British Expat Money

Is it time to leave Vanguard?

james@britishexpatmoney

Is it time to leave Vanguard? I mean, right now everybody’s pulling their money out of the once popular Vanguard LifeStrategy funds.

OK. That’s a slight exaggeration, strictly speaking everyone’s pulling their money out of the bond heavy LifeStategy funds.

But that’s still serious. Not, just for Vanguard, but also for all those bond avoiders now sitting behind the investing wheel without their seat belt fastened.

So this week we’ll answer the big questions that this episode raises:

Namely:

Is it time to exit Vanguard LifeStrategy?

You don’t have to be Sherlock Homes to deduct that it just might have a little something to do with the bond mega crash of 2022.

Many bond funds crashed harder than shares.

It’s worth digesting that for a moment, because that ain’t what it says on the tin.

And for sure most people weren’t expecting it. In fact, it’s my guess that the vast majority didn’t even think it was possible.

We are all told bonds are there to even out the ride. To provide steady income that we can rely on. To add stability in the bad times. And to provide cash to buy cheap shares when the stock markets go into free fall.

Dare I say it, to go up in value when stocks go down in value.

But here we are, still wounded from what took place a couple of years back. The world has now changed.

I mean, it always sounded good in theory, but now………no so much.

Now we know the limitations of the theory ie it doesn’t work. Well, not always anyway.

So should you pull your money out of Vanguard LifeStrategy bond funds too? Should you ditch bonds altogether?

After all, Vanguard investors are putting their money where their mouth is and going all in on stocks.

It’s an easy call for many. They don’t like bonds anyway. In fact, most people invested in them don’t really know what they are. And if they did, it wouldn’t make much difference. How can lending money to UK government for paltry interest payments compare to investing in Tesla or Nvidea?

No. Most of us have bonds in our portfolio because we are told to, by people that (we think) know better than us.

Now, full disclosure. I don’t care much for bonds either. Say ‘bond’ and my eyes glaze over too. So if you’ve managed to get this far, let me take the opportunity to thank you for your time.

For most people, most of the time, bonds are the last thing we want to read about.

But, though it pains me to say it, I think they are still important and still a vital part of every single investor’s portfolio.

So here’s a few reasons why you probably shouldn’t ditch bonds or Vanguard’s bond heavy all in ones for that matter:

Not everyone is heading for the exit

The first thing to consider is fellow investors.

Think about this for a moment. The bond market is colossal. A gargantuan giant of the investment world. And critically, bigger than it’s little brother aka the stock market.

And this is important for one simple reason. The bigger the market the more money is in it.

That’s just to say there’s far more money invested in bonds than stocks…… or gold….. or bitcoin ………. or most other investing stuff for that matter.

(Same goes for Vanguard bond funds by the way)

And just think for a moment about all those people who own all those bonds. Bearing in mind they are ninety percent plus professional ie the guys with the fancy suits, all the insider knowledge, experience, finance PHDs, Bloomberg terminals and all the rest of it.

There’s a familiar phrase to describe that kind of person:

The smart money

It’s pretty clear that the financial savvy aren’t selling. Otherwise the bond market wouldn’t be so big.

So with that in mind, if you are a seller, what exactly is it you know that those supposedly in the real know don’t know?

It’s worth taking another moment to ponder that one for a moment too.

When I did it, I realised the answer was clear.

Not much……..if anything at all.

They key being this.

If you sell your bonds or bond heavy funds, you are going against the wider market (which is 90% pro). That’s quite a call to make.

Panic selling at the wrong time

Not only that but anybody ditching bonds after a double digit drop hasn’t had the memo.

I’m talking about the most important memo in investing.

The one that says this. Unquestionably, the absolute worst possible time imaginable to sell any kind of investment at all, is after said investment has crashed spectacularly in the recent past.

Unquestionably, the absolute worst possible time imaginable to sell any kind of investment at all, is after said investment has crashed spectacularly in the recent past.

British Expat Money

It is exactly what you shouldn’t do. In fact, there’s a phrase you may be familiar with that describes it perfectly. It’s called panic selling.

Selling now is reacting to current events.

Selling now is crystallising losses.

And Selling now is ………well…….stupid.

But you know what’s most worrying about it?

Looking to the future

The most worrying thing about selling your bonds right after a bond crash (when they are practically on sale) is this. It really doesn’t bode well for your investing future. Not by a long shot.

As time goes on its becoming pretty clear to me that investing is all about staying in the game.

Who do you think will win out in the end? – the guy who makes 15% a year for five years only to panic sell out after a 50% mega crash or the guy who makes 10% every year for forty years. (Just in case you ware wondering, the ten percenter who didn’t sell makes a lot more).

