TIPS AND DOLLAR COST AVERAGING AN ROLLER COASTERS

The following is an email that I sent to a list of investors before I started this blog. I ran across it this morning and realized it has worthwhile information relevant to the current market.

A reader tells me that her financial adviser has recommended TIPS (Treasury Inflation Protected Securities) for her portfolio. I thank the reader for asking my opinion. (Just in case you don’t know, my ego loves to be stroked and I am thankful when I can be of service.)

Many studies show that if investors keep from 15 to 30% of their securities in bonds and the remainder in stocks their long-term returns will be almost as large if they had invested 100% in stocks. The long-term average return for stocks is about 11% and the long-term average for bonds is about 6%.

A portfolio of 70% stocks and 30% bonds would imply that the total return would be 7.7% and 1.8% for a total of 9.5%. In the long-run, we would all rather make 11% than 9.5%. Why should anyone accept 9.5% on purpose?

There are two reasons. The first is that the return on the balanced portfolio will actually be somewhere between 9.5% and 11%. The second is that the volatility will be considerably less than the 100% stock portfolio.

The average person chickens out of the stock market at just the wrong time. He buys when times are good and then is unwilling to buy more when times are tough. The reader who wrote about DRIP accounts for his children is practicing a very powerful concept called dollar cost averaging. The big companies, he is buying, pay a decent dividend in good times and in bad. He is buying the same dollar amount of stock when prices are low as he is when the prices are high. He is therefore buying more shares when prices are low! The chickens buy too high and then, instead of buying more, when prices are low, sell!

A balanced portfolio of stocks and bonds is another way to deploy the powerful weapon of dollar cost averaging. The reason is simple; it is often true that bonds will increase in value when stocks decline in value. Therefore when a recession is approaching (the stock market will “know” about 6 months to a year before you “know”) and stocks are falling, your bonds will be increasing in value. During a time when a stock portfolio of $100,000 drops 10% or $10,000, the stock portion of a balanced portfolio will drop $7,000 and the bond portion may go up by $1,000. If the guy with all stocks chickens out, he will miss the upturn and therefore miss the huge gains that come typically right in the middle of the recession (the stock market sees the recovery coming about 6 months to a year before you see it). The guy with the 70/30 portfolio will routinely notice that his portfolio has moved to a 60/40 position. To put things back into balance, he will sell some bonds and buy stocks while they are cheap. Psychologically it is very much easier to take a profit on bonds to buy stocks than it is to ride out a bad time in the market.

If either of the above investors gets a windfall of $10,000, the one investor may be too chicken to invest in stocks and the other may find it easier since he will put $3,000 in “safe” bond investments. Even those guys like me who would rather ride a roller coaster than a merry-go-round, may find that in a recession we have the intestinal fortitude to buy more stocks while they are cheap but recessions have a way of sneaking up when we all are short of cash for one reason or another. In a tough recession, it is difficult to find the cash but this is when you can buy to hit a home run.

What does the above have to do with TIPS?

Risk averse investors are inclined to invest heavily in very short maturity investments. Many will use an intermediary such as a bank or an insurance company to avoid losing their principle. The problem is that one guarantees oneself real long-term losses if one to invest in such accounts as savings accounts or money market instruments. The loss is a purchasing power loss. The long-term history of our country is that you have to make about 3% after tax on your investments just to stay even.

The same logic can be applied to a portfolio of money market instruments and bonds. In other words bonds will yield about 6% long term and money markets about 3%. The person who buys all long bonds will make more money but his principle value will fluctuate. The person who puts 100% in money markets will average 3% (currently about 1.5%) and his principle will not change in value. A balanced portfolio will dampen the volatility of the bonds while increasing the total return. Again, because of the dollar cost averaging effect, the person with the balanced portfolio will automatically move cash from the money market to the bond account when bonds are cheap. He will move money out of bonds when they are expensive. If he keeps 50% in each at all times his return will be higher that the average of 3% and 6%.

