## Should Young People Hold Bonds in Their Retirement Portfolios?

Investing Guide asks should young people carry bonds in their portfolio?” This is question that I have mulled over before as well. I agree with Loi that “there have been some conflicting advice on whether young people should have bonds in their portfolio.” Personally I have been through one bear market already (without any fixed income) and I do not want to go through another one without bonds in my portfolio. Some of you will know what I mean. Others will not know the agony of seeing your portfolio’s value fall month after month as the stock market tanks. However, “having some bonds (15-20%) in a portfolio lowers downside risk by a large amount.” This is one of the key reasons that I want to have some bonds in my portfolio, to reduce downside risk.

The second reason that I want have some bonds in my portfolio is because Benjamin Graham says so (at least 25% bonds). Benjamin Graham knows what he is talking about. He was around for a long time, during the depression, post-depression and all the way until the 1970s. He has seen many ups and downs. In the Intelligent Investor (1973 edition) he says that:

even high-quality stocks cannot be a better purchase than bonds under all conditions–i.e., regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds. A statement of this kind would be as absurd as was the contrary one–too often heard years ago–that any bond is safer than any stock. [emphasis his]

At the end of the chapter, after much discussion (you will have to read it), he concludes that

Just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket–neither in the bond basket, despite the unprecedentedly high returns that bonds have recently offered; nor in the stock basket, despite the prospect of continuing inflation

In Chapter 4 he addresses bond-stock allocation in more detail for the defensive investor. It can be summarized as the following:

He should divide his funds between high-grade bonds and high-grade common stocks. We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.

Note that Graham does not discriminate by age. Jason Zweig goes on in his end-of-chapter why going 100% stocks may be ok for a small minority of the population:

For a tiny minority of investors, a 100%-stock portfolio may make some sense. You are one of them if you:

• have set aside enough cash to support your family for at least 1 year
• will be investing steadily for at least 20 years to come
• survived the bear market that began in 2000
• did not sell stocks during the bear market that began in 2000
• bought more stocks during the bear market that began in 2000
• have read Chapter 8 (The Investor & Market Fluctuations) in this book (The Intelligent Investor) and implemented a formal plan to control your own investing behavior

Personally I do not think I fit into this small minority. Secondly I think that going with a 100% portfolio goes against my third and final reason for wanting some bonds in my portfolio: rebalancing. If you have a 100% stock portfolio and the market tanks by 20% this year you cannot take advantage of rebalancing. If you have a 75% equities, 25% fixed-income/bond portfolio and the stock market tanks by 20% this year, your allocation will shift to 71% stock, 29% fixed-income/bonds. Assuming you can do this in a low-cost fashion, you can instantly get a hold of cheap stocks by selling part of your bond portfolio and buying equities.

Getting back to the whole age thing, I do not think it really matters. When you get really old you should obviously be more focused on income and capital preservation than when you are young. But I do not think people in their 20s should invest any differently than people in their 30s and 40s. That is, I think they should have some bonds in their portfolio no matter what. Capital preservation should be just as important to someone in their 20s. And as Loi mentioned in his article, the average return of a 100% stock portfolio from 1960-2004 was 10.5% whereas the average return for a 80% stock/20% bonds portfolio was 10.1%. I haven’t verified those figures but I have seen similar graphs and numbers quoted before so I am not surprised. I cannot think of why anyone would not want to take a small 0.4% hit on their return for the lower risk offered by a mixed bonds/stocks portfolio.

Initially my advisor did one of those risk surveys on me and I fell into the 100% equity category. Unfortunately those risk surveys are seriously flawed. Just because you have held stocks and mutual funds in the past, have a 30+ years time horizon, have a sound knowledge of investing, and can answer a bunch of other basic questions does not mean that you should automatically be in a 100% equity portfolio. I insisted that I have 25% fixed income (à la Graham) so my new portfolio at Clearsight will hold 25% TD Canadian Bond fund for now (great for rebalancing with as their are no commissions as with ETFs).

