If we are in fact facing a prolonged period of subpar returns in both stocks and bonds, as seems likely, there are almost limitless ways this future could play out. We might, for example, simply experience long years of generally positive – but low – returns, interspersed with down years. At the end of the decade a growth-oriented portfolio might have compounded at 3% per annum.
More spectacularly, we could be battered by a massive bear market, à la 2000-2002 or 2008-2009. Stock prices could fall by half, putting valuations back in line with our stumbling economy. Thereafter, markets would recover, but the end result would likely be the same – returns of about 3% per year.
Almost no matter why we’re investing, 3%/year isn’t going to get us where we want to be. Inflation is likely to be somewhere in that neighborhood, and after taxes and spending we’ll all be deep in the hole. Even tax-exempt institutions will be severely harmed, given that most of them spend about 5% per year. And we won’t even talk about pension plans, who are typically projecting 7.5% returns just to stay even with their liabilities.
What’s to be done? Let’s take a look at the pros – and cons – of various alternatives we might employ, as follows:
a) More aggressive asset allocations
b) Taking greater advantage of the premium for illiquidity
c) Sourcing alpha from [wherever].
d) Focusing on opportunistic investment ideas
e) Reducing investment costs
f) Lowering spending
Adopting a more aggressive asset allocation strategy. Most long-term investors are employing strategies that contain 60% to 70% risk assets (like stocks), with the balance in bonds and cash. Presumably, whatever mix investors have been living with is the right one for their risk tolerance. On the other hand, what’s our tolerance for 3% returns?
Suppose that a 60-40 stock-bond mix will produce 3% per year, and that a 70-30 mix will produce a bit more. Why not move to a 90-10 mix?
Many investors, and most financial advisors, would be shocked at this suggestion, deeming a 90% equity portfolio to be far too risky for all but the youngest investors with no income needs. But one savvy investor – maybe the savviest of them all – recently recommended precisely that strategy: Warren Buffett.
Buffett has established a trust for his wife, and he announced (in his 2013 letter to Berkshire Hathaway shareholders) that he had instructed the trustee of that trust that, upon Buffett’s death, the trust was to be invested 90% in stocks – in a cheap index fund – and 10% in safe government bonds.
Is the man nuts? This isn’t a portfolio for a five-year-old with no spending needs, this is a portfolio for a mature woman who needs to live on the money. To find out just how nuts Buffett is, we can calculate the percentage of time the 90-10 portfolio would fail – that is, how often would Mrs. Buffet run out of money before she died?
Fortunately, we don’t have to run those numbers because someone already did it, namely, Javier Estrada, a professor at IESE Business School in Barcelona. (http://blog.iese.edu/jestrada/files/2016/03/Buffett-AA.pdf) Dr. Estrada made a couple of sensible assumptions about the Widow Buffett: that she would live another 30 years and she would withdraw 4% of the portfolio’s value every year for living expenses. He then calculated how often the portfolio would fail. The answer? 2.3% of the time.
The reason the 90-10 mix works is that, during good times, the portfolio compounds very rapidly, so that even the occasional bear market doesn’t devastate it. In fact, the 90-10 mix is “safer” than much more cautious portfolios, similar to the ones many financial advisors recommend for “older” investors. A portfolio of 40% stocks and 60% bonds fails more often than the 90-10 mix, and a portfolio of 30% stocks and 70% bonds fails five times as often.
But before you fire your financial advisor – who might be me – and move to a 90-10 portfolio mix, you might consider the behavioral implications of such a portfolio. A great many investors who have 90% of their money in stocks will go into cardiac arrest during a period when markets drop, say, 50%. If you wait until the 50% drop has happened, then bail out and reinvest in bonds, you are dead dead dead. You’ve already lost half your capital and now what’s left isn’t invested aggressively enough to recover.
In Buffett’s case, the assumptions (on his part) are (a) no matter how nervous his widow’s trustee might become, he can’t bail because he has been instructed to maintain the 90-10 mix at all times, and (b) the Widow Buffett will have so much money that she could lose 99% of it – twice – and still be immeasurably rich.
If you do get tired of 3% returns and decide to implement a 90-10 mix, you might heed Dr. Estrada’s “tweaks” to the Buffett mix:
First, if stocks are positive in any year, you should take your spending from the equity portfolio and then rebalance back to the 90-10 mix. If bonds beat stocks, take your spending from the bond portfolio and don’t rebalance.
Second, whether stocks are positive or not, if they beat bonds in any year take your spending from equities and then rebalance. If bonds beat stocks, take your spending from bonds and don’t rebalance.
The upshot of all this is that if you can manage the behavioral stresses of a 90% stock portfolio – a very big “if” for most investors – moving to a more aggressive asset allocation strategy might be preferable than settling for 3% annual returns.
Next up: Getting Rich in a Poor Market, Part 3
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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.