Stocks for the long run?

[DK123]

Re 6.9 % equity return on stocks over 145 years.Am i right to presume that this is adjusted for inflation i. e.buying power or real terms.If not then we are only kidding ourselves i think.

 

[Gordon Gekko]

@Gordon Gekko

If you re-read the OP you will see that the outperformance of long-term US treasuries over a 20 year period is not without precedence. Nor is 20 years the longest period where long-term US treasuries outperformed US stocks (S&P500).

And that's just the US. Long-term government bonds have outperformed domestic stocks for periods of 20 years or more in every major industrial nation.

In any event, I read the phrase "almost any reasonable long-term period" as referring to the length of the period - not the frequency of such periods.

For the avoidance of doubt, I am not suggesting that bonds have frequently outperformed stocks over long time periods - they clearly haven't.

Nor am I making any prediction - implicit or otherwise - about the future performance of any asset class.

My point is that such periods are extraordinarily rare. They’re almost black swan events.

 

[Sarenco]

My point is that such periods are extraordinarily rare. They’re almost black swan events.

According to Vanguard, stocks underperformed bonds about 18% of the time over 10-year rolling periods between 1926 and 2016.

Over 20-year rolling periods, stocks underperformed bonds over 4% of the time.

https://www.marketwatch.com/story/long-term-stock-investors-may-not-be-thinking-long-term-enough-2017-08-21

Of course, there is no guarantee that the next 90 years will follow a similar pattern.

 

[Gordon Gekko]

1/25...I like those odds...it would be interesting to see what has happened in the period immediately following those rare periods when bonds have won out. I would not like to own bonds from here. If I was a 60/40 man, I think the 40 would be cash.

 

[Sarenco]

If I was a 60/40 man, I think the 40 would be cash

While I can't predict the future, I can state as a certainty that while cash can dilute equity risk, it cannot diversify an equity portfolio.

Over the last 40 years -

Portfolio 1 comprised 50% US equities (total market) and 50% cash (3-month T-Bills), rebalanced annually. Annualised return of 7.87%, worst year -17.75%; maximum drawdown -26.83%.

Portfolio 2 comprised 50% US equities (total market) and 50% long-term (30-year) Treasuries, rebalanced annually. Annualised return of 10.68%; worst year -7.26%; maximum drawdown - 20.39%.

Over the same timeframe, a US equity (total market) portfolio had an annualised return of 10.66%,; worst year -37.04%; maximum drawdown; -50.89%.

So, over the last 40 years, the all-equity portfolio actually marginally underperformed the portfolio with 50% in long-term bonds. And the all-equity portfolio suffered some stomach churning drawdowns.

 

[Gordon Gekko]

I didn’t say that cash added diversification. My point is that if I wanted to reduce the volatility from here using a traditional 60/40 split, I’d have equities and cash. I don’t see how bonds can continue to surprise in a good way.

 

[Sarenco]

My point is that if I wanted to reduce the volatility from here using a traditional 60/40 split, I’d have equities and cash.

That's what diversification achieves - it reduces the volatility of a portfolio.

Diversification strives to smooth portfolio returns, so the positive performance of some investments neutralises the negative performance of others. The benefits of diversification only hold if the securities in the portfolio are not perfectly correlated - that is, they respond differently, often in opposing ways, to market influences.

Long-term bonds are volatile assets - far more volatile than cash. However, adding long-term bonds to an equity portfolio reduced volatility at a portfolio level to a far greater degree than adding cash to an equity portfolio over the last 40 years.

That's because bond prices often rise when equities crash (the flight to safety effect). Cash cannot "respond" to stock market crashes in this way.

Again, cash can dilute equity risk but it cannot diversify equity risk.

 

[Sarenco]

Incidentally most life companies and other pension providers are currently paying banks around 60bps for their deposits (which is obviously borne by policyholders).

In contrast, the yield to maturity on Eurozone Government bonds (EGBI) at 31 March 2020 was (positive) 0.25%.

