As one listener prepares for an early retirement, James discusses the situation, covering how to build a bond ladder based on non-retirement funds.
James provides a different way of looking at the stock-to-bond conversation.
Learn how to determine the appropriate amount to have a bond ladder and whether you should own individual bonds or bond funds as a part of that ladder.
Questions Answered:
How do you balance risk capacity and risk tolerance in portfolio allocation?
How do you build an effective bond portfolio for retirement?
Timestamps:
0:00 - Listener case study
2:37 - James’s perspective on bonds
7:42 - Considering purchasing power
10:18 - Balance of stocks and bonds
13:39 - Dividends are typically resilient
16:40 - All bonds not created equally
20:30 - Bond ladder
23:09 - Different types of bonds
24:51 - Withdrawal strategy
26:39 - More on bonds
30:09 - 3 questions to consider
Create Your Custom Strategy ⬇️
As one listener prepares for an early retirement, James discusses the situation, covering how to build a bond ladder based on non-retirement funds.
James provides a different way of looking at the stock-to-bond conversation.
Learn how to determine the appropriate amount to have a bond ladder and whether you should own individual bonds or bond funds as a part of that ladder.
Questions Answered:
How do you balance risk capacity and risk tolerance in portfolio allocation?
How do you build an effective bond portfolio for retirement?
Timestamps:
0:00 - Listener case study
2:37 - James’s perspective on bonds
7:42 - Considering purchasing power
10:18 - Balance of stocks and bonds
13:39 - Dividends are typically resilient
16:40 - All bonds not created equally
20:30 - Bond ladder
23:09 - Different types of bonds
24:51 - Withdrawal strategy
26:39 - More on bonds
30:09 - 3 questions to consider
Create Your Custom Strategy ⬇️
Today we're going to be taking a look at a listener named Mike's portfolio as he prepares for an early retirement. Now, mike's retirement money is invested aggressively, but he wants to know the best way to start building a bond ladder with his non-retirement funds, because he wants to be able to live on those as soon as he retires. So in this episode of Ready for Retirement I'm going to walk you through number one, how to determine the appropriate amount to have in a bond ladder. Number two, whether you should own individual bonds or bond funds as part of that ladder. And then number three, a different way of looking at the whole stock to bond conversation than most of us are used to. That's all coming up on today's episode of Ready for Retirement. Let's jump right in. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. As I mentioned, this question comes from Mike, and Mike says this Hi, james, I found your podcast a few weeks ago and I think it's one of the most interesting and informative podcasts on retirement out there. Each of the topics are easily digestible length and you have a knack for making complex concepts relatable and easy to understand.
Speaker 1:My question is on bonds and, more specifically, how to build a resilient bond portfolio. My wife and I are mid to late 40s and expect a substantial sum of money to pay out over time during the next four to 10 years. I work at a real estate development firm and I have invested a number of projects that will complete and be sold over the coming years. We have also saved $2.1 million in combined pre-tax 401ks. We plan to both work until the proceeds from the real estate investments pay out and build to a level that can support our day-to-day expenses kids, college, etc. My current plan is to gradually build a bond portfolio with the real estate proceeds and, in a few years, live off of the income in principle until our 60s, when we would start drawing down on 401k and social security. Our 401k is 100% invested in stocks, so we would expect to see decent growth over the next 12 to 15 years there. Because we expect to retire early and don't have any other funds saved to support an early retirement, we want to ensure that the bond portfolio is both resilient and generated good income that we can live off of. How should we think about constructing a portfolio of bonds with seed money coming in over multiple years? How should we think about allocating among short-term, slash, long-term bonds and the various types of bonds, treasuries, corporates, mortgage back securities, etc. Is it safe to expect a bond portfolio won't decline much in value, or should we build a five years of expense cash reserve to protect against a market downturn? And a final question I can't seem to get my hands on is whether it's riskier to own a bond fund that can lose value or buy individual bonds that be held to maturity. Thanks again for providing your insights. I really enjoy your show from Mike. Well, mike, thank you very much for that question. We're going to address all of that in more on today's episode. And before jumping right into should you own an individual bond, should you own a bond fund? How do you actually do this with lump sums of money coming in periodically over time?
