Thanks for the question, David! Here’s the full text –

“I lost money on bonds, should I liquidate or hold the course? Investments are in an IRA so cannot write off the losses.“

The first question to ask yourself is – “Why did I decide that bonds belong in my portfolio in the first place?”

Has that reason changed?

If an asset is part of your financial plan, recent performance shouldn’t affect your decisions. There will often be times when part of your portfolio is losing money.

This is normal and doesn’t necessarily mean it was a wrong decision to own those assets. An efficient portfolio is designed to work as a system – certain segments balance out the risks of others. Diversification and rebalancing are key for keeping risk in line, and performance should be evaluated as a whole over multiple years.

Abandoning a long-term investment strategy because of recent losses is like closing the barn door after all the cows have run away!

While bonds aren’t as volatile as stocks, they can have moderate swings in a short period as we saw in 2022. To help you better understand the fixed-income asset class, I’ll cover some fundamentals:

First, you can expect riskier (more volatile) investments to generate higher returns than lower-risk investments. This is why stocks have higher expected returns than bonds, and bonds have higher expected returns than cash.

Next, let’s talk about the two main types of bond risk: duration and credit.

Interest rates and bond values move in opposite directions so when interest rates go up, bonds fall in value and vice versa.

This asset class got slammed last year because the Federal Reserve raised interest rates seven times. There’s a silver lining to interest rate increases, though – new bonds are paying higher income (yield).

In the case of bond funds, new bonds that enter the fund to replace older ones will generate higher yields. This higher income will, over time, offset the value lost from the interest rate increases.

The number of years it takes for the effects of interest rate increases (value decrease + yield increase) to neutralize each other is approximately equal to the fund’s duration. This is a gauge of interest rate sensitivity and is a common measure to use when comparing bonds. High-duration funds hold longer-term bonds and will be more sensitive to rate changes compared to short-duration funds.

Since we know bond prices move the opposite direction of interest rates, it prompts an interesting question:

If I know interest rates will increase, should I avoid bonds or switch to short-term/short-duration?

It’s a logical train of thought.

However, even if we “know” (think) the Federal Reserve is going to increase rates, their adjustments only directly affect the overnight lending rate.

The Fed doesn’t go down the list of different bond maturities and physically adjust the 1-year rate, the 5-year rate, the 10-year rate, etc. These other rates are based on the market prices for the bonds which are set by market forces of supply and demand.

And just like any market, it’s hard to predict exactly what will happen. Expectations about the economy, inflation, and future interest rate increases are already baked in to market prices!

An example of market dynamics: If 10 year bonds are desirable, more people will be buying than selling which drives up the price. This price increase reduces the yield. When the yield gets to a point that the market no longer finds attractive, buyers stop buying and equilibrium is reached.

Overnight Rate: Fed -> Rate

Other Rates: Market -> Price -> Yield (rate)

Overnight rates are directly impacted by Fed rate adjustments. Very short-term bonds like T-bills (maturing in less than 52 weeks) will be somewhat sensitive to rate adjustments. But for longer maturities, it’s anyone’s guess and there are about a gazillion things that affect market dynamics.

Imagine grabbing the end of a 25-foot rope that is stretched out on the ground. If you swing your arm up, the rope closest to your hand will experience the greatest movement but the other end of the rope will move little, if at all.

This is a good metaphor for interest rate dynamics – the overnight rate is directly affected, very short-term bonds are somewhat affected, and longer-term bonds move much less predictably.

The other risk factor for bonds is credit risk – the possibility you may not receive the interest or principal you’re promised.

Treasuries (government bonds) are considered to be zero credit risk because the government can simply tax its way out of budget challenges. Corporations don’t have that same ability – they can go bankrupt and default on their debt.

The less stable a company is, the higher the risk of default, and the lower its bond values. Remember, lower value means higher yields! Low quality corporates are also called “junk bonds” or “high yield.”

It’s important to understand that fixed-income assets can provide varying degrees of stability, diversification, and/or income depending on the type that are selected.

Stability

• Short-term bonds are more stable and less sensitive to interest rates than long-term bonds.

