Paul Winkler: Welcome to “The Investor Coaching Show.” I am Paul Winkler, talking about the world of money and investing. There’s a ton to talk about.
Index Funds and Structured Investing Workshop
There is a workshop coming up. I think it’s September 7th. It’s going to be about index funds. Most of you probably own index funds. I’m going to guess that the percentage, if you’re investing period, the chances of you having an index fund are incredibly high. They’re very, very popular—and being misused quite often these days.
They’re actually being used as a gambling tool, which is really, really weird.
Index funds were never designed to be a gambling tool, but that’s what’s happening.
And the issue is really how they’re designed, the ones that are being most often used, how they’re designed.
I’m going to be really getting into that and getting into what’s called structured investing in this workshop. It’s going to be a little bit deeper, but it’s good stuff and I’m going to be talking about that. So if you want to sign up for that, you go to the website paulwinkler.com.
Because really, the issue is the level of additional risk that comes, especially now. There are really some interesting things going on right now that in my career, I’ve never seen as far as the concentration risk in those types of funds. So it’s what do you do about it and how do you work your way around that?
Bonds
Bonds and investment portfolio, when we look at cash, fixed income, bonds, you’ll hear me use those terms interchangeably. CDs are a form of fixed income because you have a fixed interest rate that is paid on CDs, money market accounts. There’s a lot of popularity in those types of accounts right now because the banks are paying higher interest rates. Now, certainly not higher than I’ve ever seen them by any stretch of the imagination. I’ve seen much, much higher interest rates in the past.
And it was just funny. It’s just because I think it’s been so long the interest rates have been so low that all of a sudden now, people are excited about the idea or the prospect of getting somewhat of a decent interest rate on a CD. So they’re going overboard, and this is what we’re seeing.
Interest rates have been this high before; it’s just surprising because they’ve been so low for so long.
You’re seeing cash flows into these things increasing significantly, and that’s typically what happens. And I’ll get to that in just a little bit because if you look at the data on that and how that ends, it doesn’t normally end very well.
So the question was regarding fixed income investments. And what we did is we put together some numbers. When you look at fixed income and investment portfolios, typically what we think about is safety. That is what we’re looking for in our bonds, our CDs. We’re looking for safety. Safety from what? Market fluctuations. So markets go up, stock markets go up, they go down, they go back, they go forth.
And because of that volatility, what has happened historically, we’ve had much, much greater returns after inflation in those stock market investments than we’ve had in CDs and fixed income investments. And the reason being is they have to pay you in order to put up with that. Volatility is what we’re looking for, looking at as far as the corporate world. Because corporations can issue bonds which is where they borrow money, and then they issue stock which is where they give up ownership of the company in exchange for your money. And they have to give up earnings.
And you look at it and go, “Well, what kind of return do they want to pay?” As little as possible, right, in anything. But it’s going to be commensurate with the rate of risk. If I have to put up with more fluctuation, then I have to pay you more in return to use your money. That is the way the world works.
Now, if we’re talking about long-term bonds, in other words we’re borrowing the money for a long period of time, and I issue a bond and I issue it for a thousand dollars and then I give you back your thousand dollars 20 years from now, let’s say, well, it’s going to be a long time before you get your principal back.
There’s a lot that can happen in 20 years all over the place. Interest rates can go all over the place. You can have issues with the possibility of default or the company going under or something happening that the company is less able to pay back debt or whatever because there’s so much time in order to get you to put money in these bonds.
Interest Rate Risk
There is interest rate risk like crazy with government bonds because the government can borrow money for 30 years and you’re looking at 30 years before you get that money back. So what happens is that from the investor standpoint, they’re going to demand higher interest rates for those types of bonds because of all the things that could happen in that 30-year period.
Now, when you only have a short period of time, two years, one year, there’s not as much that can happen. And if it does, what happens? The bond matures. I get my thousand dollars back and then I go reinvest at whatever the interest rates are, or I go invest in something else.
In a couple of years, the likelihood of something really, really bad happening is much, much less. So as an investor, I can’t demand as high of an interest payment.
Longer term bonds typically pay higher interest rates.
You have a positively sloped yield curve. In other words, in the short run, the interest rate is lower. In the long run, interest rates are higher.