Speaker 1:I want to start by reframing the way I would at least look at bonds. Not saying everyone does this, but this is my personal philosophy. I start by asking why own bonds in the first place? Now bonds have their role. I'm saying don't own them, but challenge that thinking just for a second. Why would we even own bonds? My personal philosophy is to start with as little in bonds as necessary, and this comes down to something that's called risk capacity versus, or which is different than, risk tolerance. Risk tolerance is what you typically hear about. What's your comfort level with investing? How would you react if the market were to drop 20%, 30% or more? It's more subjective. Risk capacity is more objective. You can come to the right answer. You can objectively say how do we minimize risk through the right portfolio construction? So when I'm starting with the concept of what's the least in bonds we can start with as possible, I'm coming at it from the risk capacity standpoint. How much risk can we accept in our portfolio? And I say risk wanting, first and foremost, to reframe what I even mean by risk. Risk shouldn't be thought of as preservation of capital. That's one way to look at it. That's not the only way you should look at it. Really, risk should be looked at from the standpoint of how do we minimize the permanent loss of purchasing power? So let me use an example to illustrate what I mean by that.
Speaker 1:Bonds are typically thought of as more safe, and even within the bond universe there's various spectrums of bonds. The safest bond is typically thought of as the one month treasury bill. So what you're doing is you're lending your money to the US government for 30 days and they are guaranteeing that they're going to pay back your principal, along with some interest, at the end of that 30 days. You go back to 1926, it's never, ever, had a negative calendar year return. So if you look at the return on it, it's never had a nominal negative return and in fact over that time period since 1926, it's had an average return of 3.2%. Now this is where I want to reframe what your goal should be with your portfolio as a whole, not just the bond portion, but your portfolio as a whole. Your goal isn't to preserve the dollar value of your portfolio. Your goal is to preserve your purchasing power.
Speaker 1:Now purchasing power is impacted by another variable and that variable is called inflation. So inflation based upon the consumer price index. So CPI inflation since 1926 has been 2.9% per year, meaning your real return on those one month T bills is 0.3%. So when we look at it, it's not truly fair to say they've returned 3.2%. I guess it's fair to say that, but the real way of looking at that is to say they've just barely maintained their purchasing power. They've grown by 0.3% as a real return. Now let's take it one step further. Let's look at the last 25 years. Now this data goes through the end of 2022, because they don't quite yet have the data all the way through the end of 2023. But the last 25 years, if you owned one year treasury bills, your real return would be negative 0.5% per year. Meaning if you look at what they actually paid and then back out inflation, you actually lost half a percent per year over the last 25 years owning one month treasury bills.
Speaker 1:Now let's take a look at the S&P 500. So stocks because stocks are not typically thought of as being safe or conservative. They're thought of as the exact opposite. They're typically thought of as risky. Well, let's take a look at owning stocks right before the worst possible time that you could have owned stocks for. So right before the Great Depression hit. If you put all of your money in the S&P 500 at the beginning of 1929, right before the stock market got totally wiped out by the Great Depression one year later. So 1929, the stock market lost 8.4 percent. In 1930, it was down negative 24.9 percent. In 1931, it was down 43.3 percent. So you just got whacked three, four years in a row. However, if you look at the 25 year annualized return of the S&P 500, starting in 1929, so arguably the worst time that you could possibly have started. Your real return was 5.6 percent per year on an annualized basis. Just for comparison, one month treasury bills during that same exact time period had a negative 0.9 percent per year real return over that same 25 year time period.
Speaker 1:So why am I even talking about this? Why am I talking about this thing? I thought we were talking about bond ladders and how to build them. We are. I'm going to get to that, but to start, I want to reframe the whole conversation, because most people think of bonds as safe and stable and secure. In a way they are, but in a way they aren't. And so, again, going back to my initial point of how can we get away, this is just my personal philosophy. This is something you have to agree with this, but this is my initial look at this is how can we get away with having as little in bonds as possible? Because bonds do absolutely play a role, but I think most people's portfolios they may be played too large of a role and it's. How can we minimize that? Because in doing so, we, in many ways, are actually minimizing some of the risk.
