Tag Archives: modern portfolio theory

What Your Advisor Believes (And Why You Should Question It)

Chances are your financial advisor believes in two related intellectual theories that you should question them about.

In a recent article, the excellent columnist Brett Arends wrote about the two theories governing most financial advisors – the efficient markets hypothesis (EMH) and the capital asset pricing model (CAPM). These sound like impossibly complicated things, but they’re not. The first theory says prices are right, or nearly right all the time, and that it’s, therefore, basically impossible to beat markets. The second theory says historical asset class returns will repeat and that the more risk you take (with risk meaning volatility), the more return you will make. So, for example, stocks are very volatile, but they’ll produce the best returns — something like 10% annualized (or 6.5%-7% after inflation) – over longer periods of time.

Theoretical Problems

But the theories aren’t always right. For example, if stock prices reflect all available information, why are they so volatile, as Arends asks? It may be because that information is always incomplete, and as more information emerges prices change accordingly — and correctly. But extreme volatility may also exist because people are irrational or emotional, and substitute stories or “narratives” for more rigorous analysis or even basic common sense. The rise of the tech bubble, for instance, wasn’t an example of new information being priced in as much as it was an instance of people’s imaginations getting the better of them, andcausing them to inflate the prices of stocks that had no underlying earnings or even revenues.

More problems: why have U.S. stocks (the S&P 500 including dividends) produced a less than 6% nominal return from 2000 through November 2018? Why did they deliver nothing but dividends from the mid-1960s through the early 1980s? And if stocks are such inflation-beaters, why did the S&P 500, including dividends, return only 65 annualized in the 1970s, far underperforming that decade’s inflation?

Future Returns

The facts of the matter are that prices aren’t efficient and asset class returns may not repeat for the, say, 25-year period your retirement plan is counting on them to do so. Bonds returns, for example are easy to forecast. They generally follow the yield-to-maturity. That means a portfolio of 8-year or so domestic investment grade bonds, such as one finds in a fund tracking the Bloomberg Barclay’s US Aggregate Index, now will almost certainly deliver around 3.3%.

And for the S&P 500 Index to return 10% over the next decade, it must trade at a higher P/E ratio than it does now in addition to delivering around a 2% annual dividend payment and 4%-5% earnings-per-share growth. That’s possible, but unlikely, because U.S. stocks are trading at around 30 times their past 10-years’ worth of earnings. They’ve only been that expensive in their runs in 1929 and 2000. Although nobody can be certain, it’s more likely that P/E ratios will decline over the next decade, not increase, cutting into the 6%-7% nominal return from dividends and earnings-per-share growth. Adherents of CAPM, don’t view the world this way, and think prices can keep rising so that it’s almost a long-term investor’s birthright to achieve 10% annualized returns.

If your broker or advisor can’t respond to these objections that their assumed future returns might be off – by a lot – there’s a good possibility that they’re too dogmatic, and have swallowed academic finance without digesting it or thinking about it.

What this means for your portfolio

The problems in these theories mean your portfolio may not be set up to satisfy your financial plan. As Arends mentions in another article, for the decade from 1938 to 1948 a balanced portfolio went backwards relative to inflation. It did the same disappointing thing from 1968 through 1983. With the Federal Reserve taking us into uncharted waters and returns prospects for major asset classes so low, investors should look at cash, real estate, foreign stocks, and commodities, including gold.

None of these by themselves is foolproof. Some of them have performed well in some instances when stocks and bonds have faltered, and others have performed well at other times when stocks and bonds have faltered. The most important thing is that an advisor sensitive to how warped the current market and situation are right now may be your best defense against tepid stock and bond returns. Making sure your advisor hasn’t fallen hook, line, and sinker for the Efficient Market Hypothesis and the Capital Asset Pricing Model may be the best way for you to navigate the next decade or so in the markets.

Volatility Is The Price Of Admission To Financial Markets

If it feels to you as if volatility has returned to the stock market, you’re right. But, although we’ve had a bad month in October so far with a nearly 10% loss in U.S. stocks, the calm we’ve had over the past few years is more unusual. And that makes this volatility feel worse than it should.

