Thursday, April 29, 2010

Portfolio 2 (simple, moderately conservative): the fixed-income story

In this post we start digging into Portfolio 2 (from my post Some Real Portfolios). There are several interesting aspects to this portfolio, so I'll use more than one post to discuss the portfolio. In this post, we focus primarily on the fixed-income portion of the portfolio. This is likely to be of more interest to retired investors, or investors who are investing for shorter term goals (less than 10 years).

Here are the target allocations for the portfolio:
  • Top level allocation
    • 40% Stocks
    • 60% Fixed-Income
  • Stock Allocation (40% of portfolio)
    • 65% US (Vanguard Total Stock Market ETF)
    • 35% International (Vanguard FTSE All-World ex-US ETF)
  • Fixed Income Allocation (60% of portfolio)
    • 80% Bonds (Vanguard Short-Term Investment-Grade Bond, Vanguard Intermediate-Term Investment-Grade Bond, Vanguard Intermediate-Term Bond Index)
    • 20% Cash (Vanguard Prime Money Market and savings/checking accounts)
Note that all investments are at Vanguard (in an IRA), except for some cash in savings and checking accounts.

The investors are a younger retired couple (age range 55-65). I stated in the Some Real Portfolios post that they have an investment horizon of 20-30 years, but this requires some clarification. They are taking fixed monthly withdrawals from the portfolio to help pay for their living expenses. At the current portfolio value, these withdrawals amount to more than 6% annually (annual withdrawal amount divided by current portfolio value), which is higher than would normally be considered prudent. However, they expect to receive a significant inheritance within 10 years, and have chosen to factor this into their investment plan. Therefore, this portfolio was designed with a 10-15 year initial investment horizon in mind, assuming that the inheritance will provide funds for the additional 5-20 years of their lifetime investment horizon. So, the portfolio has a higher stock allocation than I would consider prudent for a 10 year investment horizon, but a lower allocation than might be appropriate for a 20-30 year investment horizon.

More about the monthly withdrawals: they are not inflation adjusted. These are early withdrawals from an IRA, and are being taken under IRS regulation 72(t), which requires that the withdrawal amount is constant for 5 years (for the withdrawal method selected). So, our plan must account for these constant withdrawals for 5 years from the time the plan was initiated.

The fixed-income portion of the portfolio is designed to meet their withdrawal needs over the next 6-8 years. A money market fund is used for withdrawals over the next 2 years, a short term bond fund is used for withdrawals in years 1-4, and intermediate term bond funds are for withdrawals in years 3-8. There is overlap in the years because of the duration/horizon matching strategy being used, which I'll describe below. This isn't the place to get into detail about duration, so I'll just note that duration is a measure of risk, and it's generally recommended that the duration of a bond fund not exceed the investment horizon.

So, ideally, we'd invest in a set of bond funds each having a duration matching the time when the funds are needed; e.g., 0 year duration for money needed this year (year 0), 1 year duration for next year's withdrawals (year 1), 2 year duration for the following year's withdrawals (year 2), etc. Since bond funds with these exact durations aren't available from Vanguard, we spread the money across a few funds with different durations, so that we have about the annual withdrawal amount with an average duration that matches the withdrawal year. This probably sounds complicated, but hopefully the following explanation will make it clear.

A money market fund has a duration of 0, since the value doesn't fluctuate, so it's appropriate for money needed this year (year 0). A short term bond fund with a duration of about 2 years is available, and is appropriate for money to be withdrawn in 2-3 years (year 2). What about money needed 1-2 years from now (year 1)? By putting the 50% of the year 1 money in the money market and 50% in the short-term bond fund, we get an average duration of 1 year [ (0 + 2) / 2 = 1]. Then, with an intermediate-term bond fund with a duration of about 5 years, we can calculate the split between the short-term fund (duration 2 years) and the intermediate-term fund to meet withdrawal requirements in years 3-4. For money need in year 5 and later, we can put 100% into the intermediate-term bond fund. We don't use longer term bond funds, because they are too risky for our needs.

Following the above approach, it turns out that to meet the total withdrawal needs for 6 years (years 0-5), we want the following breakdown:
  • 25% money market
  • 42% short-term bond
  • 33% intermediate-term bond
These are percentages of the total amount to be withdrawn over the next 6 years. For example, if the annual withdrawal was $20,000, we'd withdraw $120,000 over 6 years, and we'd want $30,000 in the money market (25% of $120,000 = $30,000).

At this point, more than 6 years of withdrawals are in the fixed-income (money market and bond) funds. Anything beyond the 40% allocation to stocks is kept in the bond funds.

The specific bond funds used are Short-Term Investment-Grade Bond, Intermediate-Term Investment-Grade Bond, and Intermediate-Term Bond Index.

Initially, only the short-term investment-grade fund was used (with the rest of the fixed-income in the Prime Money Market fund). At the time the portfolio was formed (December 2008), we wanted to keep it super simple, and wanted to keep the fixed-income portion very conservative, so no intermediate-term funds were used (longer term funds have more risk). However, at the time, the short-term investment-grade fund was paying significantly higher interest than the short-term index or treasury funds (due to the financial panic), and the investor was OK with the additional credit risk.

Once the portfolio was set up, we did some more analysis, came up with the duration/horizon matching strategy (described above), and decided to start transferring money from the money market to the intermediate-term investment-grade bond fund. The strategy was to use a value averaging approach, in which an amount was exchanged each week so that the value of the intermediate-term fund would increase by a set amount. This is similar to dollar cost averaging, except that even more shares are purchased if the fund share price drops, and even fewer shares are purchased if the price increases.

Since we started, rates on investment-grade bonds have come down (and prices have gone up), and rates on treasury funds have increased (and prices have gone down). So, we've been lucky so far, and have profited from both higher rates (than treasuries) and increased fund share price. However, now the rate on the intermediate-term bond index is only slightly lower than the intermediate-term investment-grade fund, and the quality is higher. So, we're now making our weekly exchanges from the short-term investment-grade bond fund (in which we still have more than our target amount) to the intermediate-term bond index fund. The index fund also has a longer duration (about 6.4 years) than the investment-grade fund (5.2 years), so we can plan on using money from the index fund for year 6 and beyond.

In the next post on Portfolio 2, I'll discuss the stock portion of the portfolio, and the story behind how this portfolio was created, which involved transferring the funds from a high-cost money manager to the low-cost funds at Vanguard.

1 comment:

  1. I really like the way you have created this investment plan, it is ideal for the case in hand. This post is very helpful for all those looking to invest their money smartly.

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