## Portfolio Update

My RRSP holdings at TD Canada Trust have been transferred from TD to Clearsight in-kind, meaning that they been transferred whole without being sold first. I was only required to sell my TD eFunds to transfer them. Now my advisor and I are getting ready to sell all my TD holdings and start my long-term retirement portfolio anew. My advisor forwarded me a suggested portfolio on Friday:

 RRSP holding Type Account % CI Value Trust US Equity 15% Templeton International Stock Fund Global Equity 35% Canadian TSX60 index Canadian Large Cap 40% Canadian Energy Index Canadian Energy Equity 5% E&P Growth Opportunities Canadian Small Cap 5%

Here’s the total asset allocation breakdown:
15% US Equity, 35% International Equity, 40% Canadian Large Cap Equity, 5% Canadian Energy Equity, 5% Canadian Small Cap Equity

This is similar to what he suggested before, the main difference being that he suggested a lower US portfolio allocation because he thinks their currency is set to take a beating; however, he says we will shift towards my 25%-25% allocation later as he, like me, believes in keeping a fairly static asset allocation over the long term. Also, it says TSX60 Index above, but it is actually iUnits XIC ETF which no longer tracks the S&P TSX 60 but tracks the X&P TSX Composite.

Here are the changes I want to make to it:

• Add 25% to fixed-income. TD Canadian Bond fund or Altamira Bond fund would be my choices there.
• No separate energy equity right now. There is plenty of energy stocks in the Canadian index and I am just not interested in playing around with an additional energy index right now, but it is something I will consider later.
• Instead of CI Value Trust I would like to buy the Rydex S&P Equal Weight ETF. I have talked about it in several previous posts. Bill Miller’s fund is a lot riskier yet it has not managed to beat the equal-weight index.

This would make the allocation: 25% fixed income, 15% US Equity, 35% International Equity, 20% Canadian Large Cap Equity, 5% Canadian Small Cap Equity.

I am not sure what I will end up with. My advisor might be able to sway me the other way a bit, but hopefully we will end up with something he agrees is good for me and that I am comfortable with.

## How Not to Rebalance

In this article, “Rebalancing Act: Why You Shouldn’t Massage Your Portfolio Every Year” at the Wall Street Jounal Online, we are basically told to rebalance if the stocks that performed well in the previous year are not going to perform well in the upcoming year, and to NOT rebalance if the stocks that performed well in the previous year are going to do well in the upcoming year as well. Two examples are provided:

Over the five years through year-end 2004, value trounced growth. But this year, growth and value are neck-and-neck. Are growth funds on the mend? If they spurt ahead, you might hold off rebalancing, so you capture more of the recovery. Similarly, after 13 years of mostly dreadful performance, Japanese stocks started bouncing back in 2003. If you own a Japan fund, you might let your winnings run for a little longer, rather than rebalancing at year end.

This is the most ridiculous thing I have ever heard. Implementing this strategy correctly relies on having a crystal ball. And if you had a crystal ball, you wouldn’t bother with any rebalancing at all. You would just do exactly as your crystal ball told you to do. After all, a crystal ball can tell you what is going to happen in the future. It is dangerous to think that you have anything in your possession that resembles a crystal ball, or that you have any psychopathic abilities whatsoever.

Ah, but there is some sense in the article (very little), but you have to read through the entire article until you reach it:

There is, however, a risk in waiting. The further your portfolio strays from your target mix, the harder you will get hit if the market turns against you. Indeed, Richard Ferri, president of Portfolio Solutions in Troy, Mich., worries that less-frequent rebalancing is maybe too clever. “If you’re a sophisticated investor, you can look at the momentum and you might let it run a little,” he says. “But for most people, annual rebalancing works just fine. It’s ‘Happy New Year,’ I’ve got to rebalance my portfolio.” [emphasis/bold mine]

## Sector Allocation – Don’t Sweat It

I found this article on the Canadian Capitalist a while ago, “Asset Allocation Explained” and the part I found most interesting was the link to some comments by Jonathan Clements (from the Wall Street Journal) on Asset Allocation:

I used to agonize over what percentage of a portfolio should be allocated to, say, emerging-market stocks, or high-yield junk bonds, or large U.S. companies. But now, whenever somebody asks me how much to allocate to a particular sector, I usually respond that — within reason — it doesn’t much matter [sic].

Yeah, this takes some explaining. If you tap into a broad market segment using a well-diversified mutual fund, you can be pretty confident that you will make decent money over 30 years. Moreover, over those 30 years, there probably won’t be a radical difference in performance between, say, U.S. stocks and foreign stocks, or between, say, intermediate-term government bonds and intermediate-term corporate bonds.

