Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

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stuper1
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Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by stuper1 » Sun Apr 15, 2018 10:31 pm

I'm sure this has been discussed before, but I did some searching and wasn't able to find the past discussions. I'm new around here, so I apologize for posting this question which I'm guessing has been discussed before.

One of the key principles here seems to be to use an index fund to let the market decide on how much of my money should be invested with each company that issues stocks. I'm curious to know if anybody thinks the same idea should guide a person's allocation of stocks to bonds. I did a quick google search, which told me that the global bond market capitalization is about 80% larger than the global stock market capitalization. The same ratio is roughly true for the U.S. by itself. If I followed that ratio, then my stock/bond allocation would be about 36/64, which seems low, but is the allocation that the market indicates. Does anybody think that the market capitalizations should be used this way to guide a person's personal stock/bond allocations?

AlohaJoe
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by AlohaJoe » Sun Apr 15, 2018 10:43 pm

stuper1 wrote:
Sun Apr 15, 2018 10:31 pm
Does anybody think that the market capitalizations should be used this way to guide a person's personal stock/bond allocations?
Sometimes this has been brought up as a disconnect in the usual Boglehead way of thinking. "If market cap is good enough for equities (i.e. the total stock market index fund), then why not for your overall portfolio?" I think there is some truth to that -- but I think the real answer is just "well, that shows that investing by market cap simply is 'good enough' not that it is some rule from heaven".

For most people the split between stocks and bonds is the most concrete way to state your risk tolerance. And my personal risk tolerance may be different from the market as a whole.

Others often point out that there are numerous laws (in the US and around the world) that skew the amount of money invested in bonds. For instance, by law, insurance companies, pension funds, state governments, and many other kinds of institutions have to hold bonds of some sort for large parts of their portfolio.

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aj76er
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by aj76er » Sun Apr 15, 2018 10:50 pm

It would probably make sense to exclude specialty bonds - e.g. municiple, TIPs, junk, etc...

You may be interested in the World Bond/Stock Portfolio proposed by William Sharpe.

https://www.bogleheads.org/wiki/World_B ... _Portfolio
viewtopic.php?t=207804
"Buy-and-hold, long-term, all-market-index strategies, implemented at rock-bottom cost, are the surest of all routes to the accumulation of wealth" - John C. Bogle

yogesh
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by yogesh » Sun Apr 15, 2018 11:36 pm

aj76er wrote:
Sun Apr 15, 2018 10:50 pm
You may be interested in the World Bond/Stock Portfolio proposed by William Sharpe.
https://www.bogleheads.org/wiki/World_B ... _Portfolio
viewtopic.php?t=207804
Has anyone created a ETF or mutual fund based on this portfolio?
Emergency: FDIC | Taxable: VT | Retirement: TR2040

MoneyMarathon
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by MoneyMarathon » Mon Apr 16, 2018 1:31 am

stuper1 wrote:
Sun Apr 15, 2018 10:31 pm
Does anybody think that the market capitalizations should be used this way to guide a person's personal stock/bond allocations?
Minor plus: You can minimize the alpha (neither positive or negative) of your portfolio on fund flows between bonds and equities.

Major con: Your risk tolerance and need for growth are both disregarded. Typical outcome: insufficient funds.

xxd091
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by xxd091 » Mon Apr 16, 2018 4:54 am

In my 70th year -15th year of retirement-seen a few ups and downs!
A UK Boglehead.Having made my pile I use this Allocation though I am 30%Stocks/70%Bonds
Using 3Vanguard Index Trackers-could be just 2-I may get there yet for simplicity’s sake -old age comes on and for wife’s ease of use-men die first and I do the money
This arrangement lets a U.K. investor access the US market
(Vanguard has kindly created a cheap Global Bond Index Tracker hedged to the Pound for U.K. investors)
A fire and forget setup
A younger person would have more equities
xxd091

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nisiprius
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by nisiprius » Mon Apr 16, 2018 6:34 am

stuper1 wrote:
Sun Apr 15, 2018 10:31 pm
...One of the key principles here seems to be to use an index fund to let the market decide on how much of my money should be invested with each company that issues stocks... I'm curious to know if anybody thinks the same idea should guide a person's allocation of stocks to bonds. I did a quick google search, which told me that the global bond market capitalization is about 80% larger than the global stock market capitalization. The same ratio is roughly true for the U.S. by itself. If I followed that ratio, then my stock/bond allocation would be about 36/64, which seems low, but is the allocation that the market indicates. Does anybody think that the market capitalizations should be used this way to guide a person's personal stock/bond allocations?...
Yes, it's been discussed a number of times, but I, too, find the forum hard to search so I'll just summarize what I personally think. Basically, you are correct, both that the global stock/bond total capitalization is something on the order of 36/64 or 40/60 or thereabouts, and that this "seems low." Or, rather I would say that to me, the endlessly-suggested traditional 60/40 allocation "seems high."

At this point I do not believe there is any justification for 60/40 allocation as any kind of calculated optimum.

It has worked well, but so would 50/50 or 40/60 have worked well. As best I can tell, the choice is a personal decision based on risk tolerance; there is a theoretical optimum down somewhere around 30/70 or 40/60, but the theoretical curve is very wide and shallow, so the justification for 60/40 would be that "typical" investors have a high enough risk tolerance that they would prefer to take more risk and get a higher expected return even if the risk-adjusted return is not quite as good as, say, 40/60.

Benjamin Graham (Warren Buffett's guru) said in The Intelligent Investor
There is an implication here that the standard division should be an equal one, or 50–50, between the two major investment mediums... We are thus led to put forward for most of our readers what may appear to be an oversimplified 50-50 formula...
The point is not that 60/40 is wrong and 50/50 is right, the point is that despite all the false precision with which investing writing is rife, nobody can say which is "best." There's a general feeling that 100/0 and 0/100 are bad ideas and that most people ought to be somewhere vaguely in the middle.

