The relationship between season-of-life and asset allocation used to be straightforward: as investors aged and became more risk-averse, they decreased their stock exposure and increased their bond holdings. But with bond yields at lows once thought impossible, the ability of bonds to act as a shock absorber within a diversified portfolio is in question.
 
We present our thoughts on how to diversify for risk in the new era of low bond yields.

Movie audiences have been thrilled by the action-packed, nerve-wracking Jurassic Park films that have rolled out over the past 25 years. While the sequels have continued to focus on special effects, those who remember the original — or better yet, read Michael Crichton’s Jurassic Park novel — will recall the underlying theme: the critical importance of boundaries.

Boundaries exist for safety reasons; breaking through them can be dangerous. The original story is frightening because the prehistoric creatures break through physical boundaries and attack the tourists. And it provokes us to weigh the risks before breaking through scientific boundaries and playing with the building blocks of life. Crichton’s story may even have something to say to societies that are breaking through moral boundaries and removing limits that have characterized civilized societies for thousands of years.

Because SMI exists to help people invest successfully, we think there’s another application: the risks taken by those who willfully ignore time boundaries. Every human being is quite limited as to what we can know of the future with certainty.

One character in Jurassic Park is Malcolm, the “chaos theory” scientist. In the book, he explains to a co-worker why many events are inherently, inescapably unpredictable:

“Computers were built because mathematicians thought that if you had a machine to handle a lot of variables simultaneously, you would be able to predict the weather. Weather would finally fall to human understanding. And men believed that dream for the next forty years. They believed that prediction was just a function of keeping track of things. If you knew enough, you could predict anything.

“Chaos theory throws it right out the window. It says that you can never predict certain phenomena at all. You can never predict the weather more than a few days away. All the money that has been spent on long-range forecasting is money wasted. It’s a fool’s errand. It’s as pointless as trying to turn lead into gold. We’ve tried the impossible — and spent a lot of money doing it. Because in fact there are great categories of phenomena that are inherently unpredictable.”

“Chaos says that?”

“Yes, and it is astonishing how few people care to hear it.”

Consider that last line: “. . . it is astonishing how few people care to hear it.” How that applies to us when we’re making investment decisions! We refuse to believe the markets, like the weather, cannot be accurately predicted. Over the years, we’ve seen many people suffer financially because they relied on the forecasts and opinions of gurus and experts to guide their decisions. It’s important to concede, “I don’t know what the future holds. The financial commentators in the media don’t know. Investment experts don’t know. Nobody knows. So, I must face the fact that I can never know in advance which investment alternatives will make the most money, lose the most money, or do little at all.”

This uncertainty makes it difficult to know how much to increase or decrease investment risk — and the potential gains you’re hoping for — after experiencing significant changes in wealth, or as you near the end of your investment time frame.

The shifting role of bonds

In the past, the task of decreasing portfolio risk was rather straightforward. Investors could shift gradually away from stocks and into bonds as they approached retirement, and reasonably count on lower — but generally safe — returns from their fixed-income holdings. Balancing the two competing influences in your investment planning — your fear of loss and your need for growth — largely could be done by adjusting the way you divided your investments between stocks and bonds.

Times have changed. Interest rates have been forced down by global central banks to lows that once were unimaginable. What’s more, the huge government debt loads make it an open question as to how long it may be before those central bankers can allow interest rates to return to what we once thought of as “normal” levels. As Malcolm, the chaos theorist, might have said, “It’s impossible to predict what interest rates will do.” But we know that it will be difficult for them to go much lower, due to the fact that they are already so close to zero!

While some governments have crossed the zero boundary into negative interest rates, there are significant issues that accompany such a move. That’s why zero — while not an absolute lower boundary — will still present a constraint on the ability of bond yields to fall much below today’s levels. Accordingly, bonds may not be able to fulfill their historic role as a portfolio shock absorber during the next bear market in stocks.

Note that this concern doesn’t even take into account whether bond yields may rise in the future, driving bond prices down. That’s largely a separate issue. Our concern here is that if bond yields don’t have the ability to fall as they have in the past, the implications for bondholders could be significant. As the table below shows, bonds had much more appreciation potential in 2000 and 2008 than they do today, given the much lower starting point of today’s yields. In 2000, the total return from a 10-year Treasury was +16.7%, while in 2008 it returned +20.1%. Those gains helped offset the dramatic losses in investors’ stock portfolios those two years. It’s highly unlikely that bonds could provide that degree of support today if a new bear market in stocks were to begin.

Moving beyond a fixed stock/bond portfolio allocation

If the old system of combining stocks for growth and bonds for safety seems to no longer be an effective way to manage risk, how should an investor now manage it? We think there are two keys. First, an investor needs to diversify beyond U.S. stocks and bonds into other kinds of assets such as real estate and gold. And second, we think investors need to invest tactically with at least a portion of their portfolios.

