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
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.
That isn’t to say that such investments may not prove to offer
the highest future returns. But we can safely assume that global