Speaker 1:Let's continue with this, going back to that worst case scenario for stocks 25 years having a real return of 5.6 percent annualized, even if you invested right at the peak, right before the Great Depression hit versus even just comparing the last 25 years of owning the safest quote, unquote safest asset in the world, which is one month treasury bills. So when we start to reframe it from this perspective, we start to see okay, real risk isn't the volatility that we're going to go through. Real risk isn't the ups and downs of just an inevitable part of investing. Real risk is your permanent loss of purchasing power and, over time, stocks are safer. When it comes to how do we preserve purchasing power, a well-diversified mix of stocks, historically speaking, has done better, significantly better, to preserve our purchasing power, which should be our goal as investors.
Speaker 1:Bonds, on the other hand, during some of these time periods, have been horrible at maintaining your purchasing power over time. So when we're looking at that, we need to understand the role that bonds should play and the role that bonds shouldn't play. It's very clear by this that bonds aren't going to be the thing that drives your portfolio forward. They're not going to be the things that help you keep up and exceed inflation over time. That being said, they still absolutely may be necessary in some people's portfolio. So how do we determine how much? Well, as I'm going through this, what I'm trying to work towards is what's the least amount, at least as a starting point from a risk capacity standpoint. What's the least amount I could get away with, having them bonds and still have a portfolio that I know is going to deliver on all my needs in a safe way from the standpoint of preserving purchasing power over the course of my retirement?
Speaker 1:Well, let's go back to Mike's example. To take this one step further, here's two things I don't know about Mike. Number one I don't know his desired living expenses in retirement and I don't know how much he'll have in his portfolio. To use his words, he'll have a substantial sum that pays out from some of these real estate deals that we'll be selling over the years. I don't know if substantial amount means $1 million, $10 million, $20 million. I have no idea what it means. Let's assume just use a nice round number that that substantial sum is $5 million after taxes because it's a nice round number. And, by the way, if you're looking at this and saying, hey, I don't have $5 million, maybe you have $500,000, or maybe you're listening to this and you say I have $20 million, so these numbers don't apply to me. Well, they still do.
Speaker 1:The framework that we're looking at, the order of operations that you should be going through, the principles absolutely apply, even if the actual numbers are different for you. So don't listen to this and say, oh, those numbers don't apply to me because of the amount. It's the principle and the framework that absolutely applies to you, regardless of your dollar value. So let's assume that Mike walks away with $5 million from this, how much should he have in stocks and how much should he have in bonds? Well, I still don't have enough information, even though I know, or I'm assuming, a portfolio balance. The next thing I really need to know is I need to know his expenses, because Mike didn't provide them. I'm going to take the liberty of using a nice round number, just to use my example. I'm going to assume that he wants $100,000 per year, and I'm probably way off based on what Mike actually wants, but that's the number I'm going to use.
Speaker 1:Now, how much should Mike have in stocks and how much should he have in bonds? Let's continue with this line of thought that we're going down. How do we minimize the amount that needs to be in bonds, at least as a starting point? And the reason I'm starting with this is I'm going back to Mike's question and saying can we get away without having any bonds, which I know defeats the point of your question, which is how do I construct this bond portfolio or bond ladder? But let's even start or let's first start, by saying do we even need it? So I'm assuming Mike walks away with $5 million from the real estate proceeds. I'm also going to assume that his $2.1 million turns to $3 million after five years or so, which, based upon some contributions, even just a little bit of growth, is probably a pretty conservative assumption. So let's assume Mike has $8 million total that he has to live on going into retirement.
