Amazing ibonds trick #1 — Owners of ibonds are better positioned to write realistic financial plans that investors who invest only in stocks.
Stock prices often move far above or far below the fair-value price of the investment. Most stock investors use newspaper prices in their financial plans. That means that most stock investors are overcounting their stock holdings when prices are high and undercounting their stock holdings when prices are low.
Amazing ibonds trick #2 — At times of high stock prices, owners of ibonds can retire with more safety than investors who invest only in stocks.
An investor who retires today (this article was written in November 2006) with a $1,000,000 portfolio comprised of 80 percent S&P stocks and plans to take out an inflation-adjusted $40,000 each year has almost a 50 percent chance of seeing his retirement plan go bust within 30 years.
An investor who retires today with a $1,000,000 portfolio comprised of 80 percent ibonds paying a real 2.3 percent return and plans to take out an inflation-adjusted $40,000 each year is all but certain to see his retirement plan succeed for 30 years (he would only be in trouble if the U.S. government were to default on its debts).
Note: You cannot today buy ibonds paying a real return of 2.3 percent. I have ibonds paying a real return of 3.5 percent, but that’s an exceptionally high return for this safe investment class. The real return for ibonds purchased today is about 1.4 percent. If you keep your eye out for attractive prices, 2.3 percent real or something in that neighborhood may become available to you. If you see ibonds offering an attractive return, be sure to buy some before the good deal is no longer available to you. Too many fail to consider any investment class other than stocks while stock prices are going up, and then find no good options open to them when the downside of buying overpriced stocks becomes too obvious to ignore any longer. Treasury Inflation-Protected Securities are today paying a real return of between 2 percent and 2.5 percent.
This trick is not available to ibonds owners when stocks are more reasonably priced, of course. However, other tricks (see amazing ibonds trick #7) open up to the owner of ibonds when stock prices drop to moderate or low levels.
Amazing ibonds trick #3 — At times of high stock prices, owners of ibonds can retire sooner than investors who invest only in stocks.
The safe withdrawal rate (the percentage of a portfolio that can be prudently taken out to cover living expenses each year for 30 years) for an 80 percent stock portfolio at today’s valuations is about 3 percent. The safe withdrawal rate for an 80 percent ibonds (paying a return of 2.3 percent real) portfolio is about 4 percent.
The Note that applies for Trick #2 also applies here. This trick is also not available to ibonds owners when stocks are more reasonably priced, of course. However, other tricks (see amazing ibonds trick #7) open up to the owner of ibonds when stock prices drop to moderate or low levels.
Amazing ibonds trick #4 — Owners of ibonds achieve greater diversification than investors who own only stocks.
Diversification is to investing what compounding returns are to saving. Through effective diversification, you can obtain greater returns while taking on less risk. Diversification possesses an almost magical power to help you win financial freedom early in life.
During wild bull markets, many investors (and many investing “experts” too!) come to believe that being diversified means holding a variety of types of stock investments. Investment classes like ibonds exist solely to provide a “cushion” for use in the event that stock prices experience one of those “temporary” slumps, in the eyes of the wild-eyed bull. Valuation-Informed Indexers know better, eh?
Because they are an entirely different asset class than stocks, ibonds generally provide more effective diversification than owning a second class of equities. There is indeed some diversification obtained by owning more than one type of stock investment. Those wanting to maximize the benefits they obtain from the magic of diversification need to look into holding asset classes like ibonds too, however.
Say that you believe in holding stocks only for the long-term (a buy-and-hold approach to stock ownership is best, according to the historical stock-return data). Say that you have determined that you will not feel panic over your stock holdings so long as you do not experience an overall portfolio drop of greater than 20 percent. Can you own stocks at today’s prices?
Not unless you are willing to direct a good portion of your savings to ibonds (or some similar investment class, like Treasury Inflation-Protected Bonds, or TIPS) as well. It is by owning ibonds that you obtain the level of diversification needed to make ownership of stocks a realistic long-term choice at today’s prices.
