Ken chose a deliberately provocative title to get long investors to sit up and pay attention. He makes four important points:
- Our investment horizon is far longer than we think
- The conservative thing to do is to hold a higher investment in growth assets (i.e. shares). Anything else would be “hating your wife”.
- Just because we should invest more in growth assets (strategy) doesn’t mean that we can’t adjust our portfolio as circumstances change (tactics).
- Focus on total returns (not just income).
How long are we likely to live?
Ken presents us with the following scenario?
Take a normal fellow worth half a million at 70 who thinks he might live ten years and is mostly in bonds. Conservative? No, foolish. His wife is 63. She comes from a family like mine where few folks die before 90, meaning that her longevity stretches past 30 years. Her husband must hate her severely, because bond-like returns on half a million, offset by withdrawals to live on, will leave her in poverty long before the 30 years are up. Poverty in old age is brutally cruel.
Is Ken exaggerating? No, not according to these figures from the Australian Bureau of Statistics published in the JP Morgan Asset Management Quarterly Guide to the Markets.
There’s a 68 per-cent chance that a newly retired person will live to 80. That’s a 15-year investment horizon. But there’s also a 52 per-cent chance that at least one person in a couple lives to 90. That’s a 25-year investment horizon.
2.5% inflation over 25 years results in a 46 per-cent reduction in purchasing power. And if that wasn’t bad enough, it gets worse. Healthcare costs generally increase faster than the overall inflation rate.
Bonds aren’t Conservative Investments
Bonds aren’t conservative investments. At least, they aren’t conservative if your investment horizon’s 15 years or more. This chart from the JP Morgan Asset Management shows the returns for US shares and bonds over different investment horizons. The data is from 1950 through to 2017. The returns for Australian shares and bonds over the period are very similar.
Shares (green) are undoubtedly much riskier over a 1-year investment horizon. This volatility is what drives the belief that shares are risky and bonds are safe.
But stretch the investment horizon out to five years and shares are not much riskier than bonds (blue). That said, the upside is better, with shares beating bonds approximately 70 percent of the time. Lengthen the investment horizon out to twenty years and there’s no contest. Shares beat bonds 95% of the time. The worst 20-year return was 7% per year. Not bad.
A closer look at why bonds have performed so well shows that it’s almost impossible for bonds to repeat that feat in the coming decades. In 1982, the yield on the 10-year Commonwealth Government Bond was 16.40%. As interest rates fell, bondholders benefitted from both high coupons and capital gains on their bonds.
Investors now face a wholly different situation. Interest rates are now at historic lows (see chart from JP Morgan Asset Management below). The only way that bonds could generate a similar return would be deflation on a scale never before seen in history.
The likely path of interest rates is up over the long-term. This increases the risk of capital losses for bondholders. The current real (i.e. net of inflation) yield of 0.74% is very low.
The chart shows Government bond yields. Higher yields are available elsewhere. But achieving them means taking additional risk, such as credit risk. Guess what? Credit risk is highly correlated to equity risk. In other words, investors buying higher-yielding fixed income investments are possibly adding equity risk to their portfolios anyway (while kidding themselves that their portfolios are conservative).
Of course, the analysis above assumes a buy-and-hold approach (i.e. no panic selling at the worst possible time). Few people can stick with their portfolio without a well-reasoned financial plan. Your plan’s true value isn’t picking the hottest asset class or the best performing fund manager but in preparing for unexpected and protecting you from the temptation to misbehave.
A financial plan is a deeply personal thing. It’s impossible to stick to someone else’s plan. As the amateur philosopher Mike Tyson one said: “Everyone has a plan until they get punched in the mouth.” Financial loss is a visceral experience and not something that can be understood with a risk appetite/tolerance questionnaire.
A good financial plan also has some room for flexibility and judgement. This is for two reasons. Firstly, circumstances change. Secondly, it provides an outlet for the urge to “do something” without derailing the plan. More on this a little later.
Confusing Strategy with Tactics
Ken advises investors to select a benchmark allocation to shares that suits their investment horizon. They build a financial plan around this benchmark, but that doesn’t mean sticking to it rigidly. Fisher explains.:
No, you need not be 100% in equities at all times. Picture a young person who has an all-equity benchmark because he has an ultralong time horizon. Nevertheless, periodically–if he becomes bearish–he may lighten up on stocks, a temporary tactic to help with his strategy of beating a benchmark.
Notice the words that Ken uses: “periodically”, “temporary” and “lighten up”. Short-to-medium term changes are the exception, not the rule. They are measured and gradual, never one-way bets. And they should be undertaken in aid of the overall strategy (i.e. to help you stick with it instead of freaking out), never to undermine it.
All That Matters is the Total Return
Ken offers one final piece of advice:
Once you pick your benchmark, manage against it (see my May 1 column). Your goal is to maximize the likelihood each year of beating it–measured by total return, aftertax. Doing this optimizes your likely future wealth relative to your future needs. Then it doesn’t matter where the income comes from: interest, dividends or capital gains.
The investor should be agnostic to the source of return. Obviously, dividend franking (which doesn’t exist in the US) does shift the balance in favour of income over capital gains. That said, investors should not overplay the importance of dividends, as any long-term shareholder in Telstra (TLS) will confirm.
Don’t hate your loved ones. Do the conservative thing and develop a financial plan designed to manage your true risk – protecting the purchasing power of your savings.
Grioli and Company Pty Ltd, Australian Financial Services Licence: 506003
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