The question is, if stocks offer so much better returns, why should anyone invest anything in bonds? Why not put 100 percent into stocks and forget about bonds?
The standard reply is volatility. You can begin to see the bumpiness in stocks in Figure 1.2. Stock returns fluctuate much more widely than bond returns, especially over the short run. The actual year-to-year returns are shown in Figure 1.4, and they fol- low a random, almost violent up and down pattern. Bond returns, by comparison, are much steadier. Some fluctuations are still pres- ent from the before-maturity changes in the value of bonds, but the magnitude is far less than with stocks.18
These observations again made the brokers’ recommendations easy. Any investor who wished to avoid volatility and the associated risk (“conservative investors”) should put more in bonds and less in stocks. Again, the charts and the historical record supported this without question.
There is a flaw in the volatility argument, however. Volatility by itself does no harm. It becomes harmful only when it creates risk, which is the product of three factors. The first factor is, indeed, variations in the value of the portfolio resulting from fluc- tuations in stock prices (bonds are also guilty, but much less so than
$1643
$62
$0
$500
$1000
$1500
$2000
$2500
$3000
1926 1930 1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002
Large Co. Stocks (S&P 500) Int Term Gov Bonds
Figure 1.3
Large-Company Stocks (S&P 500) versus Intermediate Government Bonds, Linear Scale, 1926–2002
Source:Table 1.1.
stocks). The second factor, however, has nothing to do with the mar- ket. It is the probability that funds will have to be withdrawn from the portfolio for some reason (for an emergency, a regular with- drawal, or whatever). The third factor is probability that the stocks have to be sold at just the wrong time, when the market is down (whatever “down” means). If all three of the factors line up against the investor often enough, it could gradually consume the capital in the portfolio. This is a legitimate fear of someone who has highly probable or definite cash flow needs that must be met by the port- folio. But volatility is only one of the three critical ingredients and by itself is not harmful.
For example, someone who is saving money for retirement by depositing funds in a retirement account such as a 401(k) or a sim- ilar plan has a very low probability of needing to withdraw funds from this account. This means that there is very little risk associ- ated with the fluctuations in a retirement account during most of a person’s life. There is, therefore, little reason to include bonds in a preretirement portfolio. An argument could be made that some- one who is within 5 years or so of retirement should consider bonds to avoid the fear of a significant decline, but prior to that time, 100 percent in stocks is a winning strategy. The research presented in Chapter 4 will verify what the charts make obvious: At the end of the day, it is better to get a higher return than to worry about volatility unless you are withdrawing funds.
Asset Allocation—the Dominant but Procrustean Paradigm 15
-60%
-40%
-20%
0%
20%
40%
60%
1926 1930 1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002
Large Co. Stocks (S&P 500) Int Term Gov Bonds
Figure 1.4
One-Year Returns, Large-Company Stocks (S&P 500) versus Intermediate Government Bonds, 1926–2002
Source:Table 1.1.
In fact, a number of academic researchers have pointed out that fluctuations are actually the long-term investor’s friend because they generate higher overall returns in the long run.
Indeed, the table and figures presented here demonstrate that investors who held 100 percent small-company stocks over the long term would have a much higher ending value in their portfo- lio than those who held almost any other investment. Consider the investor who had $10,000 to invest at the end of 1925. If she had invested completely in bonds, then by the end of 2002, she would have $620,000; if she had invested completely in stocks, she would have $16,430,000. The difference, about $16 million, is a very high price to pay for avoiding volatility.
An investor who dilutes his or her portfolio’s growth by hold- ing bonds in that portfolio ends up with a much lower ending value. He or she suffers a lower standard of living as a result of needlessly avoiding fluctuations that are irrelevant and harm- less. Such people will have lost far more money from the lower return than they would have lost if they had taken other steps (insurance, loans, or whatever) to cover themselves.
Yet most financial advisers blindly and slavishly advise their clients to follow the asset allocation formulas put out by their managers and supervisors. In the long run, their clients end up worse off. They may have suffered less volatility, but was it worth it? It is a little like advising drivers to carry around 10 spare tires just in case they have 10 flat tires on a trip. Would it be worth it?
