Bfwolf wrote: ↑
Sun Jun 09, 2019 1:58 pm
So what I'm trying to get at is: forgetting about the empirical evidence for a minute, what is the theoretical underpinning which would suggest that a Total Stock Market + Long Term Treasury Bond approach would be close to the ideal way of maximizing risk/return?
The theoretical argument would flow (in HIGHLY simplified form) something like this:
1) the market portfolio reflects that aggregate (or average) of everyone's highest risk-adjusted (or mean-variance optimal) portfolio;
2) variance does not reflect every risk that investors face;
3) every investor faces a different combination of risks;
4) therefore, the market portfolio cannot have the highest risk-adjusted return for every investor;
5) each investor's optimal risk-adjusted portfolio may be different from the market portfolio.
highest risk-adjusted return portfolio will be one that is heavily exposed to risks that don't affect you and weakly exposed to risks that affect you a lot.
A slight aside that is critically important: term risk (or duration risk) is one of the risks associated with bond investing, but many people assume that allow investors in long-term bonds experience term risk the same way. This isn't true. Term risk is not merely a function of the bond's duration, but instead is a function of the difference between the bond's duration and the investor's investment horizon.
In other words, not all owners of a particular bond have the same term risk. If the bond's duration precisely matches the investor's investment horizon, that bond presents ZERO term risk to that investor.
In an efficient market, investors whose investment horizon DOES NOT match the duration of that bond will pay a premium to avoid that bond. Investors whose investment horizon DOES MATCH the duration of that bond can collect that premium (i.e. higher return) without exposing themselves to additional risk. Because that bond doesn't present term risk to them
Ergo, for any given investor their highest risk-adjusted return will result from a portfolio which contains bonds having a duration that matches as closely as possible the investor's investment horizon.
For a long-term investor that means long-term bonds.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch