Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

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alluringreality
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Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by alluringreality » Sat Apr 11, 2020 12:37 pm

Does anyone have opinions about the following quote from David Swensen in Unconventional Success? The first paragraph seems a possible critique regarding typical 2 or 3 fund portfolios, or the idea of loading up on long-term bonds as a means of diversifying stocks. I tend to think that most of the stock and bond discussion that I've read tends to revolve more around the second paragraph, so I was primarily curious if anyone had any thoughts regarding how much consideration you give to his comments in the first paragraph for your own portfolio decisions.
Portfolios dominated by traditional marketable securities exhibit even less diversification than the bond and stock distinction suggests. Under many circumstances, changes in interest rates—one of the most important fundamental drivers of market returns—influence bonds and stocks in similar fashion. When rates rise, the harsh reality of bond math calls for prices to fall. When rates rise, the discount rate applied to future corporate earnings streams rises as well, causing stock prices to fall. The converse holds, too. College and university endowment porfolios of the early 1990s exposed nearly 90 percent of assets to a common determinant of financial market returns.

Stock and bond holdings prove most diversifying when inflationary expectations fail to match the subsequent reality. For instance, in an environment of unanticipated inflation, the fixed nominal claims of bondholders become worth less. In contrast, higher-than-expected levels of inflation increase the value of a stockholder’s residual claim on corporate assets. The converse holds, too. In short, only under unusual circumstances do holdings of stocks and bonds produce substantial diversification.
Targets: 15% I Bonds, 15% EE Bonds, 45% US Stock (Mid & Small Tilt), 25% Ex-US Stock (Small Tilt)

Random Walker
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Random Walker » Sat Apr 11, 2020 12:50 pm

I agree with him. Many people consider a typical 60/40 TSM/TBM portfolio diversified. But if one looks at the portfolio from a factor standpoint, about 85% of the portfolio risk is in a single factor, the market factor. A more efficient portfolio (and more expensive) involves moving in the direction of risk parity: more evenly distributing the portfolio across less than perfectly correlated sources of risk and return. These can include geographies, exposure to size, value, profitability, momentum, even potentially alternatives. I do certainly agree though that the best (and cheapest) diversifier of equity risk is high quality bonds.

Dave

dbr
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by dbr » Sat Apr 11, 2020 1:01 pm

The first order effect of adding bonds to a stock portfolio is to reduce risk by diluting it. The second order effect is increasing portfolio efficiency through "diversification." The former is of critical interest to all investors. The latter is a secondary, not necessarily unimportant, but secondary, concern.

In any case when thinking of "diversifying" a portfolio it is also necessary to think what both the risk and the return one is choosing actually is and not just how efficient the portfolio is. Adding bonds is done by most investors to escape the overly high risk of stocks at a price in return. What can be done to improve the ratio is a second step. What does not ever exist is a high return, low risk portfolio.

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SimpleGift
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by SimpleGift » Sat Apr 11, 2020 1:11 pm

In portfolio construction, it helps to identify what major risks one is protecting against. At the highest level, stocks protect against inflation and high-quality bonds protect against deflation. Since deep, prolonged deflation has become more rare in modern economies, inflation remains the more likely severe risk.

Even though long-term expected inflation is currently very low, it's certainly the most dangerous risk for any portfolio of financial assets. Stock-heavy portfolios already have built-in inflation protection over long holding periods. Bond-heavy portfolios are best served with a healthy allocation to TIPS.

One can add further assets to try to improve diversification at the margins (foreign stocks, small and value stocks, REITs, alternative assets, foreign bonds, etc.) — but the basic combination of plain-vanilla, broadly-diversified stocks and bonds (both nominal and TIPS) can provide all the diversification one is likely to need over a lifetime, in my view.
Last edited by SimpleGift on Sat Apr 11, 2020 1:20 pm, edited 2 times in total.

