There isn’t much doubt that the bond market is rich across the board. (See, among others, my 4/16/13 post S&P YIELDS VS. BOND YIELDS: I’M YOUR MAN WHEN IT COMES TO STATING THE OBVIOUS and my 4/15/13 post SO WHY HAS THE STOCK MARKET DONE SO WELL OF LATE? for further elucidation on this issue.) As I’ve pointed out in the past, it seems like whenever anyone wants to make a case for any asset, s/he claims that it is cheap relative to bonds. But what isn’t cheap relative to bonds nowadays?
The legendary, and deservedly so, investor Lee Cooperman (pictured) appeared on CNBC this morning and, when describing the potential returns and risks of buying the 10 year treasury at this stage, came up with one of the greatest quotes I have ever heard in my investing career:
“It’s like walking in front of a steamroller to pick up a dime.”
So, yes, I, and much smarter people than I, think the bond market, and especially the treasury market, is rich. Does that mean we should all sell, or even short, treasuries, now?
No.
Why?
First, while we can be confident that the conventional treasury market is rich, we cannot be sure, or even close to sure, we are right. We might, and only might, be able to establish with some degree of probability greater than 50% that a market is rich or cheap. This ability tends to increase with years of experience, but never reaches levels approaching certainty.
Second, and much more important, is that even when we are right about a market’s being rich or cheap, as is the case with the treasury market at this juncture, we have no idea how long the market we are considering will stay cheap or rich. As the old saying goes, the markets can stay irrational a lot longer than you can stay solvent. So, yes, the treasury market probably is rich at this juncture…but it can stay that way a long, long time; it already has.
Calling markets, especially in the short term is, as I have said many times in the past, is very difficult. There ratio of people who can call short term markets to those who think they can call short term markets is nearly microscopic. So, at the expense of sounding like a broken record, the best approach to investing is a balanced approach. Hold some stocks, hold some bonds, hold some precious metals, and hold some cash. Dollar cost average if you can. REBALANCE REGLIGIOUSLY. Let the market do what it’s going to do. Leave the trading to those who can do it…and those who think they can do it. Let them provide the liquidity you need to function as a long term investor.
Taking such a disciplined, balanced approach to investing is boring…and not nearly as easy as it sounds, though it can be made much easier by simply buying a good balanced fund. (See my 10/29/12 post on the now defunct Rant Finance, PERSONAL FINANCE 101: THE REAL BEAUTY OF A BALANCED FUND, which I have reproduced in its entirety below.) But it works.
PROMISED REPRODUCED POST:
PERSONAL FINANCE 101: THE REAL BEAUTY OF A BALANCED FUND
After years of trading and investing and using numerous approaches to both, I have found that the best approach is perhaps the simplest: Invest in a balanced portfolio of stocks (equities) and bonds, and perhaps some cash and precious metals, according to your risk preferences and then religiously, faithfully, fanatically, perhaps obsessively compulsively rebalance your portfolio regularly.
What this boils down to is determining how much exposure to equities (stocks) you want and investing that proportion of your portfolio in stocks, preferably a broad based stock index. The remainder should be invested in bonds, preferably a broad based bond index, unless tax considerations dictate that you invest in municipal bonds (“munis”), in which case you would invest in a muni fund that is widely diversified and, hopefully, minimally managed. Once you determine that mix of bonds and stocks, rebalance (buy and sell the two funds to get back to the original proportions) with a fervor approaching that of a hunger striker.
Two considerations:
First, determining the right mix of bonds and stocks for you is difficult if not impossible. We tend to overestimate our appetite for risk, and thus our optimal stock allocation, when the stock market is doing very well. We tend to underestimate our appetite for risk, and thus our optimal stock allocation, when the stock market is doing very poorly. Brokerage firms, financial advisors, and mutual fund families have come up with supposedly nifty tests to determine one’s optimal allocations, but these are largely fanciful, useless, or conflicted.
Second, rebalancing can be done two ways, either by time or by boundary. When we rebalance by time, we buy and sell stocks on a predetermined and fixed date to return to our original allocation. For example, say we somehow determine that our optimal allocation is 50% stocks, 50% bonds and we have $100,000 to invest, so we invest $50,000 in a stock index fund and $50,000 in a bond index fund (assuming, say, that this is an IRA or other tax deferred account so municipal bonds aren’t warranted or our tax bracket is so low that munis don’t make sense). The stock market does very well over the next year, so after one year, our portfolio is composed of
$60,000, or 57% in stocks
$45,000, or 43% in bonds
$105,000
(Don’t get crazy here and take the proportions out to decimals of percents; investing, regardless of what one might tell you, can’t be that precise since we are dealing with the inherently unpredictable future.)
To rebalance, we would want to get our portfolio back to
$52,500, or 50% in stocks
$52,500, or 50% in bonds
$105,000
So we would sell $7,500 in stocks and buy $7,500 in bonds to get back to our 50/50 allocation. Such rebalancing can be done quarterly, semi-annually, or annually, but annually seems to work best, at least for yours truly.
The other way to rebalance is to do so by boundary. When the proportions of stocks and bonds get some predetermined percentage away from the original allocation, say 5%, we would rebalance to get back to the original allocation regardless of when the boundary is reached.
The beauty of rebalancing is that it forces us to do what we won’t want to do: sell some of our winners to invest in some of our losers. Rebalancing thus forces us to take some of our profits in good times and thus protect ourselves in the inevitable, eventually, bad times, or to put more money into stocks during bad times, when stocks are cheap, or at least cheaper than they were, so that we can benefit to a greater extent in the inevitable, eventual, good times. Rebalancing, to simplify, forces us to sell high and buy low…a strategy that generally works.
Here’s the problem: Rebalancing sounds easy and, indeed, it is simple…but not easy. I can guarantee you that the last thing you will want to do in a roaring stock market is to sell stocks in order to buy bonds which will look boring by comparison and, generally, will not have performed well in a strong stock market. Maybe that’s not the last thing you will want to do…the last thing you might want to do is to buy stocks after the market has taken a tumble and you have avoided much of the carnage by holding bonds. Such an idea will sound crazy, but that is what you will have to do if you religiously rebalance. And it’s what you should do…but you won’t want to do. So most people delay and deny; in a good market, when their rebalance date comes or their rebalance boundary is reached, they will give it a week, or a month, or a quarter, holding onto their stocks in bull markets or bonds in bear markets. They will, in effect, time the market, which balancing is designed to avoid, by playing with their rebalance rules, or at least interpreting them loosely. The results can be harmful or even disastrous.
This is where balanced funds come in. Balanced funds, as the name implies, traditionally hold a balance of, generally, 60% stocks and 40% bonds, though some hold a 50/50 split. This split is based on research, worthy or flawed, that shows that such a split provides the optimal risk/return trade-off over long periods of time. Thus, it might not work for you if you are either more or less risk averse than the typical investor, whoever s/he is. But over the broad range of investors, that 60/40 or 50/50 split seems to work in terms of risk and return. This is supposed to be the beauty of the balanced fund; the asset allocation is done for you and, for most people, it reflects at least an acceptable risk/return trade-off over the long run.
But I contend that the real beauty of a balanced fund is that the hardest part of the process, the automatic rebalancing, is done for you. You don’t have to make the gut wrenching decision of selling or buying when you don’t want to sell or buy. It is done without your even knowing it. Most balanced funds rebalance using the boundary approach, by the way. But that shouldn’t make a lot of difference, over time, and is not the most important consideration. The most important consideration is that the rebalancing is done, not how it is done.
So investing can be very simple: If you have the guts to fanatically rebalance, put about 50%, plus or minus a bit depending on your degree of risk aversion, of your funds into a broad based stock index (perhaps a total stock market index fund or a global stock index fund) and the remainder into a broad based bond index that includes governments, corporates, and agencies. You also might want to put some small proportion of your portfolio into cash and maybe a small portion into precious metals, but the latter two are not necessary.
If you are like most people, though, you will find rebalancing easy in theory and difficult in practice. So maybe you should just invest in a balanced index fund (Vanguard and Fidelity, among others, have such funds) and forget about it. You could do a lot worse and, in many, if not most, cases can’t do much better…over time.
A final note…you could certainly do this yourself, but following this simple approach does not preclude using a broker or financial advisor. Even people who follow simple strategies like the idea of working with a good professional who knows what s/he is doing, and who does so for a living, and are willing to pay for the services of such a professional. And a good broker will do what s/he can to keep costs as low as they can while still getting paid for his or her services. Finding a good broker is not easy; there are many charlatans who have hung out “financial advisor” shingles. But there are plenty, or at least some, of them out there, and several are known to yours truly personally. But I digress. Ironically, those of us who are more interested in investing, and thus more inclined to trade, might find using a broker even more helpful than those who are indifferent to investing as an intellectual proposition. Having to actually talk to someone and hear ourselves explain out loud why we want to deviate from our well reasoned strategy will serves as a deterrent to doing so. And those of us who like to invest are far more likely to want to move away from a simple approach than those who really don’t care from an intellectual standpoint.
Whether you use a broker or not, the overall rule is to keep it simple. A balanced fund, with its forced rebalancing strategy, is the ultimate in simplicity…and, over time, balanced funds tend to work for the broad range of investors.
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