One reason to hold different asset classes is that they are not perfectly correlated. Over time, if you don’t rebalance your portfolio, your asset allocation will naturally drift away from your target allocation. This drift could leave you with a much riskier portfolio than you originally intended.
Good write up, Andre. I would be hesitant to hold any bonds in your Roth, with the main goal being maximum growth on those tax-free assets. Given you still want a 15% bond allocation, that leaves pre-tax accounts or taxable accounts. I would argue that the main benefit of making pre-tax contributions for a younger investor with relatively high income from big tech is to get the resulting tax deduction each year, and less so the tax-deferred growth that a 401k or IRA offers. With that in mind, holding bonds in a pre-tax account seems optimal. You also reduce the future account size by holding lower-growth assets, which reduces RMDs and the associated taxes; however, since RMDs are so far in the future (30-40 years for most investors in this cohort) it may not be wise to rely too heavily on current tax law enduring through then. If you really want to maximize tax-deferred accounts and hold bonds only in taxable accounts, the tax drag from a 15% bond allocation likely isn’t huge - it probably becomes more of an issue as the bond goal pushes 30%-40%. Another consideration for the semi retired (or fully retired) investor is that having a bit of money in bonds in a taxable account vs. tax-deferred gives you quick access to liquidity without worrying about taxes or penalties when withdrawing from a tax-deferred account. If you need cash for expenses during a severe market downturn and don’t want to sell stocks at a big loss to cover cash needs, having taxable bond money provides quick access to relatively stable assets, usually with much lower unrealized capital gains.
Really good comment. This is consistent with how I generally have been thinking about things and explains why I have that future optimization outlined. The extra piece of the puzzle will be that because I have so many years of potential FIRE, I will have many years of being able to to roth conversions to shift most of the pre-tax funds into my roth prior to hitting RMDs (once my wife also retires).
Your point on bonds within taxable being a good hedge in FIRE is smart too. I am holding >1 year of real expenses in my emergency fund right now. I have wavered on including this within my overall asset allocation as part of my bond allocation, which is also why I have been sitting at 10% bonds for so long (I was mentally already including the excess emergency funds as part of my bond allocation).
Personally speaking I wouldn’t include the emergency fund in the bond allocation except for purposes of saying “my total stock/risky asset exposure is x% of net worth,” but there is no right or wrong answer. I see a bond allocation primarily as a portfolio diversifier/volatility damper, but depending on their location they can also be used as additional emergency funds of course.
What do you think of the advice in A Simple Path to Wealth that is, if I can summarize, "VTSAX and chill"? I haven't bought bonds as investments, I either have cash or cash-equivalent for funds that I want not to have risk, and the rest are pretty much all in some kind of total market index.
His take of focusing on just US was also held by Bogel. The belief that US companies more have so much international presence you are already getting that exposure.
I personally like still having the international allocation. You could even look at VT if you wanted a simple global addition.
I need to reread the book. He has a >15% bond allocation doesn’t he?
I thought he said that even for retirees, just keep everything in index funds, but it's been awhile since I've read it too and I don't own a copy to check.
Hi Katherine, I know you didn’t ask me but I thought I’d throw in my two cents. Typically, adding bonds to your investment mix leads to better risk-adjusted returns than holding only stocks, even compared to a portfolio mix with cash as a bond surrogate. And at least historically speaking, bonds have been able to provide positive real returns (over and above inflation) that cash hasn’t. The main benefit of course (which sounds like it may not be an issue for you) is reduced volatility and worst-case downside during market downturns.
Yeah, I guess in the timeline that I've been learning about personal finance and asset allocation, I haven't seen bonds have that higher return relative to cash. I'm 37 so I'm accepting of higher risk for now at least.
Good write up, Andre. I would be hesitant to hold any bonds in your Roth, with the main goal being maximum growth on those tax-free assets. Given you still want a 15% bond allocation, that leaves pre-tax accounts or taxable accounts. I would argue that the main benefit of making pre-tax contributions for a younger investor with relatively high income from big tech is to get the resulting tax deduction each year, and less so the tax-deferred growth that a 401k or IRA offers. With that in mind, holding bonds in a pre-tax account seems optimal. You also reduce the future account size by holding lower-growth assets, which reduces RMDs and the associated taxes; however, since RMDs are so far in the future (30-40 years for most investors in this cohort) it may not be wise to rely too heavily on current tax law enduring through then. If you really want to maximize tax-deferred accounts and hold bonds only in taxable accounts, the tax drag from a 15% bond allocation likely isn’t huge - it probably becomes more of an issue as the bond goal pushes 30%-40%. Another consideration for the semi retired (or fully retired) investor is that having a bit of money in bonds in a taxable account vs. tax-deferred gives you quick access to liquidity without worrying about taxes or penalties when withdrawing from a tax-deferred account. If you need cash for expenses during a severe market downturn and don’t want to sell stocks at a big loss to cover cash needs, having taxable bond money provides quick access to relatively stable assets, usually with much lower unrealized capital gains.
Really good comment. This is consistent with how I generally have been thinking about things and explains why I have that future optimization outlined. The extra piece of the puzzle will be that because I have so many years of potential FIRE, I will have many years of being able to to roth conversions to shift most of the pre-tax funds into my roth prior to hitting RMDs (once my wife also retires).
Your point on bonds within taxable being a good hedge in FIRE is smart too. I am holding >1 year of real expenses in my emergency fund right now. I have wavered on including this within my overall asset allocation as part of my bond allocation, which is also why I have been sitting at 10% bonds for so long (I was mentally already including the excess emergency funds as part of my bond allocation).
Personally speaking I wouldn’t include the emergency fund in the bond allocation except for purposes of saying “my total stock/risky asset exposure is x% of net worth,” but there is no right or wrong answer. I see a bond allocation primarily as a portfolio diversifier/volatility damper, but depending on their location they can also be used as additional emergency funds of course.
What do you think of the advice in A Simple Path to Wealth that is, if I can summarize, "VTSAX and chill"? I haven't bought bonds as investments, I either have cash or cash-equivalent for funds that I want not to have risk, and the rest are pretty much all in some kind of total market index.
His take of focusing on just US was also held by Bogel. The belief that US companies more have so much international presence you are already getting that exposure.
I personally like still having the international allocation. You could even look at VT if you wanted a simple global addition.
I need to reread the book. He has a >15% bond allocation doesn’t he?
I thought he said that even for retirees, just keep everything in index funds, but it's been awhile since I've read it too and I don't own a copy to check.
Hi Katherine, I know you didn’t ask me but I thought I’d throw in my two cents. Typically, adding bonds to your investment mix leads to better risk-adjusted returns than holding only stocks, even compared to a portfolio mix with cash as a bond surrogate. And at least historically speaking, bonds have been able to provide positive real returns (over and above inflation) that cash hasn’t. The main benefit of course (which sounds like it may not be an issue for you) is reduced volatility and worst-case downside during market downturns.
Yeah, I guess in the timeline that I've been learning about personal finance and asset allocation, I haven't seen bonds have that higher return relative to cash. I'm 37 so I'm accepting of higher risk for now at least.