Much of the news over the departure of Bill Gross from Pimco to Janus Capital Group serves only to distract investors from the intelligent and responsible management their portfolios. So I thought I'd give you a break from all the media hype and instead address some basics of bond investing.
Many investors improperly view the purpose of fixed income in their portfolio. They are frustrated by today's low interest rates and seek higher yields. However, to generate those yields, they will have to consider extending the maturity date of their bonds or purchasing bonds with lower credit -- or both. These strategies come at a price. They increase risk.
According to William Bernstein, the author of "The Intelligent Asset Allocator" and other excellent investing books, fixed income is "for emergency needs." Bonds should act as ballast to soften the volatility of your portfolio. Bernstein believes you should take no risk with the fixed-income portion of your portfolio. You should limit your purchases to Treasuries, certificates of deposit (FDIC-insured) and money market funds that invest primarily in Treasuries. You don't need Gross or any other fund manager to implement these purchases.
If your fixed-income portfolio is $1 million or more, you might want to consider the benefits of a laddered bond portfolio.
How to Increase Your Expected Returns
There are a number of reasons why it makes more sense to take risks with stocks rather than bonds. In a taxable account, stocks are more tax efficient than bonds. There is also evidence indicating the risk adjusted returns of stocks are greater than bonds. Finally, managing the risk of lower-credit bonds can be very challenging.
It is surprisingly easy to increase the expected return of your portfolio without taking additional risk in your fixed-income holdings. Simply increase your allocation to stocks. Of course, doing so will make your portfolio more volatile.
Some important factors that play a meaningful role in determining the expected return of the stock portion of your portfolio are:
Your exposure to small stocks.
Your exposure to value stocks.
A competent adviser should be able to structure the stock portion of your portfolio to seek the highest expected return for a given level of risk. Again, neither Gross nor any other bond fund manager is needed to do so.
Avoid Actively Managed Bond Funds
The financial media is in a dither over the effect that Gross' departure will have on Pimco, the investment giant he co-founded in 1971. There is speculation that billions of dollars of outflows will either follow him to Janus or move elsewhere. Here's what's missing from this debate. Why are you investing in any actively managed bond fund (where the bond manager attempts to beat a designated benchmark) in the first place?
One study of 2,300 bond funds covering 1991 to 2008 found that investors in actively managed bond funds lost about 0.90 percent a year compared with lower-cost index bond funds. That's bad enough, but there is also the problem of prospectively identifying an outperforming bond fund manager.
Gross is a prime example of this difficulty. He delivered many years of stellar performance at Pimco, consistently outperforming his benchmark. But if you relied on his past performance and invested last year, you would have been disappointed. Pimco's Total Return Fund (PTTRX) underperformed the Barclay's Aggregate Bond Index.
The intense focus on Gross and whether he still has the magic mojo is fundamentally misplaced. You don't need him or any active bond manager to invest in a manner consistent with the evidence and sound data.
So What If Bill Gross Is Leaving Pimco: His Mojo is a Myth
Is your water bill due quarterly? Figure out how much you need to save each month to have enough to pay for the bill when it comes, and put that amount aside each month so you'll be prepared. Do the same for any bills due regularly but not monthly.
Bills you only have to pay once a year can be even harder to remember, so be sure to note things like property taxes, auto registration fees and insurance premiums and budget for them as well.
Annual subscriptions and memberships regularly trip up people's budgets. Be sure to set aside money each month for things like:
Newspaper and magazine subscriptions.
Warehouse club memberships.
Road service membership fees.
Other expenses don't happen on a regular basis, but you can still predict the need to pay for them over the course of the year. Chief among these are repair and maintenance expenses, with the biggest ones being car-related costs (oil changes, inspections, new brakes or tires, etc.) and home costs (leaky faucets, spring-time yard work, etc.).
Some home repairs go beyond the scope of "routine" and require a significant amount of money in reserve. These can include replacing your roof, installing new windows or doing a major home renovation. You can anticipate the need for most of these repairs before you have to make them, so be sure to start budgeting for them in advance.
You also need to repair and maintain your body, so factor in medical costs like annual physicals, eye exams and dental checkups, as well as co-pays and prescriptions costs if you have any ongoing conditions.
If you plan to purchase any large items in the foreseeable future, from appliances to a new car, make sure you're putting aside enough each month to pay for them in cash. It's always best to pay for big-ticket items upfront rather than finance them (unless you can get a fantastic discount by financing and can pay the balance in full before any interest kicks in).
From birthdays to holidays, there are plenty of special occasions each year to budget for. Make sure to include:
Party hosting costs.
Dinner costs if you take someone out to celebrate.
Wedding expenses (gifts, travel, hotel stays, etc.).
Your four-legged family members also need to be part of your budget. Pet care costs to consider include:
Food and treats.
Vet bills and medications.
Boarding or pet sitting.
Do you take an annual vacation? Travel twice a year to visit family for the holidays? Set aside money each month for any travel-related costs such as airfare, hotels, meals, rental cars and souvenirs.
Whether you run a business or simply a household, there are certain expenses you may need to plan for in the business category. These can include:
Tax preparation fees and tax payments.
Dues for professional organizations.
Whether you give annually to a charity of your choice or like to have some money set aside for your friends' and family's fundraisers, make sure to allocate enough each month to cover these donations
A good budget allows for a little "free" spending money you can do with as you please. It can be $20 a month for fancy coffee at your favorite coffee shop or $100 a month to feed your favorite hobby. The amount doesn't matter so much as the fact that you're allowing yourself a little guilt-free fun to keep your budget from feeling too restrictive.
Depending on your lifestyle, your eating out and entertainment budget could be a little or a lot. Whether you prefer to have dinner out once a weekend or see a movie every few weeks, figure out how much you'd ideally like to have and then examine any budget categories you can tweak to make room for it. If you realize you need to cut back on your habits a little to save money, that's fine too-at least you're aware of it now so you can act accordingly.
Even if you're not a clothes horse, chances are there are certain items you'll need to purchase throughout the year. These can include:
Updated work clothes.
A new coat, hat and other accessories come winter.
A new bathing suit for the summer.
New shoes as yours wear out.
Back-to-school clothes for your kids.
Calculate your annual spending on all clothing and accessories and divide that amount by 12 to determine how much you should be putting aside each month.