The idea behind asset allocation is that by carefully choosing how much of each asset class (like cash, bonds, and stocks) to own, you can get higher returns without taking on more risk. Any sub-optimal portfolio can replaced with an optimized portfolio with higher expected return or lower risk. This mantra has been preached by many commentators to the point where thoughtful investors devote so much attention to their asset allocations that they lose sight of other important considerations. But, optimizing your asset allocation gives less benefit than you might realize. An Example Suppose that Jen has a retirement portfolio made up of 40% bonds and 60% stocks. We’ll assume that the stock and bond money is invested in low-cost index exchange-traded funds (ETFs) to minimize fees. Using the figures from the paper Portfolio Optimization by John Norstad (2002-09-11), Jen can expect a compound return of 5.23% per year above inflation. What happens if we allow Jen to include cash...

There is a tendency for higher investing returns to come with higher risks . The difference in expected return between safe and risky investments is called the risk premium. It’s obvious that once you choose a risk level, you should go for the highest returns possible. The challenge is to choose an appropriate risk level. One barrier to understanding risk is the way it is usually expressed. Saying that the S&P 500 has a 20% standard deviation means little to most people. In his book, The Intelligent Portfolio , Christopher L. Jones offers a good solution to this problem. Jones first assigns a risk level of 1.0 to the market portfolio , which is an average portfolio consisting of all asset classes in the proportions that exist in the marketplace. All other portfolios then have their risk level expressed relative to the market portfolio’s risk. So, an all cash portfolio has a risk level of about 0.2, and a single large-cap stock has a risk level of about 3.0. This seems l...

In his book, The Intelligent Portfolio , Christopher L. Jones discusses the average portfolio at great length. This average portfolio is also called the “market portfolio,” and it consists of every class of asset in the proportion that it exists in the marketplace. Jones attributes many qualities to this portfolio, but it has its limitations. Jones gives a table of how much money is in each type of asset (e.g., cash, various types of bonds, different classes of stock, etc.). If you believe in the market portfolio, then you should buy into each asset class in these proportions. Jones justifies this saying “when it comes to predicting the future, the market is usually smarter than any one person.” However, he exposes the problem with his reasoning when he says that the market portfolio “represents an efficient allocation of asset classes for an investor with an average tolerance for risk.” What if your tolerance for risk isn’t average? The perfect airplane seat is only perfect for t...

Many commentators tell us that we each have a certain level of tolerance for investing risk and that we should make choices that work for us. As long as we are all true to our feelings about risk, we can all be right, even if we make different choices. This is bunk. Betting next week’s grocery money on a horse is dumb whether you have a risk-taking personality or not. Buying stocks with the house down payment that you’ll need in 6 months doesn’t make sense even if you’re comfortable with it. The appropriate way to invest money depends mainly on when you’ll need it and for what purpose. How much of a risk-taker you are may determine what choice you make, but it shouldn’t. The larger the sum of money, the more important it is to be driven by rationality rather than feelings. The examples involving crazy risks are easy to agree with, but the mistakes of being too conservative can be harder to accept. Investing retirement money you won’t need for many years in bonds just doesn’t make...

Life only follows one path, but we can’t predict which path we will follow into the future. The fact that investments have risk means that we don’t know for sure what returns we will get. What we can do with some analysis is to list possible outcomes and estimate the chances of each outcome. The company Financial Engines uses a technique called Monte Carlo simulation to generate possible outcomes as part of personalized investment advice to its clients. (Disclosure: I have no connection to Financial Engines or its products.) Monte Carlo methods are well-known in the sciences, and it’s not surprising that they are useful in economics as well. Christopher L. Jones, who works for Financial Engines, includes examples of their simulations in his book The Intelligent Portfolio . I found the long-term simulations of stocks and bonds particularly interesting. The way the simulations work is that you start with some portfolio of investments, and the software generates thousands of possible...