Random Walker
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Random Walker » Sat Apr 11, 2020 1:15 pm

I’ve had Monte Carlo Simulations performed on my portfolio. One of the eye opening results for me is the lack of sensitivity of success rate to overall asset allocation. In the range 40/60 to 70/30, there is surprisingly little effect on success rate of the stock/bond mix. I suspect this is true of many Bogleheads. Saving and spending, as opposed to asset allocation, dominate the likelihood of retirement success,

Dave

Pocanutin
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Pocanutin » Sat Apr 11, 2020 1:26 pm

Greetings:

I am 78 years old and DW is 73. We have basically a two fund portfolio of 50% Total Stock Index (FSKAX) and 50% Intermediate Treasuries (FUAMX) at Fidelity in IRAs. A question that has bothered me for some time is whether TIPs are recommended for someone our age since we have several lifetime annuities and are currently taking our RMDs.

We have little use for our RMDs as far as living expenses are concerned. Much of those proceeds are invested in the same funds in our taxable account. We do have a state income tax and thus treasuries offer some relief there .

In short, are tips recommended for a life expectancy such as ours? I would not hold any tips in our taxable account.

I would appreciate your thoughts. Not intending to hijack the thread.
Thank you,
P

I

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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Northern Flicker » Sat Apr 11, 2020 2:03 pm

Mr. Swensen is not incorrect, but I think it is a little more nuanced than the quote by itself might suggest. Interest rates often tend to rise when the economy is improving and corporate revenues are rising. In this scenario, it will be rising projected corporate revenues that are being discounted back to a present value with a higher discount rate. At times, the revenue increase wins and a stock’s value still will rise with a rising rate. At other times the revenue changes are not sufficiently rising or not rising and the increase in interest rates will depress prices.
Last edited by Northern Flicker on Sun Apr 12, 2020 7:42 pm, edited 1 time in total.
Risk is not a guarantor of return.

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SimpleGift
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by SimpleGift » Sat Apr 11, 2020 2:09 pm

Pocanutin wrote:
Sat Apr 11, 2020 1:26 pm
In short, are tips recommended for a life expectancy such as ours?
It depends on one's exposure to unexpected inflation, I believe. Not knowing your circumstances, with a life expectancy of 15-20 years, a 50/50 portfolio does have some inflation risk. As an insurance policy, how would a TIPS allocation of say 25%-40% of bonds potentially hurt?

Pocanutin
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Pocanutin » Sat Apr 11, 2020 2:46 pm

Thanks Simple Gift:

I believe that you have asked a better question than the one that I submitted. What IS the downside for holding tips at our age? Indeed, what could it hurt to hold a small percentage in tips?

I did notice that Fidelity Freedom Index target date fund 2020 (which holds about 48% equity-close to our AA, except for international equity) hold about 5% Tips.

Thanks again and I will ponder this for awhile.

P

dbr
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by dbr » Sat Apr 11, 2020 3:11 pm

The risk in TIPS is low return. They are Treasuries and therefore as a class the least risky and lowest returning of all bonds. Otherwise one can select the duration one wants, own individual TIPS, build a ladder, or whatever. The TIPS market is not large compared to other Treasuries and theoretically one can worry about liquidity. People sometimes point out that inflation indexing is not perfect when considered after tax, but that is true of any assets.

It is an argument that anyone buying bonds would buy only TIPS because, after all, who wants to carry inflation risk if one does not have to. Note that TIPS are just as well adjusted to inflation during periods of low inflation as high or unexpected. The difference when inflation is expected is that all bonds have that inflation considered in their prices. So in that case TIPS don't do anything special, but they also don't do anything worse. The risk premium for both inflation and liquidity with TIPS seems to be very small.

One thing I don't understand is what could possibly be the point of making a small allocation to TIPS. Holding half of one's bonds in TIPS or a TIPS fund could make sense. So could holding all of one's bonds in TIPS, unless for some reason one wants to take more risk in bonds for more return.

Pocanutin
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Pocanutin » Sat Apr 11, 2020 3:30 pm

Thanks DBR

You have provided food for thought.

