PRAISE FOR bonds

“In the last financial crisis, Stan and Hildy Richelson’s lessons about the dangers of having risky investments were learned by millions of people the hard way by losing their money. In this book, the Richelsons educate investors about how to build safe portfolios with secure income that will enable them to enjoy the fruits of their labors.”
Kevin Adler, MBA, Editor, National Association of Personal Financial Advisors

“In their timely second edition of Bonds: The Unbeaten Path to Secure Investment Growth, Hildy and Stan Richelson provide the antidote for investors beset by erratic and volatile stock performance. Their compelling case for a high-quality bond strategy is well laid out for the prudent investor, along with extensive, practical information to help assess the opportunities and pitfalls in the fixed-income markets.”
Andrew B. Williams, CFA, Chief Investment Officer, Philadelphia International Advisors

“In the first edition of this wonderful book, the Richelsons argued that stocks and diversified portfolios would not outperform a carefully constructed bond portfolio. And that was before the 2008 Great Recession! Those who did not listen to them would be wise to grab and use the newly revised edition of this masterpiece.”
Sam Kirschner, PhD, Managing Director, MayerCap, LLC, coauthor, The Investor’s Guide to Hedge Funds

The advice of HILDY RICHELSON, PHD, and STAN RICHELSON, JD, LLM, on bond investing is sought across the United States by individuals, financial advisors, and the media. As nationally recognized bond advisors and financial authors of five bond books, they have translated the complex world of bond investing into diagrams and layman’s language, enabling motivated investors to take control of their financial lives.

Scarsdale Investment Group, Ltd. restricts its practice to the design and implementation of bond portfolios for high-net-worth individuals. Visit their website at www.allbondportfolios.com and sign up for a free newsletter to receive updates on bond market trends.

Bonds

The Unbeaten Path to Secure Investment GrowthBy Hildy Richelson Stan Richelson

John Wiley & Sons

Copyright © 2011 John Wiley & Sons, Ltd
All right reserved.
ISBN: 978-1-1180-0446-3

Chapter One

Bonds THE BETTER INVESTMENT

Watching your stocks all day long is amusing up to a point, but income is the thing if you’re shopping for anything from pajamas to pastrami sandwiches. —Joe Mysak, Bloomberg columnist

For generations, stocks have gotten top billing over bonds. Stocks, many insist, have outperformed bonds in the past, will outperform bonds in the future, and are not risky if held for 10 years or more. We believe these assertions are myths. In fact, this thinking is now being called into question by sophisticated market players such as Citigroup. Citigroup Global Markets published an article dated September 1, 2010, entitled “The End of a Cult.” The article points out that from 1950 to 1999 global pension funds and individual investors substantially increased their asset allocation to stocks and substantially decreased their asset allocation to bonds. “Back in 1952, U.S. private sector pension funds held just 17 percent of their assets in equities compared to 67 percent in fixed interest. Over the next 50 years, these weightings reversed.” Japanese pension funds in 1998 held 55 percent of their portfolios in equities. By 2010, that percentage dropped to 36 percent.

This movement from bonds to stocks is referred to as the “cult of equities.” However, in the 10-year period from 2000 to 2009, as a result of two 50 percent bear markets and brutal volatility, the cult of equities has reversed as a result of a reassessment by investors of the merits of stocks and bonds. Bonds enable investors to match their needs in retirement with their assets. Aging populations favor bonds over equities. Most importantly, the cult of equities has been severely questioned because bonds have outperformed equities from 2000 to 2009, annual performance of 0.3 percent for equities and 6.9 percent for bonds. The article concludes that an immediate reincarnation of the equity cult seems unlikely.

This chapter makes the case that the stated historical return of 9.8 percent for stocks is merely theoretical because this return is not reduced by taxes, fees, expenses, and investors’ bad timing. It is uncertain that stocks will outperform bonds in the future, and the risk of a severe stock market decline increases as the investment period increases. Stocks are riskier and less predictable than bonds. Ultimately, they are not as good an investment as bonds.

In the holy name of diversification, investors are told to balance the bulk of their investment portfolio between stocks and bonds. We think that’s a mistake. For individual investors, we believe that bonds are a better investment than stocks. Indeed, we believe that the ideal portfolio for individual investors would contain only plain vanilla bonds. That’s because after paying taxes, fees, expenses and factoring in the risk of bad timing, the return on stocks is not likely to exceed the return on bonds, particularly when the risks associated with stocks are taken into account. These risks have been clearly demonstrated as a result of the two stock market crashes that occurred from 2000 to 2009.

Even if you believe that stocks will outperform bonds in the future, consider our view that dependable and predictable cash flow from your portfolio is the best solution to your retirement problem. The bonds that we recommend are the safest investments available. If you can achieve your financial goals without taking on substantial risk, why not do so? If you cannot achieve your financial goals without taking on substantial risks, should you do so? Are there alternatives to consider?