The 2022 bond market crash was your opportunity to practice the art of ‘not panic selling.’ Doing the opposite is a mighty bad omen in my book.

You see, if you sell your bonds when they’ve dropped double digits what are you going to do when stocks get cut in half?

Because they will. It’s just the nature of things. Maybe tomorrow, maybe next week, maybe ten years later. There will be a popping of a bubble somewhere down the line and when it pops you need to be strong. And being strong means not selling.

I’m sure some people can find some justification somewhere to reassure themselves that just because they’ve panicked this time around doesn’t mean they won’t panic next time.

Perhaps something along the lines of – this was bonds not stocks………this time wasn’t really panic selling……….this time was the right time to sell bonds.

But let’s be honest. Just for a moment. Because if we are I think it’s pretty clear.

Selling bonds after a massive crash is panic selling and panic selling is never the right thing to do. It is ’emotions’ doing the talking – the monkey brain has taken over your finances.

Blood on the street

In other words, if you are selling out of bonds now you are going to be selling out of stocks with gusto when the proverbial hits the air con.

Because here’s the problem. This bond crash wasn’t a real crash anyway. It was uncomfortable, but it wasn’t a showstopper.

There weren’t mass redundancies, there weren’t mass bankruptcies, and there wasn’t any blood on the street.

That’s not to say there wasn’t some pain felt by some at some point, but it wasn’t catastrophic for the majority. Because that’s what’s coming when stocks have their next big reckoning.

The bond crash this time around was caused by sudden increases in interest rates which in turn was caused by inflation. Which by the way is pretty much one of the most natural things in the world.

Central banks increased interest rates rapidly. And as bond prices are inversely related to interest rate rises, that rapid increase caused a rapid decline in the price of bonds.

Only this

But only this.

Whilst I appreciate that higher interest rates and inflation do cause problems, I’m pretty sure the scale of problems aren’t comparable to what happens when the stock market really crashes (hard & fast).

Anybody reading this who lived through 2008 knows what I’m talking about.

The problem with major stock market crashes is they don’t come along on their own. They come along with mass unemployment, property market crashes, people going bankrupt and a whole host of other stuff that makes recent interest rate rises and inflation pale into insignificance.

Nobody knows when the next one is coming, but that doesn’t mean it won’t. The fact that there hasn’t been one for while suggests the likelihood of it occurring sooner rather than later is getting more real every day.

There will be trouble ahead

The probability that there will be a gigantic stock market crash that cuts the value of your portfolio in half or more increases the further from the last one we travel. There will be one. Just like there has been in the past more or less every decade or so since the dawn of time.

People will loose their jobs. House prices will crash and there will be bankruptcies. In other words, it won’t be a nice time.

Armageddon in the stock market

And it will all be made even worse by media companies and social media reveling in it. Swarms of experts will be crawling out of the woodwork predicting further armageddon and egging the panic sellers on.

It’s easy to think you’ll be strong enough to break away from the pack when times are good, but not so much when everything around you is going to hell in a hand basket.

You need something to steady the ship. A little something to clasp hold of. A little bit of light at the end of the tunnel.

Enter stage left. Bonds & bond heavy Vanguard LifeStrategy funds.

Here’s the thing. It’s a safe guess that the vast majority of those panic sellers will have a couple of things in common.

They’ll be the ones that sold their bonds this time around. So they’ll be the ones that don’t have bonds in their portfolio.

Because bonds really do act as your saviour in the bad times:

I know what you are thinking.

Bonds didn’t provide those feelings in 2022.

What if bonds crash hard at the same time as stocks just like they did then?

And whilst 2022 does prove that bonds don’t always save the day. There are three things to say about that.

And I think it is this last point that needs a bit more expansion.

3 flavours of bonds

Bonds come in three flavours. Short, medium and long. This is referencing their duration.

If you want to know exactly how this works, you can read more about it here, but here’s the important bit.

You can make more money the longer the duration, but you can also loose more money the longer the duration.

In other words, the longer the duration, the bigger the risk.

And yet another way of putting it is this. Very long duration bonds can be very risky. Whereas very short duration bonds can’t. Well, at least not in the same way they were in 2022.

Risk

2022’s crash was caused by bond interest rate risk. There are also a couple of more risks to think about with bonds. Namely currency & default. But these two aren’t half as problematic. Simply because you can pretty much eradicate each of them by choosing government bonds of the country where you live (or intend to retire).

(If you happen to be reading this from a country that either isn’t a developed market or that doesn’t have those kinds of bonds you might want to read this).