With that in mind, you shouldn’t fret too much over your precise allocation to large stocks, small stocks, foreign stocks, REITs, corporate bonds, government bonds and other market sectors. Instead, what counts is commitment.

In other words, whether you allocate 15% or 30% of your stock portfolio to foreign markets probably won’t make a whole heap of difference over the next 30 years — provided you stick with your target percentage. The danger: You get greedy or fearful, trade in and out of your foreign funds and end up missing out on the sector’s handsome long-run gains.

As someone who has agonized over my own allocation, as a fan of rebalancing and as someone who has seen the negative effects of too much performance-chasing and trading in my own portfolio, I found these words comforting. Diversify to reduce risk to a level that is appropriate for your situation. Pick an allocation, stick with it, and rebalance when required.

## Asset Allocation and Rebalancing

Interesting example of asset allocation and rebalancing in this article, “What the Heck is Asset Allocation.”

He illustrates two cases (over 2 years):

• Case 1: Investing $100,000 in 4 different mutual funds (large-cap, mid-cap, small-cap, and bonds), 25% each. Sell the worst performer after the first year and buy the best performer. Hold for one more year. This leaves you with$96,535 after the 2 year period.
• Case 2: Same as above, but rebalancing the funds after year 1, so that each fund was again 25% of the portfolio. This case leaves you with $103,170. He also could have shown the case where you just buy & hold for the 2 years: • Case 3: Using the returns provided in the article, the final value for each fund would be $$FV=PV \times (1+i_1)(1+i_2)$$ for each fund, where $$i_1$$ is the return of a fund in year 1 and $$i_2$$ is the return of a fund in year 2. You would end up with$102,660

It just happens to work out this way because of the data he used. Had he rigged his data so that the Bond fund continued to do poorly in year 2 and the small cap continued to outperform the others, then our results would be different. But in my opinion if you looked at past market data you would find that case 2 above is invariably the best thing to do.

## S&P 500 equal-weighted index

Found an old article from 2004 about the S&P Equal Weighted Index, “Buy the S&P 500 with better returns,” which can be bought under the Rydex S&P Equal Weight EFT (RSP). The S&P Equal Weight index holds all the stocks in the S&P 500 index equally (0.2% each). Rebalancing works like this:

If the share price of one of the companies in the index climbs sharply, the Rydex fund pares it down to a 0.2% weighting when the portfolio is rebalanced every quarter. If a stock tumbles, more is added. Thus the fund is continuously funneling profits from stronger to weaker issues; in effect, selling high and buying low.

I wouldn’t even really call this value investing. This is just common sense. If you created a portfolio yourself of 60 stocks, like the S&P TSX 60 index, would you weight them according to their market capitalization? Probably not. If one of the stocks in your portfolio went up by 50% and another went down by 50%, would you sell the one that went up and buy more of the one that went down? Yes, you probably should, if your transaction costs aren’t too high. If you want to think of it as value investing, that’s fine. I guess compared to the run-of-the-mill S&P500 it is certainly more value-oriented:

“This is a poor man’s value tilt,” says Robert Deere, head of domestic equities for Dimensional Fund Advisors, the foremost operator of customized index funds for institutions.

DFA heavily favors small and downtrodden stocks, citing academic research that shows they outperform big-cap growth stocks over long periods. Since this fund does that implicitly, “I would expect it to give you a higher return — no doubt about it,” he says.

The article pooh-poohs the Rydex Equal Weighted Index’s MERs, “The ETF’s expense ratio is 0.4%. That’s more than three times that of the Spider, eroding indexing’s greatest advantage.” But that hasn’t hurt its returns. According to the article the equal-weighted index has beaten the market-weighted index by 2% over the past 10 years,

Rydex says that the equal-weighted index has greatly outperformed the market-weighted index over the last 10 years, delivering annualized returns of 14%, compared with 12% for the index.

However, this document on S&P’s website puts the 10-year annualized returns at 12% and 9.3% respectively. I will definitely be buying RSP over SPY and not because I am chasing after good past returns but because the methodology makes sense.

