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Asset Allocation Part 3: Your Stock and Bond Portfolio Mix

[Editor’s Note: This article first appeared as part of our series on Advanced Asset Allocation Strategies. To read the rest of this series, check out: Asset Allocation Part 1: What It Is and Why You Need It, Asset Allocation Part 2: Constructing an Efficient Portfolio, and Asset Allocation Part 4: Model Portfolios and Post-Retirement Planning]

In part 1 and part 2 of my series on asset allocation, I introduced the concept of diversification and how constructing a portfolio composed of assets with low correlations reduces downside volatility (i.e., risk) and potentially increases returns as well.  I provided an example of portfolio optimization software that – along with inputs of estimated future returns, correlations, and volatilities — can help you construct an “efficient” portfolio with the highest possible Sharpe Ratio (i.e., excess return divided by annual volatility). 

Let’s face it, though: coming up with accurate data for each possible asset class to input into the software is uncertain and difficult. Most people do not have the time or passion to make the necessary calculations.  They will either pay some CFA charterholder to do it for them or, more likely, they will just muddle through based on stock market myths or what their conflicted stockbroker tells them.

Although each person’s situation is different and requires an individualized financial plan, I thought it would be worthwhile to provide a basic framework of what percentages of different asset classes should go into a portfolio of an investor with at least 20 years to retirement. General guidelines may at least steer you clear of making a really big mistake.

First Step Is to Isolate Retirement Money

Asset allocation advice is meant for your retirement money. Money that you will need two years from now for your kid’s college education or to buy your dream home should not be included.  In fact, any money that you will need to spend within the next five to ten years should be excluded from your retirement portfolio. Short-term liquidity needs should be financed out of cash, CDs, or high-quality bonds that you plan to hold until maturity. Otherwise, normal market volatility may cause your savings to be less than you need when it’s time to cash out and spend the money.

Refuting the Stocks-Only Market Myth

Many may be wondering why anyone needs to worry about asset allocation for long-term retirement assets.  After all, don’t common stocks outperform all other asset classes over the long run? Wharton Finance Professor Jeremy Siegel’s investment classic Stocks for the Long Run has become common household wisdom.  In it, Siegel notes that over a span of two centuries stocks have averaged an annual real rate of return of 6.8%, much higher than bonds or cash. On a nominal basis (i.e., not inflation adjusted), the average return of stocks is 9.3%, compared to 5.0% for bonds and 3.9% for cash. Consequently, he concludes that moderate-risk investors with a 30-year time horizon should own a portfolio that is 100% in stocks.

Siegel’s advice has been challenged for a few reasons. First, just because stocks performed so well in the past does not guarantee that they will perform the same way in the future. As Nobel Prize winning economist Paul Samuelson once said: “We have but one sample of history.” Similarly, Yale Economics Professor Robert Shiller has argued that the 20th century “was the most economically successful century for the most economically successful nation of all time. It will not necessarily repeat itself.”

Even Siegel himself in a 2009 interview admits that the past 200 years of stock market history may not be indicative of the future:

You can’t really be that certain of the long-term trend. We could be seeing that the last 200 years are the golden age of capitalism. That golden age may be over. So, even 200 years doesn’t give you confidence.

Second, even if the long-term 6.8% per year upward trend of stock prices has not changed, the future is based on probabilities, not certainties. Simple statistics concludes that while the probability of stocks underperforming bonds decreases with time, the severity of underperformance increases with time. For example, the odds that stocks underperform bonds in any given year are 34%, but this falls to only a 4% chance of underperforming bonds after 20 years. But that 4% is deadly. If stocks do underperform bonds after 20 years, the underperformance is likely to be much, much worse than it would be after a single year. Probability of underperformance is only half of the picture; the degree of underperformance is the other half.

Don’t Risk It!

So, the question boils down to this: are you willing to risk losing a substantial portion of your retirement savings on a 100% stock portfolio simply because the chance of stock underperformance is relatively small? The answer should be no. As one Morningstar writer states:

I don’t know the probability of stocks under-performing bonds over long periods. It is undoubtedly low. But it is most certainly not as close to 0% as most people seem to assume. If that’s not reason enough to own a few bonds, I don’t know what is.

Third, the market collapse of 2008 invalidated Siegel’s assertion that stocks had beaten bonds in every 30-year period since 1861. As Robert Arnott noted recently:

From the end of February 1969 through February 2009, despite the grim bond collapse of the 1970s, 20-year bond investors beat the S&P 500 investor. We’re now looking at a lost 40 years!

What if you retired at the end of February 2009? Forty years of owning a stock portfolio proved to be a mistake. It hurts just to think about it. 

60/40 Portfolio Mix

Arnott suggests a 60% equity and 40% bond portfolio as an alternative. He points out that the annual returns of a 60/40 portfolio has an extremely high 98% correlation with the returns of an all-stock portfolio. Yet, the 60/40 portfolio is 38% less volatile.  Elroy Dimson, Paul Marsh, Mike Staunton, authors of the classic investment book Triumph of the Optimists, similarly support a 60/40 split because they don’t believe stocks will perform as well in the 21st century as they did in the 20th:

The classic U.S. asset allocation is one tenth in cash, with risky assets split roughly 60 percent in stocks and 40 percent in bonds. There is for the first time a more compelling case for regarding the 60:40 guideline as reasonably sensible.