Speaker 1:So the typical line of thinking is okay, I'm retired, stock market moves up and down, I can't afford to be on stocks Now. I need to rebalance it to something like a 60-40 or 70-30 portfolio or something like that, because the market goes up and down and I can't afford my portfolio to go down when I'm retired? Right, not necessarily. There's one more thing that we need to take into account before we make the determination, and that's the fact that your stock investments assuming you're properly invested and properly diversified, your stock investments should be paying some dividends. Now, depending on what types of stocks you're invested in, that dividend rate is going to vary, but more than likely, if you own a diversified stock portfolio, you're going to be receiving something in dividends. And not just will you likely be receiving something in dividends, but those dividends typically remain pretty resilient, even when stock markets decline. To use a recent example 2022, the S&P 500 lost over 18% of its value. Now, in 2022, those same investments that were down over 18% the dividend yield on them actually increased by almost 11% relative to where it was in 2021. Which means, if you were just living on dividends, yes, your portfolio dropped by almost 20%, but the actual cash income that you're receiving from dividends increased by almost 11%. So let's play that out and see what that might look like for Mike.
Speaker 1:What if he just lived on dividends? Would that be sufficient? Because if it is, then theoretically, at least to an extent, maybe you don't even need to have bonds in your portfolio. So what could we expect Mike's portfolio to yield? Well, I don't know Mike, I don't know what his investments are, but as of this recording, the S&P 500 is yielding about 1.45%. International developed markets are yielding about 3.15% per year just in cash dividends. So let's assume that Mike has a portfolio that says 70% S&P, 530% international developed stocks Not as diversified as I'd like to see it, but just a simple starting point.
Speaker 1:Well, the blended dividend yield, based on having 70% in S&P and 30% in international developed markets, the blended dividend yield on that portfolio would be somewhere around 2% per year. So if Mike has $8 million in his portfolio and that portfolio is generating 2% per year in cash dividends and the important thing to note here is dividends typically remain very resilient. Even when the value of the portfolio fluctuates dramatically, those dividends typically remain sticky. If that wasn't the case in this approach, it wouldn't work. But if we can count on dividends to be paid regardless what's happening in the market and it's not a guarantee there have been times when dividends have been cut as the market dropped, but for the most part they stay consistent. That's important to know, because it's that stream of income that we're worried about more so than the actual value of our portfolio.
Speaker 1:So going back to Mike's $8 million portfolio, generating 2% dividend yield, that comes out to $160,000 in cash dividends, without regard to any actual market performance. You look at that and say, mike, you could live on that, assuming $160,000 covers your needs. That could last over time. And now, another really important thing to note is over the last 60 plus years, dividend growth on S&P 500 companies have averaged about 5.8%. Inflation has averaged about 3.7% or so per year. So not only are these dividends meeting his needs today assuming the $100,000 per year living expenses that I made up for him but those dividends historically grow faster than the rate of our spending grows. So not only does it cover it today, but the margin by which it covers it is likely to increase over time.
Speaker 1:Now to those of you who are extra astute listeners probably remember something I said at the beginning that of this $8 million that I'm making up here, $3 million of it is in retirement accounts. So sure he can touch that one day, but he's not going to be able to touch that when he initially retires. Really, it's just the $5 million again the number that I'm making up that he would actually be able to live on. So we can't really apply that full 2% dividend yield to his entire portfolio to see what's livable today. Really, we'd only want to apply that to his real estate portfolio or the $5 million that comes from the proceeds from real estate. But even there, what we're looking at is $5 million at a 2% dividend yield. That's $100,000 per year of dividends that Mike could expect to receive. So I'm not saying this is the only way to look at it.
Speaker 1:This is an incredibly oversimplified way to look at it. There's a whole lot more nuance we want to go through. But as a starting point, when we're trying to back into what's the right amount to have in bonds and then how do we build a bond portfolio or bond ladder, what do we even need in bonds for the first place? What role do bonds serve here? So, yes, I'm using very easy numbers here, and that's on purpose to illustrate this point here. As you're actually working through this whether Mike, it's you or whether it's anyone else who's actually listening rework these numbers to your specific situation and there's a whole lot more nuance that goes through this. So if you have any concerns about how to do this, we'll reach out to us here at rootfinancialpartnerscom to see if we can help. But this is a crucial aspect of portfolio construction is understanding how much do you actually need to have in bonds to deliver your desired standard of living or your desired level of income.