Garden Variety Correction

Here are a few statistical facts that should put the recent volatility into perspective. First, the S&P 500 Index was up around 11% for the year at its recent peak, including dividends. Now, through Wednesday, October 24th, it’s up 0.88% for the year. That means we’ve had a garden variety correction of around 10% so far. A bear market would be a decline of 20% from the market peak, and that would mean stocks would have to drop around another 10% from here to achieve that. It’s possible that will happen, but, even if it does, we’re only halfway there at this point.

And if we do enter a bear market, that won’t be so unusual either. We haven’t had one since the financial crisis and recession of 2008, after all, and this is now the longest running bull market in history. In fact, the length of the bull market, which started in March of 2009, is what makes any volatility feel unusual – even an ordinary 10% correction.

Calm Creates Complacency

Another important statistic that makes this correction feel unusual is that the S&P 500 Index didn’t drop in a single month in 2017 as it posted a nearly 22% return for the year. That was the first time in history the index didn’t record a negative month in a calendar year, and periods marked by such calm, especially if they come during  the longest bull market in history, make investors complacent.

There is a tendency for investors to feel invulnerable after such periods, even though that kind of calm should make investors nervous about when the next bout of volatility will arrive. The human mind doesn’t work that way though. Behavioral economics has shown that we have a strong tendency toward “recency bias,” meaning we extrapolate whatever hash happened in the recent past onto the future. That often makes us nervous when we should be calm and a little too calm when we should be a little nervous.

It’s true that at the beginning of this year volatility arrived again in February and March when the stock market gave up the roughly 10% gain it achieved during the first few weeks of January. But then calm ensued, and the market marched up nearly uninterrupted to match its earlier gain from January. By the beginning of October, complacency and recency bias had set in again.

Bonds Bring Ballast

Consider also that bonds have done their job by holding steady and bringing ballast to portfolios while stocks have dropped. The Bloomberg Barclay’s U.S. Aggregate Index is down 0.55% for the month of October. It’s true that you might expect bonds to be up a little for the month. It often happens that stock market declines cause a rally in investment grade corporate and especially government bonds, so a slight decline in the main bond index is a little unusual. But it’s nothing extreme, and having a part of your portfolio so stable when the stock market is declining can be a blessing.

This leads us to consider a balanced portfolio, which usually consists of 60% stocks and 40% bonds. This classic allocation has served generations of investors well with its moderate risk/reward profile, and it happens that a domestic index balanced portfolio is down a little less than 1% for the year through October 24th. A global balanced portfolio is down more – around 4%. But that’s not catastrophic either.

Also, the historical “standard deviation” or volatility of a moderate or balanced allocation has been around 10%. That means investors can expect a range of returns within 10 percentage points in either direction around such a portfolio’s average return of 7% per year. So far, we are within that tolerance. And standard deviation isn’t perfect; it only captures most of the deviations around the average return, not all of them. There are times when balanced portfolios will have a wider range of return including losses than a 10 percentage point deviation around the average return. But we are nowhere near these larger losses yet.

Here, again, investors may be fooled by recency bias. Morningstar’s moderate allocation category has delivered a standard deviation of over 9% for 15 years, but only around 6% or one-third less for 3 years.


Overall, investors should remember that although October has been a bad month, the volatility we’ve experienced over the past few years is well below average. October has been a reminder that volatility is part of the “price of admission” to the financial markets.

Are Corporate Bonds Worth The Risk?

Reprint of my latest article for Citywire —-

What are the benefits of adding exposure to investment grade corporate bonds (IGCs) in a stock and bond portfolio?

It may sound like a simple – possibly even stupid – question, but new research suggests that IGCs might not be all they’re cracked up to be. You might even be better off sticking with plain old Treasurys.

The conventional wisdom is that IGCs should improve a portfolio’s volatility-adjusted returns. After all, corporate bonds typically have higher coupons than government bonds without having completely similar trading patterns.

