Stocks Versus Bonds Today

Posted On November 14, 2022 By Admin In Portfolio Management /

Where is the best opportunity – in stocks or bonds? I’ve been enthusiastic about the rising interest rates in 2022 and this has impacted the relative attractiveness of stocks versus bonds today. What do we expect from stocks going forward?

Vanguard’s Investment Strategy Group publishes their projected return for stocks for the next 10 years. And while no one has a crystal ball to know exactly how stocks will perform, this is still valuable information. They look at expected economic growth, dividend yield, and whether stock values (P/E ratios for example) might expand or contract.

Their median 10-year expected return for US stocks is 5.7%, with a plus or minus 1% range, for a range of 4.7% to 6.7%. This is actually up from the beginning of the year. As stocks have fallen by 20%, we are now starting from a less expensive valuation. But a projected return of 5.7% for the next decade would be well below historical averages, and most investors are hoping for better.

Is Vanguard being too pessimistic? No, many other analysts have similar projections which are well below historical returns. For example, Northern Trust forecasts a 6% return on US stocks over the next five years. And of course, these are just projections. Returns could be better. Or worse!

Bonds Are An Alternative

Last week, I bought some investment grade corporate bonds with a yield to maturity of 6% over three to five years. Bonds have much less risk than stocks and have only a fraction of the volatility of stocks. As long as the company stays in business, you should be getting your 6% return and then your principal back at maturity.

If we can buy a good bond with a return of 5.5% to 6.0%, that completely matches the projected stock returns that Vanguard expects. Why bother with stocks, then? Why take the risk that we fall short of 6% in stocks, if we can get a 6% return in bonds? Today, bonds are really attractive, even potentially an alternative to stocks.

For many of our clients, bonds look better than stocks now. And so we may be trimming stocks by year end and buying bonds, under two conditions: 1. The stocks market remains up. We are not going to sell stocks if they fall from here. 2. We can buy investment grade bonds, 3-7 years, with yields of at least 5.5% and preferably 6%. And we have to find different bonds, because we aim to keep any one company to no more than 1-2% of the portfolio.

We won’t be giving up on stocks – not at all. But we may look to shift 10-20% of that US stock exposure to bonds.

Three Paths for the Market

I think there are three scenarios, all of which are okay.

Stocks do way better than 6%. The risk here is that stocks could perform much better than the 5.7% estimate from Vanguard. Maybe they return 8% over the next five years. Well, this is our worst scenario: we make “only” 6% and are kicking ourselves because we could have made a little bit more if we had stayed in stocks.
Stocks return 6% or less. In this case, it is possible we will get the same return from bonds as the expected return from stocks. And if stocks do worse than expected, our bonds might even outperform the stocks. That’s also a win for bonds.
Stocks decline. What if the economy goes into recession, and stocks drop? If stocks are down 10% and we are up 6% a year on bonds, we will be really happy. In a recession, it’s likely that yields will drop and the price of bonds will increase. The 6% bond we bought might have gone up in value from 100 to 104. Then, our total return on the bond might be 10%, and we could be 20% ahead relative to stocks’ 10% drop. And in this scenario, we don’t have to hold the bonds to maturity. We could sell the bonds and buy stocks while they are down.

Smoother is Better

I’m happy with any of those three scenarios. Many investors are feeling some PTSD from the market performance since 2020. Many will be happy to “settle” for 5.5% to 6% from bonds, versus the 5.7% expected return from stocks. And of course, stocks won’t be steady. They may be up 20% one year and down 20% the next. It is often a roller coaster, and so increasing bonds may offer a smoother ride while not changing our expected return by much at all.

Should everyone do this? No, I think if you are a young investor who is contributing every month to a 401(k) or IRA, don’t give up on stocks. Even if the return ends up being the same 6%, you will actually benefit from the volatility of stocks through Dollar Cost Averaging. When stocks are down, you are buying more shares. So, if you are in accumulation, many years from retirement (say 10+), I wouldn’t make any change.

But for investors with a large portfolio, or those in or near retirement, I think they will prefer the steady, more predictable return of bonds. When the yield on bonds is the same as the 5-10 year expected return on stocks, bonds make a lot of sense. The risk/reward comparison of stocks versus bonds today is clear: bonds offer the same expected return for less risk. We will be adding to bonds and adjusting our portfolio models going into 2023.