The purchase of a ten or thirty year TIPS is mathematically the same as the purchase of a balanced portfolio. At the moment I can’t remember how to calculate the duration but clearly the person who buys a 30 year TIPS is buying a longer duration portfolio than the person who buys a ten year TIPS. The exact percentages do not matter much so let’s say that a 30 year TIPS is the equivalent of putting 70% of your money in a 30 year treasury bond and 30% in a money market account. Let’s say another investor puts 70% in a ten year bond and 30% in a money market. Finally let’s say the current yield on the 30 year bond is 5% and the current yield on the 10 year is 4%. The investor in the ten year bond is going to experience less fluctuation in his total value but he is giving up 1% yield on 70% of his money. Both investors will have much less volatility than if they had purchased all bonds.

Another way to accomplish similar results is to build a bond ladder. By buying a series of bonds with different maturities one can have a bond maturing every month (year). By reinvesting in a bond that matures one month (year) after your longest holding, you repeat the pattern every month (year). In this way, you again get a blended rate on your holdings and dampen the portfolio fluctuations.

The above discussion simply says that the yield on a 30 year bond is equal to the projected inflation rate for 30 years plus a risk premium. Right now the yield on a 10 year bond is about 4% and the yield on a 10 year TIPS is 1.8%. The current yield on a 30 year bond is about 5% and the current yield on a 30 year TIPS is 2.2%. The TIPS value will be adjusted by the inflation rate once it is known. Therefore there does not need to be as much of a risk premium. A money market instrument is only going to average the inflation rate. In other words you get no extra return in the money market because you are not being paid a risk premium.

From my point of view, American has been a strong country because we are a country of risk takers. The comfortable Europeans stayed home and the entrepreneurs came to America. On the other hand, I believe too many Americans are afraid of what they don’t understand. Their fear causes them to waste a lot of money. If three investors each have $100,000 portfolios and if one buys money markets, the other bonds and the other stocks. The three will average about 3%, 6% and 11% respectively. At the end of 30 years, they will have $245,000, $600,000 and $2,600,000 respectively (interestingly the person with $2,600,000 will have paid less money in taxes). The person who purchases all 30 year TIPS will have an amount between $245,000 and $600,000. The person who puts $85,000 in stocks and $15,000 in TIPS and maintains the ratio will have about $2,000,000 in 30 years with far less volatility than the all stocks investor.

I personally have gotten into trouble more than a few times by being too aggressive. I admit that I like to use leverage and I like to hit investment home runs. A 10% return is not exciting to me.

Anyone who runs his own business must understand the difference in profits and cash flow. Running a resort rental business for 19 years has yielded a reportable loss almost every year. The good news is the cash flow has been sufficient to keep us afloat while our property values have increased.

Most investor should be less aggressive than I. However, most investors should probably be more aggressive than they are. Ben Graham, Warren Buffets teacher, said that most folks underestimate the ease of making a satisfactory return in the stock market and they underestimate the difficulty of achieving a superior return. By hiding in mutual funds, insurance products, banks, TIPS, and almost any brokerage product, the average investor gives up far too much in order to stay “safe”. Amazingly, many folks are paying 2+% for management services.
Another famous investor has said that individuals have lost far larger sums by playing it safe than has been lost by being too aggressive.

Every family should have access to 6 months worth of income. A money market account is not a bad place for a couple of months of this and TIPS is not a bad place for the other 4 months worth. Beyond that, one should execute a disciplined approach to investing that emphasizes proven products and strategies. Each investor must decide for himself what his mix of stocks and bonds should be. If one has 6 months income available, the amount one must drag around in bonds to stay “safe” can be fairly low. With long rates so unusually low at the current time, I discourage long-bond investments. If one feels he must have bonds in his portfolio, TIPS would be my investment of choice. If your typical plan would be to have 70% stocks and 30% bonds, I would currently move to 90% stocks and 10% cash (in addition to the 6 month reserve). I would sacrifice return on the 10% cash until such time as bond yields are attractive again. By the time that bonds rates are attractive again, it will likely be time to take some profits in some stocks. At that time, I would move back to my planned level of 70% stocks and 30% bonds.

It truly is easy to make a good return. You just need to stay in the markets in good times and bad and occasionally take a profits from the stock market to put in bonds or profits from bonds to put in stocks. If you are willing to ride a roller coaster, put all your money in stocks and let it ride. The markets have always had positive returns over any 15 year period.