Unfortunately, according to recent research by Jared Kizer of Buckingham Asset Management, the yield premium of IGCs over government bonds doesn’t add much at all to the risk-adjusted returns of a stock-and-government bond portfolio.

In a new paper, Kizer has found that the supposedly attractive premium is based on the historical numbers of the early part of one data set when, especially during the Great Depression, significant credit stress delivered high returns to investors for very highly rated corporate bonds.

Kizer went on to question the veracity of that early data, showing that in later periods – the past 50 years – corporates haven’t added risk-adjusted benefits to performance. We will come back to that dodgy dataset shortly, but for now let’s focus on the past half century.

Examining the period from 1969 to October 2017 using Ibbotson data spliced with some from Bloomberg, Kizer found a compounded return premium of IGCs over government bonds of 1.1% per year. By itself, that is statistically significant. However, Kizer also found that the return premium can be explained by different equity factors, including size, value, momentum and others.

Then, using just the Bloomberg data from 1973 to October 2017, Kizer identified an IGC premium that isn’t statistically significant even before accounting for the equity factors. Basically, adding corporate bonds to a portfolio of stocks and government bonds adds nothing to the volatility-adjusted returns of those portfolios.

Next, as he did in a different piece of research into the diversification benefits of real estate investment trusts with Sean Grover, Kizer tried to replicate the performance of IGCs in portfolios constructed without them. Using four simple portfolios of capitalization-weighted stock indices and government bonds, Kizer found that he was able to replicate the performance characteristics of corporate bonds, concluding that ‘corporate bonds are redundant in portfolios that own stocks and government bonds.’

Misdirected affection

But if this is so, why have others thought that corporate bonds added diversification?

A previous research paper by Attakrit Asvanunt and Scott Richardson touted the benefits of IGCs, but as Kizer explained, the evidence that Asvanunt and Richardson marshalled was unduly influenced by the period around the Great Depression, when corporate bonds might have added diversification. Kizer also doubted the accuracy of some of the early period data.

Specifically, Kizer found a significantly higher Sharpe ratio for the IGC premium compared with either equities or interest rate risk during the period encompassing the Great Depression. Anomalous high returns during the 1930s, a period of significant credit stress and an IGC premium in excess of 2.5% per year in this early period for an index focused on AA and AAA corporate bonds resulted in an IGC premium that seems to be completely disconnected from the frequency of corporate bond defaults.

Directing his analysis to the period between 1930 and 1968 in the Ibbotson data, Kizer found that the IGC premium for that period was ‘more than two times higher than market premium and almost five times higher than the term premium over the pre-1969 period.’ The IGC premium itself was 2.6 % per year, which is high considering that the Ibbotson data is oriented toward the highest quality (AA and AAA) corporate bonds. What’s more, Kizer found that the Sharpe ratio of the IGC premium was well in excess of one in the 1930s and 1940s, but never one or higher in any other decade through 2009. The IGC premium had the highest risk-adjusted returns in three of the four
early-period decades.

Dodgy data

All of this is suspicious because default rates were highest in the 1930s, according to Moody’s data. Somehow, the IGC premium was highest when defaults were highest. Moody’s also reports almost no corporate defaults from the early 1940s through the 1960s, meaning that one might expect the 1940s to have produced a higher IGC premium than the 1930s. Although Kizer wasn’t sure, he suspected that the early data tracked bonds that were rated AAA or AA, but then dropped them if they were downgraded or if they defaulted. That means that their poor performance might not have been accounted for accurately.

The upshot for investors is that adding a permanent allocation of investment grade corporate bonds to a portfolio of stocks and government bonds does not increase that portfolio’s risk-adjusted returns. Kizer did allow for the fact that it might be possible to add corporate bonds opportunistically, or when spreads are relatively wide, reducing exposure to them again when spreads contract. This could theoretically enhance a portfolio’s risk-adjusted returns.

Of course, just as we might be living in a period of higher equity valuations, we might also be living in a period of tighter spreads. That would make such an operation difficult to execute and perhaps not worth the risk premium – or the lack thereof.

Is Your Target-Date Fund Too Risky?

