Marketing Info

Balance Sheet Bond-Fire | money management

As millions of baby boomers enter retirement, many believe they should allocate a substantial portion of their life savings into instruments where the income is fixed (aka bonds or fixed income). The “owning your age in bond” convention was financially justified when developed decades ago, however, today the combined life expectancy of retired couples is much higher than that. Furthermore, there are two significant challenges in the world of fixed income today: one secular (10 years or more), the other cyclical. On the secular front, there has been a widespread decline in yields over 40 years. The US 10-year Treasury yield peaked at 15.8% in September 1981 and has been in steady decline since then (about 1.4 per cent today). The current cyclical challenge is that the real return is negative. The actual return is simply the current risk free rate minus the inflation rate.

With secular and cyclical factors as well as increased life expectancy, the result is a cocktail that is undeniably disastrous for wealth and would put many people’s comfortable retirements at risk. If you define money correctly it should be somewhat intuitive. The only sensible definition of money is purchasing power – not currency. With inflation rising today, with real returns negative and the potential for higher returns, bond investors are igniting their purchasing power.

Most of the potential customers who visit our offices share two similar goals:

  1. Live a comfortable and worry free retirement.
  2. Donate as much as you can and pass on to the family.

Those prospects have, in large part, been allocated to diversified equities for a variety of reasons. They support the tradition that when someone retires, they should allocate bonds because they are “safe.” They are frozen by a bombardment of spewing sewage promulgated by the financial media designed to keep their eye on advertisers. They are convinced equities cannot go higher and are questioning whether historical records can be used to inform further decisions. In other words, they use four of the most dangerous words in investing: “This time is different” (credit to famed investor Sir John Templeton).

The goal of this commentary will be to demonstrate that from a relative standpoint, given the two goals above, the primary risk for a retired couple today is an arbitrary allocation to fixed assets. However, if your thesis is “this time is different”, it is important to address the fundamental reason why an efficient market pays a risk premium to equity investors.

Equity bonds provide premium returns. Period. According to data published by Robert Schiller, the average real (net of inflation) 10-year excess return of stocks on bonds going back to 1871 is 4.33%, and the average since 1946 is 4.88%. However, the historical equity risk premium on bonds is not as true as it has been true throughout history. Without premium returns in equity investments, the world’s largest economy as we know it would not exist.

We’ve all contacted friends to invest in our next great start-up “idea.” They come to us because no bank lends an idea. It lends to mature businesses with assets and cash flow – by definition those businesses have less risk. Start-up businesses can only raise funds through equity (or debt that converts to equity) because 90% of them fail. By the same nature, the premium return on equity investment comes from the risk of investing in something that is much less certain. Amazon could never have started without a world that rewards premium returns for equity investments. What about Apple? Gold Tesla? Find a company that has changed the world with borrowed money as a transformative idea. We don’t know of one. Nothing that the Federal Reserve, the politicians, and/or (insert talking point of the day) replaces that fundamental truth.

This gap in equity investments extends to mature companies as well. If you buy a bond from Amazon, you stand ahead of equity holders in the capital structure. You are sure of your interest payments and proper security in the return of your principal. While the price of bonds can fluctuate depending on how interest rates fluctuate, your dollar with a financially sound company is worth a dollar at loan maturity. However, as a lender you do not participate because Amazon changes the world. The owner participates in that progress even if his dollar fluctuates in price around the day’s news. Equity ownership is riskier than bond ownership, and therefore equities are expected to pay a premium over debt.

Our job as consultants is to help clients devise a plan that drives the most important decision in the pursuit of optimal real life investment returns: the relationship between equities and fixed assets. Most advisors take the easy route – they tend to “protect” the client’s emotional instincts by building up an expensive portfolio of bond funds, which are usually packed with more risk than they understand. The industry at large doubles down and designs complex products that create the illusion that you can have your cake (something is safe) and eat it too (with high returns). If you’ve ever been curious what the financial alchemy looks like in retail, read Morningstar’s damning white paper on one of the worst examples ever – “Structured Notes: Buyers Beware” (If you’d like a copy, let us know) , we will send it) to you).

As established earlier, premium return on equity investment is a natural law of our world. However, it is important to understand how this applies to portfolio decision making. While the investment community estimates expected returns across different asset classes, the numbers themselves are not important for applying the relative leverage of lending versus ownership to portfolio decisions.

We can use Monte Carlo simulations to help us understand that relative advantage. In these simulations, the worst outcomes begin with extremely negative consistent equity returns early in retirement. In examining the best and worst-case scenarios for a retired couple using different asset mixes, the results comparing 500 different return paths are fascinating, and unpredictable for most clients.

In a multi-decade retirement plan with a world of worst-case equity returns, one would expect a higher allocation bond to yield better results. in view of the results of Imaginary Portfolio results on life expectancy, 10 in all findingsth percentile (50 .)th Worst) the result closes significantly in a portfolio of 30% equities compared to a portfolio of 70% equities. However, 90th percentile (50 .)th best) magnitude is better later. From that perspective, isn’t it appropriate to redefine the traditional understanding of portfolio risk?

We are not advocating a portfolio without bonds. All clients should have fixed assets in place in a planning framework to help weather inevitable bear market periods – this reserve helps equities realize their full potential. However, the asymmetry in worst/best results in our Monte Carlo test of retirement portfolios supports our claim that an arbitrary allocation to inflation-affected fixed assets is the primary risk for a multi-decade retirement and legacy investment portfolio. Everything else is just noise.

E. Peter Tiboris is a 20-year industry veteran and President of Strongpoint Wealth Advisors.

Christopher Bremer is director of research and advisory at Strongpoint Wealth Advisors,

Leave a Reply

Your email address will not be published.

Back to top button