Asset Allocation

Don’t think bonds vs. stocks – think growth vs. income vs. market insurance

by Stephen Leeb

It’s standard advice. If you’re 40 years old, your portfolio should be 60 percent stocks and 40 percent fixed income (bonds and cash). For each year past 40, subtract one percentage point from stocks and add it to bonds. Thus, when you’re 70, you should be 30 percent in stocks and 70 percent in fixed income.

Good advice? Maybe for some. But try telling 70-something Warren Buffett that he should sell most of his Berkshire Hathaway holdings and trade them in for government bonds. Somehow we don’t think he’d go for it.

The truth is that the conventional wisdom on asset allocations is pretty much an idiotic exercise in trying to formularize something that should be as individual as a thumbprint. There’s no one-size-fits-all allocation mix.

Equally strongly, we would dispute the way that most financial advisers conceptualize an asset mix. The traditional division is among stocks, bonds, and cash. We think this is a meaningless approach. Instead, we think investors should think strictly in terms of growth, income, and market insurance.

GROWTH: One relevant fact is that for 10-year periods, stocks outperform bonds about 90 percent of the time, while for 20-year periods stocks outperform more than 95 percent of the time. Even over 5-year periods stocks are better investments 80 percent of the time. In other words, if you’re interested in capital appreciation, think stocks. In addition, instead of thinking about how old you are, think about what you want from your investments. If you’re a healthy 70 year old – which according to the latest figures means you will live at least 10 more years – and have a relatively high net worth, your goal could well be further capital maximization. Holding large positions in bonds – or even worse, in lower-performing cash – just doesn’t make sense. This is true even if your time horizon is just five years or so. And if you’re the hypothetical 40-year-old advised to have 40 percent of your assets in fixed-income investments, increasing the proportion each year, it makes even less sense when you realize there have been no cases in which total returns of stocks were less than bonds over 25-year periods, the length of time, presumably, until your retirement. In other words, if you don’t need the current income, it doesn’t matter whether you’re four or 94. Emphasize a diversified collection of growth stocks.

INCOME: There’s just one valid reason to hold regular, coupon-paying bonds, and that’s if you need the current income. The proportion of bonds in your portfolio should depend on how much income you need. But even if you are primarily an income investor, we wouldn’t stick to bonds alone. Keep in mind that inflation automatically diminishes the real income bonds throw off. Thus your income needs should be satisfied with a combination of bonds and other income-producing vehicles whose income is not fixed, such as REITs and high-yielding stocks. In today’s economy when our economic indicators are pointing to about 4 percent growth over the next 12 months, we lean more toward investments that can keep up with inflation. If the economic indicators weaken, we would lean more toward bonds and cash to satisfy income needs.

INSURANCE: This is the third category we mentioned above, beyond growth and income, and it’s an important one. As we’ve noted, over most time frames stocks have generally outperformed bonds. But during times of economic weakness stocks can tank and bonds can soar, providing welcome financial and emotional security.

One important point, though, is that the bonds you buy for reasons of income aren’t the same ones you should buy for purposes of market insurance. When it comes to shielding yourself against economic and stock market downturns, your best choice by far is zero coupon bonds rather than straight bonds. Zeros don’t pay a coupon, but the trade-off is that they are much more sensitive to changes in interest rates.

But there’s no need to go overboard on zeros. Take the period 2000-2002, certainly a time that investors appreciated some insurance against falling stocks. Straight bonds outperformed stocks by more than 80 percentage points as the S&P 500 plummeted 37 percent. Zeros, though, outperformed by more than 90 percentage points. If you had invested 40 percent of your portfolio in zeros, a portion in growth stocks, and the remainder in income plays, you would have ended up solidly in the black. Even if your time frame is as short as three years and you want to hedge against the worst stock market imaginable, about 40 percent in zeros should be your upper limit.

One thing we won’t do is tell you to put a precise portion of your money into zeros or stocks or REITs or anything else based on an arbitrary statistic such as age. It all depends on your time frame, your income needs, and your tolerance for short-term uncertainty. These are the criteria that should guide you in putting together your asset mix.

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"The traditional allocation is among stocks, bonds, and cash. We think this is a meaningless approach and investors should think strictly in terms of growth, income, and market insurance."

• Asset Allocation: An Unconventional View

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Asset Allocation

Don’t think bonds vs. stocks – think growth vs. income vs. market insurance

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