What does it mean to invest “tactically?” It means that one’s commitment to a given asset class is temporary, rather than the essentially fixed allocations we used to assign to stocks and bonds under the old approach. It also means deciding which asset classes to invest in based on recent signals from the market, rather than using long-term fixed allocations based solely on their historical record.

This concern about the ability of bonds to provide downside protection during the next bear market was the initial catalyst behind the research that produced SMI’s Dynamic Asset Allocation strategy (DAA). Fortunately, we have yet to experience the next significant decline in stock prices that will inevitably come, and bonds have continued to provide solid returns. This doesn’t change the importance of DAA as a risk-prevention tool. In fact, if anything, the longer and higher this bull market in stocks goes, the more important it is that investors protect themselves using a system such as DAA.

We’re not going to take the time to explain the DAA strategy here, but if you’re not familiar with it, we encourage you to read Dynamic Asset Allocation: An Investing Strategy for the Risk-Averse, our January 2013 cover article. It provides important background for understanding the rest of this article.

Using DAA rather than only bonds to hedge against risk

It’s vital that you be emotionally comfortable with your strategy. Otherwise, you may not develop the confidence and discipline needed to hang in there when the periodic storms of market turbulence blow through.

However, it’s not enough to be emotionally steady during a season of market weakness. Even strong markets present challenges. We’ve seen many investors blown off-course during bull markets when the strategy they’ve chosen fails to keep up with the market averages or other more-aggressive approaches. This type of dissatisfaction frequently leads to making portfolio changes that involve taking on too much risk (as we saw during the Internet bubble of the late 90s), which inevitably ends badly when the next bear market arrives. So in managing an investor’s emotional needs — both during good markets and bad — balance is the key.

The research is clear that DAA is likely to provide much-needed bear-market protection to a portfolio, leading to above-average long-term returns. However, the way it builds that strong track record (“winning by not losing”) leaves it vulnerable to underperforming during bull markets in stocks. That’s why we believe our stock-heavy strategies (Upgrading and Just-the-Basics) should be paired with DAA. They’re likely to generate better returns than DAA when the market is in an uptrend, helping protect you from the dissatisfaction of watching your portfolio underperform. Also, as Malcolm reminded us at the outset of this article, the future won’t look exactly like the past. Including a second strategy hedges you somewhat against future surprises.

Patterns from the past

To help evaluate the best ways to combine these strategies, we prepared the table below. The five columns show various combinations of DAA and Upgrading within a portfolio. The left column shows the returns from a very aggressive portfolio comprised 100% of Stock Upgrading. (We didn't include any Bond Upgrading for this table, but continue to encourage members to use Bond Upgrading within the Upgrading portion of their portfolio if called for by the risk tolerance quiz and seasons of life table in the Start Here section of the SMI web site.) Our Stock Upgrading results date back only to 1996, so prior to that point we used the returns from the S&P 500 Index. The far-right column shows the returns from a very conservative 100% DAA portfolio. The three middle columns show various combinations of these two approaches. For each of the five portfolio combinations, the historical results since 1982 are shown — that’s as far back as we have really solid DAA backtesting data.


(Click chart to enlarge)

Lessons to be learned

There are multiple lessons to be learned from this exercise. Some are specific to the strategies at hand, but others are applicable to investing generally. If you study the numbers, you’ll see that:

  • The shorter your holding period, the higher the risks and potential rewards. Over a 20-year holding period (scenarios 26-30), the range of likely results is relatively narrow. They are shown on the line where it says “result 2/3 of the time.” Even in an all-stock Upgrading portfolio (such as scenario 26), this range of likely results is less than 3.5 percentage points per year from low to high. As you move up the table to shorter holding periods, the range broadens — that is, it becomes more volatile. By the time you get to a one-year holding period in the all-stock Upgrading portfolio (scenario 1), there is more than a 34 percentage-point difference from low to high in the range of likely results. Clearly then, the more you can think — and act — like a long-term investor, the more predictable your long-term results will become.
     
  • The more you allocate to aggressive strategies such as Upgrading, the higher the risks and potential rewards. The table illustrates the extent to which Upgrading has carried greater risk than DAA. As you move from right to left across the table, from mostly DAA to mostly Upgrading, the “best” and “worst” results become more exaggerated. It’s good to keep in mind the full range of possibilities. As we saw from 1995-1999 (and again in 2009 and 2013), the market is capable of unusually high returns. Of course, in 2008 we saw the opposite during the worst bear market since the Great Depression. It’s important to not extrapolate such periods as being “normal.” They’re not, and the table can help you take the emotion out of deciding on the appropriate strategy allocation for your situation.
     