Bonds in 2022

Posted On December 12, 2021 By Admin In Portfolio Management /

Resuming last week’s Investment Themes, today we consider Bonds in 2022. It is a challenging environment for bond investors. We are coming off record low yields and the yield on the 10-year Treasury is still only 1.5%. At the same time, yields are starting to move up. And since prices move inversely to yields, the US Aggregate Bond index ETF (AGG) is actually down 1.74% year to date. Even including the yield, you’ve lost money in bonds this year. With stocks having a great year in 2021, it is frustrating to see bonds dragging down the returns of a diversified portfolio.

Inflation Hurts Bonds

Inflation is picking up in the US and globally. Supply chain issues, strong demand for goods, and rising labor costs are increasing prices. The Federal Reserve this week said they would be removing the word “transitory” from their description of inflation. And now that it appears that Jay Powell will remain the Chair, it is believed that the Fed will focus on lowering inflation in 2022. They will reduce their bond buying program which has suppressed interest rates. And they are expected to gradually start increasing the Fed Funds rate in 2022.

It is difficult to make accurate predictions about interest rates, but the consensus is that rates will continue to rise in 2022. So, on the one hand, bonds have very little yield to offer. And on the other hand, you will lose money if interest rates continue to climb. Then, to add insult to injury, most bonds are not maintaining your purchasing power with inflation at 6%.

Bond Themes for 2022

There aren’t a lot of great options for bond investors today. But here are the bond investment themes we believe will benefit your portfolio for the year ahead. This is how we are positioning portfolios

We will be increasing our allocation to Floating Rate bonds (“Bank Loans”). These are bonds with adjustable interest rates. As rates rise, the interest charged goes up. These are a good Satellite for rising rate environments.
Within core bonds, we want to reduce duration to shorter term bonds. This can reduce interest rate risk.
We continue to hold Preferred Stocks for their yield. While their prices will come under pressure if rates rise, they offer a continuous cash flow.
Ladder 5-year fixed annuities. I have been beating this drum for years. Still, multi-year guaranteed annuities (MYGA) have higher yields than CDs, Treasuries, or A-rated corporate and municipal bonds. If you don’t need the liquidity, MYGAs offer a guaranteed yield and principal.
I previously suggested I-Series Savings Bonds rather than TIPS. These are linked to inflation and presently are paying 7.12%. Purchases are limited to $10,000 a year per person, and unfortunately cannot be held in a brokerage account or an IRA. Read my recent article for more details. I personally bought $10,000 of I-Bonds this week.

Purpose of Bonds

Even with a negative environment for bonds, they still have a role in most portfolios. Unless you have the risk capacity to be 100% in stocks, bonds offer crucial diversification. When we have a portfolio with 60% stocks and 40% bonds, we have an opportunity to rebalance. When stocks are down, like in March of 2020, we can use bonds to buy more stocks while they are on sale. And of course, a portfolio with 40% in bonds has much less volatility than one which has 100% stocks.

Yields may eventually go back up to more normal levels. While it would be nice to have higher yields, the process of yields going up will be painful for bond investors. Our themes are trying to reduce this “interest rate risk”. We hope to reset to higher rates in the future, while reducing a potential loss in bond prices in 2022.

Three Studies for Smart Investors

Posted On June 1, 2014 By Admin In Portfolio Management /

Over the last several years, my investment approach has become more systematic and disciplined. In place of stock picking or manager selection, I believe clients are better served by a focus on strategic asset allocation. Today, we offer investors a series of 5 portfolio models, using ETFs (Exchange Traded Funds) and mutual funds. This approach offers a number of benefits, including diversification, low cost, transparency, and tax efficiency.

This evolution in approach occurred gradually as a result of continued research, personal experience, and pursuing the goal of a consistent client experience. In my previous position, I managed $375 million in client portfolios, performing investment research, designing asset allocation models, rebalancing and implementing trades. I am grateful for having this experience and want to share the reasons why I believe investors are best served by the approach we’re using today.

My investment approach is underpinned by three academic studies. These studies look at long-term investment performance, are updated annually, and offer great insight into what is actually working or not working for investors. As an analyst, I am very interested in what data tells us, and how this may differ from what we think will work or what should work in theory. But even if you aren’t a numbers geek like me, these studies instruct us about investor behavior and where you should focus your efforts and energy. I’m going to give a very brief summary of each study and include a link if you’d like to read more.

