Ferri: How to Approach Bonds Today

Christine Benz: I'm Christine Benz for Morningstar.com, here with the Bogleheads Reunion, and I'm here today with Rick Ferri.

Rick is the founder of Portfolio Solutions. He's a Forbes columnist, and he is also the author of several books, including the Power of Passive Investing, which is due out next month.

Rick, thanks so much for being here.

Rick Ferri: Thank you for having me.

Benz: So, we have a lot of ground to cover. You certainly write about a lot of different topics and manage investor money as well.

I'm going to start with what's going on in the fixed-income world right now. We have seen a huge stampede of assets going into bonds and bond funds over the past couple of years. Curious to get your take on investor expectations for fixed income, and how investors should be thinking about allocating their portfolios to fixed income right now?

Ferri: It's an interesting question. There has been a lot of corporations that have been issuing a lot of debt, and there's been, of course, our government, which has been issuing a lot of debt, and so there is a lot of supply out there, but this huge demand has been coming in to meet the supply, and the demand had been coming in because of, I think, a fear of a double-dip recession.

So that could be slowing down now as we see that the chances for a double-dip recession are really starting to subside as corporate earnings continue to come in and as the economic data continues to come out, which shows that the economy is actually recovering and doing fairly well.

So the bond market, as a tactical asset allocation play, may not be a good idea, but if you're a long-term buyer, and you have a set strategic allocation, and your equities go up because the stock market is going up, and you want to sell some and bring it down to your allocation and buy bonds, that's perfectly fine.

Benz: I also wanted to talk to you about inflation-protecting a fixed-income portfolio, and I know this is one question our users have wrestled with, how much of their bond portfolios belong in TIPS. What's your take on a question like that? And where should investors find guidance?

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Ferri: First, the inflation expectations are already fixed into every asset class. So, they are already worked into expected returns from stocks, they are already worked into expected returns from bonds, corporate bonds. Now, Treasury is a little bit different because the Fed is influencing Treasury rates right now in an artificial way.

What TIPS do is they don't protect you from inflation, because this is already worked in. They protect you from an unanticipated jump in inflation. The important word is unanticipated. So, we're going along thinking that we're going to have 2% inflation, and the next thing you know it jumps to 4% or 5%, well that's what TIPS are going to protect you from.

So how much did you have as part of your bond portfolio. It's a good question. Some people say 50%, some people 10%. I like to use 20%. 20% seems like a good number as a hedge against this unanticipated jump in inflation. I don't know if that's the right number. We won't know what the right number is until 10-20 years down the road, but I use 20% of the fixed-income portfolio.

Benz: Also in the realm of inflation protection, a lot of investors have toyed with commodities over the past few years to varying effects. I'm wondering if you can discuss that category, whether you think commodities investments make sense as a routine part of investor portfolios?

Ferri: I have always been on the other side of the fence with commodities. I have a background in commodity trading and using commodity trading advisors that goes back 20 years. So I'm very familiar with commodities. I stopped using them about 15 years ago.

The reason why I say that: Commodities sound good in a portfolio. They just don't work good, and I think that a lot of people have been using commodities over the last few years are beginning to realize that. They don't do what people think that they should do or the way that they are advertised to do by the product providers that provide commodity funds. But that's here nor there.

I think that you have to separate out investors from those who are long-term strategic investors, who are going to do a buy, hold, rebalance strategy to their needs, and the tactical asset allocator that's trying to get in and get out of stuff.

Certainly for the tactical asset allocator who believes that they can predict what's going to happen next, commodities are fine because of that it is, is a tactical play that you can hold for a month, a year or two years, and then you're going to get out of it.

But for the long-term investor, who is going to hold their portfolio for the long term in, say, a 60/40 portfolio and do rebalancing--commodities don't produce any income. They don't produce any dividends, no interest income; all you have is basically this table, and you're hoping that somebody buys this table from you at a higher price later on down the road. Ten years from now, you still only have one table. A 100 years from now, you will only have one table; you don't have two tables.

So, you're taking money away from things that provide income, stocks provide dividends and dividend growth, and then bonds provide income, and you're putting there something that provides no income, and you're hoping for growth. It just doesn't work well for long-term investors.

Benz: Last I wanted to follow-up on rebalancing, and investors often wrestle with how often and how to do it? Do you have any thoughts on that for the individual investors who is managing his or her portfolio?

Ferri: Sure. Rebalancing controls the risk in a portfolio, and at times, when there is a very volatile market like we've seen over the last 10 years, it actually enhances return. So if your stocks go up and you want to be at 50-50 and your bonds are down, you sell some stocks and buy some bonds and come back to 50-50, and then vice versa. And in a very volatile market, you actually add return to your portfolio.

In a market that is going up, a the stock market that's going up, rebalancing controls risk, because if you don't, then your 50-50 portfolio will become 60-40, 70-30, and eventually 80-20 at a time, when you're getting older and getting closer to retirement, so that you need to rebalance and bring that risk back down to 50-50.

How should you do it? There's two schools of thought. One of them is just do it once a year, and that's perfectly fine. In all my books, I talk about rebalancing once a year because it's easy. The other way is to do it by bands. So if your portfolio gets out of parameters by maybe 5% or 10%, you're going to pull it back. But that requires monitoring, whereas the calendar method doesn't.

Now which works better? It is debatable.

I mean, what works best is the one that you do, and you do it religiously; that's the one that works best. So, it doesn't really matter whether you're doing it by the calendar or you're doing it by percentages. It's the one that you're going to be disciplined about.