Tuesday, 28 April 2020
How should you choose between stocks and bonds?
Financial advisors are risk averse. Their risk aversion may have less to do with your financial situation than their reputations. Conventional wisdom is that a portfolio that is invested one-third in bonds and two-thirds in stocks is the way to go irrespective of the level of your assets. The one-third, two-thirds formula is the standard. It is safe because that is what the herd recommends.
The conventional model of portfolio construction, the one-third bonds two-thirds stocks, requires that you periodically rebalance your holdings. By this, they mean that if your stocks had a particularly great year and now are 75% or 80% of your portfolio, you should sell some stocks and invest the proceeds in more bonds. That is like selling your winners and reinvesting in your losers.
The major brokerage houses issue "asset allocation" formulas depending on their view of the stock market in the near term. This sounds like market timing.
However, people are different. Your financial assets and your needs vary tremendously.
The two most important considerations in formulating an asset allocation formula are:
Jeremy Siegel's book - Stocks for the Long Run
In every rolling 30-year period between 1871 and 1992, stocks as measured by an index, beat bonds or cash in every period.
In rolling 10-year periods, stocks beat bonds or cash 80% of the time.
Bonds and cash did not beat the rate of inflation over 50% of the time.
So why would anyone own a bond? The answer comes back to age and need.
If you are young (20 years to 35 years) and have a job that pays your bills, you can take a long view on investments.
A lot of what you do in investing is just simple common sense. Many investors think they should be proactive and keep looking for ways to tweak their investment portfolio when just sitting tight, if they made the correct choices in the first place, often would be the better course.
Examples:
Asset allocation is based on age and need.
1. A friend liquidated an asset and wished to invest in the stock market. However, he will need this money for a project he is working on at end of the year. He should not invest this money in stock, as his need for the money did not anticipate any setback in the stock market. If he could not be in for the long term, he should not be in.
2. In early 1980s, a widow inherited a $4 million account with an investment firm and in addition $30 million of Berkshire Hathaway stock. She anticipated retiring and needed some income going forward. She had lived comfortably but modestly, given her wealth. The reason she was so rich was because all her assets had been well invested in stocks. Her accountant replied that she had all her assets in the stock market which was, by definition, risky. He suggested a charitable remainder trust into which she could put the Berkshire stock, sell it without paying any capital gains taxes, and reinvest the proceeds in bonds for current income. On the other hand, her investment advisor replied even if the stock market dropped 50%, she had enough money to live comfortably until her very old age and asked why she would want to stop enjoying the benefits of future appreciation. She decided to leave everything as it was and received her income needs out of the money she had invested with the investment firm. A number of years later, she reviewed her plan. She had $180 million. Today, she has upward of $300 million.
Financial advisors are risk averse. Their risk aversion may have less to do with your financial situation than their reputations. Conventional wisdom is that a portfolio that is invested one-third in bonds and two-thirds in stocks is the way to go irrespective of the level of your assets. The one-third, two-thirds formula is the standard. It is safe because that is what the herd recommends.
The conventional model of portfolio construction, the one-third bonds two-thirds stocks, requires that you periodically rebalance your holdings. By this, they mean that if your stocks had a particularly great year and now are 75% or 80% of your portfolio, you should sell some stocks and invest the proceeds in more bonds. That is like selling your winners and reinvesting in your losers.
- How smart is that?
- If you already have enough cash to ride out three down years, why do you need more?
The major brokerage houses issue "asset allocation" formulas depending on their view of the stock market in the near term. This sounds like market timing.
However, people are different. Your financial assets and your needs vary tremendously.
- What if you have a lot of dollars and need only a pittance to maintain your lifestyle?
- Why would you invest one-third of your money in an under-performing asset?
The two most important considerations in formulating an asset allocation formula are:
- age. and
- how much money you have to support your desired lifestyle.
Jeremy Siegel's book - Stocks for the Long Run
In every rolling 30-year period between 1871 and 1992, stocks as measured by an index, beat bonds or cash in every period.
In rolling 10-year periods, stocks beat bonds or cash 80% of the time.
Bonds and cash did not beat the rate of inflation over 50% of the time.
So why would anyone own a bond? The answer comes back to age and need.
If you are young (20 years to 35 years) and have a job that pays your bills, you can take a long view on investments.
A lot of what you do in investing is just simple common sense. Many investors think they should be proactive and keep looking for ways to tweak their investment portfolio when just sitting tight, if they made the correct choices in the first place, often would be the better course.
Examples:
Asset allocation is based on age and need.
1. A friend liquidated an asset and wished to invest in the stock market. However, he will need this money for a project he is working on at end of the year. He should not invest this money in stock, as his need for the money did not anticipate any setback in the stock market. If he could not be in for the long term, he should not be in.
2. In early 1980s, a widow inherited a $4 million account with an investment firm and in addition $30 million of Berkshire Hathaway stock. She anticipated retiring and needed some income going forward. She had lived comfortably but modestly, given her wealth. The reason she was so rich was because all her assets had been well invested in stocks. Her accountant replied that she had all her assets in the stock market which was, by definition, risky. He suggested a charitable remainder trust into which she could put the Berkshire stock, sell it without paying any capital gains taxes, and reinvest the proceeds in bonds for current income. On the other hand, her investment advisor replied even if the stock market dropped 50%, she had enough money to live comfortably until her very old age and asked why she would want to stop enjoying the benefits of future appreciation. She decided to leave everything as it was and received her income needs out of the money she had invested with the investment firm. A number of years later, she reviewed her plan. She had $180 million. Today, she has upward of $300 million.
