The market continued to be nice to you this month. I am likely going to rebalance again within the next few days or so. Selling various stock categories and buying more short-term bonds (in mutual fund format). The market has increased so much that the stock allocations are over target and fixed (bond) allocations are below target. As a result, you are exposed to more risk than we agreed. The rebalancing reduces your risk.

But why short-term bonds?

Bonds are very much not risk free. A bond has a coupon (your income amount), a maturity amount, a maturity date, and a price on the market. The income, maturity amounts, and dates are fixed. I will receive $500 per half year and a payoff of $15,000 on December 31, 2022. Notice that I did not mention interest rate. That rate is determined by the market. The bond issuer has no control over that number. The market also has complete control over the price of the bond.

For example, ignoring maturity amounts/dates, a bond paying $1,000 per year when general interest rates are 3% is going to be worth $33,333. $1,000 divided by $33,333 is 3%. You may have paid much more or much less than $33,333. Maybe you bought the bond when interest rates were at 5%. You paid, therefore, $20,000 ($1,000 divided by $20,000 is 5%). You lucky soul, you have a $13,333 profit from interest rate fluctuations. Of course, you could have bought the bond when interest rates were at 1%. You paid $100,000 for a bond now worth $33,333. I will pay for your next cocktail, you probably will need it.

My point here is that interest rates can cause drastic changes in bond prices. But not all bond prices. Remember In the last paragraph, I ignored maturity amounts/dates. That assumption is wrong. Maturity information matters. If the maturity amount is $10,000 and it pays off tomorrow, today’s price will be darn close to $10,000 regardless of interest rate. There will be almost no fluctuation. If it matures instead in ten years, the maturity information is of little importance. Only interest rate matters. Pricing is a discounted cash flow calculation for those who are interested. Distant cash flows matter less than closer flows.

I rebalance in and out of short term bonds so as to avoid the risk of bonds. Short term in my mind is no more than one to two years. If you want the risk, I would rather have the risk in stocks than bonds. The reward is greater. I rebalance to reduce risk.

An additional factor is the extraordinarily low interest rates right now. When interest rates go up, bond prices come down. Of course, the opposite is also true, when interest rates go down, bond prices go up. Obviously, we do not know the future of interest rates. But what do you think is more likely? Are rates likely to go up or likely to go down? Me too.

Sincerely,

Dan

Investment Fee Schedule

A single rate is applied to the whole account. Compared to my old fee structure, under the new fee structure the cost for a $1 million account would be $500 lower per year and the cost for a $1.5 million account would be $1,500 lower per year. I will still waive personal tax return fees for accounts over $1 million. All services stay the same. I am just lowering my upper end fees. For accounts that are above $5,250,000, we’ll need to discuss a custom rate.

As I’m writing these to help my readers, I would be very appreciative of any input in regards to what I should write next. If you want me to write about a particular topic, please contact me. Please contact me if you would like to submit a post to my blog.

If anything that I mentioned above interests you, please consider downloading my free e-book. The book contains my thoughts on investment management and some information that I think everyone should know. You can also download it below.

E-Book Download

Questions for the comments

Did my newsletter make sense? Do you agree or disagree with what I said?

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The market was kind this month and you all have decent results for the quarter as well.

Last month I discussed bubbles in real estate under the theory that the crowd is an idiot. Well, irrational greed (or fear) is not just restricted to real estate. It happens in the stock market also. Crowd overreactions, however, have a different practicality in the stock market.

In both investment arenas (real estate and stocks), bubbles have basic similarities. First, their demise (or birth but that’s not todays conversation) cannot be predicted. We do not know when they will start dying, whether they will deflate with an implosion or a long slow hiss, how deep and ugly it will get, or when it will turn around and go back up. All these things are unpredictable because they are based on crowd behavior. Despite what many efficient market researchers claim (like Nobel winner Eugene Fama), the crowd is not always right. We just do not know when they are wrong (Nobel winner Schiller).

So what’s the difference between the two arenas? I see three major differences.

1. Real estate has imperfect information flow. Some people know the neighborhood, the builder, etc. Some people under construction and so on. Many other people have different information or wrong information or nearly no information. In the stock market, except for insiders (illegal to trade on inside information), everyone has access to the same information. Some or many may not look at that information but it’s there. I can get exact prices on any stock any day (hour, minute) that I wish.
2. Real estate has poor liquidity. Selling a property takes a 7% commission plus escrow fees and 60 days closing time. I can sell stock at any moment with only a few dollars in commission.
3. The number of participants is vastly different. The townhouse in my neighborhood may have a few dozen potential buyers because the knowledge is local. No one in another state would even look. A stock might have 100,000 potential buyers.

The bottom line here is that my spectacular knowledge means more in real estate. It also means that on a particular parcel, I am either in or I am out. I cannot rebalance and sell 4% of the townhouse. In stock, both of these statements are false. I can rebalance and I have the same information as anyone else.

With so many participants in the stock crowd, the idiot factor is not all or none. The crowd has every shade in between at times. I can weight against the crowd in little layers.

My way of addressing the stupidity of the crowd is by adhering to a disciplined plan using mutual funds. Based on your situation, we establish target percentages in different categories of stocks and bonds. When the crowd swings the actual percentages out of target, for little cost I can bring the actual back to target. I can buy a little here and sell a little here by rebalancing. I have essentially just bet against the market but not all or none like I have to in real estate.

Greed and fear are universal. Discipline is rare.

Investment Fee Schedule

A single rate is applied to the whole account. Compared to my old fee structure, under the new fee structure the cost for a $1 million account would be $500 lower per year and the cost for a $1.5 million account would be $1,500 lower per year. I will still waive personal tax return fees for accounts over $1 million. All services stay the same. I am just lowering my upper end fees. For accounts that are above $5,250,000, we’ll need to discuss a custom rate.

As I’m writing these to help my readers, I would be very appreciative of any input in regards to what I should write next. If you want me to write about a particular topic, please contact me. Please contact me if you would like to submit a post to my blog.

If anything that I mentioned above interests you, please consider downloading my free e-book. The book contains my thoughts on investment management and some information that I think everyone should know. You can also download it below.

E-Book Download

Questions for the comments

Did my newsletter make sense? Do you agree or disagree with what I said?

Learn About My Business