in nominal rates -- then TIPS will indeed do better than nominal bonds of same maturities. But again, though the two are related, inflation can rise without increases in nominal interest rates and vice versa. In fact, one possible cause of inflation would be lack of necessary rise in nominal rates. And it could work the other way -- rising interest rates can snuff out a possible inflation outbreak.

Coming back to your original question, cash is definitely the place to be in the scenario you describe. Before you jump to be all in cash you should have an answer to why you believe that interest rates will rise even faster than the market already expects? Because the market definitely does expect rising rates and is pricing all the different maturities of bonds accordingly.



2. Reader Question

I would appreciate your perspective… Here is the scoop: I want to retire TODAY…..
I want gross ~ 180K - 200K per year
SSN (Combined with spouse) - Start in 2 years @ 60K per year
All kids adult children Have 529 for each of my 4 toddler aged grandchildren funded with initial one initial payment of 15K
Investments: 4.1M in Schwab..-Details:
~469K in Stocks - Taxable Account
~2.5M in HYG -Taxable Account
~462K in HYG - Non Taxable Account
~Cash - 155K
120K in I-Bonds ( face value of 60K…I have had since 2001)
Real Estate
Primary Home - Value ~1.1M / 344K mortgage @ 2.85%
Second Home (Mother Lives in it) Value 200K mortgage 115K @ 3.2%
I am ready to move to a balanced portfolio…my guess was 70% Income (VBMFX) & 30% Growth (VTSMX) What do you think…can I make it?…..Does this pass the sniff test?

My Reply

You didn't mention your age and the numbers you gave for investments don't quite add up to $4.1M but, yes, this does pass the sniff test -- especially if you you would be willing and able to come down a bit from $180-200K gross annual expenses should future market returns end up much lower than historical averages. But even $180-200K all the way has a very good chance of happening. Here is a quick breakdown:

1. You will need to withdraw $180-200K (before taxes) in the next two years and $120-140K thereafter. Going with your $4.1M figure that's about withdraw 4.5-5.0% in the next two years and 3.0-3.5% thereafter. Historically you would have had no problems meeting those withdrawals (while increasing them annually with inflation) for 30+ years, including using a 30% stocks/70% bonds portfolio.
2. I would hold municipal bonds over VBMFX in taxable. They provide very reasonable safety and quite a bit higher yield than VBMFX, especially after taxes.
3. Your mortgage rates are low enough that there is no big advantage in paying them off. After the interest deduction the effective rate you are paying is similar to what's available from quality muni bonds and interest rates seem more likely to up then down in the future. Not that paying off the mortgages would be a big mistake either, but I would keep them -- at least the 2.85% one.
4. Keep those old I-Bonds as long as you can -- their combination of yield and safety is better than anything available now and may remain that way for a long time.

Today's bond yields are low by historical standards. But even your entire portfolio merely achieves 0% real return (meaning just keeps up with inflation), it would still be sufficient to support your $120-140K withdrawals for about 30 years (though it would be just about at zero by then of that period). Realistically you hopefully wouldn't be blindly withdrawing that amount year after year even if you see your portfolio shrinking significantly. If such an adverse scenario happens, you would hopefully scale down your expenses to be met by, say, $60-80K in withdrawals plus the SS benefits. If you have that flexibility, then a 30% stocks/70% bonds portfolio should work just fine. Again, even this is probably being too cautious, but better to be safe than sorry.

For the actual investments I would make the targer allocation be something like 15% US stocks / 15% international stocks / 70% bonds/cash as follows:

• Keep the existing I-Bonds as long as possible.
• Keep the cash buffer of, say, $400K in a couple of "high-yield" account like Ally bank. This will fund much of your next two years and serve as an emergency fund thereafter.
• Keep another $2.3M or thereabouts of taxable in a quality muni bond fund. Both VWLUX and VWALX are reasonable choices in my opinion. VWALX is lower quality but rewards you in higher yield. Pick one or the other or split the difference.
• Keep ~ $600K in taxable in VGTSX (actually its Admiral version VTIAX)
• Keep ~ $140K or thereabout in VTSMX (actually its Admiral version -- VTSAX)
• Keep ~ $460K in tax-sheltered account in VTSMX/VTSAX.

FDIC-insured CDs that have good yields and an option to break early (e.g. PenFed) are a reasonable alternative and/or complement to the big chunk in munis. Such CDs would bring extra safety, both from default and from unexpected increases in interest rates (via breaking the CD early) by giving up some yield. I think either CDs or munis are a better choice than VBMFX because of the suppressed yields on treasuries that dominate VBMFX.

Another option is to recognize today's low bond yields and increase your stock allocation from 30% to 40-50%. I think that would be likely to result in a higher ending portfolio if you care about that. But I think the 30%-in-stocks will meet your needs as well, at lower volatility. As long as you have some reasonable flexibility in future withdrawals you should be able to enjoy a long and prosperous retirement starting today with any number of possible asset allocations.

Withdrawals would be done by spending down interest and dividend and by selling portfolio assets that grew "too much" so that the overall portfolio maintains the 15% US stocks / 15% international stocks / 70% bonds/cash ratios (or whichever final ratios you settle on).