I coach youth baseball, and we’re in the middle of the provincial championships. Last night we fell behind 4-1 late in the game. Things were looking grim, but not hopeless. As a coach, it was tempting to try to take some chances to “make something happen”. Fortunately, we stuck with the game plan and asked each of our hitters to relax and approach the game the same way they had all season. We were lucky enough to score 13 runs in the last inning to win 14-4. What has this got to do with investing? Well, just as we resisted the temptation to throw away our game plan when things weren’t going well, investors need to stick with their plan when investment returns are lower than they hope for. Many investors abandon a sound plan and sell out when prices are lowest. This can be a very expensive mistake. The most compelling reason I’ve heard for holding bonds for the long term is to lower portfolio volatility so that investors won’t panic at the wrong time and sell everything. Persona...

Canada’s Supreme Court has decided that the planned BCE takeover does not violate any agreement with bondholders, and that the bondholders are not due any consideration beyond the contents of their contract. Like the Asset-Backed Commercial Paper fiasco, the BCE battle illustrates the risks of fixed-income investing. The safest bonds are offered by the government. If the government doesn’t pay on its bond obligations, then money probably isn’t worth much either. On the down side, government bonds pay the lowest interest rate among available bonds. Corporate bonds pay higher interest rates to compensate the bondholder for the risk that the corporation won’t be able to meet its obligations. It can be tempting to buy corporate bonds to get the higher interest, but there is always a slim chance that something will go wrong. In the case of the Bell Canada bonds, the promise to pay the bond principal and interest has not changed. But the huge amount of added debt to be taken on by BCE i...

Watching the U.S. Open Golf Championship and its top prize of $1.26 million made me think about windfalls. Many of us dream of coming into a large sum of money whether it is by winning a sporting event, a lottery, or getting an inheritance. If only you could win a million dollars; you’d be set for life, right? Not so fast. A little analysis will show that with a million dollars, you’re nowhere near as rich as you might think. Let’s assume that our lottery winner, Leon, starts out with a lump sum of one million dollars. He gets his winnings immediately, and if he has to pay U.S. taxes on lottery winnings, the prize was large enough that he is left with a million dollars after taxes. If Leon wants to be set for life, he has to grow his windfall by at least enough each year to cover inflation. He can only spend the investment gains that exceed inflation. Otherwise he is dipping into his capital and will eventually run out of money. Let’s start by assuming that Leon invests the who...

It seems to be conventional wisdom that once you start drawing from retirement accounts, your investments should be shifted into income generating assets such as bonds and dividend-paying equities. This makes little sense to me. Let’s consider an example. Suppose that Sam starts retirement with a million dollars in a tax-sheltered account. He invests in dividend-paying stocks and in the first year he makes $40,000 in dividends plus $60,000 in capital gains. He withdraws the cash dividends to live on and leaves the capital gains in the account. Another new retiree, Linda, invests her million dollars in non-dividend paying equities and makes $100,000 in capital gains in her first year of retirement. She sells $40,000 worth of stock to generate cash to live on. What’s the difference between these two cases? Not much. What matters are the returns you get and the risk you take to get these returns. In tax-sheltered accounts, the difference between capital gains and dividends isn’t i...

Warren Buffett’s company, Berkshire Hathaway, has sold put options on four stock indexes including the US S&P 500. These are essentially bets that the value of the stocks in the indexes will go up. This is curious considering that Buffett was quoted in the rest of the article saying that stock market returns will be less than people think. This isn’t necessarily contradictory, though. The put option prices may have simply been too good for Berkshire to pass up. In these transactions, Berkshire is providing insurance to stock investors. Berkshire has collected option premiums from the investors and has promised to cover these investors if their stock doesn’t rise to agreed upon prices at some point in the future (between 2019 and 2027). Given Buffett’s lifetime investment record, it seems safe to assume that these put options were mispriced and that Berkshire collected large enough premiums that these transactions are expected to be profitable for Berkshire. I wonder if ...

