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May 27 2010

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Beating the Market with Bonds


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Years ago I read a great book by Michael O’Higgins, titled Beating the DOW with Bonds: A High-Return, Low-Risk Strategy for Outperforming the Pros Even When Stocks Go South.

It made a lot of sense, and anyone following O’Higgins’ advice would have made a lot of money since its publication in 1999.

When it was published, the book received chilling reviews. The former bestselling author of Beating the DOW: 1992: A High-Return, Low-Risk Method for Investing in the Dow Jones Industrial Stocks With As Little As $5,000 was saying what people didn’t want to hear: that markets were overheated in 1999, and bonds paying 7.5% annually were a better bet than having money in stocks.

It turns out that he was right. Did I follow his advice? Sort of.

Sidenote—O’Higgins went to the school I teach at (Singapore American School) but his dad withdrew him for having such poor grades.

We’ve had a volatile 11 years of market movements that have gone up and down, but overall, they’ve moved sideways.

I believe (most of the time) in having a high bond allocation matching your age. It ensures that your investments are less volatile as you get older, and it gives the dispassionate investor a fabulous war chest when things get cheap. For example, as a 40 year old, I have 40% of my portfolio in bonds.

In 2008/2009, I enjoyed selling off bonds to buy cheap stocks.

A cheap stock market is safer than an expensive stock market. But most people don’t understand that concept.

Unlike O’Higgins’ approach, which was to be “all in” stocks or “all in” bonds (depending on a mechanical decision he explains in his book) I shift my money slowly. When the markets fell in 08/09, I started selling off bonds to buy stocks. The lower the markets fell, the more bonds I sold—and the more stocks I bought.

The market’s recovery in 2009/2010 ensured that I made large profits as the DOW recovered from roughly 7,400 points to something around 11,000 points. And because my account is tax-sheltered, I was able to rebalance again, buying bonds when the markets got more expensive.

But with the current market jitters, I’m starting to take advantage of the short term thinking again. Last night I sold about $70,000 worth of my Canadian short term bond index (XSB-TO) to buy some relatively cheap Coca Cola shares, adding to the shares that I bought in 2003 and 2009.

The more the markets fall, the more bonds I’ll sell and the more stocks I’ll buy. And frankly, if the DOW falls back to the 7000 point level (or below) I’ll be happy to be invested 100% in equities.

Thank you Michael O’Higgins!

Readers, what do you think? Are you prepared to deal with the opportunities of a plunging market? Or do you think I’m nuts?

About the author

andrew hallam

I'm a freelance finance writer, lucky enough to have been nominated as a finalist for two Canadian National Publishing Awards. I'm also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, a book explaining how I became a millionaire on a teacher's salary, while still in my 30s. Working to empower people financially, I'm available to motivate and inspire people on basic retirement planning and index investing. I'm happy to comment on your questions, first, please read the Terms of Use.

Permanent link to this article: http://andrewhallam.com/2010/05/beating-the-market-with-bonds/

11 comments

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  1. avatar
    Kevin@InvestItWisely

    Hey Andrew,

    I was reading the article you sent to me and they come to a striking conclusion: that a high equity exposure in retirement can be a good thing, as long as you are withdrawing a low amount per year (3% to 4%). In fact, they also recommend going to 100% stocks whenever a "black hole" event arrives, like we experienced in 2008-2009.

  2. avatar
    Andrew Hallam

    Hey Kevin,

    I totally agree with going 100% equities during a black hole time. Even the dividend yields will pay 3-4% at that rate (at least) so an investor won't have to sell anything to live off 3-4% of their portfolio.

  3. avatar
    The Passive Income E

    Well done!

    I like the strategy of always having cash on hand to buy during drops. This is where patience pays. I have to admit that I have not thought much about moving away from 100% equity yet but your bond allocation strategy is very interesting.

  4. avatar
    Andrew Hallam

    Hey Passive Income Earner:

    When valuation levels for stocks get a bit silly (say, a PE of 22 or above) the decade that follows is bad for stocks. I backtested this in an article I wrote in 2002. We'll get back to dumb PE levels again, at some point in the future (and you'll be happy because the rising market, in the process, will make you wealthy) but that's the time to buy nothing but bonds. The business yield on stocks will be lower than the yield on bonds. And then you can build your war chest for the big drops that will come. Big drops will always come, if history is an indicator. What do you think?

