It’s a tough time to be an investor. The stock markets have been on a two-year run, with New York’s S&P 500 hitting record highs. That’s great if you’ve been in the market for the ride up but now the big fear is that we’re overdue for a major correction. Who wants to buy stocks just before a plunge?
Normally, people would turn to bonds in this situation. But that doesn’t look like a great idea with interest rates apparently poised to rise. Higher rates translate into lower bond prices, as we saw in 2013. For the first time in several years, the average Canadian fixed-income fund finished in the red. It appears the long 30-year bull market in bonds is over.
So what to do? There’s been a running debate in the States for several years between two prominent author-academics who advise exactly opposite courses of action.
Prof. Zvi Bodie of Boston University, author of such books as Risk Less and Prosper, is of the opinion that stocks are too risky for long-term investing, particularly if you’re saving for retirement. His advice is to put almost everything into bonds, specifically U.S. Treasury Inflation Protected Securities (TIPS). Our equivalent would be Government of Canada Real Return Bonds (RRBs).
His point is that a portfolio that is top-heavy in stocks is always at risk, as we saw in the crash of 2008. Bonds may produce a lower return but the principal is guaranteed and, in the case of TIPS and RRBs, inflation-protected.
The opposing view is advanced by Prof. Jeremy Siegel of the Wharton School of Economics, author of the best seller Stocks for the Long Run. As the book title indicates, he advises people to put their money in equities, pointing out that over time, going back to 1871, stocks have outperformed bonds by more than three percentage points a year.
So here we have two highly respected economists offering entirely opposing views on how we should invest. Who do you believe?
In my opinion, neither one. Successful investing is not about extremes, it’s about balance.
One of the fundamental requirements of investing is to understand asset mix. This is simply the way in which your money is allocated.
Basically, there are three types of assets: cash, fixed-income (e.g. bonds), and growth (e.g. stocks). The higher the percentage of cash and fixed income investments you own, the lower your risk. But the corollary is you must settle for minimal returns. Prof. Bodie argues that the trade-off is worthwhile because your capital will be protected.
As you increase the percentage of growth securities in a portfolio, you add more return potential. But you also incur more risk. When a major market crash hits – and we have had two since the turn of the century – a growth-oriented portfolio will get slammed.
The impact of the credit crunch of 2008 offers a dramatic example of the value of a diversified portfolio. According to CNN, U.S. stocks fell 37 per cent that year while long-term U.S. government bonds gained 27.7 per cent and U.S. Treasury bills yielded 1.5 per cent.
So a $10,000 portfolio that was entirely invested in U.S. stocks (the Siegel approach) at the start of 2008 would have been worth only $6,300 at year-end, while a long bond portfolio would have grown to $12,770. But in 2013, with the bond market in turmoil and stocks soaring, the end result would have been completely different.
It’s fine for academics to talk about the long term but most people are uncomfortable with such financial fireworks along the way. That’s why I prefer a balanced asset mix of, say, 10 per cent cash, 40 per cent fixed income, and 50 per cent stocks. Using the CNN numbers, that portfolio would have lost only 7.2 per cent in 2008 and would have been well positioned for the stock market rally that began in March 2009.
So leave the extremes to the theoreticians. Investing is a balancing act. Get it right and you’ll do just fine.
Gordon Pape is editor of the www.BuildingWealth.ca Internet Wealth Builder newsletter. His new book, RRSPs: The Ultimate Wealth Builder,
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