We hear about studies all the time. If I’m to believe what I read in the newspaper, I should cap off each meal with a couple of glasses of red wine, a beer, some chocolate, and a couple of cups of coffee. There must be a study out there somewhere showing that heroin is good for me as well. When I’m sceptical of a study’s results as described by a reporter, I sometimes read the technical paper by the study’s authors. Reporters sometimes leave out crucial details. For example, a study might show that coffee improves concentration. You might view this result differently if you knew that the subjects were denied caffeine for two days before the tests were performed. It’s not always the reporters who get it wrong, though. Sometimes the authors of the study mess things up. This is the case with a study by Schleef and Eisinger called  Hitting or missing the retirement target: comparing contribution and asset allocation schemes of simulated portfolios (pdf) . These researcher...

Why does the stock market give higher returns, on average, than bonds or interest on cash? We can observe that this has been true in the past, but why is it true? There are many ways to answer this question, but I’ll pick just one. Everything else being equal, people tend to prefer lower risk investments. Most people would take a sure 5% return over an investment that has a 50/50 chance of giving either 0% or 10%. It’s just sensible to reduce risk if you can do it without giving up anything else. All investments have some type of risk. With an individual stock, the main risk is that the company will produce lower than expected profits. Stocks are riskier than bonds and interest on cash. So, stocks have to offer higher returns than bonds and cash to attract investors. Suppose that most people believe that the stock market will give lower returns than bonds for the next decade. This would cause people to sell stocks and buy bonds leading to stock prices dropping and bond pr...

When we save for retirement, we tend to focus on that magical day when we will stop working. However, you won’t need to withdraw your entire retirement savings all at once on that day. For the most part, you’ll just need a certain amount per month plus the odd larger amount for things like a car, boat, or skydiving gear. Your retirement could easily last for more than 20 years. So, you’ll have to continue making decisions about how to invest your savings after you’ve retired. Most people (including me) believe that it makes sense to invest more conservatively as you get older. This usually means increasing the amount of money you invest in bonds and cash rather than stocks. In his book “Rational Investing in Irrational Times”, Larry Swedroe offers the following guidelines for percentage of money in stocks vs. how long it will be until you need the money: 0-3 years: 0% 4 years: 10% 5 years: 20% 6 years: 30% 7 years: 40% 8 years: 50% 9 years: 60% 10 years: 70% 11-14 years: ...

Before reading her latest book “Women & Money,” I didn’t know much about Suze Orman other than the fact that she is a TV personality who talks about money. I wasn’t expecting much from her book but was pleasantly surprised. The book is billed as “for women only,” but this mostly applies to the first 55 pages devoted to motivating women to read (and act on) the rest of the book. If you have thoughts on how useful these 55 pages are, I’d be interested in hearing them; they didn’t really apply to me. The actual financial advice starts in Chapter 6, and most of it applies to men as well. The section on retirement investing (page 115) is particularly good. Much of the detailed advice is intended for Americans, but the broad advice is useful for Canadians as well. Orman recommends that until you are a few years away from retirement, 100% of your retirement money should be invested in stock index funds. She prefers low-cost index exchange-traded funds (ETFs), but considers low-cost ...

Most commentators advise people to reduce the percentage of stocks in their portfolios as they age. Some popular rules of thumb are to make the stock percentage 100 minus your age or 120 minus your age. Larry Swedroe in his excellent book “Rational Investing in Irrational Times” offers his own advice. Swedroe expresses his advice in terms of how long until you need the money (time horizon) rather than age. Here is Swedroe’s table of time horizon vs. percentage in stocks: 0-3 years: 0% 4 years: 10% 5 years: 20% 6 years: 30% 7 years: 40% 8 years: 50% 9 years: 60% 10 years: 70% 11-14 years: 80% 15-19 years: 90% 20 years or longer: 100% How do we test this advice? Unlike almost everything else in his book, Swedroe offers this table with no analysis of where the numbers came from. I decided to try to come up with my own answer to this question. It is surprisingly difficult to come up criteria for optimizing a portfolio for some end time. The best I have come up with so...

