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Shares & Bonds question
Frenchman 96
Posted: 21 August 2017 08:19:42(UTC)
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Hi Guys

Could anyone tell me the importance, or not, of mixing shares and bonds eg Vanguard Life 60/40 % etc.

I realise it's meant as a safety factor but not sure what the growth or income of the bonds might be and how safe they are..
markus
Posted: 21 August 2017 10:22:14(UTC)
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I assume you've tried the asset mixer tool on Vanguards web site... mix the equity/bond mix & see *how* it would have performed since 1985?

https://www.vanguardinvestor.co.uk/investing-explained/tools/asset-mixer

appropriate mix for your risk level controls worst drawdown & volatility.

surely growth & income of the bonds is irrelevant its the overall performance of the LS product that is important.

based on the above tool there isn't that much historical difference in average annual returns: 8.76% for 20% equity rising to 9.77% for 80% equity... but its the number of years with losses & drawdown sizes that are minimised as equity level decreases...which is probably why books like Investing demystified proposes a 50/50 portfolio (global equity tracker:high quality gov bonds)

with the current yield on bonds the income versions of LS generate more income as equity % increases. (if you have the income units)

How safe they are? who knows - you can drill down into the bond element of the LS product by going to the underlying Vanguard bond fund & seeing the credit quality & maturity compositions
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Tim D on 21/08/2017(UTC)
Frenchman 96
Posted: 21 August 2017 12:31:54(UTC)
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Thanks Marcus

I had not used the tool, but have visited Vanguard many times, their choice is vast.

I do hold their Europe ex UK.

where can I see bond yields.
P L
Posted: 21 August 2017 13:09:47(UTC)
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The theory behind the process is call Modern Portfolio Theory.
A portfolio is comprised of a number of different asset.
Each asset has effectively three primary characteristics

The Return - Equities expected to be higher - Bonds Lower

The Variance (or standard deviation) - The range by which the return can vary from the expected average. Again Equtiies are higher and bonds lower. This is often modelled as a normal distribution (bell curve), albeit it is a simplified view. Also described as risk.

The coefficient of correlation - The amount by which the two assets move in line with each other. So if one moves exactly in tandum with the other the correlation would be 1 and if they move in exact opposition the correlation is -1 and can be anywhere inbetween (or it you prefer the amount one zigs whilst the other zags).

If you mixed the two assets then the expected return becomes the weighted average.
So if A gives a 10% return and B a 2% return and you mix them 50:50 you'd expect a return of 6%. As you go from 100% asset B to 100% asset A the return goes from 2% to 10%.

However the interesting thing is what happens to the variance. It doesn't behave in the same linear way.
I'll not go into the algorithm but effectively the correlation (or lack of it which is the key) between the assets use reduce the variance so that the combined variance is lower than the weighted risk ie reward with less (or possibly almost no) risk or saying it another way a better return for the risk you are prepared to take.
There is what is also know as the efficent frontier which covers the lowest variance to the highest return portfolio, with each point along the line having (in theory) the perfect mix of assets. You choose your risk/reward parameters and mix accordingly.

Unfortunately theorectical maths/economics isn't much good when it comes to the real world. For a start low or negatvie correlation is often rather difficult to find and it isn't a static quantity either. The financial crisis proved that all too well, as most assets classes suddenly became very correlated.

But the general thrust of the theory is combining assets with historical low or negative correlations would be expected to reduce the overall variance, meaning you are effectively getting a return with a lower overall risk (which most people know as not putting all your eggs in one basket). Obviously to obtain a meaningful effect the quantity of the risk reducing asset(s) must be large enough hence why you get 80/20, 60/40 mixes etc.

Historically bonds (debt) has not highly correlated with equities and individual equity markets haven't been perfectly correlated either.

Not sure what data Vanguard use but it nicely illustrates the general theory.

A final point is that there is no such thing as a perfect mix in the real world so there is nothing to be gained in stressing over whether it should be 60 or 70 in equities.

I believe one of the authors of the theory invested his own portfolio by simply splitting it 50/50.





