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February 24 - March 15, 2018
the interest payment is based on a principal amount that rises with the consumer price index (CPI). If the price level were to rise 3 percent next year, the $1,000 face value of the bond would increase to $1,030 and the semiannual interest payment would increase as well.
No other financial instrument available today offers investors as reliable an inflation hedge. TIPS also are great portfolio diversifiers. When inflation accelerates, TIPS will offer higher nominal returns, whereas stock and bond prices are likely to fall. Thus, TIPS have low correlations with other assets and are uniquely effective diversifiers. They provide an effective insurance policy for the white-knuckle crowd.
TIPS do have a nasty tax feature, however, that limits their usefulness. Taxes on TIPS returns are due on both the coupon payment and the increase in principal amount reflecting inflation.
Thus, TIPS are far from ideal for taxable investors and are best used only in tax-advantaged retirement plans.
Is the bond market immune to the maxim that investment risk and reward are related? Not at all!
High-yield or junk-bond portfolios are not for insomniacs. Even with diversification, there is substantial risk in these investments. Moreover, they are not for investors who depend solely on interest payments as their major source of income.
Foreign Bonds
There are many foreign countries whose bond yields are higher than those in the United States.
EXERCISE 7A: USE BOND SUBSTITUTES FOR PART OF THE AGGREGATE BOND PORTFOLIO DURING ERAS OF FINANCIAL REPRESSION
In the specific recommendations that follow, I recommend such a partial substitution of stocks for bonds in that part of the portfolio designed for lower risk and more stability. During periods of financial repression the standard recommendations regarding bonds need to be fine-tuned.
EXERCISE 8: TIPTOE THROUGH THE FIELDS OF GOLD, COLLECTIBLES, AND OTHER INVESTMENTS
But there could be a modest role for gold in your portfolio. Returns from gold tend to be very little correlated with the returns from paper assets. Hence, even modest holdings (say, 5 percent of the portfolio) can help an investor reduce the variability of the total portfolio. And if inflation were to reemerge, gold would likely produce acceptable returns. Small gold holdings can easily be obtained now by purchasing shares in one of the mutual funds or ETFs concentrating on gold.
Practically all gold trading is for the purpose of hoarding or speculating so that the bullion can be sold later at a higher price. Almost none of the gold is actually used. In this kind of market, no one can tell where prices will go.
What about diamonds, which are often described as everybody’s best friend? They pose enormous risks and disadvantages for individual investors.
My advice to the nonprofessional investor: Don’t go against the grain. I would also steer clear of hedge-fund and private-equity and venture-capital funds. These can be great moneymakers for the fund managers who pocket large management fees and 20 percent of the profits, but individual investors are unlikely to benefit.
EXERCISE 9: REMEMBER THAT INVESTMENT COSTS ARE NOT RANDOM; SOME ARE LOWER THAN OTHERS
If you want your hand held, if you want general portfolio advice and investment suggestions, the discount broker may not be for you. If, however, you know exactly what you want to buy, the discount broker can get it for you at much lower commission rates than the standard full-service house, especially if you are willing to trade online. Trading stocks online is easy and cheap. But let me warn you, few investors who try to trade in and out of stocks each day make profits.
Remember also that costs matter when buying mutual funds or ETFs. There is a strong tendency for those funds that charge the lowest fees to the investor to produce the best net returns. The fund industry is one where you actually get what you don’t pay for. Of course, the quintessential low-cost funds are index funds, which tend to be very tax efficient as well.
You can’t do anything about the ups and downs of the stock and bond markets. But you can control your investment costs. And you can organize your investments to minimize taxes. Controlling the things you can control should play a central role in developing a sensible investment strategy.
EXERCISE 10: AVOID SINKHOLES AND STUMBLING BLOCKS: DIVERSIFY Y...
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Therefore, within each investment category you should hold a variety of individual issues, and although common stocks should be a major part of your portfolio, they should not be the sole investment instrument.
Although the price levels of stocks and bonds, the two most important determinants of net worth, will undoubtedly fluctuate beyond your control, my general methodology will serve you well in realistically projecting long-run returns and adapting your investment program to your financial needs.
WHAT DETERMINES THE RETURNS FROM STOCKS AND BONDS?
long-run returns from common stocks are driven by two critical factors: the dividend yield at the time of purchase, and the future g...
