When we introduced our new bond Upgrading strategy in the January issue, one of the questions raised in the Comments section concerned its suitability for investing an accumulation fund: "How does this compare to the Vanguard bond portfolios referenced in the past for the purpose of saving for future needs? Are you recommending this new strategy only for long-term investing? What kind of a time frame is recommended?"

Indeed, we designed bond Upgrading with long-term investing in mind. Accumulation funds, on the other hand, typically have time horizons of only a few years. My response was that the strategy could be used for such a brief time horizon, but the additional risk must be taken into consideration.

I've gone back to our original research and run a few tests using "rolling periods." After looking at the results from buying on January 1, 1996 (the beginning of our research) and holding for 12 months, I then “rolled” to the next month to see what happened if the fund had been purchased on February 1, 1996 and held for 12 months. Then I moved to March 1 and did the same thing. And so on. Continuing in this way, I computed the results for a total of 217 different 12-month holding periods. This is in contrast to just 19 12-month periods when only calendar years are considered. Using this more exhaustive process provides a somewhat better picture of the degree of volatility and level of returns that can be expected from an investment.

The table below shows the annualized results from testing 12-, 24-, and 36-month holding periods.

  12 Months 24 Months 36 Months
Average +7.9% +7.9% +7.9%
Best Case +24.7% +20.2% +14.6%
Worst Case -2.2% +2.8% +4.0%


Interestingly, the "average" result was the same, regardless of the length of the holding period. This was surprising. I didn't expect them to converge until I looked at longer periods (for example, it wouldn't surprise me if the average results from 4-year and 5-year periods were close to the same). I double checked the numbers, and all seemed in order. Not sure to what I should attribute such similar outcomes at shorter holding periods, but I can say it's a good thing. Speaks to the "steadiness" of the strategy, at least during the test period from 1996-2014 (which is admittedly a relatively brief one, but all that the available data allowed).

Looking at the "best-case" numbers, one would expect a lower return as the holding period is lengthened. Longer periods dilute the effects of unusually strong months. The longer periods, therefore, move closer to a realistic expectation as to best-case potential.

For purposes of the question at hand (is the strategy suitable for an accumulation fund?), the worst-case data are where we should focus our attention. Since protecting capital is a primary goal for such a fund, we would obviously rule out using the strategy for periods of less than 24 months.

A 24-month holding period is somewhat borderline. Yes, the worst-case shown in the table is on the positive side of the ledger, but this may be a little optimistic given the test period was dominated by a climate of falling interest rates (which is great for bond returns). A 36-month holding period would be better/safer because it provides more of a cushion against loss.

It's also good to keep in mind that looking ahead, we will soon encounter rising rates. (Today's WSJ has a headline, "Fed on Track to Raise Rates in 2015.") Such an environment could push the worst-case numbers into even more negative territory.

I would feel most comfortable recommending the bond Upgrading strategy only for those with accumulation-fund holding periods of 36-months or longer. Even then, it must be realized that sudden losses can play on the emotions and cause one to abandon the strategy rather than hold on. Selling at that stage would lock-in losses rather than give the strategy time to recover. Only those with risk-tolerant temperaments should employ this strategy for money where losses would impose a hardship.

There may be a fortunate few reading this who have cash holdings that are not part of an accumulation fund. They're just part of a surplus you've built up over the years, and you have no specific purchase/purpose in mind for those reserves. Because interest rates are so low at present, you may be willing to take on more risk in a search for higher returns. Perhaps your time horizon is undefined, but expected to be relatively long. If you want to try bond Upgrading for part or all of that excess, that's worth considering (again, assuming you have the risk temperament for it). In your case, if you incur a loss it doesn't mean postponing that major purchase for which you've been building your accumulation fund.

Anyone intending to use bond Upgrading for an accumulation fund or other shorter-term needs? Longer-term income goals? If so, feel free to share your plans and reasoning.