Andrew Hallam

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?

Investors:

I woke up this morning to see that the markets had fallen a bit again last night (as a guy in Singapore, my perspective of day and night might sound off to some of you, but it is what it is).

Unfortunately, 78% of our “Stock” dollars rose last night instead.  Our overall account gained another 1.5% yesterday, while the market dropped nearly half a percent.  Naturally, we don’t want market prices to rise—we’d rather get good deals instead.  Since July 1, 2009, the S&P 500 index has increased 13.5%.  But since the same time period, our account has gained 26.4%.  I’m not happy about that.  Our new investors might be surprised to hear this, but if we’re going to be net purchasers, we want cheaper prices, not higher prices.

If you don’t mind me standing on the soap box, I could give a bit of written advice to anyone handling their own personal account money, outside the club.  At least, given where I am, nobody can hit me with an egg from where they’re sitting.  So here goes:

Clever portfolio asset allocation, with your own private funds, is likely going to have a bigger impact on your investment performance than what you choose to buy does.  People are often pretty surprised to hear that, but it’s true. 

Yale’s University Endowment Fund manager has beaten the market handily over the past couple of decades, despite having a large bond component.  In fact, it’s easy to argue that—even before the 2008 market crash—he had beaten the market because of his large bond component.

One of my clients recently asked me about the correlation between the stocks in her account, and the bonds in her account.  She asked, “Do bonds go up when stocks go down, and do bonds go down when stocks go up?”  The answer is yes, most of the time, that’s what happens.

Here’s the emailed explanation I gave her yesterday:

The stock and bond markets do operate somewhat inversely to each other.  It’s all based on supply and demand.  When people want something, they buy it, driving the price up.  People don’t tend to be emotionally intelligent.  They like to buy things that are going up in value.

Think of it this way:  if the markets have made 10% per year, as an average, for the past 100 years, and then suddenly, they start making 15% per year, most people start getting ecstatic about that and they buy more.  But if the 100 year average is 10%, then the market (if it makes 15% year over year) is going to get ahead of itself.  And at some point, it has to take a breather and/or a drop, because it can’t sustain that kind of growth.  (FYI—the markets made 17.5% as an annual average from 1982 to 2001)  Most people are emotionally foolish.  When the markets are rising more and more, they say “to hell with safety and bonds”, and they buy the rising stock products.  Where do they get that money?  Often it comes from bonds, CDs, mattresses etc.  And then what happens to bond prices, because people are selling bonds to buy stocks?  Bond prices then fall.

That’s the time to be buying bonds, rather than stocks.  When stocks fell, earlier this year, you made a small killing on your bonds.  Why?  Because everyone else was scared of the stock market, and they wanted to buy some of your bonds.  This drove the prices of bonds up.  But you already owned them, so you benefitted from their fear.  Likewise, when the stock markets got hammered, you shunned buying bonds and you bought the stocks that everyone else was selling.

Bonds are generally pretty sleepy—they don’t move a lot.  But your own bonds  have made more than 7% this year, even though they only had an interest payout of 3%.  The price of them rose as more and more people ventured into them from the stock market.  At one point, your bonds were up something like 8%+.  But the stock markets started rising, so people joined in and lightened up on bonds a bit.

We are sticking to a simple, non emotional plan.  Your bond allocation will equal your age, more or less.  When stocks rise, you’ll need more bonds.  When stocks fall, you’ll need more stocks—in order to keep the balance exactly where we want it.  According to research by David Swenson, Yale University’s endowment fund manager, (he’s an amazing investor) no matter how smart an investor is, his/her likelihood to rebalance is nearly 0.  People have a tough time buying something out of favour and shunning something in favour.   If you can remove your emotions and follow textbook allocation principles (time tested since the dawn of time) then you won’t be a victim, long term, of the markets.  Instead, you’ll be like that Buddha that works in partnership with it.  I hope that answers your question.

To walk the walk, I found myself looking at my account recently, with some money to invest.  Stocks aren’t unreasonably priced, but my bond allocation had dropped to about 36% of my total portfolio.  So to rebalance, all I had to do was buy some bonds. 

I bought 407 shares of the Canadian short term bond index (ETF) earlier this week.  The ticker symbol is XSB-To.  And I’ll keep buying bonds until they represent 40% of my account again.  If my stock market holdings keep rising, of course, I’ll have to keep buying bonds.  But here’s the beauty.  When the market crashes, I can sell many of these bonds (because again, I’ll need to rebalance) and I can concentrate on buying stocks with the proceeds, and keep buying stocks with my monthly investable money until I get back to the allocation I need.

If you want to see how an annually rebalanced portfolio of stocks and bonds has beaten a straight portfolio of stocks over the past 33 years, have a look at this one.  The tracking, I believe, is the brainchild of Ian McGugan, the founding editor of MoneySense: CCPP – Historical Performance

A blend of 33.3% bonds and 66% stocks has beaten a portfolio of 100% stocks by 28% since 1976.

It won’t do it every year, but overall, rebalancing stocks and bonds will add safety and, studies show, increase your overall raw performance.