3. Reader Question

My current stock allocation is:
40% US-Total Stock Mkt (VTSAX)
20% US-Extended Mkt (VEXAX), performs very similar to SmallCap (VSMAX or VB)
10% US-REIT (VGSLX)
30% Intl-Total Intl Stock Mkt (VTIAX)
I am strongly considering changing from SmallCap to SmallCapValue:
40% TSM (VTSAX)
*20% SmallCapValue (VSIAX or VBR)*
10% REIT (VGSLX)
30% TISM (VTIAX)
Thoughts? Many thanks!

My Reply

This is an very small change overall. I am not a big believer in tilting to small/value (mainly not to the "small" part of that equation) but plenty of very intelligent people do believe and invest to capture the so-called small and value premia. My reasons are not nearly strong enough for me to insist that I must be right and everyone else must be wrong. Since, as you point out, those 20% are already invested in "small" I don't see much downside in also tilting them towards "value" -- especially since that's the historically stronger of the two premia.

My only note of caution would be that you have a talk with yourself about how the new portfolio will be a commitment for a decade or three and not just for a couple of years. Making changes in your portfolio frequently is just not a good idea, even if examined individually every one of those changes appears to be done for a good reason. The less tinkering the better.

With that caveat, I see no problems with the change you are thinking of.



4. Reader Comment

I think a deconstruction of the following story on Yahoo could be a fun post but also an important learning tool for newcomers. http://finance.yahoo.com/blogs/breakout/16-old-actress-turns-stock-day-trader-143823005.html

My Reply

I almost made a post about it when I came across this story myself but then decided against it. The entire story is cringeworthy, even by Wall Street marketing standards. That the main character is a successful and seemingly business-savvy 16-year old actress makes it a bit hard to publicly call the whole thing a charade. After all, hating on teenage girls doesn't seem like the optimal marketing strategy for an investing blog... Awww to heck with it...

Yes, the whole thing is a charade. Yes, it can pass for finance-flavored entertainment. Yes, if you interested in Rachel Fox's stock tips, then you should be aware that numerous members of Nigerian royal family are willing to pay sizable fees to to trustworthy individuals to temporarily hold their funds.

Here are some of the tidbits of the Yahoo story that should have set off your bovine excrement radar:

• The story comes right from the intersection of Hollywood Boulevard and Wall Street. No matter how naive you are, these two industries will surely not be the ones you think of as trustworthy. After all, both specialize in spinning a good tale.
• By second paragraph you learn that Rachel Fox made 30.4% in 2012. No proof of these returns is given (or even hinted at as being available) so you would do well to question the truthfulness and/or accuracy of this number. Apparently outstanding investing returns are often the result of either willful lying or simple not knowing how to calculate profits -- see this and this for the more famous examples.
• Even if the 30.4% figure is accurate and truthful it still simply does not matter. Anything can happen in a short period of time with a handful of trades. There are many thousands, if not millions, of investors who have achieved those levels of returns in 2012. For example, looking at Covestor we see that about 5% (7 out 137) of its "investments managers" managed to do the same. That means nothing unless it's repeated year after year after year after year... And I strongly encourage you to read my Covestor review before you conclude that its managers are even more likely than Rachel Fox to make you rich.
• In third paragraph of the Yahoo story you see no fewer than three links to Rachel's blog and I counted five links total in the piece. If you are not familiar with how business on the web works, here it is in three words: links are money. If nobody links to you, then you will never make a dime. Links from popular sites (such as Yahoo Finance) are extremely valuable. Link-stuffing like this is a good sign of advertising as opposed to a genuine news story.
• The story ends with a link to Yahoo Finance's Facebook page and a request for readers to comment there. Even by Yahoo Finance own standards, that's crossing the line from journalism to self-promotion.
• Now let's play the actual interview... Rachel's story of how she started in trading, her instincts-plus-technicals strategy, and her market commentary all sound ridiculous, but that's par for the course. Just go back and read what grown men who are professional economists and/or traders have been saying for the past ... well, pretty much ever. Compared to that, investing by talking to parents and trusting your instinct seems to be just as valid as any other approach. I did find it amusing how she plugs Yahoo Finance around 2:25 into the interview. You scratch my back and I'll scratch yours.
• Finally, a brief look at her blog suggests that either (a) Rachel is a wunderkind who is not only a talented actress and market-crushing stock trader but also a top-notch web designer or (b) somebody other than her does at least the design of her blog. The latter explanation seems a whole lot more likely, which leads me to wonder about the blog's content too. And that in turn isn't helped by the fact that Rachel's posts read like half was written by Valley Girl and the other half by Gordon Gekko.

And speaking of Gordon Gekko... last time that I remember a Hollywood celeb publicly dabbling in stocks it was Shia LaBeouf, in preparation for "Wall Street: Money Never Sleeps". After allegedly turning $20,000 into $489,000 in a few months while training for the role (which is quite the training; somebody ought to make a movie in which Shia cures cancer or perfects cold fusion), Shia had these pieces of advice in early 2010:

1. Buy Apple (AAPL)
2. Buy oil
3. Short gold
4. Buy InterOil (IOC)

Following Shia's advice would have paid off big with Apple, gone nowhere or lost a bit with oil, lost a lot with gold, and either gone nowhere or lost a bit with IOC. Had you put equal amounts in each of the four trades in early 2010 you would have come out positive overall (thanks to Apple's outstanding run), but trailed the market which returned over 40% during the same time frame. Not exactly awe-inspiring results.