## Diversify, or Quit Your Day Job

Saw this article, “To Diversify or Not to Diversify” on the Canadian Capitalist’s blog and at Consumerism Commentary. Kiyosaki seems to recommend not diversifying (for “any investor who wants to be a rich investor”) yet he keeps reminding us that “to become a professional investor, the price of entry is focused dedication, time, and study” and that finding the best investments (focusing) means “sifting through hundreds of offers, studying, analyzing, and determining the pros and cons of each.” He is correct. For me to not diversify my portfolio, I would have to devote my entire day (and life) to investing.

And finally he says one of the reasons “the rich get richer is because they are focusing, while the middle class is diversifying.” He fails to mention the possibility that the rich are getting richer because they have access to far better (and more costly) financial advice than the rest of us, and access to far more capital which gives them access to far more investment and speculation opportunities. And he fails to mention getting better financial advice as an alternative to diversifying. Instead, he tells us blindly focus our investments rather than diversifying, because after all “people like Warren Buffett, Oprah Winfrey, or Lance Armstrong, they have all focused intensely in order to win.” He also fails to mention that some of the rich have probably become poorer because they are focusing.

So what’s the point of the article? I think it’s that you should quit your day job, and start “focusing on finding the best investments” so that you can be the next Warren Buffett. Or “if you choose to remain an amateur — a passive investor — then, by all means, diversify.” Well folks there’s no shame in being an amateur or a passive, defensive investor. In fact you will probably have far better success if you pursue this path. Benjamin Graham explained the dangers of trying too hard so well in the first chapter of the Intelligent Investor:

A creditable, if unspectacular, result can be achieved by the lay investor with a minimum of effort and capability; but to improve this easily attainable standard requires much application and more than a trace of wisdom. If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.

Since anyone–by just buying and holding a representative list–can equal the performance of the market averages, it would seem a comparatively simple matter to “beat the averages”; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years as has the general market. [italics his]

## Cut and run: portfolio update

After reading this bearish post, “Sell some winners and most of your losers” I am thinking of increasing the cash-equivalents (bonds, money market, cash) portion of my portfolio.

I have an all-equity portfolio right now at TD, but I am just a few months away from transferring all my investments to Clearsight. Just waiting for the no-sell period to expire on some of my funds so I don’t get dinged with early redemption feeds. Once I switch to Clearsight I will assume a 25-75 bonds/equities ratio eventually. So I do not see this as a market timing strategy, but simply a re-allocation to where I will be in a few months/years from now anyways. This is my portfolio at TD as of now:

 Fund % of holdings TD CDN Equity 4.450% TD CDN Money Mkt 7.680% TD CDN Small-Cap Equity 4.460% TD Emerging Mkt 1.770% TD Global Select 13.320% TD Science &Tech 3.480% TD Energy 4.920% TD US RSP Index-e 10.770% TD Int’l Index-e 11.030% TD CDN Blue Chip Equity 14.470% TD Dividend Growth 14.230% TD US Mid-Cap Growth 14.230%

The reason the money market fund is there is because that is the only thing I could put money into that doesn’t have a 90-day no-sell period. Before the monthly transfers from Clearsight were in effect I wanted to put my money somewhere (so I couldn’t spend it). Don’t ask me why I don’t have 25% bonds in my TD portfolio. I actually used to have at least that much but for some reason (can’t even remember), I sold them. That’s partly the reason I’m leaving TD. I want an advisor between me and my portfolio to stop myself from excessive trading and pointless fiddling. I think I’ll sell the Science & Tech fund. I’ve wanted to get rid of that for a long time. I have nothing good to say about tech funds or technology stocks in general. History has proved time and time again that they are nothing but trouble. I will probably also sell TD CDN Equity which has had a good run and did not perform as well in the previous bear market as did TD Dividend Growth or TD Blue-chip Equity.

I do not have access to the original article, but here is part of what The Big Picture quoted:

The disquieting overwhelming agreement among Street folk that we’re in a rally mode whose only real danger is that of missing out on the fun and profit that lie ahead is not the sole reason for our skepticism. The inevitable speculative excess that such an attitude begets is another tangible cause for unease. Speculation, of course, is always with us. And thank heavens it is, since it’s truly a vital investment ingredient, adding spice and whetting appetites. Heck, without speculation, Wall Street would be the epitome of dullness. But it’s the classic good thing that you can quickly and easily get too much of.