But having a balanced account is tough.  Because the biggest enemy to our financial success is the person we face in the mirror each day.  People get swept up trying to jump on the fastest horse.  But doing so might ensure a trampling, rather than a market-beating performance.

In this entry, I make references to “bonds”.  But not all bonds are created equally.  In this case, I am referring to safe, government bonds, not risky, high yield (high risk!) corporate debt.

Few things are more fascinating for me, than rifling through other people’s private investment statements.

It’s not that I climb people’s backyard trees to reach their second story windows, where I  break into their offices or bedrooms to—James Bond style—snap photos of their Merrill Lynch statements.  It’s a lot easier than that.  People volunteer.  Where I work, at Singapore American School, I’ve examined the investment accounts of at least 30 of my colleagues.

And something always strikes me as odd.   It’s not that most of them pay higher account fees than they should—including sales fees and wrap fees.  I’m used to seeing that.  Nor am I surprised that their advisors buy them tax-inefficient actively managed mutual funds (which pay their advisors and the IRS well) instead of buying index funds (which, long term, pay the investors well instead).

What surprises me is my average colleague’s bond allocation.   When markets tank, bonds can be a more welcome site than a fireman to a treed cat.

I’ll be the first to admit—I’m what many people would call a wimpy investor.  But I work at a private school and won’t be able to enjoy a state or provincial teacher’s pension when I retire.

For that reason, I can’t afford to take silly risks.  I follow a widely accepted rule of thumb suggesting that I should have a bond percentage that somewhat equals my age.  For example, as a 39 year old, roughly 40% of my portfolio is in bonds.  It’s not sexy, but it can definitely protect my ass…ets during a downturn.

But pouring over my colleagues’ investment account statements is like watching my buddies going down class 5 rapids in leaking boats without life jackets.  I’ve seen accounts of 60 year olds that are 100% exposed to the stock market.   Without pensions, these guys are metaphorical “non swimmers” when markets fall, because their accounts have so little time to recover from a downturn, before they need to start selling off portions of their nest egg to cover life’s expenses.  Bonds can act as welcome life preservers when stock markets drop.

In fact, none of the dozens of accounts I’ve seen had a bond allocation as high as my own.  And most of the accounts I scrutinized belonged to investors much older than me.  I would have expected higher bond allocations.

There are a handful of possible reasons that my friends have such high stock allocations—and such limited exposure to bonds.

1.     In some cases, their advisors might not know any better.  A young or inexperienced advisor may be innocently unaware of how volatile a stock portfolio can be.  In these cases, the past year probably served as a great lesson.

2.    I hate to be cynical with this one, but it’s a possibility.  Under certain circumstances (depending on the financial service company you use) advisors receive higher “trailer fees” (meaning that they get paid more) for getting you into stock funds than they do into bond funds.  I like to hope that nobody makes a decision on your behalf, based on their own economics.  But it happens.

3.    For some people, the promise of higher returns with a portfolio weighted more heavily in stocks than bonds is worth the risk.  Or so they think.

This is what I find most fascinating.  How educated is the average investor, based on the probabilities of what that extra risk could mean?  And how great are the rewards reaped from taking on more risk?

If you had invested your portfolio 100% in a U.S. stock market index from 1973 until 2004, without a single bond index or bond fund, your annual return would have averaged 11.19% per year.

And if you had invested 60% of your money in stocks, and 40% in bonds, you would have averaged 10.49% per year.  Overall, you would have been rewarded for taking on more risk, with the 100% exposure to stocks.  But you’d be a bit like that gal on American Idol who auditioned in her bikini to an internationally televised audience.  Her body and audacity moved her into the next round—but beyond that?

The annual advantage, if you had invested 100% in stocks, would have amounted to just 0.7% per year during this time period, compared to an account that had just 60% allocated to stock, and the rest to bonds.  Like the gal on American Idol, you would have made the next round as well.  But at what risk?

Ryan Seacrest may not have mocked you on national television, but the 2008 market crash may have felt like you were strung up naked from a lamppost.

A quick check on the American Funds website www.americanfunds.com reveals that their average U.S. based fund, at the time of this writing, is down more than 30%, from May 31, 2008 to May 31, 2009.  When you’re down 30%, you have to gain 43% just to break even (It’s interesting math– if you’re down 50% in one year, you have to gain 100% the following year, just to break even).  If you were 55 years old, and hoping to retire in a handful of years, losing 30% could be devastating.

But if you were 55 years old, and had only 45% of your money exposed to the U.S. stock market instead, you would only be down about 12% during the same one year time period.  You’d only have to gain 13.6% to break even.  You’d have your back against the lamppost, but you’d be fully clothed, and your feet would still be on the ground.

If you’re still comfortable taking higher risks for only slightly higher return potential, you might consider this:  the U.S. markets didn’t move from 1965 until 1982.  For 17 years, they didn’t appreciate.  If that happens again, after a retiree or near-retiree loses 25% to 30% of their portfolio, they’re going to be hurting when they need that portfolio to cover living expenses.

Shakespeare said that nothing is either good nor bad, but thinking makes it so.  I think I’d prefer to keep my clothes on, stay out of leaking boats, and keep my feet on terra firma.  But that’s just me:  a wimpy investor.