We developed the All-Bond Portfolio as a strategy that individuals can use to achieve their financial goals, taking into account their capabilities and limitations. Individual investors can’t use the advanced techniques or participate in big institutional deals, but they can and do invest in stocks and stock funds, and that puts them at risk. The All-Bond Portfolio does not include investments in stock, stock funds, commodities, real estate, or bond funds. It’s a strategy that individuals can use to keep their assets safe and growing.

This chapter examines the myths surrounding the historical returns on stocks and bonds—without equity-colored glasses—in a noninstitutional portfolio. The results will show you why we believe that the All-Bond Portfolio is the best strategy for individual investors. Keep in mind that when we refer to bonds, we mean individual bonds and not bond funds.

Examining the Myths

To compare historical and potential returns from stocks and bonds, some important questions have to be addressed:

• Is it accurate to say that stocks had an historical return of 9.8 percent?

• If stocks outperformed bonds in the past, why can’t we assume that stocks will outperform bonds in the future?

• Does the historical return on bonds compare favorably with the historical return on stocks?

• How can a portfolio of bonds provide both income and growth?

• Are bonds a better investment than stocks?

Our answers to these questions cast doubt on the old assumptions of investing, which the media and most financial advisers accept as gospel. We’ve developed some new thinking that reflects decades of observing and investing in the financial markets. Let’s evaluate stocks and bonds in light of the new thinking we propose and see if you are persuaded that bonds are a better investment than stocks. If you are and you are willing to change your approach to investing, the All-Bond Portfolio can maximize your investment returns with the highest degree of safety.

Historical Annual Return

Old Assumption

The historical annual return of stocks is around 9.8 percent.

New Thinking

The actual annual historical return of stocks is much less than 9.8 percent when taxes, transaction costs, fees and bad timing of the stock market are taken into account.

Morningstar’s Ibbotson SBBI 2010 Classic Yearbook—SBBI standing for stocks, bonds, bills, and inflation—provides one of the staples for obtaining historical data to compare the returns of stocks and bonds. However, the Ibbotson data are misleading when applied to individual investors. The Ibbotson data reflect a 9.8 percent return on stocks. However, these data are merely theoretical because they do not take into account the actual frictions of real-life investing. You cannot measure the actual performance of a stock portfolio or stock fund for individual investors without taking into account the burden of income taxes, transaction costs, investment management fees, and the possibility of an individual investor’s poor timing when he buys and sells stock based on emotion. Because of these real-life costs, it is impossible for individual investors to have realized the stock market returns reported by Ibbotson.

Unhappy Returns: Uncovering the True Returns on Stock Investments

To find the actual historical performance of stocks, we must reduce the theoretical Ibbotson stock returns by three elements: taxes, transaction costs, and bad timing:

1. Taxes. Individuals are subject to federal and often state and local taxes on income as well as on dividends and capital gains. If stock is held in a stock fund and the fund trades its stock portfolio a great deal, some or all of the reportable gains may be treated as short-term capital gains, which may be taxed at ordinary income rates. The outcome is the same if an individual holds his stock for one year or less before its sale.

2. Transaction costs. Individuals must pay transaction costs to buy and sell stocks including commissions on individual stocks, managed account fees, and management fees and other expenses on stock funds. “It’s fair to estimate that the all-in annual costs of equity fund ownership now run in the range of 2.5 percent to 3 percent of assets,” says John Bogle, founder of the Vanguard Group of mutual funds.

William Bernstein examined fund management fees and reported the following in the April 2001 issue of Financial Planning:

• The average actively managed large-cap fund has annual fees and expenses of about 2 percent.

• The average small-cap and foreign fund has annual fees and expenses of about 4 percent.

• The average microcap and emerging market fund has annual fees and expenses of almost 10 percent.

3. Bad timing. The most costly element of all is the buying and selling habits of individual investors. Investors are generally emotional in their investment choices and often have an atrocious sense of timing. They tend to buy into the stock market when it is “hot” after it has gone up a lot. They often lose their nerve and sell after a severe decline. Making money in stocks requires making two correct decisions: when to buy and when to sell. “From 1983 to 2003 index funds tracking the Standard & Poor’s 500 index returned 12.8 percent and the average mutual fund gained 10 percent annually,” says Michael J. Mauboussin, a strategist at Legg Mason Capital Management. “Meanwhile, the average investor earned only 6.3 percent annual returns.” Mauboussin attributes this seemingly impossible result to poor “market timing” and “the extraordinary proclivity for investors to invest in the wrong place at the wrong time.”

The buy-high, sell-low behavior pattern of individual investors observed by Mauboussin has been verified by research undertaken by Dalbar, Inc., in Boston, which tracked investor behavior for 20 years, beginning in 1986. Through all kinds of markets, “investors achieved an average annualized return of just under 4 percent, compared with a return of nearly 12 percent from a buy-and-hold strategy using the Standard & Poor’s 500 index.” According to the Journal of Indexes, “The most recent Dalbar study covering a 20-year period ending in 2009 found that equity mutual fund investors had average annual returns of only 3.2 percent while the S&P averaged 8.2 percent …” Why is the actual performance of the dollar-weighted returns so much lower than the traditional reporting methods? “It says something about human nature,” says Ilia Dichev, an accounting professor at the University of Michigan. “When things are going up, people get excited. That’s when the money pours in.”