Diversification

• Treasuries are a better diversifier for a stock-heavy portfolio than corporate bonds because treasuries are free of credit risk.
• There is usually a flight to safety during economic downturns, and this often causes treasury prices to rise while stocks are falling. This effect stabilizes the overall portfolio and reduces volatility.
• Corporate bond values get dragged down during recessions (due to credit risk) and fail to provide diversification when it is needed the most!
• Long-term treasuries are considered to be better diversifiers than short-term treasuries.

Income

• Short-term bonds are less risky (duration) than long-term bonds so they pay lower yields.
• Treasuries are less risky (credit) than corporate bonds so they pay lower yields.
• High-yield corporates (junk bonds) are riskier than other corporates and generate higher income.

As you can see, there is no free lunch.

If you want more stability, you’re giving up some diversification and income.

If you want more income, you’re giving up some stability and diversification.

It can be alarming when you lose money on a “safe” asset like bonds, but it’s always important to keep a long term view.

• Is your plan still on track?
• Have you rebalanced to manage risk?
• Is your portfolio designed to work as a system or is it a hodgepodge collection of assets you threw together?

Don’t look at the bond portion of your portfolio in isolation – think about your asset mix (stocks/bonds/alternatives/cash) as a whole and the role(s) you want bonds to play. Choose the appropriate type for this objective.

A suitable portfolio balances risk with return and aligns with your goals, timeline, and risk tolerance.

Book a free consultation if you’d like help creating a financial plan and designing an investment portfolio that is right for you!

Financial Services is a difficult industry for the average person to understand.

Simple concepts are overcomplicated and cloaked in jargon. Fees are often buried in product commissions or aren’t clearly communicated. Conflicts of interest are rarely disclosed.

Financial Advisors (or Financial Planners, or Wealth Managers, or Investment Advisors – what’s the difference?) usually have a string of letters after their name. What do all these credentials mean? Are they working in my best interest or their firm’s?

How are you supposed to figure out who to trust with your life savings?

My goal is to shine a light behind the curtain and arm you with information.

This set of articles, “The Advisor Series”, will help you understand the basics of pricing models, typical services provided, issues like conflicts of interest, and questions you should ask when deciding to work with a financial advisor/planner.

Part 1 starts the series by exploring the standard pricing models and the typical services each arrangement provides.

So let’s dive in!

One of the most misunderstood aspects of personal finance is the advisor’s pricing model.

Although it seems like a minor detail, how the advisor is compensated is essential – it introduces conflicts of interest into the equation which can bias advice, and it also determines how much of your hard-earned money you’ll part with. Unfortunately for the clients, this can vary widely.

Choosing Advisor A can cost 5-10x for the same service as Advisor B in many situations!

Until about 50 years ago, advisors made their living primarily through commissions from product sales and trading fees. This often led to advisors prioritizing the mutual funds that paid them the highest commissions rather than what was best for the client. It also incentivized excessive trading (churning) in investment accounts to drive up the per-trade revenues.

At that time, the advisors were essentially salespeople and the conversations often started with products – specific mutual funds or insurance schemes – rather than questions about the client’s situation and goals.

Imagine going to the doctor’s office and, before asking a single question about your symptoms, he hands you a prescription!

A new model started gaining popularity during the ’80s and ‘90s – Assets Under Management (AUM). Under the AUM model, clients pay advisors directly rather than the advisors receiving commissions from their firms for product sales.

Fees are quoted as a percentage of the managed portfolio size (1%, for example). Charging customers directly was a huge step in the right direction for transparency and reducing conflicts of interest.

Currently, about 90% of firms use the AUM model for at least a portion of their fees, with many firms choosing to receive commissions from product sales (mutual funds, annuities, insurance) as well.

New pricing models such as Flat-fee have entered the market in recent years, and are proliferating due to consumer demand. These alternative models are a natural evolution of the business and they offer many advantages for clients compared to legacy fee structures.

When describing the different pricing models, I like to separate everything into two categories:

1. Those who receive commissions on product sales: Commission-based
2. Those who are paid directly from the clients: Fee-only

You may have heard the term “Fee-based”, but it is not the same as #2.

