New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 16,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

Why Do Bond Prices Work the Way They Do?

A reader writes in, asking:

“I know that interest rates and bond prices move in opposite directions, but I don’t honestly understand why that is the case. And while we’re at it, why do bond funds with a long duration have bigger price fluctuations than bond funds with a short duration?”

Imagine that you buy a $1,000, 10-year Treasury bond, with a 2% coupon rate. (That is, it pays $20 of interest per year.) And you hold that bond for five years, such that it is now effectively a 5-year Treasury bond with a 2% coupon rate.

And imagine that, over those five years, interest rates have risen, and newly-issued 5-year Treasury bonds are now paying 3% interest.

In such a scenario, if you wanted to sell your bond for $1,000, you’d have a very difficult (i.e., impossible) time. Nobody would want to buy your bond with its 2% interest rate, when they could just buy new 5-year bonds with a 3% interest rate instead. In order to sell your bond, you’d have to sell it for less than $1,000. That is, its price has gone down because interest rates have gone up. (Specifically, you would have to sell your bond at a sufficient discount that it would offer the same yield to maturity as newly-issued bonds of the same duration.)

And the same sort of thing happens in reverse. Imagine instead that rates on 5-year Treasury bonds had fallen to just 1%. In that case, people would be willing to pay more than $1,000 for your bond with its 2% coupon rate. That is, interest rates fell, so the value of your bond went up.

Why Do Longer-Term Bonds Have More Interest Rate Risk?

When interest rates change, the price of a bond fund will move (in the opposite direction) by an amount approximately equal to the average duration of the fund, multiplied by the percentage change in applicable interest rates. For example, if the whole Treasury yield curve were to rise by 2%, a Treasury bond fund with a 3-year average duration would fall in price by roughly 6%, and a Treasury bond fund with a 7-year average duration would fall in value by roughly 14%.

But why do longer-duration bonds experience more severe price fluctuations? Without getting into the underlying math*, I think the concept is most easily understood with an example.

Imagine that on a given day you purchase a 1-year Treasury bond and a 20-year Treasury bond, both of which you plan to hold until maturity. Then, on the very next day, the entire Treasury yield curve moves upward by 1%.

  • Holding the 1-year bond to maturity means you’ll be collecting a subpar interest rate (i.e., missing out on an additional 1% yield, relative to new bonds) over the next year.
  • Holding the 20-year bond to maturity means you’ll be collecting a subpar interest rate each year for the next twenty years.

Missing out on an additional 1% yield for a year isn’t great of course. But missing out on 1% per year for twenty years is a much bigger deal. And that is essentially why longer-duration bonds have larger price fluctuations when current interest rates change.

*For those who are interested in the technical explanation: The market value of a bond at any point in time is equal to the sum of the present values (i.e., discounted values) of each of the future cash flows the bond holder will receive. When market interest rates change, the discount rate we use to calculate present value changes. And a given change in discount rate (e.g., 1% higher or lower) has a much greater effect on cash flows far in the future (such as you would receive with a long-term bond) than cash flows in the near future.

Investing Blog Roundup: “Heads I Win, Tails I Win”

Housekeeping note: I’ll be traveling this upcoming week, so there will be no articles on Monday 7/18 or Friday 7/22. And I may be somewhat slower than usual in replying to emails. Things will return to normal on Monday 7/25.

There’s a good bit of research (see here for one recent example) showing that investors tend to underperform their own investments, due to buying and selling at the wrong times.

This week I read WSJ editor Spencer Jakab’s new book Heads I Win, Tails I Win: Why Smart Investors Fail and How to Tilt the Odds in Your Favor, which takes a look at that gap in performance and discusses steps investors can take to minimize it.

In my opinion, the best thing about the book is the perspective of the author. Prior to working in the financial media, Jakab was a stock analyst. As a result of his experience, Jakab is able to shed light on the tricks that both the brokerage industry and financial media use to make money from you — regardless of what is in your best interests.

In any event, it’s an entertaining book, with good information. (Chapter 10 of the book — “Seven Habits of Highly Ineffective Investors” — would make a good mini-book all on its own.)

Here’s the Amazon link for those who are interested:

Investing Articles

Other Money-Related Articles

Thanks for reading!

How Many Mutual Funds is “Too Many”?

A reader writes in, asking:

“I read your book investing made simple. The book does not mention how many  funds are too many to have in a portfolio. Do you think 9 funds is too many to have in my 403b portfolio?”

There is no broadly applicable, definitive answer for how many funds is “too many.”

The only time that a portfolio could be clearly, objectively said to have too many funds is when the portfolio includes a fund that serves no purpose, because it does nothing other than duplicate other funds in the portfolio. For instance, if an investor had an IRA that included:

  • Vanguard Total Stock Market Index Fund,
  • Vanguard Total International Stock Index Fund, and
  • Vanguard Total World Stock Index Fund…

…then it would be clear that this investor has “too many” funds, because the same overall allocation could be achieved using fewer funds. That is, any desired domestic/international breakdown can be achieved using the Total Stock Market and Total International index funds — no need to include the Total World index fund as well. (Alternatively, if the investor is happy with the domestic/international breakdown included in the Total World index fund, he/she could use only that fund and eliminate the other two funds.)