To summarize, the theory of asset allocation suggests that the proportion of money invested in various asset classes explains a large part of why portfolios move the way they do. Primarily for this reason, most financial advisers recommend that their clients follow an asset allocation plan based on an XYZ formula. For investors who fear the risks of short-term volatility more than they fear long-term loss, the generic recommendation is to put more in bonds and less in stocks. For aggressive investors who can better tolerate volatility, the reverse is recommended: Put more into stocks and less into bonds. The financial community embraced asset allocation because it promised significant advan- tages that were especially compelling in the adviser/client inter- face:
1. It was easy to understand (on the surface).
2. It promoted uniformity in recommendations.
3. It appeared to explain 90 percent of the variability in returns.
4. It was a great sales pitch.
The next chapter explores the down side of asset allocation as an approach to personal investing. For large, multimillion-dol- lar portfolios (such as pension funds and mutual funds), asset allocation may make sense as a way of dealing with the problems faced by their managers. But the rest of this book challenges its efficacy for the investment issues faced by individual investors who are not concerned with managing millions of dollars. They simply want guidance to avoid major blunders in managing their retirement funds so that they can live normal lives free of finan- cial fear. Asset dedication will provide that guidance.
NOTES
1. Gary P. Brinson, L. Rudolph Hood, and Gilbert L. Beebower, “Determinants of Port- folio Performance,” Financial Analysts Journal, July-August 1986, pp. 39–44.
2. Ibbotson Associates, SBBI 2003 Yearbook: Market Results for 1926-2002: Stocks, Bonds, Bills, and Inflation (Stocks, Bonds, Bills and Inflation Yearbook, 2003),p.
116.
3. Roger G. Ibbotson and Paul D. Kaplan, “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal,January-February 2000, p. 26.
4. William F. Sharpe, Gordon J. Alexander, and Jeffery V. Baily, Investments,5th ed.
(Englewood Cliffs, N.J.: Prentice-Hall, 1995), p. 478.
5. William W. Jahnke, “The Asset Allocation Hoax,” Journal of Financial Planning, February 1997, pp. 109–113.
6. Brinson, Hood, and Beebower, “Determinants of Portfolio Performance.”
7. The generic term for stocks is equities and that for bonds is fixed-income securities.
Cash means any liquid investment, such as a money market account, a savings account, Treasury bills, or any equivalent security that can be quickly converted into cash.
8. This is why financial advisers tend to focus on annual rates of return. Minor differ- ences in rates can make major differences in dollar amounts over time.
9. The statistical tool used was regression analysis, and the 94 percent comes from the measure known as RSquared. It is beyond the scope of this book to go into the statistical merits and caveats regarding the Brinson study. Interested readers are referred to the papers in the next note.
10. Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, “Determinants of Portfolio Performance II: An Update,” Financial Analysts Journal,May-June 1991, pp. 40–48. Many other articles have been written comparing the absolute or rela- tive performance of mutual funds to index funds or to each other, but a sampling would include the following: (1) E. J. Elton, M. J. Gruber, and C. R. Blake, “The Persistence of Risk-Adjusted Mutual Fund Performance,” Journal of Business69,
Asset Allocation—the Dominant but Procrustean Paradigm 17
April 1996, pp. 133–157. (2) W. N. Goetzmann and R. G. Ibbotson, “Do Winners Repeat? Patterns in Mutual Fund Return Behavior,” The Journal of Portfolio Man- agement20, Winter 1994, pp. 9–18. (3) M. Grinblatt and S. Titman, “The Persis- tence of Mutual Fund Performance,” Journal of Finance47, December 1992, pp.
1977–1984. (4) M. J. Gruber, “Another Puzzle: The Growth in Actively Managed Mutual Funds,” Journal of Finance51, July 1996, pp. 783–810. (5) D. Hendricks, J.
Patel, and R. Zeckhauser, “Hot Hands in Mutual Funds: Short Run Persistence of Relative Performance, 1974–1988,” Journal of Finance48, March 1993, pp. 93–130.
(6) R. D. Henriksson, “Market Timing and Mutual Fund Performance: An Empirical Investigation,” Journal of Business57, January 1984, pp. 73–96. (7) M. C. Jensen,
“The Performance of Mutual Funds in the Period 1945–1964,” Journal of Finance 23, May 1968, pp. 389–416. (8) Jeffrey M. Laderman, “The Stampede to Index Funds,” BusinessWeek, Apr. 11, 1996, pp. 78–79. (9) B. G. Malkiel, “Returns from Investing in Equity Mutual Funds 1971 to 1991,” Journal of Finance50, June 1995, pp. 549–572. (10) W. F. Sharpe, “Mutual Fund Performance,” Journal of Business 39, January 1966, pp. 119–138. (11) Marlene G. Star, “Active Investing vs. Index- ing: The Bogles Disagree,” Pensions and Investments,Feb. 19, 1996, p. 3. (12) R. A.
