Traditionally, most mainstream advice on asset allocation within investment portfolios has tended to lean toward emphasizing common stocks over fixed income to take advantage of the higher long-term rates of return traditionally offered by equity investments compared to bonds.
This philosophy lead to typical portfolio allocations for retired individuals of 60 percent in stocks and 40 percent in bonds. Of course, the recommended allocation could vary based on the individual situation and personality for assuming risk.
Now that we have experienced one of the somewhat rare “dead decades,” where equities did not provide a positive return and government bonds provided returns closer to what is normally expected from equities, many advisors and investors are re-thinking their position on risk and which asset class should be dominant in the portfolio.
It comes down to a decision of what return will be sufficient and the probability that the return can be achieved. In big picture terms over very long periods of time, stocks have provided annualized returns of 9 to 10 percent. Ten year U.S. Government bonds have average just over 5 percent during the last 80 years. A portfolio allocated with a 50/50 mixture of these assets could have provided about a 7 percent annualized return since the 1920s.
Most of us would snatch up a 7 percent annualized return over the last 10 years. Even with current 10-year bond yields down around 3.5 percent, a 50/50 portfolio mix could result in a 6 percent annualized return in the next decade if stocks return to their average results of 9 percent or so.
Further, higher yields are available on non-government bonds, such as those issued by corporations and also bonds issued by foreign governments. So for a slight amount more risk (U.S. government bonds are considered to be the most secure securities in the world), you can earn a little more yield. A blend of bonds from across the spectrum could be put together to yield in the 4 to 5 percent range without taking a tremendous amount of risk. This may be attractive to investors currently being offered CD yields of 2 percent or so, even though the bond portfolio would have some limited fluctuation of principal value.
With the foundation of a bond-based, fixed-income portfolio in place, an investor could then add in a limited amount of equity exposure in the amounts formerly assigned to bonds (30 to 40 percent) and most likely enhance the return of the portfolio with limited risk.
For example, a portfolio made up of 70 percent, fixed-income securities yielding 5 percent and 30 percent of the portfolio in equities providing a 9 percent annualized return would provide an overall return (based on these return assumptions) of just over 6 percent annualized. Better than the pure fixed income portfolio, but with the peace of mind of knowing that a smaller portion of your investments are in the riskier asset class of stocks.
I believe there are two important considerations to acknowledge as you decide whether a bond-based portfolio is right for you.
1. The very safe government-issued bonds are unlikely to return the profits achieved in the last 30 years in the next 30. Starting at such a low level of interest rates makes that a tall order to fill because rates are unlikely to drop further and, more likely, may rise in the future. In other words, buy government bonds today with the expectation of collecting the indicated interest yield and nothing more.
2. The fact that so many people are now considering bond-based portfolios is obviously being driven by their bad experience in the stock market using a rearview mirror approach. I have written many times about how when an investment idea becomes too popular, it is generally time to look at other strategies, and this may fall into that category.
However, I think the concept of bond-based portfolios will not prove to be a case of people losing money by using the popular idea, but rather one of them earning less return that they could have achieved by sticking with the more traditional allocation. Of course, for some, earning 4 to 6 percent without a guarantee is better than the 2 percent the banks are offering at present, even if it comes with some limited fluctuation risk.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.