Speaker 1:Let's go back to Mike's case for a second and let's assume that instead of walking away with $5 million from his real estate portfolio, he walks away with $2.5 million. Again, the actual numbers don't matter, it's the principles here that do matter. So he walks away with $2.5 million. How would that change things? Well, if we assume the same 2% dividend yield, now his income from his stock portfolio his all-stock portfolio would be $50,000 per year, but he needs $100,000 per year. So if $50,000 is coming in but he needs $100,000, there's a $50,000 per year shortfall. That shortfall is now what we need to build a portfolio round.
Speaker 1:Because if I could guarantee that stocks were just going to go up let's say they're going to go up exactly 8% to 10% per year we'd be totally fine. 2% per year is being paid to Mike as a dividend. He would need to end up selling another 2% per year of his portfolio just sell the principal to come up with the remaining $50,000. He needs to get the $100,000 total. So he'd be taken 4% per year out total from his portfolio, 2% from dividends, 2% from selling principal. If he's growing at 8% to 10% per year, no issue. His portfolio keeps growing even as he's pulling money out.
Speaker 1:But we know stocks don't just grow by 8% to 10% per year. They might average that, but there's also going to be some years when they're down 30, 40, 50% and in those years where they're down 30, 40, 50%, those years represent the greatest risk to our financial security and those are the years that we don't want to have to sell stocks. That is where cash and bonds come into play. This is where I'm going to go back to Mike's question. He says, quote how should we think about allocating among short term slash, long term bonds and the various types of bonds Treasuries, corporates, mortgage Back Securities, etc. Is it safe to expect a bond portfolio won't decline as much in value, or should we build a five years of expenses, reserving cash to protect against a market downturn? End quote. Well, this is a very important aspect of your question, mike, because not all bonds are created equal.
Speaker 1:We saw this in 2022. 2022 was the worst year on record for many different types of bonds. In fact, 20 year Treasury bonds meaning if you lent your money to the US Treasury or the US government for 20 years, the value of a bond, the value of a 20 year bond, decreased by 31% in 2022. So if you had that, stock market was bad. The S&P 500 was down 18%. The bond market was down significantly more. So the safe asset dropped by over 30%. Very few people almost nobody, actually saw that coming in 2022.
Speaker 1:That's not a safe asset. That's not an asset that I want to have in my bond ladder or my reserve fund that I'm going to turn to live on when stock markets do poorly. Well, that's just 20 year US Treasuries and in fact, 30 year US Treasuries did significantly worse. But what if we looked at 90 day Treasury bills in 2022? So it's still the same issuer still lending money to the US government. The only difference is we're looking at the timeframe, the maturity of those bonds. Well, 90 day Treasury bills were up almost 2% in 2022. So not a significant amount of money, not something that's going to ever make you wealthy. But if you need to pull money from somewhere, it's much better to pull from something that's up 2% than it is to pull from something that's down 18, 20, 30%.
Speaker 1:So, as we go back to Mike's question or anyone listening to this of how do we construct a bond portfolio? What role does it play? This is what we need to be mindful of. It doesn't matter that you have bonds If they're all very risky bonds. The stock market could drop if those drop at the same time, and drop dramatically. It did no value to you, there's no value to you. It's of no purpose for you to actually have those bonds. So make sure you own the right types of bonds to complement what you're doing in your stock portfolio, so that you're ready to start living on those funds when it is necessary or when it's needed.