And whether you feel we’ve reached that state depends mostly, we reckon, on whether you own a stock that’s kicking up its speculative heels or not. What is clear, however, is that there’s no shortage of such stocks and their numbers do seem to be steadily rising. Here, we suspect the revived passion for momentum investing, the opportunistic approach of many hedge-fund managers, reminiscent of the day traders in the late ‘Nineties, to buy anything that moves, and the hyperventilating habitués of the online chat rooms are major stimulants

. . .

Stepping back a ways to get a little broader perspective, it seems to us that we are witnessing the beginnings of the end of the fabled era of easy money. And anyway you slice it, that shapes up as not exactly good news for a lot of businesses that battened rich in that extraordinary era

I do NOT listen to this kind of stuff. I do not buy in to any predictions about what the stock market is going to do next as it is completely unpredictable. I like to have a balanced asset allocation and rebalance from time to time. Predictions like these are not anything to be taken seriously or to lose sleep over; they are only a reminder that it is wise to not be 100% in equities.

## Value Investing and the Death of Efficient Market Theory

This article by Joseph Nocera about the recent annual Graham and Dodd breakfast at Columbia University brought up a few interesting things that I hadn’t read too much about before, mostly concerning the theory behind how 95% of the world invests today. Apparently most business schools across the United States teach Modern Portfolio Theory as a way to minimize risk in a portfolio. It (MPT) holds that because the market is efficient (an assumption), it cannot be beaten, and therefore the only way to minimize risks and maximize returns is through diversification. This is essentially the theory from which banks and other financial managers from all over will tell you things like “Experts agree that the asset mix of your investments – safety, income and growth, account for more than 80% of your portfolio’s return.” This statement doesn’t even make sense to me, although I have sort of accepted it gospel for a long time, since it was posted on TD Canada Trust’s website, and of course the big banks know everything.

Bruce Greenwald, who runs a value investing course at Columbia, like Benjamin Graham and Robert Heilbrunn before him, says that “efficient market theory is basically dead.” Warren Buffet says modern portfolio theory is akin to the theory that the “world is flat.” Well that was enough for me… I guess modern portfolio theory is just a theory and the efficient market hypothesis is just a hypothesis.

There is also talk in the article about why value investing is so unpopular, even with the success of Buffett and Graham and many others and the fact that studies that have been published which show that “a portfolio of value stocks generally outperformed the market.” There are many reasons given. Jason Zweig (who wrote the updated in comments in Graham’s latest Intelligent Investor), says that value investing is “just plain hard,” (ie. takes a long time pouring over statements) and others say that there simply aren’t as many value stocks out there these days (could be true, if you look at the long term trend in P/E ratios). But Jean-Marie Eveillard, a successful value mutual fund manager said what Joseph Nocera thought was the best answer, that “It goes against human nature . . . You have to be very patient. You’re not running with the herd — and it’s much warmer inside the herd.”

## Proposed Changes to XIC, XGV, XSP, XIN

Barclay’s is having a special meeting of unitholders, to decide on proposed changes to iUnits ETFs: XIC, XGV, XSP, XIN [pdf]. The most significant proposed change is to have XIC track the S&P TSX Composite rather than the TSX 60 index. Reasons given are:

1. More securities and more diversified exposure to large-cap, mid-cap and small-cap stocks improves diversification which helps reduce volatility risk.
2. The Composite Index is the most widely used benchmark of Canadian equity performance, which improves investors’ ability to compare results to other Canadian equity funds.
3. Offering funds which track the S&P/TSX 60 Index and the S&P TSX Composite Index provides investors in iUnits funds with more choice.
4. The increased fee reflects the time, expertise and expense involved in managing a portfolio of over 200 securities versus 60 securities.

XIU, the non-capped S&P TSX60-tracking ETF will still exist, it is only the capped XIC which is being changed.

XGV is becoming more diversified, to include provincial, municipal, and corporate bonds, rather than just Government of Canada bonds. It will now be tracking the Scotia Capital Short Term Bond Index.

XSP (S&P 500 tracker) and XIN (MSCI EAFE International Index tracker) will now be unaffected by exchange fluctuations. I assume this was done because of what happened in the last couple years, where Canadian investors’ in the US indexes were hurt by the falling US dollar in relation to the Canadian dollar (and every other currency for that matter).

We will know on November 15 the outcome of the vote by unitholders on the proposed changes. More detailed information can be found in the information circular.