I always believed that stocks would provide some protection from inflation, and at our age (I thought) that the risk of runaway inflation would be relatively low and although our annuities are not inflation-adusted, we would be able to survive.

I did run a 10 year, 5 year,1 year comparison of U.S. Bond index, Intermediate treasury index and 8 year duration tip index at fidelity and in all cases tip index underperformed.

I must admit, however, I don't really know if that is a fair comparison..it seems to me that tips are basically like an insurance policy..

Thanks again.

P

dbr
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by dbr » Sat Apr 11, 2020 3:51 pm

Pocanutin wrote:
Sat Apr 11, 2020 3:30 pm
Thanks DBR

You have provided food for thought.

I always believed that stocks would provide some protection from inflation, and at our age (I thought) that the risk of runaway inflation would be relatively low and although our annuities are not inflation-adusted, we would be able to survive.

I did run a 10 year, 5 year,1 year comparison of U.S. Bond index, Intermediate treasury index and 8 year duration tip index at fidelity and in all cases tip index underperformed.

I must admit, however, I don't really know if that is a fair comparison..it seems to me that tips are basically like an insurance policy..

Thanks again.

P
If you want more return it would make sense to increase your allocation to stocks.

Pocanutin
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Pocanutin » Sat Apr 11, 2020 3:55 pm

DBR, Yes, an increase in equity makes sense for expected greater return.

P

pascalwager
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by pascalwager » Sat Apr 11, 2020 6:01 pm

Pocanutin wrote:
Sat Apr 11, 2020 3:55 pm
DBR, Yes, an increase in equity makes sense for expected greater return.

P
I'm age 77 and have 55/45, stocks/bonds. I don't have SS and my pension CPI adjustment is 2% max (although the pension does have an 80% floor), so I do include TIPS: 53% of bonds. The rest is TBM, but mainly because of account bond fund limitations: no TIPS fund offered.

Stocks are not an inflation hedge.
Retired, pension, no SS | Bond funds: TIPS, TBM | Global stocks: total market, large value, small company, emerging market funds

Topic Author
alluringreality
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by alluringreality » Sun Apr 12, 2020 8:01 am

Thanks everyone for the replies.
Random Walker wrote:
Sat Apr 11, 2020 1:15 pm
I’ve had Monte Carlo Simulations performed on my portfolio. One of the eye opening results for me is the lack of sensitivity of success rate to overall asset allocation. In the range 40/60 to 70/30, there is surprisingly little effect on success rate of the stock/bond mix. I suspect this is true of many Bogleheads. Saving and spending, as opposed to asset allocation, dominate the likelihood of retirement success
Meb Faber's Global Asset Allocation book takes a historical look at a number of portfolios, over the period of 1973-2013. It ultimately makes a similar point about how the strategies examined generally differ to a somewhat limited extent and that "exact percentage allocations don’t matter that much". Javier Estrada appears to have a more extensive historical data set, and I likewise read his work as suggesting there are likely a number of reasonable routes for accumulation. For my own uses, I'll probably stick with Swensen's "equity orientation" recommendation by including at least 60% stocks, but I agree that your point here makes a lot of sense.
https://blog.iese.edu/jestrada/files/20 ... depath.pdf
Last edited by alluringreality on Sun Apr 12, 2020 9:57 am, edited 1 time in total.
Targets: 15% I Bonds, 15% EE Bonds, 45% US Stock (Mid & Small Tilt), 25% Ex-US Stock (Small Tilt)

