nisiprius wrote:And now that we've excluded TIPS "for the moment," can we please include them again? Because they do exist now, even if they do complicate the simplistic argument that you cannot keep up with inflation except with stocks.
Good point. I started with the basic 3-fund portfolio that holds stocks and nominal bonds, and showed that nominal bonds are quite risky over the long run due to inflation risk which can exceed equity risk. So what I've achieved so far is not to find the best portfolio, but just to show a severe flaw with the traditional 3-fund portfolio.
Next step I would like to add TIPS, but that is difficult because they are a new asset so data is limited.
What I can do is this: Current 20y TIPS yield is 0.96%. Since TIPS are the ultimate risk-free asset, we can assume the real return of a 20 year TIP held for 20 years will be exactly 0.96%. There is no term risk if held to maturity and there is no inflation risk because it is adjusted for inflation--unless you subscribe to the conspiracy theory that the government intentionally understates CPI so it can evade paying inflation-adjusted claims
So then I can do this: Suppose an investor today can choose between 20y TIPS at current rates, or they get a random 20 year stock return from the 125 overlapping sequences available from 1871-2015.
20 Real Returns, S&P 500 & 20y 0.96% TIPS
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AA Mean SD Worst
0% 0.96% 0.00% 0.96%
10% 1.66% 0.29% 1.04%
20% 2.34% 0.57% 1.10%
30% 2.98% 0.85% 1.14%
40% 3.59% 1.14% 1.16%
50% 4.17% 1.43% 1.15%
60% 4.73% 1.71% 1.12%
70% 5.25% 2.00% 1.07%
80% 5.75% 2.30% 1.00%
90% 6.21% 2.60% 0.90%
100% 6.65% 2.90% 0.77%
And here are the preferred stock % allocations for investors of different risk aversions and horizons. I call ra=2 low, ra=4 medium, and ra=8 high
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ra=2 ra=4 ra=8
N=5 100% 70% 40%
N=10 100% 80% 40%
N=20 100% 100% 80%
If TIPS yields were a bit higher this would be entirely different. Suppose the 20y TIPS yield was back its juicy 3% from ten years ago? Then Mr. 8 would prefer only 40% equity for 20 year horizon and Mr. 4 would prefer 70%.
In summary it may not be fair to assume current TIPS yields but historical stock yields, with CAPE high and earnings growth low. So I think TIPS definitely do have a role in a portfolio. But the classic 3-fund portfolio that is just stocks and nominal bonds? May as well be a 2-fund portfolio for anyone with a horizon longer than a decade because those nominal bonds just have too much inflation risk for their returns. As a result of this analysis I don't think I will ever let my portfolio have more than more than 10 or 20% in nominal bonds, and they would be short to intermediate in duration. As I approach retirement, I will be selling equities for TIPS, not nominal bonds.
On the OTHER HAND, maybe the historical inflation outcomes, now that the Fed has "matured" and learned its lesson, are very unlikely to be repeated? Who knows! If so, then nominal bonds won't be such a bad idea after all. But they do have incredible left-tail risk is all it takes is one run of the printing press and your nominal bond returns disappear.
So in summary I think it is highly irresponsible for the 3-fund portfolio to not include TIPS. For an aggressive accumulator who is 80-100% equity it won't matter. But for retirees holding 30-60% allocations in nominal bonds it is a huge mistake. Even the Vanguard Target Retirement Income has a 16% holding of TIPS, although its nominal bond holdings are 53% which would scare me to death if I was a retiree. That's just asking to lose all your money to inflation. I would reverse the ratios entirely: 53% TIPS and 16% nominal bonds would be better. And if the yield is too small, increase equities, which you can now afford since you shed that undesirable inflation risk for more desirable equity risk.