The average price drop on the three earlier occasions when we traveled to the la-la land stock prices that apply today is 68 percent. For an investor seeking to limit his or her overall portfolio loss to 20 percent, owning 80 percent stocks or 60 percent stocks or 40 percent stocks is out.
But how about 30 percent stocks and 70 percent ibonds (or TIPS)? An investor who experiences a two-thirds loss on an investment class comprising 30 percent of his portfolio has experienced only a 20 percent loss of overall portfolio value. Ta-da! The ibonds investment class does the job that the investor seeking to own stocks at today’s prices needs to have done.
Would bonds that are not indexed for inflation do the job? Not as well. Bond prices have been known to go down at the same time at which stock prices go down. Real estate prices can go down while stock prices are going down too.
TIPS and ibonds yield predictable returns. That’s why in many circumstances they supply precisely the sort of diversification needed to counter the short-term unpredictability of stock prices.
Amazing ibonds trick #5 — Owning ibonds may permit you to move ahead in your career more quickly.
My general guidance for the typical middle-class investor is to put about 30 percent of his portfolio in stocks at today’s prices. Why then, I am sometimes asked, am I going with a zero percent stock allocation myself?
The answer has to do with another aspect of the diversification magic explored a bit in the discussion above of amazing ibonds trick #4. Most people think that the diversification magic only comes into play when you counter the pros and cons of one investment class against the pros and cons of another investment class. It’s not so! Diversification is a much broader and more powerful concept than much of the conventional investing advice suggests.
For most of us, the time we invest in the work we do is our most important investment of all. You earn money from your job, right? By changing jobs, you can increase or diminish the amount of money coming in from the work you do, no? There are risks associated with any job change, are there not? You need to be thinking holistically when constructing your investment plan. You need to be assessing the pros and cons of your job options as well as the pros and cons of various investment classes when seeking to obtain the maximum benefit available to you from Diversification Magic.
I have made a move from doing work that pays a solid and predictable wage to work that pays a highly unpredictable but potentially very large “wage.” If my book were to be bought by a big New York publisher and sell a million copies, I would earn more from it than I could have earned by staying at my safe job at the accounting/consulting firm.
The other side of the story is that it is possible that I will earn little from sales of my book, far less than I would have earned by staying with the safe job. My job shift meant taking on a good bit of risk. Both the potential financial upside and the potential financial downside are high.
I can’t afford at this stage of my life to take on additional risk in the investment classes I choose for myself. It might make sense for you to have 30 percent of your savings invested in stocks today. I doubt whether it makes sense for me to have 30 percent of my savings invested in stocks today.
If ibonds were not available to me at the time I was seeking to make my job shift, I couldn’t have done it without first saving more. My move would have been too risky had I no choice but to invest my money in stocks or some other high-risk asset class.
The ibonds option allowed me to move to a different sort of work at any earlier stage of my life than otherwise would have been possible. As a result, I am advancing faster in my acquisition of writing skills than I could have had I remained at the safe but far less challenging job. In the right circumstances, buying ibonds means buying quicker career growth!
Amazing ibonds trick #6 — Owning ibonds lets you sleep easier at night.
Stocks make you feel like a genius when prices are going up. Stocks make you feel like a fool when prices are going down. Stocks are a crazy-making investment class.
It took me years to save the wealth I have accumulated as of today. I sure don’t like the idea of watching my net worth rising and falling in crazy ways as my fellow investors try to get a fix and then a re-fix on how they feel about stocks.
If it weren’t for the compelling long-term returns offered by stocks, I wouldn’t get involved with them at all. The reality, though, is that the returns generally offered by stocks are too good to pass up, in my view.
That doesn’t mean that I can’t prefer the stability of ibonds.
When stocks are being sold at prices at which they offer far better returns than ibonds, I feel compelled to buy stocks despite their history of making those who hold them go a bit crazy. When stocks are being sold at prices at which they offer lower returns than ibonds, I happily buy ibonds. Why shouldn’t I?