Random Walker
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by Random Walker » Sun Apr 12, 2020 9:00 am

alluringreality wrote:
Sun Apr 12, 2020 8:01 am
Thanks everyone for the replies.
Random Walker wrote:
Sat Apr 11, 2020 1:15 pm
I’ve had Monte Carlo Simulations performed on my portfolio. One of the eye opening results for me is the lack of sensitivity of success rate to overall asset allocation. In the range 40/60 to 70/30, there is surprisingly little effect on success rate of the stock/bond mix. I suspect this is true of many Bogleheads. Saving and spending, as opposed to asset allocation, dominate the likelihood of retirement success
Meb Faber's Global Asset Allocation book takes a historical look at a number of portfolios, over the period of 1973-2013. It ultimately makes a similar point about how the strategies examined generally differ to a somewhat limited extent and that "exact percentage allocations don’t matter than much". Javier Estrada appears to have a more extensive historical data set, and I likewise read his work as suggesting there are likely a number of reasonable routes for accumulation. For my own uses, I'll probably stick with Swensen's "equity orientation" recommendation by including at least 60% stocks, but I agree that your point here makes a lot of sense.
https://blog.iese.edu/jestrada/files/20 ... depath.pdf
I agree with you. In accumulation I’d tend to go heavy on equities. But close to and in retirement where sequence of returns starts to be very important, is where I’d give more thought to lower equity allocations doing the job.

Dave

grok87
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by grok87 » Sun Apr 12, 2020 9:07 am

alluringreality wrote:
Sat Apr 11, 2020 12:37 pm
Does anyone have opinions about the following quote from David Swensen in Unconventional Success? The first paragraph seems a possible critique regarding typical 2 or 3 fund portfolios, or the idea of loading up on long-term bonds as a means of diversifying stocks. I tend to think that most of the stock and bond discussion that I've read tends to revolve more around the second paragraph, so I was primarily curious if anyone had any thoughts regarding how much consideration you give to his comments in the first paragraph for your own portfolio decisions.
Portfolios dominated by traditional marketable securities exhibit even less diversification than the bond and stock distinction suggests. Under many circumstances, changes in interest rates—one of the most important fundamental drivers of market returns—influence bonds and stocks in similar fashion. When rates rise, the harsh reality of bond math calls for prices to fall. When rates rise, the discount rate applied to future corporate earnings streams rises as well, causing stock prices to fall. The converse holds, too. College and university endowment porfolios of the early 1990s exposed nearly 90 percent of assets to a common determinant of financial market returns.

Stock and bond holdings prove most diversifying when inflationary expectations fail to match the subsequent reality. For instance, in an environment of unanticipated inflation, the fixed nominal claims of bondholders become worth less. In contrast, higher-than-expected levels of inflation increase the value of a stockholder’s residual claim on corporate assets. The converse holds, too. In short, only under unusual circumstances do holdings of stocks and bonds produce substantial diversification.
well remember he wrote that pre-financial crisis of 2008 and also pre corona-crisis.
in both cases long term treasuries have proved to be a power diversifier of equity risk.
RIP Mr. Bogle.

magneto
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by magneto » Sun Apr 12, 2020 10:55 am

From a simplistic view :-
Bonds tend to show a -ve correlation (flight to safety) in the short term (cyclical)
But tend to show a +ve correlation (inflation/interest rate driven) longer term (secular)
This investor is troubled by :-
https://www.multpl.com/10-year-treasury-rate
and holding ample cash, albeit less since the stocks downturn.
maybe I worry too much about uncertainty in siding with Swensen ?
'There is a tide in the affairs of men ...', Brutus (Market Timer)

dbr
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Re: Stock and bond diversification - Swensen quote on "Investment Principles in Practice"

Post by dbr » Sun Apr 12, 2020 11:33 am

magneto wrote:
Sun Apr 12, 2020 10:55 am
From a simplistic view :-
Bonds tend to show a -ve correlation (flight to safety) in the short term (cyclical)
But tend to show a +ve correlation (inflation/interest rate driven) longer term (secular)
This investor is troubled by :-
https://www.multpl.com/10-year-treasury-rate
and holding ample cash, albeit less since the stocks downturn.
maybe I worry too much about uncertainty in siding with Swensen ?
Yes, it is bad luck to invest when interest rates are low. This punishes savers and rewards spenders. There is no scheme that fixes this problem.

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