A buy-and-hold strategy may not solve the market-timing problem with respect to stocks. Buying and holding works well for stocks in a bull market like the one from 1982 to 1999. But a buy-and-hold strategy results in serious losses and creates a great deal of wear and tear on individual investors in a bear market, such as the one from 2000 to 2002. The Nasdaq lost 77.9 percent of its value during the collapse of this market bubble. As a result of both the banking and real estate crisis of 2008, there was a fear of an economic collapse and depression. As a result, the stock market as represented by the S&P 500 Index declined from an all-time high close of 1,565.15 on October 9, 2007, to a close of 676.53 on March 9, 2009, a fall of 56.78 percent. Over the decade from 2000 to 2009, called the “lost decade,” U.S. large company stocks returned an average annual loss of almost 1 percent. After a review of the history of the stock market Ibbotson comments that “The history of stock market [losses] shows that investing in stocks can be very risky business, and that the current crisis is hardly a once-in-a century event.” The success of a buy-and-hold strategy depends on the period in which the stock is held.

Consider, for example, the story of Boots, a drugstore chain in the United Kingdom. After making spectacular gains in the 1990s bull market in stocks, it fired its portfolio manager in 2001. Instead of watching its assets decline, the Boots pension plan sold all its stock and purchased high-grade bonds. This action enabled the chain’s management to guarantee that there would be enough assets to satisfy its pension liabilities. The Boots pension fund ended up with a surplus, while many other pension funds had big losses as a result of the bear market in stocks.

Because individual investors have limited life spans, the holding period is of more than theoretical interest. For example, in the years 1965 to 1982, the Dow started out at about 1,000 and ended the period at pretty much the same place. As stated above, the stock market ended 2009 at about the same place where it started in 2000, and this does not take into account reductions caused by taxes, expenses, and bad timing. If you were retired or saving for retirement during one of these periods, you would have been out of luck. It would be no help to you that the historical return on stocks was 9.8 percent.

Taxes, Costs, and Risks of Investing in Bonds

By taking a savvy approach to bond buying, you can minimize your taxes, limit your expenses, reduce your risk, and increase your profit. But let’s first examine the taxes, costs, and risks of investing in individual bonds:

1. Taxes. If you are in the 25 percent marginal federal income tax bracket or higher, the impact of federal and possibly state income taxes is generally large enough to indicate that you should purchase tax-free municipal bonds for your taxable nonretirement account. By purchasing tax-free municipals, you avoid paying federal income tax and possibly state and local income taxes as well on the interest income. In addition, you will avoid paying the new 3.8 percent Medicare tax on investment income that will apply beginning in 2013. Though the interest rate on tax-free municipals is lower than the interest rate on taxable bonds, after taxes you will come out ahead. Tax-free municipal bonds provide the best legal tax shelter available to individual investors.

Many taxpayers are now subject to the alternative minimum tax (AMT), which is pushing more taxpayers into paying higher federal income taxes. Municipal bond interest is not subject to the AMT, except for the interest income from the municipal bonds called AMT bonds. If you are in a lower federal income tax bracket and live in a high-tax state you can reduce your state income taxes by purchasing Treasuries, home-state taxable municipals (“munis”), and certain agency bonds that are exempt from state and local income taxes, but not from federal income tax.

2. Transaction costs. The cost to purchase a bond is called the “spread,” which is the difference between the price that the broker paid for the bond and the higher price at which he sells it to you. In addition to a spread, discount brokers may charge you a fee for service. Discount brokers do not save you money in the world of bonds. However, if you buy a bond on its initial public offering, you will receive an institutional price—the best possible price. If you hold an individual bond until it comes due, there are no further transaction costs.

3. Risk. With high-quality bonds, you have no significant loss of principal to worry about as long as you hold the bonds until they come due at their face value. We believe that in a comparison of stocks and bonds, high-quality bonds should be given a significant premium over stocks because these bonds are generally safe, dependable, and pay a steady rate of interest that can be counted on.

4. Bad timing. The risk of bad timing is small if you hold your bonds until they come due because every bond comes due at its face value, no matter what the price fluctuations might be before its due date. Keep records of your bond purchases so that they are recorded at face value, rather than adjusting their value every month as valued on your brokerage statement. If you keep your bonds recorded at face value, you will be less likely to sell your bonds before they come due and make a market timing mistake.

(Continues…)

Excerpted from Bondsby Hildy Richelson Stan Richelson Copyright © 2011 by John Wiley & Sons, Ltd. Excerpted by permission of John Wiley & Sons. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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