Now, what’s interesting right now is that if you look at different maturities, if you look at two-year bonds, for example, like a two-year global type of a portfolio, if you look at the yield to maturity, in a fund that I use for my own personal portfolio, the yield to maturity is almost 6%. That’s pretty high for that short of a period of time. If you look at five- to 10-year investment grade corporates, it’s about the same. So you look at it and go, “Well, wait a minute. Wow, that’s pretty wild that they’re fairly close.”
And that is what we refer to as a flat yield curve. And typically, what happens is bond markets look around at what’s likely to happen in the economy. And if the short-term interest rates are high compared to the longer-term interest rates, that tells you that the market thinks at some point those interest rates are probably going to come down some. And whether they will or not, nobody knows, but I just wanted to get the idea that that is what’s going on, it’s almost like trying to figure out what’s going to happen.
And then investing money based on a long-term period of time, like 10 years, let’s say, 10 or 20 years, if I’m not demanding a really high interest rate or if I’m demanding an interest rate that is really like the one-year rates, then what I’m assuming is if those rates are super, super high in the short run but about the same in the long run, I must be thinking that it may not last forever, these higher interest rates. Because otherwise, I demand a higher interest rate, right? Because I’m locking it up for so much longer.
Now, with that in mind, I may lock it up for that longer period of time because I think interest rates are going to go down and I am going to be, well, I guess the word would be rewarded, for having locked it up for longer periods of time.
Now, I’m not saying do that by any stretch of the imagination. As time goes on, you’re going to understand why you don’t do that. Who would do it? Well, a lot of times, companies that know that they’ve got liabilities and absolutely must pay those liabilities down the road.
Yield to Maturity
For example, an insurance company, that doesn’t take a whole lot of risk and they know that they’ve got so many claims that are going to come in because so many people die every year, let’s say. And they know the life expectancy of their customers, then they would be more likely to lend money long term.
Whose money are they lending? Think about it. Yours. If you own an annuity or a life insurance policy, they’re loaning your money for long periods of time. They’d much rather you take the risk than they take the risk, which is like, “Oh, wow, I really never thought about it that way,” right?
So it’s interesting when you look at these yield to maturities, they’re very, very high. And one of the things that people wonder about is, “Well, why do we have all of these? When we put a bond portfolio together, why do we have them in the portfolio?” Number one, stability. So that if you have a stock market decline, especially as you get older. You have a market decline.
Market declines don’t last forever.
We look historically at market declines and we see that you might have, well, the average from the 1950s till today, it’s somewhere in the neighborhood of a little over a hundred days for a market to recover from a decline.
Now, that’s average. So some of them are a little bit longer, some of them a little bit shorter. But because you can have declines and because they can be severe and they might last even a year, you think back to 2008 and you had a couple of years, and then you look back at some periods of time and maybe a couple of months.
But if it lasts a year or two years or something like that, or three years, I want to have a repository, a bunch of fixed income that I can pull money from. When stocks are down, I have those bonds that are holding value and I can yank money from there to buy me time for when markets recover, because historically they’ve always recovered.
Why? Because when you own a company, you run a company, you’re a CEO of a company, if that stock doesn’t recover, you don’t get paid. You don’t get rehired. You lose your job. And there are a lot of things riding on that, on your company’s stock, recovering, not the least of which is the reason the company’s stock went down—because earnings went down.
If earnings go away, you’re going to be reducing staffing. You’re going to be firing people. You’re going to be reducing expenses. You’re going to be reducing costs of goods sold. You’re going to be reducing a lot of the things that you have spent money on.
And as a result, what happens is tax revenue can go down for the governments. The government doesn’t like it. And when employment goes down, the government gets really antsy because these people are going and trying to get reelected, and if employment numbers look really bad, their likelihood of getting reelected is significantly declined.
So there’s a lot riding on whether stock markets recover. That’s really a big deal to make sure that they don’t go down forever because that’s politically horrible and it’s bad for the CEOs of the companies and people that run companies. And employees of course don’t really like it either because they’re unemployed.
Choose Bonds Based on Durations
So we own bonds, but we don’t own them for really, really long periods of time because historically what happens? After inflation, your rates of return are pretty much non-existent. You might be looking at 5% inflation. You’re getting a 5% interest rate on your bonds and you’re going, “I’m making nothing.” That’s not such a good deal.
So how we choose bonds are based on durations. How the duration affects the price of the bond is it’s a direct thing. So if I have a duration of two, for example, if I’m looking at those two-year global fixed income bonds that I was just talking about a second ago, duration is a little bit under 1%.