When stocks are being sold at prices at which they offer returns only slightly better than ibonds, I still prefer ibonds. I would rather have a slightly lower return that comes from holding an asset class that doesn’t drive me nuts.
My view is that it makes sense to buy mostly stocks only when stocks offer a reasonable expectation of providing strong returns over the next 20 years.
Amazing ibonds trick #7 — Owners of ibonds can obtain greater returns from stocks.
Stocks are expected to provide an annualized real return of about 2.6 percent over the next 20 years. When stock prices return to fair-value levels, the expected 20-year return will be an annualized return of over 6 percent real. Which investors will be lucky enough to be positioned to buy lots of stocks when prices return to fair-value levels? Investors who today are going with high ibonds allocations and who manage to hold onto much of their life savings when many others are losing much of theirs.
Many investors look at ibonds when they are providing an annual real return of 2.5 percent or so and find themselves less than excited over the idea of buying into this wonderful asset class. That’s an unfortunate way of assessing the potential of ibonds to advance your hopes of winning financial freedom early in life. It is by owning ibonds now that you become able to own stocks when stocks are priced to provide truly mouth-watering returns.
Amazing ibonds trick #8 — Owning ibonds can over time make you a better-informed investor.
Investing is primarily an emotional endeavor and only secondarily a rational one. Any investment class you own, ibonds included, will cause your thinking processes to go kerplooey from time to time.
Not all investment classes present an equal challenge to the investor seeking to invest rationally, however. Stocks, because their returns are so volatile, are the worst of the lot. Stock investors are often worried about what is going to happen to their money and the worry causes them to tell themselves tall tales about how stocks really perform in the long run.
IBonds, because their returns are so stable, are the best of the lot. Investing is ibonds is calming. Calm is good.
As a general rule, the larger the percentage of ibonds you have in your portfolio, the more able you will be to learn about investing as time goes by. None of us starts out knowing it all. It’s a very good thing to learn from your investing experiences and from the investing experiences of those around you. Owning ibonds permits you to be less emotional about investing and thereby leaves you more open to learning experiences.
Amazing ibonds trick #9 — Investors holding ibonds may enjoy seeing their returns compound like crazy.
The compounding returns phenomenon has been described as the eighth wonder of the world. Investors holding ibonds are positioned to enjoy a whole bunch more compounding in years to come than are investors holding only stocks.
The average price drop we saw on our three earlier trips to the la-la land stock prices that apply today is 68 percent. A price drop of that size would leave an investor with $100,000 invested solely in stocks with $32,000. In contrast, it would leave an investor with $70,000 invested in ibonds and $30,000 invested in stocks with about $80,000.
That’s a difference of $48,000! Think of how having an extra $48,000 to invest after the big price drop will help you achieve your financial freedom goals after the magic of compounding returns kicks in.
Amazing ibonds trick #10 — Buying ibonds early provides you a way to impress your friends.
How often have you heard those who are overinvested in stocks brag about how much they have earned by being “smart” enough to go wild for this wild investment class? It’s human nature. We all want to impress our friends with demonstrations of how smart and brave and special we are.
One investment class can remain the impressive one for only so long. Once just about everyone has caught on to the idea that it is by overinvesting in stocks that one “earns” outsized returns, the gig is up. It’s when just about everybody thinks that stocks are safe that stocks are truly risky, and it’s when just about everybody thinks that stocks are risky that stock are truly safe. What a conundrum!
Anyway, stocks have had their day in the sun for about 20 years now. Move over, stocks. It’s ibonds’ turn!
When stock prices go down and ibonds keep paying out those same dependable positive returns, which do you think is going to be viewed as the cooler investing class? Yep, it’s gonna be ibonds. You’ll soon be seeing lists of what’s fashionable that will list ibonds as in “in” investment class and stocks as the investment class that is now “out.”
Do the fashionable thing before it becomes so fashionable that it looks like you are just following the crowd. Buy ibonds now!
You might want to get rid of some of those goofy-looking stocks before someone asks you if you have a Nehru jacket and granny glasses hiding somewhere in your closet too.