Contingencies Online - September/October 2009

rare investor who was only 50 percent into the market during the second half of 2008?

I don’t think so. First, we need to consider an investor’s entire retirement portfolio, including any expected pension benefit. One element of that is Social Security. For a healthy 65-year-old who exercises regularly, the capital value of a state pension of $25,000 per year now exceeds $400,000. Arguably, this portion of the retiree’s portfolio has actually increased in value over the past year. For those lucky enough to retain a company pension, up to $54,000 per year is guaranteed by the Pension Benefit Guaranty Corp. and therefore subject to a similar multiplier. Under the circumstances, it’s not so unusual for a middle-class family to own over $1 million of virtually guaranteed “pension assets” that act as a heavy counterweight to equity investment.

One might argue that I’m taking advantage of a one-time fact pattern, when Treasuries and cash outperformed virtually all other types of bonds, which were suffering losses across the spectrum. On the contrary, I believe these performances emphasize a long-term truth about market risk and return that strayed out of balance for a number of years because of a monetary policy that was historically lax.

Higher yields on lower-grade bonds signal risk of the same nature as equity risk, and all such risk is the price of higher returns. Intuitively, we know that by buying lower-quality, high-yielding bonds we can’t objectively expect to exceed earnings gained from AAA-rated bonds. The market has decided that the extra yield is offset by the chance of default. If we make a different judgment, we are simply betting on our own subjective risk model in preference to the market’s ultimate “model of models.” Our model may reflect history, but the market may have decided on a permanent paradigm shift. If this logic applies to the performance of junk bonds, recent history shows how tightly coupled the equity market’s performance is. Just as falling equities are linked to the descent of future consumer price expectations, the same can be said for corporate bonds in inverse proportion to their quality.

It’s for this reason that I can simplify my model portfolio into the S&P 500 and cash. A more normal portfolio will include many types of bonds, but these can all be considered some combination of cash, equity risk and interest-rate risk. Since equity risk includes interest-rate risk, we can limit ourselves to equity risk and cash. I believe that any equity/bond portfolio can be broadly mirrored over the long term by a combination of equity indices and cash. For my purposes here, I will take as a given our ability to develop an effective financial tool that allows us to make such a conversion. To the extent we own real-estate equity, I believe it can also be so converted. My point is that when viewing total wealth, a 50/50 equity/cash equivalent doesn’t seem excessively cautious yet has maintained its global purchasing value quite well through devastating times

for investors. And this is even before we account for appreciation already earned prior to the slide.

A Portfolio for All Seasons

Nor does the upside of such a 50/50 portfolio sound too pedestrian. Until recently, we were often reminded that equities have returned about 12 percent per year over the past century. Assuming historic inflation at 3 percent and a real return on cash of 1 percent, a repeat of the past would deliver us 8 percent nominal or 5 percent real, which is quite consistent with most advisers’ projections. However, suppose history truly goes into reverse, at least for our own retirement years. Japan offers the perfect model. From its peak through the end of 2008, a period of 19 years, the Nikkei declined almost 80 percent. At the same time, apart from appreciating against the dollar by some 60 percent, yen on deposit earned a respectable real interest rate, despite its negligible nominal return because of falling consumer prices.

Of course, there’s nothing magical about a 50/50 split, any more than the 60/40, 65/35 or 70/30 splits so often agonized over by retirement-fund strategists. I’ve used that ratio to illustrate that it would have kept the retirement investor on course throughout the long history of bull and bear markets, provided he or she understood the relationship between interest rates and prices on the one hand and the securities markets’ behavior on the other.

There’s one critical conclusion to draw from such an analysis. We shouldn’t advise equity investment for retirement purposes because it provides superior returns in the long term. To a 55-year-old who used yen cost averaging in the world’s second largest economy for his or her entire career, this is not only untrue; it’s off the mark to a huge and tragic extent. We should advise equity investment because, in the right (i.e., limited) dosage, it tends to correlate with expected future prices and living standards. We have to use the term “expected” because the market can only project and is just as likely to be wrong as right. But we can be sure it will never remain wrong in the face of mounting evidence to the contrary.

Once we accept this reason for equity investment, we realize just how little work has been devoted to determining the correct dosage. Moreover, it becomes immediately clear that the S&P 500 is a very blunt instrument for this purpose. It would seem that utilities, commodity companies, health care, real estate investment trusts, agriculture and some targeted manufacturing would offer us the best protection. Gaming and entertainment, many high-tech, financial services and pretty much any hedge fund activity would have much less correlation, at least with the bulk of retirement expenditure that’s needed to make our lives basically comfortable.