Here are two other data points. An important point is that 1926-present does include the forty-year period, about 1940-1980, of rising interest rates and two periods of high inflation. Thus the higher-than-traditional bond allocation is not the result of looking solely at a "bull market in bonds."

1) Executive summary: from 1926 through 2017, the MPT optimum stock/bond ratio was 30/70.

Details: based on the SBBI series for large-company US stocks (S&P 500 and predecessors), and for intermediate-term government bonds, and adjusting for inflation, the allocation for the MPT tangent portfolio--the portfolio that would have had the highest risk-adjusted return as measured by the Sharpe ratio--was 30.22% stocks, 69.78% bonds.

Without inflation adjustment, 27.05% stocks, 72.95% bonds.

2) Executive summary: for the same time period, the "risk parity" allocation was 26/74.

Details: "risk parity" is a slogan used by a prominent hedge fund manager, Ray Dalio, to describe his overall strategy for one of his hedge funds. The idea is to take equal amounts of risk in four different asset classes, for intuitive reasons. If you decided that you wanted to take equal risks in stocks and bonds alone, over that time time period, the standard deviation, inflation-adjusted, was 19.803 for stocks, 5.930 for bonds, leading to 26/74 for equal risks.

Without inflation adjustment, 19.688 for stocks, 5.582 for bonds, 22/78.

Also: the justification for cap-weighting is important to understand, because for self-serving reasons everybody wants a gimmick, and a popular gimmick these days is to put a twist on cap-weighting and call it "smart beta" or "fundamental indexing" or "factor-based investing." As a result, there is a lot of talk about cap-weighting being bad. Well, it may or may not be, but it is not just one of many choices, there is a well-founded rationale. The rationale is that a cap-weighted total market index, and an index fund that tracks it, reflect the "market portfolio," the actual set of all stocks in the stock market. And under a set of idealized but not crazy assumptions the market portfolio is special. The financial economists say that (under a set of assumptions) it is mean-variance optimum (which may or may not be something you want). It is also the weighting that makes you speculation-neutral, puts you on both sides of every speculative transaction, so that if a big trade causes one set of stocks to rise and another to fall, the effect on the market itself and in your portfolio is equal and cancels out.

Everything that isn't cap-weighting amounts to saying "I have a rule for picking stocks, in a gentle sort of way involving large categories of stocks, that not only lets me participate in the general performance of the market, but also, in addition, lets me automatically and systematically take money away from other investors who are not following this rule." The people who advocate these strategies have interesting reasons for thinking such a rule can work, and "there might be something to it." But all these strategies are claiming that they are a formula for eating someone else's lunch. For some reason, the people advocating them often fail to make that clear.

(Footnote: there is a case to be made, and I think that this is what Eugene Fama says, that you could depart from cap-weighting not in a belief that you are improving risk-adjusted return, but because you have a personal taste for some particular risk characteristic not measured by standard deviation. My skepticism about this is that I have doubts that any such supposed "characteristic" is actually dependable or robust).
Last edited by nisiprius on Mon Apr 16, 2018 6:54 am, edited 2 times in total.
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lazyday
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by lazyday » Mon Apr 16, 2018 6:47 am

Just to clarify on "Valuations" in the title. In investing, this usually either means how cheap or expensive something seems, or refers to estimates of value--not based on the trading price, but on characteristics such as earnings.

So we might claim that tech companies have poor valuations because prices seem too high relative to earning potential. Or we might estimate a valuation of what we think a company is really worth, which might be quite different from the current price.

"Market Cap" can be used to refer to the total market value of equity, and for bonds I guess you could say "total debt". Or just "total market value" for either.

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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by afan » Mon Apr 16, 2018 7:52 am

The problem is inefficiencies that prevent people from holding the true market portfolio then adjusting their risk level with leverage. In theory, everyone could borrow at the risk free rate. Those who wanted a higher expected return than the market portfolio would hold the market portfolio as the only risky asset and borrow to bring the risk up to desired levels. But few people can actually do this. So they have to use an alternative to get their risk to the desired level.

Holding the market portfolio and using leverage is effectively both lending money with bonds and borrowing money for leverage. In the real world this is highly inefficient.

Another inefficiency is taxes. The bond portion of the portfolio would throw off a lot of taxable income, reducing returns. Tax laws favor equity investment, not something recognized in the MPT theory.

Many people also hold risky investments that are not in the overall market. They own real estate, for example, or parts of privately held businesses. In theory, no such illiquid and private investments exist. Everything is available for trading in an efficient market. In reality, most investors hold these investments and have to deaign an overall portfolio that takes them into account.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

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aj76er
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Re: Using Stock/Bond Market Total Valuations to Guide Portfolio Allocations

Post by aj76er » Tue Apr 17, 2018 6:24 pm

yogesh wrote:
Sun Apr 15, 2018 11:36 pm
aj76er wrote:
Sun Apr 15, 2018 10:50 pm
You may be interested in the World Bond/Stock Portfolio proposed by William Sharpe.
https://www.bogleheads.org/wiki/World_B ... _Portfolio
viewtopic.php?t=207804
Has anyone created a ETF or mutual fund based on this portfolio?
Not that I'm aware of. There used to be an index that tracked the global portfolio, but I believe it was discontinued. The moderate lifestrategy funds offered by Vanguard get pretty close, but still rebalance (daily?) according to fixed percentages.
"Buy-and-hold, long-term, all-market-index strategies, implemented at rock-bottom cost, are the surest of all routes to the accumulation of wealth" - John C. Bogle

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