 

[Gordon Gekko]

And cash clearly reduced volatility which is all I am saying. i.e. that, going forward, if I was someone who couldn’t deal with volatility, I would have (say) 40% in cash rather than bonds.

 

[Sarenco]

Do you mean volatility at an overall portfolio level or volatility within the fixed-income portion of a portfolio?

 

[Gordon Gekko]

Do you mean volatility at an overall portfolio level or volatility within the fixed-income portion of a portfolio?

Volatility at portfolio level. As in, let’s say I’m of a nervous disposition and can’t really take drawdowns of more than, say, 20-25%. So full equity risk isn’t a runner. But if I have 60% equities and 40% cash and global equities fall by 35%, as they have recently, my portfolio falls by 21%.

 

[Duke of Marmalade]

Incidentally most life companies and other pension providers are currently paying banks around 60bps for their deposits (which is obviously borne by policyholders).

In contrast, the yield to maturity on Eurozone Government bonds (EGBI) at 31 March 2020 was (positive) 0.25%.

Let us get this diversification thing in perspective. The first and foremost consideration for an asset class is its long term growth prospects. Next we consider its short to medium term price volatility in its own right. If it cuts mustard on this risk reward assessment then we consider as a bonus its diversification possibilities.
In "normal" times (before the financial crisis) we might be looking at equities with long term growth prospects (net of annual management charges) of, say, 6% p.a. and short term volatility of 20%. We might be looking at bonds with yields (net of AMC) of 3% p.a. and volatility of 5% p.a. Throw in a lack of correlation and we have a good case for a diversified equity/bond portfolio. Indeed this was the mainstay of the collective investment industry in its heyday (90s and early noughties). This is the world that is depicted by looking at 20 year historic performance. But we are in a completely different place today.
Today we actually would probably have the same assessment of equities (6% growth/20% volatility). But the bond universe has changed utterly. Now we have yields of around -1% p.a. net of AMC. Bonds do not even get past first base - they are actually guaranteed to destroy nominal wealth over the long term. It doesn't matter if they have total negative correlation with equities i.e. perfect diversification, they simply do not belong in a retail portfolio.
But neither does cash. Cash is yielding about -2% p.a. after AMC.
So the retail investor should decide her appetite for equities and yes satisfy that with a low charge, tax efficient collective vehicle - passive investment trusts spring to mind.
Ignoring property, the rest of her investments should be in state savings and/or retail bank deposits.

 

[Gordon Gekko]

Duke, for the avoidance of doubt I’m not suggesting that someone keep cash in their portfolio incurring costs.

Say my wife and I had €500k to invest and were candidates for a traditional 60/40 portfolio because, from a behavioural perspective, we just couldn’t handle a 30-40% drawdown.

I believe that a more sensible approach would be for us to keep €200k separately in cash or State Savings, have a €300k equity portfolio, and treat it as a single €500k portfolio with rebalancing undertaken as required.

So by 23 March, our ‘portfolio’ would have declined by around €105k / 21% and not €105k / 35%.

 

[Sarenco]

Today we actually would probably have the same assessment of equities (6% growth/20% volatility).

Are we? I personally think it is highly unlikely that we will see an equity risk premium of 6%+ over the coming decades.

Ignoring property, the rest of her investments should be in state savings and/or retail bank deposits

But Duke, it's not possible to hold State Savings products and/or retail bank deposits within a pension wrapper.

I certainly think that State Savings Certificates are an excellent home for after-tax savings, while maintaining a higher allocation to equities within a pension vehicle. I've been making that argument for some time, however, I would suggest that most folks won't have that flexibility.

 

[Duke of Marmalade]

Duke, for the avoidance of doubt I’m not suggesting that someone keep cash in their portfolio incurring costs.

Say my wife and I had €500k to invest and were candidates for a traditional 60/40 portfolio because, from a behavioural perspective, we just couldn’t handle a 30-40% drawdown.

I believe that a more sensible approach would be for us to keep €200k separately in cash or State Savings, have a €300k equity portfolio, and treat it as a single €500k portfolio with rebalancing undertaken as required.

So by 23 March, our ‘portfolio’ would have declined by around €105k / 21% and not €105k / 35%.

Gordon, I think we are on the same page. Cash is king these days for your flight to safety but not within a collective vehicle.
My main point is that bonds today are utterly unrecognisable from the animals of the same name that I remember during the 90s/noughties. They are not investments in the traditional sense of meaning assets with a prospect of a positive return. They are purely technical instruments in the ALM requirements of financial institutions. Investing in German long bonds at negative yields can make sense to a bank if it reduces its capital requirements. A reduction in capital requirements has no value for the retail investor so it is completely priced out of that market. I Googled a few fund brochures and amazingly they are still waxing about the bond content of their diversified portfolios.

 

[Gordon Gekko]

I agree 100%. Bonds have no place in a private investor’s portfolio. And what’s even worse is that, because of the lack of return, lots of wealth managers have pushed their clients into higher yield corporate bonds and loan funds for the ‘40%’ and many of these things are now behaving like equities.

 

[Sarenco]

Ok, I'll try it a different way.

What is somebody in their 60s with all their retirement savings wrapped up in a pension to do? State savings or retail deposits aren't an option within a pension.

Would you advise that individual to hold an all-equity portfolio?

 

[RobFer]

Let us get this diversification thing in perspective. The first and foremost consideration for an asset class is its long term growth prospects. Next we consider its short to medium term price volatility in its own right. If it cuts mustard on this risk reward assessment then we consider as a bonus its diversification possibilities.
In "normal" times (before the financial crisis) we might be looking at equities with long term growth prospects (net of annual management charges) of, say, 6% p.a. and short term volatility of 20%. We might be looking at bonds with yields (net of AMC) of 3% p.a. and volatility of 5% p.a. Throw in a lack of correlation and we have a good case for a diversified equity/bond portfolio. Indeed this was the mainstay of the collective investment industry in its heyday (90s and early noughties). This is the world that is depicted by looking at 20 year historic performance. But we are in a completely different place today.
Today we actually would probably have the same assessment of equities (6% growth/20% volatility). But the bond universe has changed utterly. Now we have yields of around -1% p.a. net of AMC. Bonds do not even get past first base - they are actually guaranteed to destroy wealth over the long term. It doesn't matter if they have total negative correlation with equities i.e. perfect diversification, they simply do not belong in a retail portfolio.
But neither does cash. Cash is yielding about -2% p.a. after AMC.
So the retail investor should decide her appetite for equities and yes satisfy that with a low charge, tax efficient collective vehicle - passive investment trusts spring to mind.
Ignoring property, the rest of her investments should be in state savings and/or retail bank deposits.

Are they such thing? I cant find any examples.

 

[Sarenco]

Are they such thing? I cant find any examples.

No, there's no such thing.

And, no, bonds are not guaranteed to destroy wealth over the long-term.

 

[Duke of Marmalade]

No, there's no such thing.

And, no, bonds are not guaranteed to destroy wealth over the long-term.

I felt when I invented "passive investment trusts" that they would be a unicorn. For pension investments the investment trust aspect is not required.
The guaranteed was bold in my original so I don't think robfer was questioning it. Please describe the circumstance where a 20 year bond yielding -1% p.a. after AMC would add to wealth over the long term

Ok, I'll try it a different way.

What is somebody in their 60s with all their retirement savings wrapped up in a pension to do? State savings or retail deposits aren't an option within a pension.

Would you advise that individual to hold an all-equity portfolio?

No. I suppose it has to be part cash or maybe short bonds which are quasi cash. It's the long bonds that I see no role for in a retail fund. The combined drag of AMC and negative wholesale deposit rates/bond yields could produce situations where it would be better to cash out of the ARF despite the negative tax consequences but I haven't thought that through. Certainly "gross roll up" is a negative in this scenario.


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