Understanding Cash Will Make You a Happier Investor (Tyler)

Discussion of the Cash portion of the Permanent Portfolio

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grapesofwrath
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by grapesofwrath » Fri May 26, 2017 8:21 pm

Tyler, Didn't you once include TIPs in your Portfolio Charts and then they disappeared, or am I mistaken ? I would think TIPs would be an insightful asset class to include given their performance/correlation is (supposedly) relatively unique. Even though TIPs are relatively recent invention I understand "synthetic" data exists for how they likely would have performed earlier. (But a question would be what duration..) Thanks.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by Tyler » Fri May 26, 2017 10:43 pm

grapesofwrath wrote:Tyler, Didn't you once include TIPs in your Portfolio Charts and then they disappeared, or am I mistaken ?
Yep -- I used to have TIPS on the site. Late last year a group of smart guys on the Bogleheads forum (including the guy I really trust who manages the Simba spreadsheet) sought to reproduce the study that reconstructed all of the synthetic data and basically determined that the data was junk. And it wasn't just the methodology of a single study but the nature of TIPS themselves.

The thing about TIPS is that because of the additional value of the guaranteed inflation adjustment their yields are lower than normal treasuries of the same maturity. That makes sense, otherwise nobody would purchase normal bonds. However, the difference is not tied to a measurable inflation number but is instead equal to whatever the market believes is the expected inflation over the life of the bond. Believe it or not, TIPS were invented at least in part to try to predict inflation. You can probably guess how well that has worked out.

Basically, to accurately model the behavior of TIPS you have to quantify the emotional belief of the market at a given point in time regarding expected future inflation. Studies have tried to do that but none I'm aware of have come close in any repeatable way. So while I haven't totally given up on the idea, for now I don't trust it enough to use synthetic data and there's not enough real data to make backtesting worthwhile.

BTW, several of the people who looked into modeling TIPS left the exercise swearing them off with their own money.
Last edited by Tyler on Sat May 27, 2017 11:24 am, edited 1 time in total.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by grapesofwrath » Sat May 27, 2017 5:47 am

Thanks for the reply Tyler. I had been wondering if a short term TIPS fund (eg VTAPX) or a ladder of 5yr discrete TIPS bonds held to maturity would be a suitable/sensible substitute for a cash component in a portfolio (if one didn't want immediate liquidity). My naive understanding is the yield might be slightly lower/comparable than that of regular bonds of same duration, but they would offer better protection if there were a substantial rate rise - hence decent alternative to cash. I've seen some portfolios (Swedroe ?) where the (heavy) treasury bond/note allocation is split equally between regular bonds/notes and TIPS of comparable duration. Seems like doing this is hedging one's bets on rates ? My other understanding is holding TIPS only really makes sense in tax deferred accounts, correct ? Further comments from others much appreciated.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by sophie » Sat May 27, 2017 9:06 am

Tyler, that's the best summary of TIPS I've heard anywhere. We'd had previous threads about keeping TIPS funds as an extra inflation hedge, but it always looked to me like you had to give up too much in order to get it.

Anyway, it's not really needed. The PP provides consistent enough returns over inflation that you don't really have to worry about it.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by eufo » Sat May 27, 2017 10:58 am

Tyler wrote:BTW, several of the people who looked into modeling TIPS left the exercise swearing them off with their own money.
Wow, that is very telling about TIPS. I remember liking the concept of protection against inflation in a bond, but I never really cared for their ultimate performance. Plus, the conspiracy theorist in me suspects the government will always fudge inflation numbers to their own benefit, so how can I trust that I'm going to have any protection against my own perception of real inflation?
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by Tyler » Sat May 27, 2017 12:01 pm

grapesofwrath wrote:My naive understanding is the yield might be slightly lower/comparable than that of regular bonds of same duration, but they would offer better protection if there were a substantial rate rise - hence decent alternative to cash.
I definitely wouldn't use TIPS as a substitute for cash. Think about it this way:

Bonds are affected by basically one thing -- interest rates. Values rise when rates fall and fall when they rise, and they pay out the coupon along the way.

TIPS are affected by three things -- interest rates, measurable inflation, and the market guess of expected future inflation. So there are multiple variables involved, and just because TIPS are adjusted for measurable inflation does not mean they track it particularly well. They are harmed by rising rates just like normal bonds, and the market guess for future inflation can be wildly wrong. That's how intermediate TIPS had a real return of -10% in 2013 and how short term TIPS trailed normal short term treasuries three out of the last four years (compare VTIP to VFISX).

All that said, you might want to read books by Swedroe, Swensen, and Israelsen to understand why they like TIPS. While they're not the automatic inflation-protecting vehicles they're made out to be, TIPS are an interesting asset and I think they can be fine in certain portfolios.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by grapesofwrath » Sat May 27, 2017 12:52 pm

Tyler wrote:That's how intermediate TIPS had a real return of -10% in 2013
With my limited understanding isn't such a loss just a consequence of selling in a TIPS fund?
What if you hold the Note or TIPS from issue to maturity ? Looking at typical numbers for a 5yr Treasury Note vs 5yr TIPS :
A 5yr Treasury Note currently has a nominal yield of ~1.8% which is pretty much zero real yield with current inflation, so if inflation remains unchanged you get all your money back (in real terms) at end of 5years (ignoring tax). If inflation increases/decreases over the period your 5yr Note will lose/make money (in real terms). i.e. you are not protected against inflation.
Now a 5yr TIPS bond has an interest of ~0.125% (negligible). My understanding this yield is on the principle value, and this underlying principle value of the TIPS bond increases/decreases to track inflation. i.e. the TIPS guarantee to give you a (currently negligible) positive real return at the end of 5years regardless of how inflation moves. i.e. you are protected against inflation.
So if you laddered the TIPS and held them from issue to maturity how would that be a bad substitute for cash or short term fund ? Thanks.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by Tyler » Sat May 27, 2017 12:59 pm

Yes, holding TIPS to maturity bypasses the interest rate risk. There's still the future-inflation-guessing risk, though, as normal bonds held to maturity will pay a higher yield and will be a better deal if future inflation is below current expectations. For example, using your numbers it would only make financial sense to prefer a 5-year inflation-adjusted bond paying 0.125% over a non-adjusted alternative paying 1.8% if you expect inflation to average more than 1.675% over the next 5 years. In that context, buying TIPS is just a wager that inflation is currently under-priced. It's a speculative investment.

In any case, I'll amend my previous statement and clarify that I don't think short term TIPS are automatically a poor substitute for cash. Just perhaps unnecessarily complex. Going back to the link in the OP, cash already tracks inflation pretty well on its own without the extra layer of uncertainty.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by pugchief » Sat May 27, 2017 2:50 pm

Tyler wrote:Yes, holding TIPS to maturity bypasses the interest rate risk.
This is a fallacy regarding bonds of all types. You get your whole principal back at maturity, but you lose out on the opportunity to invest at the new, higher coupon as rates rise. The loss of additional interest should be exactly equal to the capital loss you would occur if selling prior to maturity.
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Re: Understanding Cash Will Make You a Happier Investor (Tyler)

Post by Tyler » Sat May 27, 2017 2:53 pm

Good point! The treasury market is remarkably efficient in balancing things out.
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