Speaker 1:So how do you build that bond ladder? Well, ideally, I like to think of it as having at least five years of living expenses set aside in some type of a bond ladder. For example, you'd want to have enough for one year of living expenses and something with a maturity of one year or less. Now, how do we determine living expenses? Let's use Mike's situation again as an example. Are Mike's living expenses 100,000? So we put a full $100,000 into something like a bond fund Not necessarily Now you could, but the minimum amount that we would need to put aside is 50,000. And I say the minimum because 50,000 is already coming from cash dividends from the rest of his portfolio. Again, if he needs to live on 150, he's already covered through dividends. It's only the remaining 50,000 that we need to set aside to have stable and liquid to be able to use if and when it's needed. So it's the portion of his living expenses that aren't already covered by another income source, which in this case is dividends.
Speaker 1:So he would need $50,000 and something with a maturity of one year or less. Then he would need another part of his portfolio. He would need another $50,000 that had a two-year maturity or less. Now, I say two-year maturity or less, that doesn't mean you have to have just bonds with a two-year maturity. You could simply own T-bills that mature every three months and just continue to reinvest those as those mature, either through a fund or owning them directly. So you just want to have that money liquid and you don't want to extend the maturity past two years for the portion that you could potentially need, because anything within a maturity past that could potentially drop in value by the time that you actually need to access it or live on it. Then you would do the same thing for year three and year four and year five. You can take this out for as many years as you want to.
Speaker 1:I typically look at five years as a good starting point. There's no magic to that, but where it comes from is if we look at the US market since the end of World War II, the longest it's taken. What we want to understand is what's the longest it's taken for the stock market to drop and then fully recover and break even. The reason for that is, during that time when the market is dropping and then breaking even, ideally we're not selling our stocks. That's when we're using our bonds and our cash to live on, giving time for our stocks to recover. The longest time frame it's ever taken since the end of World War II in the US stock market has been about five and a half years or so. So if you have five years set aside, you're pretty well covered in terms of your ability to minimize the negative impacts of that downturn. Now, could there be downturns in the future that take longer? Absolutely there could. So this is where it goes back to your own personal risk preferences and risk tolerance of. Do you want to do six years, seven years, 10 years. At a point it becomes unnecessary and too much. But five years is a good starting point.
Speaker 1:Now, what types of bonds should you deal with this with? Should they be corporate bonds? Should they be treasury bonds? Should they be municipal bonds? Should they be mortgage-backed securities? Well, really, what it depends upon is two things. Number one your tax bracket. So look for the highest after-tax yield.
Speaker 1:Assuming safety of principal is your first priority, meaning you can get some bonds that yield crazy high rates, but they're typically doing that because these are very distressed companies that you're lending to, or very distressed governments. Those are called junk bonds or high yield bonds. You don't want that. You don't want those bonds to take this place in your portfolio because they're quite risky. But what you are looking for is assuming safety of principal. So, assuming a highly rated bond, what's the highest after-tax yield? For some people that could be corporate bonds. For some people that could be treasury bills. For some people that could be municipal bonds. So this is going to fluctuate and it's going to depend, but different types of bonds are taxed differently. In terms of some, you are paying state taxes. On some, you are paying federal taxes on some you're not. So take a look at what makes sense for your tax situation. And then, number two what are current rates? This isn't static. It's not like these bonds pay this rate and these bonds pay that rate. This is something that fluctuates, and so you want to make sure that this is something in your portfolio that's fairly adaptive, so that you're looking for the thing that's paying the highest rate and the highest after-tax yield, while, first and foremost, preserving the principal preserving the safety of the value of those assets. And so, when you do this correctly, yes, you are preserving the value of those assets so that the rest of your portfolio can be used to preserve your purchasing power over time, and the best way to do that is through owning stocks, well-diversified stock portfolio.
Speaker 1:Now here's the last thing that I want to say. With this part, you now need to apply the right withdrawal strategy. Just because you have the perfect ladder bond strategy doesn't mean you should use it right when you retire. A lot of people they say, okay, I'm going to retire at 50 or 60 or 70 or whatever it is, so they build their ladder bond portfolio and then they retire, and then they immediately start spending down the ladder bond portfolio. It's not the right way to look at it. Just because you have that ladder bond strategy doesn't mean you should use it right away.
