Larry the Index Investor - A Super Story

Good question indeed @Nodrog !

If we look at a typical AU bond fund (VAF) you will see that this is largely Federal Government and Government related (90%) and 90%+ AAA/AA. As safe as a bond fund gets. With local bonds, you don't need to worry about the effect of hedging on distributions, although bond prices are nowhere near as volatile as stocks, hedging plays havoc with distributions. A quick look at VIF and VCF will show both paid out +9% in the past year. The other consideration is matching bonds with the interest rate environment of the holder.

If one was interested in corporate bonds, then definitely I would be looking to diversify internationally, given the small pool of local issuers and industry concentration of same. However, for AAA/AA paper, I see less of an advantage. If bond allocation is significant (20%+) then I think you could certainly make a case for putting something like the global aggregate bond fund into the mix for sure.

 

Thanks mate.

If corporate bonds are a concern then there’s the Vanguard International Gov’t bonds ETF (VIF) with same fee. I actually meant to refer to this in my initial post sorry, I don’t like Corp Bonds:

https://api.vanguard.com/rs/gre/gls/stable/documents/8260/au

To entertain myself I looked at what I’d feel comfortable doing if I decided to switch to the dark side.

I see bonds as the thing that will save your ar*e when growth assets get decimated. If a given country (eg Australia) in a worse case scenario got into a real mess then there’s the possibility that the Gov’t might default on its debt. Or default on local bond holders to keep foreign investors on side. I think this has happened at some stage from memory. Unlikely but this is what protecting against Own Country Risk is all about. It’s common to protect equities against this by holding overseas equities. Given Bonds are your safety net I would have thought it even more important to diversify overseas with bonds too?

It’s about admitting we don’t know the future and protecting our ar*e. With country risk being one of the bigger risks and insurance being so cheap (VIF @ 0.20%) I would personally include it if I was an asset allocator.

So my pretend portfolio including risk concerns mentioned above and taking into account correlation including research by @The Falcon this would be what I’d do:

DEFENSIVE:
VAF
VIF

GROWTH:
VAS
VGS
DJRE
VGE (optional)

The inclusion of International property and Emerging Markets in the Growth Holdings potentially improve the correlation factor there.

Only doing this to amuse myself as it’s too sloppy and wet to do anything in the yard. And my head has had enough of thinking about idiot Shorten’s proposed franking credit changes.

 

Fair enough, if planning for AU Govt default, in AU denominated debt no less, then I think 5% buried gold bullion under the clothes line makes a lot of sense too. Last default (great depression) was due to Pound denominated debt.

 

Hedged funds would have higher internal costs due to protection and money moves required, the more cross-currency based swaps made, the higher the expenses

Take $100 bucks into your local Travelex, convert it to USD and then ask them to change it back again, you wont get your $100 AUD back



Canadian based view but still worth a read

Currency-Hedged S&P500 Funds: The Unsuspected Challenges

Abstract
When investors opt for currency-hedged foreign-equity funds, they usually assume that this will eliminate the impact of currency fluctuations and get them a return similar to a domestic portfolio. This paper documents many of the pitfalls of currency hedging, through a study of S&P500 index funds offered on the Canadian retail marketplace. I conclude that currency hedging can be far more expensive than expected. Most of these costs can be attributed to the unforeseen but significant technical challenges involved in effectively hedging an equity portfolio. Institutional and retail investors are equally exposed to these high costs

 

Speaking of Opes Prime

Stock broker collapse traps $200 million from thousands of investors

The corporate watchdog has suspended the financial licence of a stock broker that collapsed just before Christmas trapping more than $200 million in client funds.

Administrators from Ferrier Hodgson have likened the collapse of Halifax Investment Management to other high profile stockbroker collapses in recent years including BBY, Sonray and Opes Prime.