  • Small differences add up over time. It’s easy to mentally minimize the difference between a “best” 15-year result of +18.1% in scenario 22 and +15.3% in scenario 25. Both are great results, right? And the average result of those two scenarios is exactly the same, so why take the higher risk? Things look a little different when you consider that in dollar terms. Scenario 22’s “best” return of +18.1% would have turned $10,000 into more than $120,000 while scenario 25’s “best” return of +15.3% would have grown to “just” $84,651. The tendency to prefer lower-risk strategies such as DAA is understandable, but we encourage SMI readers, when possible, to have both DAA and Upgrading strategies in their portfolio. They march to different drummers, and it’s easier to stay on track when your portfolio always has a strong current performer, regardless of what the market is doing.
     
  • There’s no sure thing. Pretend you watched SMI’s Stock Upgrading strategy return an average of +19.5% per year, every year, for five years. This is what happened from August 2002–July 2007. You say to yourself, “I want to get in on this!” and in August 2007 you invest your retirement money in that strategy. You are sorely disappointed as the next five-year period unfolds and you do little better than break even, earning an average of 0.4% per year. You didn’t earn the “average” +12.8% gain typical of a five-year holding period (scenario 11). Nor did your returns fall within the range of results that investors who held on for five years received two-thirds of the time. You, unfortunately, were invested during the terrible bear market of 2008, leading to one of the few five-year periods that was an uncharacteristic underachiever. You knew it could happen; scenario 11 shows that stocks have indeed lost money during some five-year periods, the worst being an average loss of -2.6% per year. You were hoping it wouldn’t happen to you. But it can, and almost did. That’s why Wall Street is always reminding you that “past performance is no guarantee of future results.”

Applying this to your situation

First, if the thought of trying to keep up with multiple strategies makes you feel slightly ill, don’t panic. There’s nothing wrong with using a single strategy. If you’re going to choose only one, in the current environment we’d suggest DAA be the one, as it historically would have produced the best long-term returns with less risk. It has done this in the past primarily by doing a better job of protecting capital during bear markets. However, we think including multiple strategies in your portfolio is optimal due to the emotional challenges it steers you around, so consider that additional diversification as a longer-term goal. (If you want multiple strategies in your portfolio but you’re not up for implementing them yourself, consider the available automated approaches.)

There undoubtedly are readers wondering at this point why we’re not including our Sector Rotation strategy in this discussion. We still think it’s a great addition to most portfolios, but it lies even further out on the higher-risk/higher-reward spectrum beyond Upgrading. In this article, we wanted to highlight the interplay of risk and return between Upgrading and DAA, our two core strategies, without Sector Rotation’s historically large gains clouding the issue. (Those wanting more information on the best ways to blend all 3 of these popular SMI strategies should read Higher Returns With Less Risk: The Best Combinations of SMI's Most Popular Strategies, our May 2014 cover article.)

Others may look at the table with some confusion, as the average returns for the various portfolio blends all seem so similar. This is actually one of the main points we want to convey. It’s not that either strategy is better or has historically produced better returns. It’s because they earn their returns in such different ways that makes them so perfect to combine within a portfolio. Stock Upgrading tends to race ahead during stock bull markets, then gives up some of those gains during bear markets. DAA plods along steadily during stock bull markets, but gives up relatively little during bear markets. It’s the portfolio version of The Tortoise and the Hare, except in our version the moral isn’t “slow and steady wins the race,” but rather “slow and steady keeps you in the race” — so you can eventually win!

There is one practical application to these data that goes beyond the simple takeaway that most portfolios will be better off owning some combination of these strategies. For those who no longer have as great a need for portfolio growth, or who don’t mind lagging the market as long as they don’t lose significantly along the way, shifting more money to DAA makes sense. The primary benefit of including Upgrading in the portfolio is emotional, for periods like the past few years when DAA is lagging a rising market. If that truly doesn’t bother you (and it’s vital that you’re completely honest with yourself about this), owning a higher portion of DAA and a lower portion of Upgrading is likely appropriate.

Also, the length of time you plan to invest should affect how you view the table. If you are:

  • Within five years of retirement (or other financial goal), your focus should be on the worst-case scenarios. You don’t have the time cushion to recover from severe losses, making preservation a higher priority than growth. This will lead you toward the portfolios with higher allocations to DAA.
     
  • More than 10 years away, your focus should be on the averages. As the table shows, at 15 years the worst-case scenarios of all the different allocations start to bunch together. So do the averages, which is why we generally recommend a fairly even split between these strategies.

Conclusion

Let’s return to the opening theme of this article — no one knows what the future holds or which investments will do best in the coming years. That’s why our SMI portfolios have always been based on a strategy of diversification — spreading out your money into different types of assets so that (1) you won’t be over­invested in any single hard-hit area, and (2) you’ll have at least some investments in the more rewarding areas. In recent years, we’ve added further diversification by encouraging readers to utilize multiple strategies within their portfolio.

You can’t avoid risk altogether, but you can tailor your portfolio to reduce risk while having reasonable expectations of achieving your goals. The historical record shown on our strategy pages here and here can help you select the mix of assets that combines profit potential and risk avoidance in the way that makes most sense for your personal situation. That’s Sound Mind Investing.