If you’re planning to retire in or around 2020, and you have most or all of your assets in a target date fund, is that fund too risky? It might be given current stock market valuations.

I recently published an article on how various allocations served a hypothetical investor retiring in 2000. Any backtest begun that year would admittedly be unflattering to stock exposure, but retirees must think in worst-case scenarios because they are at risk of running out of money. And stocks may not be much cheaper now than they were in 2000.

In that article, I used the following chart to show how each hypothetical portfolio performed using the so-called 4% retirement rule, whereby the retiree withdraws 4% from his account in the first year of retirement, and boosts whatever the dollar value of that initial withdrawal by 4% each year thereafter.

It turned out that a pure stock portfolio couldn’t withstand the 4% rule given the amount of declines in two bear markets – from 2000 through 2002 and in the 2008-early 2009 period. The original $500,000 would have declined to a little more than $100,000 in the 18 year period. A balanced portfolio did much better; it would be down to a little more than $400,000. A still more conservative portfolio – 30% stocks and 70% bonds – would have remained intact. In other words, the more bonds a portfolio had, the better it held up despite the fact that stocks outperformed bonds on a compounded annualized basis – 5.4% for stocks  versus 5.1% for bonds.

And now most 2020 retirement funds have more than 50% stock exposure, potentially setting up their investors for a bumpy ride and loss of capital. On our list of some of the largest funds with 2020 dates, only the American Funds offering and the JP Morgan entry have less than 50% stock exposure.

Stocks reached a Shiller PE (price relative to the past decade’s average real earnings) of 44 in 1999, and they are at 32 now. The 44 reading seems far away, but, besides that extravagant reading during the technology bubble, the metric has been over 30 only one other time – in 1929.

Moreover, the median stock, on a variety of valuation metrics, is more expensive now than it was in 2000. For example, GMO’s James Montier recently showed that the median price/sales ratio is higher now than it has been in any other time in history. During the technology craze, small cap value stocks and REITs, for example, were left for dead, and investors prowling for cheap stocks could buy them, and wait. They wound up delivering boffo returns for the next decade. From 2000 through 2009, when the S&P 500 Index delivered no return, the Russell 2000 Value Index delivered an 8.3% annualized return to investors. But now there are arguably no cheap parts of the market.

Valuation metrics aren’t crash predictors; they don’t tell you a crash will occur next week, next month, or next year. But it’s reasonable to anticipate that the higher valuation metrics go, the more likely a significant decline or significant volatility become. And big declines hurt retires withdrawing from their accounts dramatically.

It’s also true that foreign stocks are cheaper, but they’re not that cheap. GMO’s most recent asset class return forecast shows no region of the world is poised to deliver inflation-beating returns. That means target date funds may be putting their client assets unnecessarily at risk. In 2013, Jack Bogle argued that target date funds were too heavily weighted in bonds, potentially crimping investor returns. With a Shiller PE above thirty and bond yields creeping up, the opposite might be the case now.

Financial planner and author Michael Kitces has shown that the Shiller PE works well as a financial planning tool, indicating what future returns stocks might deliver over intermediate time frames — around 8-18 years. Though a bit short on details, Kitces argues that the metric can help retirees facing sequence of return risk by encouraging them to adjust their spending. But it’s unclear why the metric can’t influence gentle portfolio modifications as well. When the Shiller PE is over 30, the likelihood of robust returns — or even returns that can beat bonds, despite low yields — is diminished after all. Nobody should ditch all their stock exposure; markets can always surprise investors. But retirees face such a harsh outcome if their portfolios suffer big declines during the first decade of retirement that modest stock exposure — even less than 50% stock exposure — appears the most prudent course. Unfortunately, judging from their allocations, target date funds may not be aware of the risk they’re imposing on their shareholders.

Target date funds are allocated based on investors’ distance from their spending goals. Even setting aside the difficulty of the retirement spending goal, which run over years and decades, distance from goal shouldn’t be the only consideration in answering the allocation question. Target date funds should also consider valuation and sensitivity to volatility.