Underweight Government Bonds (but TIPS are ok)

As for what type of bonds to include, Arnott says that conventional mainstream bonds (e.g., U.S. Treasuries) are not sufficient; one should add inflation-protected bonds (e.g., TIPS), foreign bonds, and high-yield bonds into the mix. As I stated in part 1, the bond market is 39.5% government treasury/agency, 34.0% mortgage-backed, and 26.5% corporate, so you should have all of these types in your 40% bond allocation. Underweighting government bonds currently makes sense, however, given their current low rates of interest, which are the result of a “flight to quality” during the 2008 financial crisis. With all the deficit government spending going on around the world, the likelihood of future inflation is quite high, which is the death knell for government bonds.  Both Warren Buffett and Julian Robertson, two incredibly smart investors, are betting on increased inflation. In fact, in his 2009 annual shareholders letter, Buffett went so far as to say that government bonds are an asset bubble ready to burst:

When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary. Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long.

Underweighting of government bonds applies only to regular bonds. Given the likely inflation scenario, inflation-adjusted bonds (TIPS) should be a core component of a bond portfolio. In fact, money manager Geoff Considine recommends a bond portfolio that is 80% composed of TIPS and economist Zvi Bodie recommends a 100% allocation to TIPS. The easiest way to buy a diversified portfolio of bonds is through ETFs and mutual funds.  Personal Finance and Global ETF Profits, two of KCI’s market-beating investment services, both offer excellent guidance on which bond funds to choose. 

Both Bonds and Stocks Appear Overvalued

The financial crisis has caused the Federal Reserve to drop short-term interest rates down to zero for an extended period of time. The result has been one of the strongest bull markets in history. All financial assets are inflated by a zero interest rate policy (ZIRP).  Kansas City Fed President Thomas Hoenig recently gave a speech criticizing ZIRP because it risks creating new asset bubbles that will inevitably lead to a “financial collapse.”

According to Andrew Smithers, who compares stock prices to their intrinsic replacement cost (the Q ratio), the stock market is 50% overvalued. Rather frightening.

Similarly, Peng Chen of Ibbotson Associates argues that bonds are also overvalued. Bonds have enjoyed an unprecedented 40-year period of declining interest rates that cannot possibly be repeated. Yikes.

Rebalancing is Crucial

What to do? You need to get active, buddy. Passive buy-and-hold strategies work great during bull markets but are lousy during choppy, overvalued markets.  Ed Easterling, author of Unexpected Returns, argues that investors need to rebalance their asset allocations frequently. He calls it “rowing,” versus the easy “sailing” of past bull market periods:

In choppy and volatile markets, like secular bear markets, a more frequent rebalancing approach can add significant additional return to an investor’s portfolio. It enables the soon-to-be better-performing investment to be increased to a larger part of the portfolio as capital is reallocated from the investment that has begun to peak, into the investment that is expected to increase. In addition, rebalancing also harvests some profits from the currently outperforming asset classes, thereby reducing the risk of giving back profits in a subsequent decline.

As I demonstrated in part 2, stocks and bonds have a low correlation so when one is up the other is often down. Consequently, after one year, a 60/40 portfolio could easily become a 65/35 or a 55/45 portfolio depending on which asset class is doing relatively better. By rebalancing back to 60/40 at the end of each year, you harvest profits and get to invest more in the asset class primed to outperform going forward.

Overweight Value Stocks

Since stocks are generally expensive, it may make sense to limit your purchases to the stocks with cheaper valuations (i.e., value stocks). The cheaper they are, the less they have to fall in a bear market. Granted, some of these stocks could be cheap for a reason, but studies show that value stocks outperform in aggregate. If you rebalance your value stocks annually, you sell the value stocks that have bounced and reinvest in stocks that have recently become cheap.

Don’t Buy Long-Term Bond Maturities

With interest rates so low, going far out on the yield curve does not compensate you enough for the added risk you are taking. Stay short and intermediate term in your fixed-income holdings. That way, the bonds mature in a reasonable amount of time and you will have the opportunity to reinvest the cash at higher interest rates.

Don’t Forget Cash

Lastly, a 10% allocation to cold, hard cash makes some sense. Even though ZIRP insures that you won’t earn any interest on your cash, it lowers your risk and provides you with some dry powder to buy more stocks (or bonds) at cheap prices if there is another bear market. I feel sorry for fully-invested folks who couldn’t take advantage of the once-in-a-lifetime stock market bargains available in March 2009.

Next: Asset Allocation Part 4: Model Portfolios and Post-Retirement Planning.

Editor’s Note: For more information on this topic, check out our FREE special report on Asset Allocation Strategies

 


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