What that means, it’s 0.57% for the particular fund that I happen to own myself. But if you look at that and you go, “Well, what does that mean?” That means if interest rates go off 1%, the bond goes down 0.5%, so half percent. It’s not a big deal. But if interest rates go down, they go off a half a percent. That’s what duration means.
Now, you might have some bonds that would be like, for example, one- to five-year investment grade corporates and they might be like 2 1/2 duration. What that would mean is if it’s a 2 1/2 duration, that means that if interest rates go up 1%, they go down two and a half, or vice versa. If the economy gets soft and things get bad and interest rates go down, then all of a sudden they jump up 2 1/2 percent.
Then you’ll have some bonds that are 6% duration. That will be in a portfolio of bonds that are going to be well mixed between short and longer duration. If the interest rates go up 1%, they go down 6%. But if they go down, interest rates go down 1%, they jump 6.
Now, when do we typically see interest rates dropping significantly? When things go, “Whoa, we got a worse economy we thought we had here. This is not going well and we need to get things going again.” And all of a sudden you see interest rates dropped. And that’s why when we hold bonds, those longer duration typically are the thing that comes to the rescue when we have bad market downturns.
When interest rates are high, they have further to fall.
And that’s what we saw in 2008. You saw a 13% increase in those intermediate bonds, a 16% increase in 2002. So the big jumps. Back at those points in time, short-term interest rates were super low. So if you look at that and you say, “Well…”
If we have higher interest rates right now, they have further to fall than they did in those years that I just named, so you can have even bigger jumps in bonds during those types of years. So it can be a huge deal to have those intermediate bonds in the portfolio.
Now, sometimes you have some cash in the portfolio. You typically have a little bit of cash in the portfolio. And it’s interesting because companies will actually, if they’re custodian that does all the trading for your investment portfolio, a lot of the custodians, they are just bottom of the barrel pricing on what they charge for that now.
Custodians
So $60 per year for an entire year for a $100,000 portfolio is all they charge for all of the trading and all the reporting on your portfolio and sending out tax information, all that stuff. It’s really, really cheap. So a lot of the custodians, quite frankly, what they’re going to do is they’re going to require that some money be held back in cash and they’re going to pay a really super low, lower than market interest rate on that.
And it’s just one of those things you may not be able to avoid because certain custodians, you won’t only get access to certain funds with certain custodians. They have you over a barrel. So typically what we do in that particular case is keep the cash holdings as low as we possibly can. But it’s nice to have those cash holdings there.
At the same token, it’s nice to have that there because that’s the part of the portfolio that no matter what happens doesn’t go down. So if we look at it, typically you’re going to have FDIC insurance on it and you’re not worried about it. The likelihood of loss is almost non-existent. It’s pretty much what we’re dealing with there.
So the bond part of the portfolio, and the shorter your time horizon, the more you’re going to hold fixed income or bonds in the portfolio. So if you’re physically in retirement taking an income from a portfolio, you’ll often hear me say that you’re going to have anywhere from 50% to maybe 25% of the portfolio is all you’re going to have in bonds or fixed income.
The reason being is I want to make sure I have a lot of money in the other areas that have the ability to protect me against inflation. Because once inflation prices go up, who’s raising prices? Companies. What do you own when you own stocks? You own the entities raising prices. Whereas we don’t have that protection from fixed income.
Somebody was asking a little bit about bonds. Why do we have to have them? Now, what happens is so often, it was interesting because he’s like, “I don’t want any bonds,” or, “I want very little bonds,” in this particular person’s case. And it’s so interesting because we’re seeing the opposite with some people. Isn’t that funny how some people are like, “No, no fixed income, no bonds because the market has gone down in value and markets don’t go down in value forever.”
You’ll get that attitude. Then you’ll get the opposite attitude. “The market’s gone down and this guy’s falling and I’m hearing all this negative stuff so I’ve got to have more bonds.” And you go, “Wow.”
Isn’t it interesting to have two diametrically opposed ways of looking at this in the same circumstances?
And the reality of it is you’re not going to see me change my bond to stock holdings very fast at all in the vast majority of circumstances. Unless somebody’s circumstances are changed completely, then I might change a portfolio mix more drastically. But typically no, because what is that? It’s market timing. And what do we know about market timing? And the research is not pretty. We don’t usually see any kind of good positive data coming out of people that engage in market timing.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