  5. avatar
    ThinkDividends

    Have cash on hand: That's why holding XSB makes more sense than GICs.

    What kind of bonds was O’Higgins buying in 1999?

  6. avatar
    Andrew Hallam

    Hey Think Dividends:

    Thanks for visiting!

    I think he was buying ten year U.S. Treasuries at the time. But his formula had him switch to gold at one point as well. It was a mechanical strategy where he'd move from stocks to either bonds or Gold depending in the yields on certain debt. Either way, whether he went into gold or bonds (or back and forth) his strategy had him out of stocks, and into making a bit of a relative fortune, compared to most of us. The book got slammed for its poor editing, but I think the message upset people in a "go go" stock era. I'd be curious to hear what you think of the book. You should be able to pick it up cheaply.

    Thanks for joining us on this one.

    Andrew

  7. avatar
    Financial Cents

    Absolutely prepared to deal with opportunities presented by a low market…simply wish I had more to invest! I'm not "the borrowing type" so I tend to use market lows as an opportunity to put a few hundred dollars into an OCP (optional cash purchase) for one of my dividend-payers, say BNS or ENB. Your move to buy US:KO is perfect! I'll have a post this week about adding to my JNJ position/adding more U.S. stocks to my RRSP. JNJ has taken a good beating of late.

    I agree with you, a bond allocation to match your age, although defensive, is a good play for most people and an act I too am trying to follow.

    In closing, what a great line: "A cheap stock market is safer than an expensive stock market." For sure!

  8. avatar
    DIY Investor

    Just some quick observations. O'Higgins was not much appreciated because many investors don't understand how bonds work. I'm not even sure most investors understand how well they did in 2008.

    I agree with your move from bonds to stocks but it needs to be looked at from a long term perspective. Furthermore, I don't invest more than 5% in any particular name (bonds and stocks together!) for diversification purposes so I would limit exposure to Coke to that – even given your excellent analysis.

    It is important to get that U.S. Treasury notes and bonds are the safest asset on the face of the planet. When investors get scared they pile into Treasuries and people have been getting scared a lot lately. Thus, be prepared to question your asset shift in the future whenever international tensions etc. pick up. As long as you keep a long-term perspective in mind you'll do fine.

  9. avatar
    Andrew Hallam

    DIY Investor:

    I remember the Motley Fool guys not liking what O'Higgins wrote in 1999. And he was the hero they trumpetted for his influence on their Foolish 4 approach of high dividend yielders. Like you, I agree that most people don't understand how bonds work. And I also think that O'Higgins was saying some things that made people feel pretty uncomfortable about the frothy markets.

    Your suggestion of not having more than 5% in a single entity is a good one. I haven't set limited parameters myself, but currently, my Coke stock makes up about 6% of my portfolio, so perhaps I'll take your advice and keep it as is.

    I do have a lot more Berkshire Hathaway than Coke, but I think my largest single equity holding is with Vanguard's ETF, VEA (first world international).

    My largest bond holding is a Canadian short term government bond index (XSB.TO). Just from dumb ass like, it's up about 18% including interest over the past two years—when measured in U.S. dollars!

    But as a Canadian, my future bills are likely going to be in Canadian dollars, so I don't make one more or another based on currencies, really. In the end, I'm not smart enough to do that, and it will likely, over many years, end up a "wash" anyway.

    I'd love to hear your opinion on whether you believe that good investors are "wired" to do it, or they aren't. Can you "set free" all of your clients after educating them, or are there some really smart clients who just won't be able to do it themselves because they're too emotionally influenced by news, fear and greed?

  10. avatar
    Michael

    I had check out this book a few months ago but became discouraged to read it after seeing such poor reviews. I'll definitely give it a second shot though, sounds like a made a bad call not reading it.

    1. avatar
      Andrew Hallam

      Hey Michael,

      If Michael O'Higgins' book, Beating the Dow With Bonds, was reviewed today, it would be hailed as pure genius. It will go down as one of the smartest investment books ever written. A must read! Enjoy and marvel at how prophetic it is, while filled with common sense.

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