 

Bonds are not often talked about and are as exciting as a plain baked potato when compared to the degustation feast available that is the excitement and volatility of the stock market

For Larry though, bonds are the safety harness or fall arrest device, kind of like a financial parachute you won’t fall as fast or as hard

Friends who have skydived rate it as an exhilarating, once-in-a-lifetime experience, though they wouldn’t enjoy that free falling experience at 250 kph without the knowledge and safety of a parachute (and a reserve chute) to be honest though, that’s not for me I’m an indoor skydiving kind of guy

The only man to jump out of a plane at 25’000 feet (or 7.62 km) still had a safety net



The Sky is not the limit, the ground is

Dr William Bernstein, coined the phrase: "Bonds are the underwear in your portfolio – unexciting and not much thought about, but select the wrong pair and you’ll be surprised at just how uncomfortable you are."




Bonds deserve love too, a bond is a debt instrument, the easiest way to think of a bond is to liken it to an interest only loan.

When you purchase a bond, you are essentially loaning money to an entity under an IOU, typically to a corporation or government, to fund projects or activities for a specific period of time and at a specific rate of return. Bonds make money in two ways: interest payments and capital appreciation.

Bonds and Bond Index funds are quoted on ASX. They can be broadly classified into the type of interest they pay (fixed, floating or indexed) effectively and as per above, they are an IOU between a borrower (the issuer of the bond) and a lender (the investor who purchases the bond) – just as a bank deposit is effectively an IOU between the bank as borrower and the depositor as lender.

When a government, corporation or other entity needs to raise money, they can borrow money from investors by issuing bonds to them. Investors who purchase that bond from an issuer are essentially lending money to the issuer for a fixed period of time. In return, investors receive an instrument (the bond) promising that they will receive interest payments at certain intervals and also have their principal returned on a stated future date.


Where the bond is quoted on a stock exchange, such as ASX, the investor can realise their investment by selling that bond to another investor at the current market price.

Issuance of Treasury Bonds in the 2018 financial year totalled $30.3 billion.

Gross Treasury Bond issuance in 2018-19 is expected to be around $52 billion. Weekly tenders of around $900 million each week (in addition to tenders held in conjunction with buyback tenders) will be held for the remainder of 2018-19 FY

From the ASX

Why are they popular investments?

The main reason is that, unlike equities, bonds generally provide greater certainty as to their income stream and return of capital. For retirees or others who need a predictable source of income, a bond’s regular interest income and principal repayments at maturity provide a comforting level of security. There are other advantages too, including:

• investment diversification, which can either reduce risk or improve a portfolio’s overall rate of return (because, with bonds as an anchor for a portfolio, an investor may feel more comfortable taking on greater risk with other investible assets in the hope of achieving a greater return);

• in the case of corporate bonds, a better return than some other debt investments – for example, income from corporate bonds is typically higher than the interest paid on bank deposits (although the same is not true with government bonds);

• in the case of government bonds, high levels of liquidity and security; and • the opportunity to profit from anticipated movements in interest rates.




If interest rates increase then investors can earn more interest on other bonds. To attract buyers to a bond if people want to sell it, the bond price must decrease.

On the other hand, if interest rates decrease then the bond’s price will increase. This is because the fixed-rate bond is now paying a higher rate compared to what investors are getting in the market.

One popular bond investing strategy is called “laddering” and provides a trade-off between lower rates on short-term bonds and higher interest rate risk of long-term bonds. In this strategy, you invest in a group of bonds at different maturities.

Interestingly here’s 1 year of STW vs VGS vs VAF




And a slightly longer 5-year time period due to the age of some funds




In exchange for your loan the bond issuer will pay you regular and ongoing interest (the coupon) until the end of the loan period, after which you will receive your initial loan back (the maturity), basically, when market interest rates fall, your bond with a high coupon is more valuable as it continues to offer the higher rate, thereby creating market demand.

When interest rates fall any new bonds issued will offer a correspondingly lower rate of return, of course, in times of rising interest rates, the reverse would be true.

Basically, when stocks fall hard, bonds like gold, the price of spam and shotgun shells tend to rise unlike cash, this doesn’t happen every single time in the markets, but on most occasions it does

If interest rates rise, and bond prices fall, that would be a bonus for Larry as he's in his early 50’s, because he still has an income and could buy bonds at a lower price. If stocks markets fall, he would have a great time rebalancing and selling bonds to buy cheaper stocks ala Warren Buffett’s “stay in the market and buy at a bargain” strategy, a cheaper stock market is safer than an expensive stock market.

