Investing by definition involves making decisions under uncertainty, as the future is unknowable. Given the regime change underway in Washington, uncertainty of current events is at or near its zenith. The anxiety behind the heightened degree of uncertainty is apparent in my conversations with investment planning and portfolio management clients. There are any number of factors driving this anxiety, and the complexity of the human mind is so great we will never know with any – pardon the pun – certainty.
One factor that may lie underneath current investor sentiment is the fact that the stock market is at or near historic highs. For example, the Shiller PE Ratio, named for economics Nobel laureate and Yale professor Robert Shiller (“PE” being an abbreviation for Price-to-Earnings) measures valuation levels of the S&P 500 Index while adjusting for the business cycle and for inflation. The Shiller PE is over 28, compared with the long-term historical average of less than 17. Even the fearless investor will pause upon seeing the proximity of the current Shiller PE ratio to its level before “Black Tuesday,” the stock market crash of October 29, 1929 that preceded the Great Depression.
Another and perhaps more pernicious factor behind the current level of stress among investors may be the quirks in our thinking for which psychologist Daniel Kahneman and his late collaborator Amos Tversky are known. The story of these two remarkable researchers and the impact their findings have had on the world is illustrated with flair in Michael Lewis’s new book, The Undoing Project: A Friendship That Changed Our Minds (W.W. Norton & Company, 2017). The range of their findings that have had an impact on the field of economics and beyond is vast. Transcending the discipline silos of the ivory tower, Kahneman won an economics Nobel for their work (Tversky had passed away and the prestigious prize is not awarded posthumously).
One of Khaneman and Tversky’s most impactful findings is known as “prospect theory,” which describes how different we are in the way we tend to cling to gains and avoid losses. In experiment after experiment, the two researchers found that subjects were risk-averse when it came to protecting gains and risk-seeking when it came to avoiding losses. Perhaps this phenomenon is behind the phrase, “double-down,” which we hear when a colleague participating in the office college basketball tournament pool is determined to avoid locking-in losses and instead increases his investment in a bet that already threatens to deplete his lunch money budget.
If we are in fact near the end of one of the longest bull markets in history, those of us lucky enough to own stocks may be feeling a heightened degree of risk-aversion about our investment gains. One of the few means of protecting ourselves against this type of loss is the diversification of our investments. In particular, certain low-cost diversified bond funds (those holding the thousands of bonds in an attempt to track the performance of the total US bond market) have tended to serve this role well over time. Upon mentioning this observation to clients, I often hear objections. Bonds have taken a hit since interest rates began rising from their historic lows in 2016, as bond prices and interest rates move in opposite directions. But these types of funds (low-cost diversified domestic US bond index funds) have not over time posed the same risk of investment loss as has even the “blue-chip” stocks of the S&P 500 index. Not by a long shot.
Take a look at the following chart of the worst one-year return for stocks and bonds. For stocks, I use the S&P 500 Total Return Index as reflected in the data by the Vanguard 500 Index fund (Admiral shares). For bonds I use the Bloomberg Barclays US Aggregate Bond Total Return Index. For reasons too complex to get into here, this common US bond market index is considered “intermediate-term” as well as “high credit-quality.” According to Morningstar, the worst one-year period for the S&P 500 index dating back to the eighties was March 2008 to February 2009. That period is represented by the bar on the left. In contrast, the worst one-year period for the Bloomberg Barclays Bond index going back to the seventies was April 1979 to March 1980. See the bar on the right. The difference between the worst one-year stretch for the stock index (-43%) and the worst one-year period for the bond index (-9%) is almost a factor of five.
If we look at this difference on a calendar year basis, the contrast is even more stark. The worst calendar year decline since the eighties in the stock index was in 2008 (-37%), compared with the worst calendar year decline since the seventies in the bond index (-3%). The decline in stocks is represented by the bar on the left in the chart below, the decline in bonds on the right. The difference here is more than a factor of twelve. Much of the recent financial press coverage of the bond market seems intended to convey an image akin to the fire-breathing she-monster of Greek Mythology. Do these charts evoke that image to you?
True, interest rates may have only begun to rise from historic lows. True, bond prices, which move in the opposite direction from rates, could fall off a cliff if interest rates surge. Also true is that we have an incoming administration indicating the desire to spend on large-scale infrastructure and reduce taxes rather than funding that spending with new taxes. This likely will mean increases in the federal deficit and as a result upward pressure on interest rates. These facts could mean a rough patch for bonds for the next few years or more. All in all, the reasons for being tense about the outlook for bonds include both the way our brains are wired (see Kahneman and Tversky) as well as the posturing of the incoming administration and the grip of the anti-tax movement on both the upper and lower chambers of the United States Congress.
The thing is, as retail investors we do not have many alternatives to bonds as a means of managing the risk of our stock holdings. Cash in the form of savings accounts and CDs continues, despite recent interest rate increases, to pay next to nothing. And cash does not diversify stocks, for reasons I have written about in past posts (e.g., diversification is achieved only by combining assets whose values tend to move in opposing directions). If we hold all our assets in cash, we will fall behind long-term as inflation erodes away at the value of our savings.
Let’s say the policies of new regime in Washington do lead to an increase in the deficit, higher interest rates and reduced bond prices. Given the above illustrations, what are the odds that the losses we will suffer in our bond holdings will be greater than the losses we will suffer in our stock holdings? Granted, history is not predictive, but it is the best that we have as a basis for making investment decisions amidst the inescapable haze of uncertainty.
Most retail investors will benefit from combining stocks and bonds in the form the low-cost diversified index funds tracking the indexes such as the ones used here, rather than trying to time the stock or bond markets or pick the next individual stock or bond. The low or negative correlation between these broad domestic US stock and bond indexes will serve to dampen the volatility of the overall portfolio. This reduced volatility derives from the diversification effect. For the investor who does so, the losses from the next “bear market” in all likelihood will be lower for a portfolio combining the two asset classes (both stocks and bonds) in a proportion geared to his or her risk appetite than the losses from an all-stock portfolio.
Moreover, the long-term return potential of a sensible combination of these two asset classes is greater than a combination of stocks and cash or cash alone. The two-and-a-half percent dividend yield earned in 2016 from the Vanguard Total Bond Market Index fund (Admiral shares), for example, is far higher than what one will earn from a savings account or money market fund. (Most money market funds are not guaranteed, by the way.) The bond fund price will fluctuate with interest rates as discussed above, but those reduced fund prices in the short- and intermediate-term mean the reinvested dividends (which will tend to rise with rising interest rates) are purchasing an increased number of new shares each month. Over the long-haul, the investor who resists the temptation to sell ends up owning a greater number of shares and therefore enjoys the benefit of that greater number of shares if and when fund prices recover. The diversification benefit and the higher dividend yield together make a compelling case for the inclusion of a low-cost diversified intermediate-term and high credit quality US bond funds (offered by Vanguard, Fidelity, others) as opposed to attempting to hedge our bets by holding large proportions of cash.
The prevailing fear of the impact of developing political economic events on diversified bond holdings, used in prudent proportion to a diversified allocation of stocks may well prove as mythological as the Chimera.