5 users thanked P L for this post.
Vince. on 21/08/2017(UTC), Frenchman 96 on 21/08/2017(UTC), Guest on 21/08/2017(UTC), Guest on 21/08/2017(UTC), Tim D on 21/08/2017(UTC)
King Lodos
Posted: 21 August 2017 15:32:51(UTC)
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And of course the secret to making a mix of assets work together is 'rebalancing' .. So if you hold 50:50 stocks and bonds -> when stocks go up over the year, and bonds go down, you'll be selling stocks (securing gains) and buying bonds when it comes to getting stocks and bonds back to a 50:50 balance.

And longer-term, this has the effect of buying low and selling high, and means you can profit just from volatility in markets (presenting opportunities to buy cheap).

Generally, value has to be going somewhere .. So when it's leaving stocks, it will usually be finding its way into Government Bonds .. Right now, if I decide Stocks look bad over 10 years, I can either move to cash (and earn nothing) or buy 10yr Treasury bonds and secure a 2.5% annual return with virtually no risk (if I buy-and-hold).

The enemy of bond returns is inflation – which could make that 2.5% negative in real terms .. So then you need the third class of diversifier: Real Assets (gold, commodities, inflation-linked bonds).

I think because it's been about 40 years since we've had a decade of high inflation and low growth, retail investors probably don't think enough about inflation protection enough today.

2 users thanked King Lodos for this post.
Guest on 21/08/2017(UTC), Guest on 21/08/2017(UTC)
Mr Helpful
Posted: 21 August 2017 15:56:38(UTC)
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Frenchman 96;50039 wrote:
Hi Guys

Could anyone tell me the importance, or not, of mixing shares and bonds eg Vanguard Life 60/40 % etc.

I realise it's meant as a safety factor but not sure what the growth or income of the bonds might be and how safe they are..


PL above provides a thorough academic review.
For the layman mid to long term duration Bonds have :-
1. Most times provided -ve correlation when needed, in times of Stocks' stress, benefiting from cash moving to Bonds in a 'flight to safety' effect as Stocks fall, all as noted by KL.
2. Meantime also providing a reasonable income.
Questions are being asked today if these attributes still hold up with QE, etc having pushed Bond prices up.

One of the most important things to understand about Bonds is the 'Bond Duration' which can be quickly googled, to grasp how Bonds of different durations will respond to interest rate changes.

Personally we are today sheltering our non-Stocks assets in Cash, Short Duration Bonds and more contentiously in the now fashionable yield-seeking so-called Fixed Income Alternatives such as Real Estate, Infrastructure, and Renewable Energy.

Apart from the usual US books, we are lucky for once on this subject to have a good UK text-book available :-
'The Sterling Bonds and Fixed Income Handbook' by Mark Glowrey.
King Lodos
Posted: 21 August 2017 16:24:18(UTC)
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You can see bond yields did get nearly this low during WW2:



But then spent the next 40 years effectively returning nothing or negative (real terms).



Today you can buy TIPS with yields from slightly negative, to up to about 0.9% if you go long duration (>2042) .. You can see Ruffer's thinking in holding very long and very short-dated TIPS and Inflation-linked bonds .. Of course the risk with long-dated TIPS is inflation tends to mean rates rises = duration risk .. Ruffer may use Options to try and protect them.

Short-dated TIPS should be the more reliable inflation hedge, but then they're already pricing in a low or negative return above inflation .. So there are no easy answers ... For me, this is where trend following feels like the easier alternative
Frenchman 96
Posted: 21 August 2017 16:35:06(UTC)
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King Lodus

Your first quote below, do you mean 10 years in the future? if so, how can you possibly know, or have a feeling that far ahead.

Right now, if I decide Stocks look bad over 10 years


And when you quote bonds giving you a 2.6 % yield, is that not gobbled up with inflation, would it not be better investing a a large blue chip which I assume will never go bust, and will always yield more than those bonds.

These are genuine innocent questions as I am a rookie in this field.
1 user thanked Frenchman 96 for this post.
Guest on 21/08/2017(UTC)
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