So, at least in my view, pointless duplication of holdings is the only time that a portfolio would objectively, clearly include “too many” funds.

There are many cases, however, in which an investor could say, “this is too many funds for me.”

That is, some investors (myself, for instance) place a high value on simplicity and do not care so much about being able to custom-tailor their allocation in various ways, so they use a single all-in-one fund (e.g, target retirement or Vanguard LifeStrategy fund) for their portfolio.

Conversely, some investors don’t at all mind managing a portfolio of many holdings, and they do care quite a bit about holding some very specific asset allocation (e.g., overweighting certain groups of stocks in their portfolio by holding a REIT fund, small-cap value fund, etc.), so they will select a portfolio consisting of several different funds.

And some investors are somewhere in the middle of that spectrum, preferring to use something like the “three-fund portfolio” often discussed on the Bogleheads forum (made up of a domestic total stock market index fund, an international total stock market index fund, and a diversified bond index fund).

Any of the above approaches can be perfectly rational — it’s simply a matter of personal preference.

Investing Blog Roundup: An International Look at the “4% Rule”

Over the last several of years, researcher Wade Pfau has put out an incredible amount of useful research into various retirement planning topics. This week, he provides us with an update into one of his first pieces of research, which looks at how the “4% rule” (which was originally based on U.S. market returns) has historically fared around the world.

Investing Articles

Other Money-Related Articles

Thanks for reading!

Investing Blog Roundup: Every Financial Crisis is Different

Housekeeping note: There will be no article this upcoming Monday (July 4). We will return to our regular schedule on Friday.

The famous investor John Templeton once said that the four most costly words in investing are “This time is different.” The idea is that the general principles of investing are always true and it is a mistake to think that today’s particular circumstances are somehow different and those principles no longer apply.

It’s hard to argue with that line of thinking. Still, I’ve never been particularly fond of that quote, because it glosses over the fact that, every time something scary happens in the markets, it is different. It is new. That’s what makes it scary! (But the timeless principles do still apply.)

Or, as Morningstar’s John Rekenthaler puts it this week: Every Financial Crisis is Different, and the Best Investment Response is the Same.

Investing Articles

Other Money-Related Articles

Thanks for reading!

Brexit, and How to Respond to Major Economic Events

A reader writes in, asking:

“You said on Friday that you won’t make any portfolio changes as a result of the Brexit vote. But I just don’t see how you can write it off so easily as no big deal. This seems like a very big deal to me.”

To be clear, my point on Friday was not that Brexit is “no big deal.” There’s no doubt that it is a big deal, which will have all sorts of consequences that we’ll see play out over many years.

So, to the question, “is Brexit a big deal?” the answer is a very easy “yes.”

But that’s not the question that investors need to ask themselves. The question investors need to ask is whether the results of the referendum merit a change to their portfolios.

For example, imagine that you hold shares of Vanguard Total International Stock ETF (VXUS).  The results came out Thursday evening, and when the market opened on Friday morning, the price of VXUS fell by approximately 6%. So the question a VXUS shareholder had to answer on Friday was: is a 6% price decline an overreaction or an underreaction to the economic events that had transpired?

Personally, I wouldn’t even know where to begin such a complex analysis.

But let’s imagine a hypothetical investor (Bob) who is more confident than I am. Bob decides to take a crack at assessing whether VXUS is under- or overvalued.

If his analysis is in the same rough ballpark as the overall market consensus (i.e., that international stocks as represented by the Vanguard Total International Stock ETF have declined in value by roughly 6%), then he probably shouldn’t make any changes.

But what if Bob’s analysis shows that international stocks have declined in value by 20%? If he’s even close to right — even if he’s off by several percentage points — he would likely benefit by decreasing his allocation to international stocks.

But if the market says that international stocks are worth 6% less than they were worth the day before, and Bob’s analysis shows that they’re worth 20% less, what’s the most likely explanation for that discrepancy? Unfortunately for Bob, the most likely explanation is simply that his amateur analysis isn’t very good. (After all, the alternative explanation is that his amateur analysis is on target, while the collective analysis of a huge number of true experts is way off the mark. To any outside observer, it’s obvious which explanation is more plausible.)

Even if Bob weren’t an amateur — even if he were a financial analyst or macroeconomist with relevant experience, for example — it would require an extraordinary degree of self confidence to think that his one-person analysis is probably right while the market’s analysis is wrong.

And, more broadly speaking, this is the way it goes with any economic event — even ones that are likely to go down in history as significant turning points. The event occurs, and the market reacts. And if you hope to beat a simple passive index fund strategy, you must try to determine whether the market has overreacted or underreacted. If your conclusion is close to the market’s conclusion (and you therefore make no changes to your portfolio) then you’ve simply wasted your time. And if your conclusion is very different from the market’s conclusion, then you have to consider the possibility that the discrepancy is simply because your analysis is very flawed.

Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2016 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy