Revisit asset allocation in present environment

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Revisit asset allocation in present environment

Postby Justise » 10 Sep 2010 09:40

Is the asset allocation e.g. some say 60% stocks, 40% bonds, still a logical choice in the present environment of exceptionally low interest rates or bond yields? In the present interest rate cycle, insurance companies are mostly in the penalty box. Therefore, strategically, shouldn't bond portion be allocated to livecos?
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Re: Revisit asset allocation in present environment

Postby scomac » 10 Sep 2010 11:05

Justise wrote:Therefore, strategically, shouldn't bond portion be allocated to livecos?


Not if you need the cash with certainty at a specific point in the future. A bond will do that for you. There are no such assurances from owning shares in lifecos.
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Re: Revisit asset allocation in present environment

Postby queerasmoi » 10 Sep 2010 11:22

Justise wrote:Is the asset allocation e.g. some say 60% stocks, 40% bonds, still a logical choice in the present environment of exceptionally low interest rates or bond yields? In the present interest rate cycle, insurance companies are mostly in the penalty box. Therefore, strategically, shouldn't bond portion be allocated to livecos?


The whole point of a bond allocation is that it's less volatile. You don't know with certainty what any company's equity shares are going to do. You just hold onto your allocation, stick to the plan, rebalance periodically, and take a long view. Considering that CDN equity indexes are already heavily weighted towards financials (~30%), your equities are already pretty correlated to lifecos. If you take a sector bet today, all you do is concentrate your risk.
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Re: Revisit asset allocation in present environment

Postby MaxFax » 10 Sep 2010 11:34

I think your decision depends on whether your goals are optimizing returns, or asset class diversification.
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Re: Revisit asset allocation in present environment

Postby Justise » 10 Sep 2010 12:32

MaxFax wrote:I think your decision depends on whether your goals are optimizing returns, or asset class diversification
queerasmoi wrote:The whole point of a bond allocation is that it's less volatile. You don't know with certainty what any company's equity shares are going to do. You just hold onto your allocation, stick to the plan, rebalance periodically, and take a long view.


1. Many of us are having the goals of optimizing returns. My point is that with bonds yields so low and interest rates so low, there is tremendous risks of the pendulum swinging. Therefore bonds having low yields with low interest rate environment, there is exceptionally high risk of bond prices dropping. Because of the low bond yields, lifecos are having very low returns from their investments, therefore lifecos are mostly in the penalty box. Applying the buy low, sell high theory, in the present environment, bond prices are high therefore yields are low. OTOH, lifecos are suffering now because bond yields are low and therefore lifecos' earnings are low and therefore share prices are low. On this logic, it is time to sell the high [bonds] and buy the low [lifecos].

2. The up-to-now concept of "The whole point of a bond allocation is that it's less volatile" is true to a point, but when the pendulum swings, the word "less" may have to change to "more" volatile some time in the future. Remember the pendulum swings from the highest bond yield of around 20% in 1981 to almost scraping the bottom in bond yields presently. Therefore, in this interest rate cycle, diversification may likely become dieworsefication.
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Re: Revisit asset allocation in present environment

Postby queerasmoi » 10 Sep 2010 18:04

Justise wrote:1. Many of us are having the goals of optimizing returns. My point is that with bonds yields so low and interest rates so low, there is tremendous risks of the pendulum swinging. Therefore bonds having low yields with low interest rate environment, there is exceptionally high risk of bond prices dropping. Because of the low bond yields, lifecos are having very low returns from their investments, therefore lifecos are mostly in the penalty box. Applying the buy low, sell high theory, in the present environment, bond prices are high therefore yields are low. OTOH, lifecos are suffering now because bond yields are low and therefore lifecos' earnings are low and therefore share prices are low. On this logic, it is time to sell the high [bonds] and buy the low [lifecos].

2. The up-to-now concept of "The whole point of a bond allocation is that it's less volatile" is true to a point, but when the pendulum swings, the word "less" may have to change to "more" volatile some time in the future. Remember the pendulum swings from the highest bond yield of around 20% in 1981 to almost scraping the bottom in bond yields presently. Therefore, in this interest rate cycle, diversification may likely become dieworsefication.


In regards to #1, okay sure, let's say lifecos are "in the penalty box". How do you know their next move is up, though? Take a look at financials from August 2006 to March 2008 for example. XFN was on its way up, reached a high of about 28.22 in May 2007, and then started to decline. I started converting to passive investing shortly after March 2008 (XFN = 22.80), and had owned a different but similar mutual fund through an advisor which tracked financials and had lost quite a bit of value. Many people were saying "the financials have had a slump, hold onto it and you'll get your money back". In fact I believed this line of reasoning enough that it was the only fund I didn't sell. I converted everything else to passive indexing but I kept this one fund and even allowed myself to believe that I could reduce my bond allocation while I waited for that fund to recover. Instead, financials tanked further in the big crash. The fund took over a year to recover that lost value, and still has yet to return anywhere near its 2007 high. I rebalanced back to my *originally intended* allocation at some point later and ditched the fund for a cheaper broader index, but my little experiment in active management did cost me a few thousand. How confidently can you say that the next move is up? There may be other factors at play.

As for the bond pendulum, remember that duration matters. If you're invested in the historically low bond yields but your duration is not too large, this will reduce the bond volatility. If you stay invested and reinvest the interest at new yields, you recover the difference over time. They are still a long-term investment. If your stomach for risk is making you rethink holding bonds with higher interest rates ahead - then do you have the stomach for overweighting a specific sector of equities instead? After all, equities on the whole don't perform all that well in times of rising interest rates either.
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Re: Revisit asset allocation in present environment

Postby Justise » 10 Sep 2010 23:49

[In regards to #1, okay sure, let's say lifecos are "in the penalty box". How do you know their next move is up, though?/quote]


As for the bond pendulum, remember that duration matters. If you're invested in the historically low bond yields but your duration is not too large, this will reduce the bond volatility. If you stay invested and reinvest the interest at new yields, you recover the difference over time. They are still a long-term investment.



Sure, no body knows, but at least I know that the bond holder is selling when bond prices are very high and yields very low and the because the lifecos’ share prices move in inverse resonance to that, lifecos will be the most logical choice which is better than anything but bonds in taking profit from bond sale. Holding on, the opportunity cost will be too high and the risk is too high too. The move will actually be managing risk for which the theory of asset allocation is based on.


Looking from the opportunity costs point view, this will most likely be a wrong-turn investment when holding to or buying bonds now rather then a long-term investment.

Let's hear the views of others.
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Re: Revisit asset allocation in present environment

Postby Sensei » 11 Sep 2010 03:43

Hi,

Quite a bit of received wisdom and assumptions out there.

Going back to the original question, while I'd always recommend some kind of couch potato / asset allocation formula to beginner investors (and part of my investments are managed that way), I think the 60/40 split is way too simplistic. Even if we accept it, it is quite conservative. For example, another formula widely seen is 120 minus you age = your equity holdings, so if you are are 30, 90% of your holdings should be in equity, 10% in 'other'. Personally, I don't find either very satisfying.

I think other factors are more important. I think net worth has a decided influence on how you should invest. In my view, people with a net worth of over a million tend to be, and can be quite a bit more conservative and a large whack of bonds might be able to contribute to an adequate return for their needs depending on what those are.

Otherwise, if your savings and investment horizon are limited, being too conservative would appear to be riskier than following any set formula especially one with that allocation of bonds. Your goals are then important as mentioned above. I also think your age, your risk tolerance, and your strategy are equally important. For example, if your goal is to save for retirement, you are under 45, and you take a value approach, I would have no hesitation saying that bonds are not necessary at all as long as you can accept big swings in the market. Stocks clearly outperform as long as you can stand the volatility. I also find that within a dividend growth strategy, too many bonds at any age are just dead money. As a mainly dividend investor, I feel quite comfortable with 15% - 20% bonds (none in Canada) and I'm 56.
Cheers

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Re: Revisit asset allocation in present environment

Postby Taggart » 11 Sep 2010 14:10

The ironic thing, the older I get (near 61), the less interested I am in nominal bonds. In this market, I buy a few value equities here and there, but mostly just building up cash.
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Re: Revisit asset allocation in present environment

Postby Park » 11 Sep 2010 14:25

About Sensei stating that stock clearly outperform, I believe that Schiller has found that US stocks in the 1830-1860 period showed 0% return. IIRC, there is also a 67 period in the 19th century in the US where bonds outperformed stocks. As this is relevant to you Sensei, consider where the Japanese stock market was at the end of 1989 and now. Yes, stocks will outperform in the long run. But most investors have an investing horizon of no more than 40 years.
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Re: Revisit asset allocation in present environment

Postby like_to_retire » 11 Sep 2010 15:52

Park wrote:About Sensei stating that stock clearly outperform, I believe that Schiller has found that US stocks in the 1830-1860 period showed 0% return. IIRC, there is also a 67 period in the 19th century in the US where bonds outperformed stocks. As this is relevant to you Sensei, consider where the Japanese stock market was at the end of 1989 and now. Yes, stocks will outperform in the long run. But most investors have an investing horizon of no more than 40 years.

My income investing always seems to do well compared to the wacky world of stocks.

You don't have to look much further than the last ten years to prove that bonds outperform stocks.

FPX INCOME 2000-2010 > 5.72%
Income.JPG


FPX GROWTH 2000-2010 > 3.08%
Growth.JPG


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Re: Revisit asset allocation in present environment

Postby Taggart » 11 Sep 2010 16:06

Park wrote: As this is relevant to you Sensei, consider where the Japanese stock market was at the end of 1989 and now.


According to James Montier just buying the cheapest stocks in Japan based on price to book value would have generated a return of 3% p.a.vs a market return of -4% p.a. (1990-2007).

Deflation, Depressions and Value.

----------------------------------------

Net-net stocks in Japan outperformed the market by 15% from 1985 to 2007.

Graham Net-Nets: Outdated or Outstanding? Pages 232-233
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Re: Revisit asset allocation in present environment

Postby queerasmoi » 11 Sep 2010 16:55

like_to_retire wrote:You don't have to look much further than the last ten years to prove that bonds outperform stocks.


Can you show us some comparisons for times of rising interest rates? Whether slowly or rapidly.
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Re: Revisit asset allocation in present environment

Postby like_to_retire » 11 Sep 2010 19:20

queerasmoi wrote:
like_to_retire wrote:You don't have to look much further than the last ten years to prove that bonds outperform stocks.


Can you show us some comparisons for times of rising interest rates? Whether slowly or rapidly.


The FPX calculator only has data to '96. It would have to go back further than that to experience rising rates.

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Re: Revisit asset allocation in present environment

Postby Shakespeare » 11 Sep 2010 19:41

The FPX calculator only has data to '96.
That's when the FPX was started. I believe Norbert has compiled earlier data on various components. Norm has a calculator that allows asset mixes to be simulated.
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Re: Revisit asset allocation in present environment

Postby Sensei » 11 Sep 2010 21:08

Hi,

like-to-retire, I enjoyed looking at the FPX site, although I had to look around for it. It makes a good case for having owned the FPX Income portfolio over the other two portfolios in the last 10 years. No comparison is without fault however. Nothing is very typical about the last 10 years. Just as one example, we are lucky to have a financial system at all after the fun and games of 2005 - 2009. Also, your data is not actually a straight up comparison of bonds vs. stocks. since both the indexes, Growth and Income, hold stocks and bonds. All of the indexes are heavily weighted towards Canadian investments. Finally, you wrote,

You don't have to look much further than the last ten years to prove that bonds outperform stocks.


WADR, yes, you do, and I suppose I could trot out a lot of studies and reference them just by walking into my living room. I won't do that, though, because that is not the gist of my post and since I see nothing upthread (and nothing referenced) that disproves my thesis that stocks outperform bonds. Also, if you read the post carefully, I don't say 'Don't own bonds because stocks are better.' I am actually saying that almost everyone should own bonds but with common sense according to their situation. Neither the 60 / 40 split nor the 90 /10 split make sense for everyone and the 60 / 40 split makes sense only for a very few people. The received wisdom is that since pension funds often use this allocation, everyone else should too. However, managing a pension fund and managing your own portfolio are completely different and the risks and possibilities are completely different.

If you have a 20 year investment horizon as I implied

For example, if your goal is to save for retirement, you are under 45, and you take a value approach,


I see no reason to be anywhere near as heavy as 40% in bonds and probably 0% would be fine. After 45 adding bonds makes more sense, but again wrt one's own situation.
Cheers

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Re: Revisit asset allocation in present environment

Postby Lazy Ninja » 11 Sep 2010 21:29

Sensei wrote:The received wisdom is that since pension funds often use this allocation, everyone else should too. However, managing a pension fund and managing your own portfolio are completely different and the risks and possibilities are completely different.


One important difference is that the pension fund likely has a theoretically infinite timeframe. Individual investors are statistically unlikely to be as fortunate :lol: . That's a good reason to consider alternatives to equities for a substantial portion of the portfolio.

Sensei wrote:I see no reason to be anywhere near as heavy as 40% in bonds and probably 0% would be fine.


If I had any guts at all, I probably would be 0% in bonds right now. As it is, I'm trying to stick to the "equities = 100 minus your age 'rule' ".
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Re: Revisit asset allocation in present environment

Postby Park » 11 Sep 2010 22:14

About a 100% stock allocation and a 20 year investing horizon, I'd like to make the following points.

1.A small allocation to bonds will help you learn about bonds. One day, that knowledge will be useful.

2.A small allocation to bonds has a greater effect on risk than it does on return. Its effect on annual % growth will not be great.

3.IIRC, in the US, there is about a 5% chance that over a 25 year investing horizon, bonds will outperform stocks. Please remember, that is based on historical data. I would agree with you that the probability of bonds doing at least as well as stocks over the next 20 years is unlikely. However, it is possible, and it is possible that it will happen over the next 40 years.

4.IIRC, stocks went down about 85% during the depression. IIRC, bonds went up about 13% during the same time period. In 1932, I doubt that too many investors were interested in hearing about "stocks for the long run". Most likely as a result of that experience, the investors of that generation tended to later underinvest in stocks, and have poorer long term results as a consequence. I doubt that present day investors would react differently if something similar were to happen. If it did happen again, a balanced portfolio might decrease the later tendency to underinvest in stocks.

5.Are you sure that you won't use that money in the next 20 years?
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Re: Revisit asset allocation in present environment

Postby adrian2 » 11 Sep 2010 23:21

Park wrote:About a 100% stock allocation and a 20 year investing horizon, I'd like to make the following points.

1.A small allocation to bonds will help you learn about bonds. One day, that knowledge will be useful.

2.A small allocation to bonds has a greater effect on risk than it does on return. Its effect on annual % growth will not be great.

High quality bonds, over the long term, are quite predictable in their return: it's their yield-to-maturity. As a good approximation, it's the current yield of new issues with similar time horizons. For 5 year Canadas, this yield is just over 2%. I just don't feel enticed to allocate any capital for a 2.x% annual expected return.

OTOH, in the past few months I did increase my fixed income allocation by about 10%, from -30% to about -20%, and decreased my equity portion from 130% to 120%.
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Re: Revisit asset allocation in present environment

Postby Sensei » 12 Sep 2010 05:49

Hi,

Park, if you mean by a small allocation of bonds 10 - 20% you won't get any argument from me personally. As I mentioned, I think everyone should have some bond exposure to reduce risk as you say. Of course, like any sensible investor, I don't want to have to cash in an equity position at an inconvenient time. I'm as sure as I can be about my investment horizon.

However, getting back to the FPX data, I propose we look at some other data at http://www.fundlibrary.com

They have a very handy stock screener and we can make some realistic comparisons.

1. The top performing bond fund over the last 20 years has been the PHN Bond Fund. Average annual return = 8.35% The 15 year return was an equally impressive 7.15%.

2. The top performing non-specialty stock fund was the Saxon Stock Fund. This fund is described thus:

This fund is for significant long-term capital growth by investing primarily in a well-diversified portfolio of Canadian equities.


20 year performance clocks in at 11.01% and 15 years is 9.85%

On top of that, many specialty funds have done much better than that.

3. The top performing income fund does not invest in bonds at all and nor do the next five. This is the description of the PHN Dividend Income Fund:

The fundamental investment objectives of the fund are to provide long-term capital growth and income by investing primarily in a well-diversified portfolio of dividend income-producing Canadian securities that have a relatively high yield.


20 year average annual return = 11.48
15 year average annual return = 11.85

In the short term, which seems to be the focus of the many, bonds have done much better.

The best two year performance for which we have a fund description is Manulife Strategic Income GIF Select Elite:

This fund invests primarily in government and corporate debt from developed and emerging securities. It also invests in U.S. government and agency securities and high yield bonds. The fund may also invest in preferred shares and other types of debt securities.


Two year annual return 13.51%

In fact most of the best performers in the past few years are High Yield or Global which translates to high percentages of bonds in emerging or developing countries. I can't say these are as safe as a garden variety Canadian bond fund although I own one such fund.

I'm not sure why people get so agitated the stock vs bond issue. There are advantages and disadvantages to owning both, so that is why we should own both. But if you are young and looking to build your wealth faster, a high allocation of equity makes a lot more sense to me.
Cheers

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Re: Revisit asset allocation in present environment

Postby queerasmoi » 12 Sep 2010 12:30

You're of course free to do as you wish with your asset allocation. What I was simply trying to get across earlier is, don't allow yourself to be convinced that a sector bet on lifecos will perform the same function in your portfolio as the bonds you're replacing. Our expectations of interest rates are one factor that will affect the forthcoming performance of both investments, but they are not the entire story.
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Re: Revisit asset allocation in present environment

Postby Justise » 12 Sep 2010 20:50

If I had any guts at all, I probably would be 0% in bonds right now. As it is, I'm trying to stick to the "equities = 100 minus your age 'rule' ".



I HAD the guts to be either 100% bonds or 100% stocks during yesteryears when bond yields was around 6%; but at current bond yields of around 2%, I NEITHER HAD the guys nor can afford to have, say, 40% bonds as the yields are too small and the risks are too high for a miserable approx. 2% yield. GIC would have been a much safer bet for fixed income.

If I were to rank reward to risk from a scale of 1 to 10 [10 being the highest], then I would rank bonds now 1, GIC 3, XIU 6, and Yellow Pages 7.
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Re: Revisit asset allocation in present environment

Postby Justise » 14 Sep 2010 11:11

like_to_retire wrote:
queerasmoi wrote:
like_to_retire wrote:You don't have to look much further than the last ten years to prove that bonds outperform stocks.


Can you show us some comparisons for times of rising interest rates? Whether slowly or rapidly.


The FPX calculator only has data to '96. It would have to go back further than that to experience rising rates.

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Looking at bonds for the last ten years [or even the last 29 years i.e. going back to 1981] bonds will outperform stocks on the basis of 'DRIP'. No question. But looking at that rear view mirror is very dangerous, without looking into the mathematics of it and the interest rates curve. To draw that conclusion for the last 10 years or even the last 29 years is like a frog's eyeview of the horizon from a well.

Want to know in rising rate environment on a 'DRIP' basis? Bonds will be in the dog house compare to stocks. The mathematics of it is very simple, as interest goes up, say slowly, your initial bond is loosing money like going down a slippery slope, when you reinvest your bond interest money, the reinvested bond and the original bond in turn drop in value as interest rate continues to go up. This phenomena is like when AIG or Citigroup or GE share prices dropped slowly and you DRIPed which is the equivalent of averaging down as the stock prices kept going down. The cycle from 1950 to 1981 shows more or less that patern.
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Re: Revisit asset allocation in present environment

Postby queerasmoi » 14 Sep 2010 11:25

Justise wrote:Looking at bonds for the last ten years [or even the last 29 years i.e. going back to 1981] bonds will outperform stocks on the basis of 'DRIP'. No question. But looking at that rear view mirror is very dangerous, without looking into the mathematics of it and the interest rates curve. To draw that conclusion for the last 10 years or even the last 29 years is like a frog's eyeview of the horizon from a well.

Want to know in rising rate environment on a 'DRIP' basis? Bonds will be in the dog house compare to stocks. The mathematics of it is very simple, as interest goes up, say slowly, your initial bond is loosing money like going down a slippery slope, when you reinvest your bond interest money, the reinvested bond and the original bond in turn drop in value as interest rate continues to go up. This phenomena is like when AIG or Citigroup or GE share prices dropped slowly and you DRIPed which is the equivalent of averaging down as the stock prices kept going down. The cycle from 1950 to 1981 shows more or less that patern.


I still want to see the math. Yes, a bond will lose market value when interest rates are rising. But that bond also creeps towards maturity year over year, causing its price to converge towards its face value regardless of rate environment; and new units purchased at that point go in at the higher yield. In a bond fund, the higher-duration bonds will tick down over those years and converge towards their own face values.

There's a huge difference between bond prices that drop because of interest rates, and share prices of AIG/Citigroup/GE that drop due to investor confidence. Shares of those companies have no underlying redemption value. Bonds do, regardless of the market prices they encounter along the way, and duration is what measures how far their market prices will deviate. If I hold a 20-year government bond and the market value drops 20% due to a rise in interest rates, it doesn't mean there's a risk the bond will go bankrupt. I will still collect all the payment and recoup the face value if I hold it to maturity. Whereas if my AIG shares have plummeted, there's a good chance I'm not going to keep receiving the dividend payments I'd been expecting, and there is no defined "safe exit point" I can wait for.

Now if bond prices were to drop based on risk that they won't be paid at maturity, the same analysis wouldn't apply - but if that were ever to happen to CDN government bonds, even the cash under your bed wouldn't save you.
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Re: Revisit asset allocation in present environment

Postby AltaRed » 14 Sep 2010 13:30

Good post on bonds QAM. I would go further to say a 10 year bond ladder of AAA bonds is about as good as chicken soup Mom makes. People get hung up on the vagaries of 'loss of market value' of bonds as interest rates rise. But all that is moot with staggered maturities and bonds are kept to maturity. Getting hung up on near term interest rates is not investing.
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