As an example, a UK resident investing in short UK government bonds reduces the risk of their bonds crashing hard to an amount that is so small I don’t think its really worth thinking about. (There are bigger things to worry about!).

Sure, if the government went bankrupt you may have a problem, but as they own the printing machines that seems pretty unlikely.

And I suppose the pound could crash against all other currencies but even then, if that happened your share prices would likely skyrocket (because nobody is suggesting ditching your shares!).

And I guess we could have another sudden burst of interest rate rises similar to 2022, but that’s not quite the big deal with short bonds as it is for their brothers medium and long.

The table below shows the performance of US government bonds of different durations over the last 5 years. (Yes, UK sources would be better, but it’s just harder to get hold of the data, and in any case rest assured you see something similar).

Bond Returns (No wonder people want to leave Vanguard’s bond heavy options!)

Source: Portfolio Visualizer

You can see pretty clearly what goes on with bonds here. Long duration (orange) usually make more money, but also have the potential to loose more. Short duration (blue) don’t usually make as much, but they don’t loose as much either. And medium (red) usually sit somewhere in between.

Hedging your bets with medium bonds

That’s why financial advisors will usually point you in the direction of medium bond funds or a mixture of durations (which end up behaving like medium anyway because they all average each other out).

You see, most pros seem to accept that long bonds are little bit too risky to have in your portfolio (unless they are mixed with those of a shorter nature).

These experts prefer the risk/reward associated with medium bonds, and they also like the fact it’s easier to guesstimate what returns you are going to get with them (compared to long).

You see, the yield to maturity (which you can find on a bond funds fact sheet) predicts about 90% of the returns you get from short to medium bonds.

But it’s clear from the chart, medium bonds still have some risk and so there’s a minority out there that think short term are the one to go for. (Spoiler alter: I’m one of them).

Go shortie

And here’s why it makes a lot of sense.

In other words, you are basically reducing risk from that (bond) side of your portfolio, but still get most of the benefits.

You get your cake and eat it too.

There’s another benefit you get which is often overlooked. Because short bonds don’t loose lots of money when interest rates rise, they act as a counter weight to most people’s other investments ie stocks and property.

Short bonds aren’t exposed to interest rate risk, or at least not in the same devastating way the other three are.

All things being equal, interest rate rises mean property, stocks and long bonds loose value.

On the other hand, any losses from short bonds (within) a fund are small and quickly negated by the fact older bonds with lower interest rates are quickly replaced with newer ones with higher rates (read this for more on this topic).

Yes, short bonds can loose a little in value when interest rates rise, but their increasing interest rates will more than make up for it.

I’d even go so far as to say interest rate rises are actually pretty good for short bonds.

Yes, leave Vanguard, yes, leave long bonds but don’t whatever you do leave bonds altogether…..

The only thing you don’t get with short bonds, is quite as high (expected) returns on average over the long term as you get with longer durations.

But this might not be a dealbreaker. Here’s why.

Depending on which source you look at, over the long term you can expect short bonds to underperform their medium counterparts by about 1%. Yes, that’s a difference to consider, but at the same time, it doesn’t describe the real impact on your total investment portfolio.

Because, the vast majority of people have stocks to go with their bonds. And that matters. Let me explain.

If you were 50/50 stocks/bonds a 1% impact on your bonds is 0.5% on your overall results ie because half your money is invested in stocks.

But as most people have less bonds than stocks the impact is going to be even less for most people most of the time. Think 60/40, 70/30 and 80/20s. All common.

Time to take out insurance

In other words the impact on your overall returns will be less than 0.5%.

You can kind of look at it like insurance. You are paying a maximum of 0.5% to more or less not take any risk with the bond side of your portfolio.

And to be honest I think that will pay dividends (excuse the pun) in the bad times when it means you can sleep at night when everybody else is panic selling.

How much do they end up loosing in the end? (A lot more than 0.5% per year me thinks).

Having bonds in your portfolio will allow you to stay in the game letting compound interest work its magic over the very long term.

Bonus time

One final point that is topical right now is this.

Whilst we expect medium and long bonds to give you greater returns (but with more risk) that’s not always the case.

Right now UK short, medium and long bonds all have yields to maturity of about 4%.

And remembering what we’ve already touched upon ie that the yield to maturity describes 90% of your expected returns from short & medium bonds it seems like opting for short bonds could be a no brainer right now.

So should you leave Vanguard?

In other words, this has been a really longwinded way of saying you probably shouldn’t leave Vanguard full stop, and you probably shouldn’t leave Vanguard’s bond heavy LifeStategy funds either.

But if you do.

Just make sure to keep some bonds in your portfolio.

I like shorts.

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