Ladders, barbells and bullets:
Choose your savings tool
you're building your investment portfolio, it can be easy to focus
too much attention -- and too many resources -- on the stock portion
and give short shrift to the other two members of the investing
trinity: fixed income and cash.
Fixed income can look timid and wasteful, especially
if the stock market is doing well. But, when it's tanking, fixed
income can be a welcome port in the storm.
For many people, fixed-income investments focus
on certificates of deposit, corporate and municipal bonds and Treasuries.
For this report we're going to look at five-year
strategies for maximizing profit. Because of the five-year time
frame, we'll be talking mainly about CDs and Treasury bills and
notes. You could, however, add some short-term corporate notes to
Barry Vosler of LPL
Financial Services in DeWitt, Iowa, and Stephen Barnes of Barnes
Investment Advisory in Phoenix are certified financial planners
who are sharing their knowledge and advice for this report.
Building your ladder
Both agree you should have at least $25,000
for this type of five-year fixed investment plan, but Vosler says
don't let that stop you from trying it with less money. The approach
costs $5,000 for each year of the five years of the plan, but you
could try it with as little as $1,000 for each year.
Here's how laddering
You go to the bank with $25,000, buy a $5,000
one-year CD, a $5,000 two-year CD and so on until your last $5,000
buys you a five-year CD. Each year is a rung on the ladder. When
the one-year CD matures you can take the $5,000 and roll it over
to buy another five-year CD because by that time your current five-year
CD will have four years left before it matures. As each year's CD
comes due, you roll it into a five-year CD until you have five of
the five-year CDs in a rotation that means one expires each year.
It is roughly the equivalent of dollar-cost
averaging when you buy stocks or mutual funds.
A benefit of this type of laddering is you're
never more than a year away from at least some of your money. That
can give some peace of mind to investors who think two- to five-year
maturities are too long.
The five-year plan with one-year rungs we're
developing is simply an example. Barnes says there really isn't
an optimal term to focus on when laddering.
"It depends on each individual's requirements
for the money. If you don't have any need for the money for a while,
that would indicate a different allocation. If you have needs, you'll
bring it in shorter.
Barnes says his firm ladders bonds at six-month
Vosler has four reasons for laddering a portion
of your fixed-income investments:
"Typically for longer term investments
you'll get a higher yield than with shorter term investments."
"Structured investment plans, like laddering, keep
investors true to their goals. It helps avoid all the buzz from
the Internet that confuses people."
"It helps eliminate guessing about the direction of
future interest rates. It's difficult if not impossible to predict
and this makes it irrelevant."
"A properly structured ladder will reduce interest
rate risk, marketing risk and reinvestment risk."
Barnes says CD laddering is not only a way to
maximize yields, but a second layer of risk control -- the first
being adding CDs to a portfolio to offset stock market risk.
Where Barnes and Vosler differ is that Barnes
doesn't believe in varying strategies in a laddering plan in a changing
interest rate climate.
"We don't want to get into the game of
guessing rates," he says. "The Fed will lower rates --
take a number and get in line -- everybody knows that. It's already
figured into securities now. Don't try to guess the direction of
interest rates. This strategy is a defacto ignorance of where rates
may be headed."
Vosler agrees laddering is designed to eliminate
interest rate guesswork, but thinks there's some merit to having
different laddering plans depending on whether interest rates are
rising or falling.
When rates head down
"If rates are trending down, like now, line up the short end
of the ladder in CDs and the longer end in Treasuries. Banks tend
to be more reactionary in their pricing of CDs than the bond market
and banks are usually behind the curve -- so as rates trend down
you'll find the higher rates at the banks."
"On the longer term of the ladder, if
given the choice between CDs and Treasuries at the same rate, I'd
want Treasuries on the long end with rates coming down because it
could give us some appreciation in value as rates come down."
"The trade off between rates and principal
is they move in opposite directions. If rates go lower, bond prices
go higher. We'd want that possibility of price appreciation."
"If rates were going up I'd want to flip
that around and have Treasuries on the short end of the maturity
cycle and CDs on the long end. Same reason on the short end -- banks
will probably be behind the curve and not offering rates that are
as attractive. The reason banks are usually behind the curve is
they're reacting to their customers and the need for funding loans
at that time," says Vosler.
Bullets and barbells
Barnes says that while he'd build a ladder without regard to the
interest rate environment, the way he'd take advantage of changing
interest rate climates is by mixing in "bullet" and "barbell"
strategies with the ladder:
"With a bullet, you put all your money
in one particular maturity. If you believe interest rates are going
to rise significantly down the line, you'd buy all six-month securities
now," says Barnes. "In the barbell strategy you believe
the best rates are in the short term and the long term -- the middle
isn't rewarding you sufficiently. So, you want money market funds
and 30-year treasuries. It's a bet on rates coming down."
Some planners consider bullets and barbells
too sophisticated for the average investor, so if these strategies
interest you, be sure to do plenty of research and consider talking
to a professional.
Vosler cautions against using callable CDs
in a laddering plan -- if interest rates drop, the whole ladder,
or a significant portion of it, could be called.
-- Posted: Jan. 19, 2001