More investing answers from Vanguard's experts
Which way is the bond market headed?
Retirement plan participants posed questions like these to Vanguard during a recent live webcast. Answering them were two Vanguard investing experts:
In case you didn't catch the webcast, we thought we'd share their questions and answers here.
Watch a replay of the show and find out about upcoming episodes at the MoneyWhys Talk website.
In a worst-case scenario, how rapidly could short-term interest rates rise?
Short-term interest rates have risen rapidly in the past. For instance, the federal funds rate increased from 1% to 5.25% between mid-2004 and mid-2006. The increase can be severe. However, such increases are usually a sign that the economy is firing on all cylinders and the Federal Reserve is concerned about inflation.
It seems that when the stock market drops investors tend to run from stocks straight into bonds. What is the attraction for somebody to do that?
This trend is often a flight to quality. When there's a lot of fear around what's happening in the stock markets, investors look for options that are relatively safe. Bonds are generally viewed as a safer asset class than stocks that does not have a lot of volatility associated with it. Hence, some investors turn to bonds during market downturns.
What is meant by a bond bubble?
Bond bubble refers to the idea that bond prices are at an irrationally high level not supported by market fundamentals. If such a bubble were to "pop," investors would see a sharp fall in bond prices. In the current market, some analysts are worried because bond prices keep rising despite low interest rates. If interest rates were to increase sharply, those bond prices would fall.
It's important to keep in mind that a sharp fall in bond prices is not the same as a sharp fall in stock prices. A major fall in the bond market could be a loss of 5% to 10%, whereas a major fall in the stock market could be a loss of 50% to 60%. In some downturns, losses in stocks or bonds could be greater.
For a more in-depth information and some thoughts from Vanguard on the prospect of a bond bubble, read this article.
Do you think the Fed's current policy of buying back Treasury bonds will ultimately lead to inflation?
It may, but then again a slight uptick in inflation is probably the goal. The Federal Reserve's main concern is the possibility of deflation. Deflation is a worst-case scenario where prices are constantly dropping, diminishing economic growth. The Federal Reserve wants to avoid this at all costs.
By making these Treasury purchases, the goal is to ultimately get inflation to creep up a small degree.
If interest rates rise and bond fund share prices drop, why should I keep investing in bonds instead of selling to avoid losses?
Your portfolio should always reflect your objectives and risk profile. If you have a portfolio diversified among asset classes, a loss in one class may be balanced by a gain in another. Trying to move your balance back and forth between stocks and bonds to chase performance is a good way to end up buying high and selling low. You can't predict which asset class will perform better in advance.
Vanguard's Investor Questionnaire can help you determine what mix of stocks and bonds might be appropriate given your risk tolerance and time horizon. Once you have a mix that is in line with your goals, you should think carefully before changing your mix in response to short-term market movement. The market will go up and down regardless of what you do.
It's a balance. You keep your portfolio well diversified and there's no need to run to stocks when bonds are down or vice versa.
Where do you see the bond market going from here?
It's difficult or impossible to say exactly where the bond market, or any market, is going. That's why we recommend diversification, so that your portfolio matches your goals and preferences in any market environment.
We've been in a scenario where interest rates have been at historically low levels. So over time you would think that would normalize and we would see a rise in rates. There's no way to accurately predict when that increase might occur in the short term, so it becomes important to focus on investing for the long term.
What is deleveraging?
Simply put, deleveraging is reducing one's debt level. In consumer terms, this can mean paying off credit card debt or car loans. Repaying a debt early removes a monthly payment from your budget and results in your paying less interest on that debt.
Deleveraging has become a trend among consumers for the last two years. They've been paying with cash. They haven't been investing quite so much in the market. And they've been saving more.
The financial companies also had to go through a significant deleveraging process because they had too much risk on the books. And they figured that out during this whole period that by having so much risk, they were going to have tremendous losses in their balance sheets and things of that nature. So the goal was to try to bring that risk down in their overall holdings.
Is it too late to get into the bond market?
That depends on your motivation for getting into the bond market. If you're chasing performance, there's no way to tell whether bond prices will continue to go up or not. On the other hand, if you're adjusting your portfolio so it is more in line with your goals, you don't need to worry whether it's too late. If you make the change gradually, instead of in one huge move, you decrease the chance that you'll end up investing just as prices peak and begin to fall.
Since bonds have had a better return than a money market fund, would it make sense to place some of my money into bond funds using the money market as a temporary holding for dollar cost averaging?
The best way to think about that is that you know as you're moving out of a money market fund into a bond fund, you're taking on additional risks. You are getting additional yield and you want to be compensated for when you're taking on risk. You just have to be cognizant that that's what you're doing.
So with a money market fund, you don't expect any principal losses. The principal's basically stable, though not guaranteed. But when you're talking about a bond fund, if you move out to try to get that incremental yield, if interest rates rise, there is a potential that you can lose some of the principal.
It's important to think about why you have that money market investment. If it's your emergency fund, it doesn't make sense to take on additional risk in exchange for higher returns. The purpose of an emergency fund is to be there when you need it, not to make money. On the other hand, if you want to move into bonds gradually as an investment, it might make sense from a convenience perspective to hold money in the money market fund and transfer it to bonds bit by bit.
Does the traditional advice to shift from stocks to bonds as one approaches retirement still hold true?
Typically people tend to get more conservative as they get closer to retirement because when they stop working, they don't have that same opportunity to continue to reinvest in the market with new money. Whether or not this strategy is right for you depends on a lot of things.
This is one of those times when it's great to have advice as you approach retirement. Do you have other assets that are available to you? You might have a spouse who's continuing to work and you may not have to shift your risk profile.
You may have pensions available to you. You may not have to shift your risk profile. Or you may find you can actually be more risky than you were before.
What have we learned from the recession and what should we change in our investment strategies?
A lot of investors learned that chasing return is going to put them in a riskier position than they intended. They didn't realize just how much exposure they had given themselves. As a result, many of them dialed themselves back and got themselves into a circumstance where they had a much more balanced portfolio.
How often should one adjust their portfolio to ensure it is balanced and on target for their long-term plans?
You can check often, that doesn't mean you change often. There are many people who check their portfolio every day just because they like to, but they don't make any moves unless their portfolio is out of balance by a certain amount. And you can set that amount yourself.
Some people decide they'll move money out of stocks or bonds when that asset class is 5% over what they thought their allocation should be. Some people take a look at it on their birthday or every three to six months and say if I'm 5% to 10% out of my allocation, then I'm going to bring it back in.
It's a tough thing to do. It's hard to sell winners when you have to buy in someplace else where it's a little lower. But a well-diversified portfolio means you're actually going to reallocate every now and then. And oftentimes it's about once you're 5% or more over. You can take a look at that as a guideline.
All investing is subject to risk. While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. The market values of government securities are not guaranteed and will fluctuate. Investments in bond funds are subject to interest rate, credit, and inflation risk.
Past performance is no guarantee of future returns.
An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
Dollar-cost averaging does not guarantee that your investments will make a profit, nor does it protect you against losses when stock or bond prices are falling. You should consider whether you would be willing to continue investing during a long downturn in the market, because dollar-cost averaging involves making continuous investments regardless of fluctuating price levels.
Diversification does not ensure a profit or protect against a loss in a declining market.
Except where noted, opinions presented are those of the author or speaker, and do not necessarily reflect the views of Vanguard or its management. None of the financial strategies outlined here should be construed as advice from Vanguard. Such examples are educational only and do not take into consideration your personal circumstances or other factors that may be important in making investment decisions. We recommend that you consult a qualified investment or financial advisor for guidance concerning your own situation.
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