Strong, Practical Investment Management(Cincinnati, Ohio: South Western Col- lege Publishing, 1998), p. 432. (13) Vanguard Corporation, Vanguard Index Trust: A Broad Selection of U.S. Stock Index Funds(Valley Forge, Pa.: Vanguard Marketing Corporation, 1998). (14) E. T. Veit and J. M. Cheney, “Are Mutual Funds Market Timers?” The Journal of Portfolio Management8, Winter 1982, pp. 35–42. (15) D. A.
Volkman and M. E. Wohar, “Abnormal Profits and Relative Strength in Mutual Fund Returns,” Review of Financial Economics5, January 1996, pp. 101–116.
11. The percentage allocated to cash, by the way, usually plays a minor role in the decision-making process. This is due to the fact that cash traditionally offers a very low return. It tends to be used primarily for emergencies or as a temporary parking place for stock or bond money (or, as some cynics suggest, a convenient source for paying adviser’s fees). The real decision point is the split between stocks and bonds.
12. The terms small cap, large cap,and so on have technical definitions that will be discussed in Chapter 11, but the intuitive interpretations are correct. “Cap” stands for capitalization. Small cap companies are those with annual sales of less than $1 billion, whereas large cap companies have over $10 billion. The terms small-cap, small-company, large-cap,and large-companywill be used interchangeably.
13. The Center for Research in Security Prices (CRSP®) is one of the premier providers of high quality data for research. Statistics on the performance of small cap stocks are compiled by Dimensional Fund Associates. Its principals include Eugene Fama and Kenneth French, who wrote the original papers that led to the classification scheme for public companies, such as small-cap growth, small-cap value, mid-cap growth, mid-cap value, and so on (http://www.dfaus.com/).
14. ©June 2004, CRSP® Center for Research in Security Prices, Graduate School of Business, The University of Chicago; used with permission. All rights reserved.
www.crsp.uchicago.edu. Data provided as follows:
Asset Class 1: 1925-2002, CRSP Cap-based 9-10
Asset Class 2: 1925-2002, CRSP S&P 500 Value-weighted Index Asset Class 3: 1925-2002, CRSP 30-day T-Bill Index
Asset Class 4: 1942-2002, CRSP 5-year Treasury bond (see Note 2) Asset Class 5: 1942-2002, CRSP 20-year Treasury bond (see Note 2)
15. © June 2004, Global Financial Data, Inc., Los Angeles, CA 90042 USA. All rights reserved. www.globalfindata.com. Data provided as follows:
Asset Class 4: 1926-1941, 5-year U.S. Treasuries (TRUSAG5M File)
Asset Class 5: 1926-1941, estimated from regression analysis of CRSP 20-year Treasury bond data and GFD 10-year U.S. Treasury bond data (TRUSAGVM File)
Asset Class 6: 1926-2002, Dow Jones Corporate Bond Total Return Index (DJCBTM File)
16. Many times people do not really know where their portfolio ought to be at each point in time if it is to have a particular growth rate. Chapter 4 will introduce the critical path concept, which shows what a portfolio should be worth at each point if it is to reach a specified target. Chapter 5 will explain the critical path in detail.
17. These figures are slightly off because of rounding errors. Also, inflation would reduce these figures by a significant amount but would not change the relative position. As prices rise, the ending value of the portfolio has to be discounted by whatever amount prices have increased. Between 1926 and 2002, inflation aver- aged 3.0 percent per year. So items that cost $1 in 1926 would have risen to $10.09 in 2002. This means that the stocks’ ending value of $1643 is worth only $163 in real purchasing power ($1643/10.09 = $162.83), and the bonds’ $62 is worth only $6 ($62/10.09 = $6.14). These are a better reflection of the true value of each portfolio and illustrate that both stocks and bonds beat inflation, but stocks do so by a far greater margin.
18. Forecasting these year-to-year fluctuations is a challenge to statisticians and econo- mists who are trying to provide accurate projections. Day-to-day fluctuations are even more violent in relative terms. Much of a year’s total gain is typically achieved in just a few trading days, with bland returns the rest of the year. This “biggest days” impact drives forecasters to the brink of insanity. No one can forecast them (see Chapter 14).
Asset Allocation—the Dominant but Procrustean Paradigm 19