Stocks for the long run?

[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.


.

 

[Sarenco]

Please describe the circumstance where a 20 year bond yielding -1% p.a. after AMC would add to wealth over the long term

I was simply contradicting your statement that bonds are guaranteed to destroy wealth over the long-term. That is simply untrue. We could be entering a period of long-term deflation for all I know.

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.

Fine. In effect you are saying you have an edge over one of the largest, most liquid markets in the world. I have no idea what interest rates will look like in the future so I am agnostic on duration - I let the market decide.

 

[RobFer]

No, there's no such thing.

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

Well I won't stop looking. There must be some conglomerate somewhere that at least acts like that like Berkshirehathaway.

 

[Gordon Gekko]

Well I won't stop looking. There must be some conglomerate somewhere that at least acts like that like Berkshirehathaway.

What about...Berkshire Hathaway?

 

[Duke of Marmalade]

I was simply contradicting your statement that bonds are guaranteed to destroy wealth over the long-term. That is simply untrue. We could be entering a period of long-term deflation for all I know.

I have inserted the word "nominal" to the original post. We are not in a court of law - you know what I meant. We are comparing with retail deposits and state savings and these do guarantee to add to nominal wealth.

Fine. In effect you are saying you have an edge over one of the largest, most liquid markets in the world. I have no idea what interest rates will look like in the future so I am agnostic on duration - I let the market decide.

Ahhh! a little side swipe. I am not claiming any edge over anybody. I have already explained that there are technical reasons why institutions will hold long term bonds at negative yields - it does not mean they think they are good investments. I don't know if you ever heard of an outfit called EIOPA. They regulate EU life companies and pension funds. They have the concept of a Ultimate Funding Rate which funds can use to discount their liabilities. The argument goes that they don't trust the markets beyond the 20 year point and so they put in their own estimates of what ultimately interest rates will be. They have come up with the figure of 3.75% despite yields on 30 year money being effectively zero. Are you shocked to know that EU life companies and pension funds value their liabilities on the assumption that they will ultimately earn 3.75% p.a.? So whilst not claiming any edge over the experts but rather sharing the view of the experts the future trajectory of yields has to upwards - there is a definite floor to how far lower they can go and there are very strong economic and empirical reasons to believe that we are near that floor. There is no upside left but very considerable downside risk. There is no role for long bonds in a retail portfolio. (My emphasis)

 

[elacsaplau]

Are you shocked to know that...….pension funds value their liabilities on the assumption that they will ultimately earn 3.75% p.a.

Me shocked! Me very shocked. Please explain in the Irish context.

 

[Sarenco]

I am not claiming any edge over anybody

German bond yields range from around -0.70% (3 months) to +0.06% (30 years).

By favouring securities at the short end of the yield curve, you are implicitly claiming that the market has mispriced longer-term yields.

Market participants already know the demands of certain institutions for bonds of different durations. There is no reason to believe that isn't already reflected in bond prices.