Speaker 1:I want you to think of it more like an emergency fund. Think of it for protection. So, for example, in your working years you probably have an emergency fund and most months, most years, you're not touching your emergency fund. Your emergency fund is there if and when you need it because you lose a job or take a significant hit to your income. But if you don't take a hit to your income, if you don't lose your job, well then you're just using your paycheck to live and your emergency fund is staying put. Think of your bond portfolio in the same way. When things are good in the stock market, your bond portfolio should just stay put. Your stocks are delivering the income you need. That's where you're living on most of your income, either from dividends from stocks or from selling stocks to create the cash that you need. It's when times are bad in the stock market. It's when things aren't going so well and you don't want to have to be forced to sell stocks. That's where you start capping into your bond portfolio or your bond ladder. So think of your bond portfolio, and when I say bond portfolio, not literally having a separate bond portfolio and one account and the stock portfolio and another for most people it's all in one account. But think of the bond portion of your portfolio. In the same way you would think of your emergency fund when you're working, as we're only going to tap into it when there's an emergency, and in this case, an emergency isn't a car breaking down or you losing a job. An emergency in this case is a market downturn and, in fact, we're going to expect emergencies, and that's why we have this bond portion there.
Speaker 1:Now the final part of Mike's question is about should I do individual bonds? Should I do bond funds? I think this is a question that gets probably more attention than it's worth sometimes. I think that both can be excellent options if you're doing it the right way. I think the wrong way to do it is, as I mentioned, it is nice to have intentionality in terms of the types of bonds that you own. So, if you want one-year bonds, so maturity with one year or less, and then another part of your bond portfolio two years or less and another part of your portfolio five years or less, depending on how you structure your bond portfolio. When you're actually retired and living on that money.
Speaker 1:You probably don't want all those bonds in the same fund because when it comes time to retire or to live on that bond money, you can't tell the fund manager hey, sell only the one-year maturity bonds, sell only the five-year maturity bonds. It's all grouped into one fund. So the one fund is going to be fluctuating in value. It doesn't give you as much intentionality around what part of your bond letter you're pulling from. So assuming you have, say, a separate short-term bond fund, a separate intermediate-term bond fund, a separate long-term bond fund, that I would necessarily recommend a long-term bond fund in this type of an example. But if you can get intentionality there, that's the biggest thing to me.
Speaker 1:Individual bonds they still fluctuate in value. I think that's a big draw for most people is they say, oh, I can buy an individual bond and it doesn't fluctuate in value. It absolutely does. It's just like your home. You don't necessarily see your home fluctuating in value unless you have to sell it. Well, same thing with an individual bond. You just see how many shares you own. If you hold it to maturity, you're going to get paid back the entire amount plus interest along the way. Well, if you actually had to sell it along the way, there's no guarantee that you're going to be able to sell it for the full par value. So it's misleading to say that that bond isn't fluctuating in value, because the actual market value driven by market forces absolutely is.
Speaker 1:But owning a fund there are some benefits. There are some pricing benefits in terms of an institution, buying bonds is going to get much better pricing than an individual buying bonds. Bond pricing isn't something most people think about, but when you go buy a bond as an individual, you're not getting great pricing. You never see it because it's not like you're paying a significant commission for it or anything like that. It's just there's a bid-ask spread and you're going to be on the wrong end of that bid-ask spread. There's a lot of money that is lost, sometimes buying bonds the wrong way as an individual versus if you're doing it within a bond fund. It's being done by institutions and professionals who are typically getting better pricing.
Speaker 1:On top of that, one of the downsides with individual bonds is, as I mentioned, if you're using them correctly, you're not necessarily living on those right away. So you might have your bond portfolio, but you might not live on this for five years or six years or seven years until the market stops doing well and you have to start living on your bond money as opposed to your stock money. Well, if you're owning three month treasury bills or six month treasury bills in your bond portfolio, it would be one thing if you knew you're going to live on that money in three months or six months. But if you're not going to live on that money for potentially five years or seven years or 10 years, because the market just keeps going up and up and up, are you really going to be going in and trading those bonds every time they mature? A lot of people, they just don't. They buy one bond and it matures and they don't get around to purchasing another one, so it just stays in cash. Well, with a bond fund, you have a professional managing that and as one bond matures it's being reinvested for you. So it just tends to be a much more turnkey way of getting the exposure of the right types of bonds that you want and having that be there for you without you having to go and constantly repurchasing bonds as they start to mature.