“Fee-based” is a marketing term that product salespeople likely introduced to make it sound like they only are paid through fees. It’s actually a hybrid model that compensates the advisor through fees AND commissions. They can be paid with either (or both) depending on the product/service being offered.

Before we go any further, let’s introduce a visual aid to help you understand how everything fits together.

Notice everything on the right side is Commissions, the left side is Fee-only, and the overlap in the middle is Fee-based (paid through product commissions and fees).

Now that we’ve got a high-level understanding let’s dive in a bit deeper into the two primary models and typical services provided.

A commission-based advisor (salesperson) gets paid based on products they sell. They may pitch themselves as “free” to the client but make no mistake – they are paid through the fees or costs baked into the product.

Selling a whole life insurance policy can earn thousands of dollars in commissions, and selling a front-loaded mutual fund can earn 5% or more of the initial investment. Advisors operating under commissions typically offer minimal financial planning to ultimately sell a product.

Think of a car salesman asking you about your family size, how much driving you do, etc. The end goal is to sell you a product that may or may not be the best fit for you – they’re certainly not going to direct you to another dealership if that happens to be a better option. Ongoing guidance is uncommon with commissioned sales, because there’s no incentive to continue providing advice after the transaction.

Pretty straightforward, right? Let’s move on to the Fee-only side.

An advisor who is “Fee-only,” receives no sales commissions and is compensated only from clients directly. Fee-only is often confused with Flat-fee, but Flat-fee is a specific subset of the Fee-only category.

The two branches of the Fee-only category are Assets under Management and Flat-fee. The difference is in how the fees are calculated.

For advisors using the AUM model, the price depends on the size of the managed portfolio. 1% is a typical figure and many firms offer a tiered model with discounts at certain levels (first $1M at 1%, next $1M at 0.75%, etc.)

A 1% AUM fee on a $1 million portfolio would cost $10,000 per year, rising over time with the portfolio’s growth. Investment management was historically the only service provided (with planning available for an additional cost), but now many firms include financial planning in their AUM fee.

Fees are deducted straight from client accounts which makes it is a “frictionless” transaction compared to paying with a check or credit card. Many families have no idea how much (in dollars) they’re actually paying their advisor because they haven’t multiplied the AUM percentage times their portfolio size!

Pro Tip: The AUM fee is usually in addition to the fund fees in the investment portfolio (often 0.5% or more), so be sure to add the two together to understand what you’re paying in total.

Kitces.com studies have benchmarked the average “all-in” fee for < $1M to be at least 1.65% (see image below). This would cost $8,250 annually for a $500K portfolio. If the advisor offers a “wrap fee” program, this includes the AUM fee and trading costs but typically excludes fund expense ratios.

Under the Flat-fee model, price depends on the service provided rather than the portfolio size – clients pay a flat dollar amount whether they have $50K of investable assets or $5M.

Comprehensive financial planning is the core focus of most Flat-fee firms, and this covers a broad scope of topics including retirement planning, tax-efficient accumulation/distribution strategies, investments, education funding, charitable giving, estate planning, employee benefits, etc.

Advice-only is a great option for clients who have the time, talent, and temperament to manage their investments but still want guidance on how to allocate their accounts and have a professional look at the rest of the planning areas. Advice is either one-time (project-based/hourly) or ongoing. Price ranges vary, but one-time projects usually cost $1,000-$6,000 depending on scope, and ongoing is in the $5,000-$10,000 per year range.

Clients who would rather have their investment accounts managed can pick a Flat-fee advisor who offers this service. Most will start the process with a comprehensive financial plan and offer investment management as part of the ongoing planning process or as a separate add-on fee.

Understanding how an advisor gets paid can be one of the most confusing aspects of finding a financial professional, but at a high level, remember these four points:

1. Fee-based advisors also receive commissions from product sales.
2. The cost for Commission-based advisors depends on products they sell.
3. The cost for AUM advisors depends on the size of your portfolio.
4. The cost for Flat-fee advisors depends on the services they provide.

Check out Part 2 of the Advisor Series, where I cover the real juicy stuff – conflicts of interest and other issues unique to each fee model!

7 Saturdays Financial is proud to be a flat-fee firm that receives no sales commissions.