Over the longer-term a short-term government bond index will always outpace inflation, because the bonds renew their holdings as they expire on a regular basis, no matter what inflation does.

When global interest rates rise, the yields on short term bond indices will vault over yields on longer-term bond indices. If interest rates were at an all-time high, you would go with a long-term bond index.

When stocks rise, bonds often fall in price. Having bonds in the portfolio gives me an opportunity to re-balance during market mood swings

Here’s iShares Core Composite Bond ETF

In the past five years, $10,000 grew to roughly $14’238 (plus interest)




Australia - Review

Figure 1 shows that, over the last 116 years, the real value of equities, with income reinvested, grew by a factor of 1948 compared to 6.8 for bonds and 2.2 for bills.



Figure 2 displays the long-term real index levels as annualized returns, with equities giving 6.7%, bonds 1.7%, and bills 0.7%.




Figure 3 expresses the annualized long-term real returns as premia. Since 1900, the annualized equity risk premium relative to bills has been 6.0%




Credit Suisse Global Investment Returns Yearbook 2016

Larry tends to think of stocks and bonds the same way; If you’re buying them, you should be celebrating when they get cheaper.

Over the long-term, stocks beat the crap out of bonds, but like Rocky having the crap beaten out of you by Drago doesn’t mean you won’t have your time in the sun, stocks don’t always beat a diversified portfolio mix of stocks and bonds.




You never know where the market will be when you retire, projections and time frames can always make or break an assumption

From 1996 to 2012 the S&P 500 gained a CAGR of 6.92 %, a combination of 60 % stocks and 40% bonds however did better at 7.01%

If somebody invested in the S&P 500 in May 2009, it would have grown 209.046% by May 2019, that’s not normal.

When the stock market has a mood swing and drops like an elevator, I always know I can sell some bonds and buy the stock market indices at a discount. Rebalancing makes me an offensive player rather than a defensive player

Stocks have demonstrated that they outperform other investments over the long term, whilst bonds can outperform during certain phases of an economic cycle

$10,000 invested in major asset classes over historical periods per Vanguard Australia’s charts shows the below since 1970

 

And over more recent times




Larry’s initial rules:

• Buy a low cost, short term government bond index

• Buy a low-cost U.S. stock market index

• Buy a low-cost international stock market index

• Buy a low-cost Australian stock market index

Sell portions of the bond index to buy into the stock market indexes when the stock market drops, with a longer-term collector view there's no fear of buying into a falling asset class

The Australian corporate bond market has grown by more than 40% since 2010, currently reaching over $1 trillion of Australian corporate bonds outstanding.

This is more than two-thirds the size of the Australian stock market

Notes- looking at the effect of convexity on bond returns

Why Own Bonds in a Portfolio?

By Ben Carlson (A Wealth Of Common Sense)

Comments are interesting also

 

Bonds - For Support in tough times

 

Vanguard Australian Government Bond Index ETF (VGB) below compared to the S&P/ASX 200 over 1 year only

Dividend (interest) payments are quarterly

02-07-19 $0.299973
01-10-18 $0.24083
02-01-19 $0.291369
01-04-19 $0.245351

 

I find it very hard to believe that Australian property growth was 2.9% PA 2008-2019.
Add the compound effect and most did much better.

Ftr Paul Clitheroe was suggesting index funds in the 90s too, although in the late 80s everyone was told that their super would be worth millions in 20yrs.

 

I must correct myself on this.
It was referring to Noel Whittaker who was a proponent of index funds in the late 80s and early 90s.

 

Probably right, I'm sure he oft touted the All Ordinaries Accumulation Index. I have several of his old books

Free Historical Stock Market Calculator | Noel Whittaker

 

Just had a quick look at current status via Sharesight

• Total Return 15.78% p.a.
• Capital Gain 10.89% p.a.
• Income Gain 4.89% p.a.

I'd let this portfolio run in sharesight

Figures look a little bit off though (actual account value etc should be higher so I'll have to investigate)

 

For posterity posting the below here on the W-8 Ben Form

The below from Aussie Firebug