As William Faulkner wrote, "It's not even past."
This month's headline comes from a William Faulkner novel, Requiem for a Nun. According to an authoritative Faulkner Web site, the line refers to the way that people's present actions tends to mirror their past behavior.
I think it provides an answer to the question Mark Spangler posed at a recent NAPFA session about hedge funds. He asked, "Why do investors continue to believe in a simplistic investment model that has produced such discouraging results?" (He was referring to the traditional approach to diversifying portfolios by allocating resources between publicly owned stocks and bonds.) Spangler thought "wishful thinking" might explain why three years of pain has not changed behaviors; a 60/40-stock/bond portfolio worked for two decades, so advisors hope it will continue to work. Faulkner's notion that most folks simply do not change the way they behave may seem a little dark, but it does have a ring of truth about it.
Indeed the 60/40 club, to which most of us have belonged at some time in our careers, still seems to boast a very large and active roster. I dropped out and formed a 30/70 splinter group some years ago; but while this change has kept our clients in the black during the ferocious bear market, it has not provided the kind of absolute returns that retirees require.
As I contemplate the ways in which the world has changed and continues to change, it occurs to me that investment success in the future may not depend simply on our arriving at an appropriate stock/bond mix. Rather, to provide truly profitable advice, we may have to abandon the entire stock/bond allocation paradigm to which we have become accustomed.
Underlying Assumptions
Two fundamental assumptions that we rarely think about are imbedded in the concept of providing diversification by diluting stock market exposure with a modest dose of bonds. First is the assumption that over a long enough period of time, stocks will provide the patient investor roughly twice the returns on bonds, about 10% versus 5%, right? Therefore, all things being equal, stocks are the asset class of choice. But, of course, as history teaches us, a stock investor may from time to time have to endure relatively brief periods of negative returns, a.k.a. losses, and sometimes rather serious losses, as recent events have impressed upon our collective consciousness. This can be vexing, particularly to the retiree who is making regular withdrawals from his or her portfolio. Hence, the species Homo sapiens investori evolved the concept of blending the asset class of choice with bonds, a non-correlated, lower-return investment class that tends to reduce portfolio volatility. Enter the second assumption underlying the traditional approach to asset allocation: that interest-bearing debt securities will be stable in price and rarely experience a year of loss.
Armed with these assumptions, a mainstream advisor is expected to examine historic periods of stock market decline, ask his client to declare the degree of loss he could endure without leaping from the Talahatchee bridge, and then mix in enough low return, low-volatility bonds to seriously reduce the risk of such a tragedy. But how trustworthy is this traditional approach? And how valid are its underlying assumptions?
Does an examination of historic returns adequately describe stock market risk? Or opportunity? Perhaps we can best answer with another question: Did history prepare advisors for a third down year in the averages? Or, what experience suggested to advisors in 1966 that 1,000 in the DJIA would prove virtually impenetrable for 16 years? Did anyone forecast that for 13 years from 1990 through 2002 stocks would return less than long Treasuries (9.7% versus 10.1%)? Or that for the 15 years through 1979 stocks would earn less than inflation (5.6% vs. 6.2%)?
How dependable is the assumption that stocks of the publicly traded variety will provide higher returns than bonds; enough higher to compensate investors for the risk of ownership? (In recent weeks WorldCom bondholders emerged from that company's ashes; shareholders did not.) Such highly regarded investment thinkers as John Bogle, Bill Gross and Peter Bernstein believe that for the next decade stock and bond returns may be nip and tuck. Now, a ten-year outlook may not matter to the Coca-Cola pension fund or Harvard Endowment, but it could be enormously important to the 68-year-old retiree whose equity portfolio, having shrunk 40%, still looks pricey at 32 times trailing 12-month earnings.
And what about that assumption regarding the low volatility of bonds? And just what bonds are we talking about? Junk bonds, always volatile, are a much bigger part of the bond pie than they have ever been. And an investment-grade rating doesn't offer the assurance we once ascribed to it; witness radical downgrades pursuant to headlined accounting scandals.
Just how much portfolio protection can we expect from a 2.8% coupon on a 5-year Treasury bond? If rates rise to a rather normal-sounding 4.8%, the price of that bond could tumble 8%. TIPS, a new entrant in recent years, have exhibited heroic upside volatility as inflation fears subsided in 2002-03; where there is upside, there is downside, n'est ce pas?