1) Standard & Poors Index Versus Active (SPIVA)

Published semi-annually, SPIVA looks at all actively managed mutual funds and calculates how many active managers outperform their benchmarks. The long-term results are consistently disappointing. As of December 31, 2013, 72.72% of all large cap funds lagged the S&P 500 Index over the previous five years.

Sometimes, I hear that Small Cap or Emerging Market funds are better suited for active management because they invest in smaller, less efficient markets. This sounds plausible, but the numbers do not confirm this. The data from SPIVA shows that 66.77% of small cap funds lagged their benchmark and 80.00% (!) of Emerging Market funds under performed over the past five years.

The lesson from SPIVA is that using an index fund or ETF to track a benchmark is a sensible long-term approach. Indexing may not be exciting or produce the best performance in any given year, but it has produced good results over time and reduces the risk that we select the wrong fund or manager. Our approach is to use Index funds as a core component to our portfolio models.

The other conclusion I draw from SPIVA is that if large mutual fund companies, with hundreds of analysts, cannot consistently beat the benchmark, it would be foolish to think that a lone financial advisor picking individual stocks could do better.

2) S&P Persistence Scorecard

After looking at SPIVA, it may occur to investors that 20-35% of funds actually did beat their benchmarks over 5 years. Why not just pick those funds? Why settle for average when you can be in a top-performing fund?

The S&P Persistence Scorecard looks at mutual funds over the past 10 years. At the 5-year mark, the scorecard ranks funds in quartiles by performance and looks at how the funds’ returns were in the subsequent five years. This tells us if a top performing fund is likely to remain a leader.

Looking at all US Equity funds, we start with the funds which were in the top quartile in September 2008. Below is breakdown of how those top quartile funds ranked in the subsequent five years, through September 30, 2013:

1st Quartile: 22.43%

2nd Quartile 27.92%

3rd Quartile: 20.53%

4th Quartile: 16.71%

Merged/Liquidated: 12.41%

Of the funds in the 1st Quartile in 2008, only 22% remained in the top category in the following 5 years. 29%, however, fell to the bottom quartile or were merged or liquidated in the following 5 years. So, if your method is to go to Morningstar and find the best performing fund, please be warned,past performance is no guarantee of future results. In fact, the Persistence Scorecard tells us that not only is past performance not a guarantee, it isn’t even a good indicator of future results. The results above aren’t much different than a random chance of 1 in 4 (25%). Albeit disappointing and counter-intuitive, the reality is that past performance offers virtually no predictive information.

3) Dalbar Quantitative Analysis of Investor Behavior (QAIB)

Now in its 20th year, QAIB compares mutual fund returns to investor returns. The reason why they differ is because of the timing of investors’ contributions and withdrawals from mutual funds. For example, people may think that it is safer to invest when the market is doing well and they buy at a high. Or, investors chase last year’s hot sector and sell out of a fund that is at a low and just about to turn around. Investor decisions are consistently so poor that we can actually measure the gap between the average investor’s return and the benchmark. You might want to sit down for this one – over the 20 year period through 2013, the S&P 500 Index returned 9.22% annually, but the average investor return from equity mutual funds was only 5.02%. The behavior gap cost investors 4.20% a year over two decades.

We can draw three very important conclusions from QAIB:

– We should avoid trying to time the market (buy/sell);

– Chasing performance is more likely to hurt returns than improve returns;

– Without a disciplined approach, including a target asset allocation and monitoring/rebalancing process, what may feel like a good investment decision at the time may ultimately prove to be a poor choice in hindsight.

These three studies are so important that I carry excerpts from the reports with me to discuss with investors. They’re fundamental to my investment approach, and hopefully, their significance can easily be grasped and appreciated by all our clients.

While we’ve focused exclusively on investment philosophy in this post, I would be remiss to not add that the benefits of working with a CFP(R) practitioner are not limited to portfolio management. A comprehensive financial plan includes many elements, such as savings/debt analysis, risk management, tax strategies, and estate planning. The investment management component tends to get the greatest attention, but the other elements of a personal financial plan are equally important in creating a foundation for your financial security.