There was an interesting discussion earlier this week over at Canadian Financial DIY about how much people should invest in stocks. This post pointed to an article by Zvi Bodie and Paul Hogan that discussed the cost of insuring a portfolio against loss among other things. You may remember Bodie as a co-author of the book “Worry-Free Investing” (see my review of this book starting here ). He is a big proponent of investing in inflation-protected bonds rather than stocks. His reasoning is basically that stocks are too risky, even though they are expected to give higher returns. In their article, Bodie and Hogan make the following claim about insuring a portfolio: “proof positive of how stocks are risky even in the long run is that if you try to insure a portfolio against a shortfall, you will find that the premium rises as the time horizon lengthens.” An Example Let’s look at an example to explain what they mean. Suppose that you are about to invest $10,000 in a stock index, but...

How you ever wondered what all the fuss is about with pension disputes? We often hear about battles between a company and its workers over pensions. The workers accuse the company of stealing from the pension fund, and the company denies it. The stories rarely make it clear what is going on. In his usual clear and compelling way, Warren Buffett discusses pensions in his latest letter to shareholders on page 17 in a section called “Fanciful Figures – How Public Companies Juice Earnings.” Why Should Pension Funds Exist at All? Let’s consider the case of a 45-year old worker William who works for the fictitious company SomeCorp. A traditional pension is a promise made by SomeCorp to pay William certain amounts of money each month after he retires. Given this situation, it’s not immediately clear why a pension fund should exist at all. As long as SomeCorp makes the promised payments, the company should be able to run its affairs as it sees fit, right? Not so fast. What happens if SomeCorp...

A major concern for many people is how old they will be when they can retire. This depends on a number of factors such as how much you save, how well your investments perform, how much you spend during retirement, and how long you live. Retirement calculators can figure this out for you based on a number of assumptions. However, most of them don’t give you a feel for how the final answer would change if your investment returns are volatile instead of perfectly steady. There was a good post over at the Canadian Financial DIY blog about using Monte Carlo analysis for financial planning. Monte Carlo analysis just means simulating possible outcomes many times to see how the final answer changes. I decided to use Monte Carlo to see how the mix of stocks and bonds in a portfolio affects when you can retire. I had to make some assumptions: - Stocks and bonds will have the returns and volatility as reported in the paper Portfolio Optimization by John Norstad (2002-09-11). - Retireme...

Most commentators agree that we should include some bonds in our long-term investments. My quest for a reasonable analysis to support this conclusion continues. Previously, I have discussed the ideas of Gordon Pape and Morningstar on this subject. I’m starting to feel like I’m in some sort of boxing match. So, let’s do it right: “In this corner ... Roger C. Gibson, esteemed author of ‘Asset Allocation: Balancing Financial Risk’ now in its fourth edition. He’s a well-respected expert whose ideas have been endorsed by Sir John M. Templeton and Don Philips, Managing Director, Morningstar.” “And in this corner ... some guy who figured out how to use Blogger.” Oh well. I lose on the credibility meter. My only chance is that people actually think about the arguments. Gibson does an impressive amount of analysis and explains many important concepts clearly. When it finally comes time to figure out an optimal asset allocation, he tosses in an interesting assumption about our tolera...

Everything I read about asset allocation says that investors are very conservative and must put a significant fraction of their money into fixed income investments like bonds even though stocks have historically given much higher returns. All of these commentators may be right about their assessment of investor psychology. Of course, this says nothing about what would be best for investors; it is just a reflection of how investors think. Morningstar has formalized this view of investors in a formula for assessing investments. This formula calculates what they call the Morningstar Risk-Adjusted Return (MRAR). I spoke about this somewhat in a previous post . Morningstar describes it in more detail in a 4-page write-up that is no longer available online, but that's okay because all the math in their expanation tends to obscure what is going on. Let’s look at a simple example. Suppose that each year a particular investment returns either 50% or -20% with equal probability. A si...