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a share of common stock is worth the “present” or “discounted” value of its str...
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The discounted value of this stream of dividends (or funds returned to shareholders through stock buybacks) can be shown to produce a very simple formula
Long-run equity return = Initial dividend yield + growth rate.
From 1926 until 2013, for example, common stocks provided an average annual rate of return of about 10 percent. The dividend yield for the market as a whole on January 1, 1926, was about 5 percent. The long-run rate of growth of earnings and dividends was also about 5 percent. Thus, adding the initial dividend yield to the growth rate gives a close approximation of the actual rate of return.
Over shorter periods, such as a year or even several years, a third factor is critical in determining returns. This factor is the change in valuation relationships—specifically, the change in the price-dividend or price-earnings multiple. (Increases or decrea...
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When interest rates are low, stocks, which compete with bonds for an investor’s savings, tend to sell at low dividend yields and high price-earnings multiples. When interest rates are high, stock yields rise to be more competitive and stocks tend to sell at low price-earnings multiples.
When interest rates rise, bond prices fall so as to make existing bonds competitive with those that are currently being issued at the higher interest rates. When rates fall, bond prices increase. The principle to keep in mind is that bond investors who don’t hold to maturity will suffer to the extent that interest rates rise and gain to the extent that rates fall.
In principle, common stocks should be an inflation hedge, and stocks are not supposed to suffer with an increase in the inflation rate.
Thus, even though all required returns will rise with the rate of inflation, no change in dividend yields (or price-earnings ratios) will be required. This is so because expected growth rates should rise along with increases in the expected inflation rate. Whether this happens in practice we will examine below.
Recall that stock returns are determined by (1) the initial dividend yield at which the stocks were purchased, (2) the growth rate of earnings, and (3) changes in valuation in terms of price-earnings (or price-dividend) ratios. And bond returns are determined by (1) the initial yield to maturity at which the bonds were purchased and (2) changes in interest rates (yields) and therefore in bond prices for bond investors who do not hold to maturity.
Although I remain convinced that no one can predict short-term movements in securities markets, I do believe that it is possible to estimate the likely range of long-run rates of return that investors can expect from financial assets.
Holders of good-quality corporate bonds will earn approximately 4½ percent if they hold the bonds to maturity. Holders of ten-year Treasury bonds until maturity will earn just over 2 percent. Assuming that the inflation rate does not exceed 2 percent per year, both government and corporate bonds will provide investors with a positive but quite meager rate of return.
It is hard to imagine that bond investors will be well served by the yields available in 2014.
Adding the initial yield and growth rate together, we get a projected total return for the S&P 500 of just under 7 percent per year—higher than bond yields but somewhat below the long-term average since 1926, which had been close to 10 percent.
The Shiller CAPE in 2014 averaged just over 25. CAPEs do a reasonably good job of forecasting returns a decade ahead and confirm the expectation presented here of modest single-digit returns over the years ahead. But if your investment period is for less than a decade, no one can predict the returns you will receive with any degree of accuracy.
The most important investment decision you will probably ever make concerns the balancing of asset categories (stocks, bonds, real estate, money-market securities, and so on) at different stages of your life.
more than 90 percent of an investor’s total return is determined by the asset categories that are selected and their overall proportional representation. Less than 10 percent of investment success is determined by the specific stocks or mutual funds that an individual chooses.
FIVE ASSET-ALLOCATION PRINCIPLES
1. History shows that risk and return are related.
2. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the likely variation in the asset’s return.
3. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk o...
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4. Rebalancing can reduce risk and, in some circumstances, increas...
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5. You must distinguish between your attitude toward and your capacity for risk. The risks you can afford to take depend on your total financial situation, including the types and sour...
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What about investing in common stocks? Could it be that the risk of investing in stocks also decreases with the length of time they are held? The answer is a qualified yes.
A substantial amount (but not all) of the risk of common-stock investment can be eliminated by adopting a program of long-term ownership and sticking to it through thick and thin
if you held a diversified stock portfolio (such as the Standard & Poor’s 500-Stock Index) during the period from 1950 through 2013, you would have earned, on average, a quite generous return of about 10 percent.