Speaker 1:So before we start to wrap up today's episode. I want to make it very, very clear that the approach I just went through is not right for everybody. I start and this is a little bit of a personal bias of mine of looking at can we get away with having as little in bonds as possible? That's looking at things from the risk capacity standpoint. How much capacity does your portfolio have to be able to be mostly in stocks? The second step, but an equally important step, is now looking at risk tolerance. So we start by with risk capacity. So from a financial standpoint, how much can you afford to have in stocks? But now we have to balance that with your personal comfort level with having all, or maybe potentially almost all, of your portfolio in stocks. Now there's not necessarily a framework step one, step two, step three framework that you can do to determine what's your risk tolerance, as much as it comes down to a deep understanding of your emotional capacity to handle a significant drawdown in your portfolio.
Speaker 1:So everyone has a higher risk tolerance when the market's good, it's easy to say, yeah, of course I love risk because you're making lots of money. A lot of those same people wouldn't claim to have a high risk tolerance when the market is bad. So it's not enough to say, yeah, I like risk when things are good. You have to know yourself at a level of how will you react when the market drops and not just when the market drops, but everything you look at on TV, everything you read, is saying the market's horrible, it's never going to recover, you should sell everything you have and go to gold. That's just going to be the message that you hear over and over and over.
Speaker 1:Do you have the discipline and fortitude within you to be able to actually hold an all-stock portfolio, or mostly stock portfolio, when you're also living on these assets? That's risk tolerance. So you have to marry your risk capacity, which is what's the right mix of stocks and bonds, almost from a mathematical standpoint, with my risk tolerance, which is what's my personal comfort level in terms of how do I get the right stock to bond allocation to make sure I can stick with this portfolio. And you need to combine those two to get to the right portfolio allocation for you. So to go back to Mike and his example, if you're Mike and you have $8 million in your portfolio and you need $100,000 per year, then your risk capacity could very well be 100% stock portfolio.
Speaker 1:Now some of you listening are probably feeling a knot in your stomach as you hear that. If that's you, your risk tolerance probably isn't such that you should have 100% stock portfolio, and if that's the case, it's perfectly fine. It just means your risk tolerance isn't suited for 100% stock portfolio. That's where you'd introduce more cash, more bonds, more conservative assets to your portfolio, not because of the long-term returns they provide, but because of the way they can smooth out the range of outcomes that you might expect from your portfolio on a year-to-year basis. One word of caution at some point you can actually increase the risk of your portfolio by becoming too conservative, and that goes back to my initial point of bonds seem safe. Bonds seem stable because they don't fluctuate quite as much as stocks do.
Speaker 1:However, what we want to worry about overall with our portfolio overall is how is this maintaining our purchasing power and increasing our purchasing power over time, not just protecting the principal balance? So make sure you're coming at this from the right standpoint of how do you understand? Number one, first and foremost, how much should you have in stocks and bonds? Number two how do you start to allocate a bond portfolio to the right types of bonds to protect in case stock markets are down? And then number three how do you combine both your risk capacity and your risk tolerance to come up with the right allocation that's right for you? So, mike, thank you very much for that question. I hope that was helpful.
Speaker 1:Thank you to all of you who are listening. If you're enjoying this podcast and you're listening on YouTube, please make sure that you give it a thumbs up and make sure that you subscribe. If you're listening on Apple Podcasts or Spotify, would really appreciate if you left a five star review. Tell your friends, tell your family, if there's anyone that you think might find value in this podcast or in this show. That's it for today. Thank you for listening and I'll see you all next time.
Speaker 1:Hey everyone, it's me again. For the disclaimer, please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.