Friday, 1 February 2008

Equity-only or Bond with Equities: Objection and Nuances

Yesterday's post Why Not All Equities attracted a valuable comment by blogger Michael James to the effect that the math alone indicates it is highly unlikely that bonds could actually increase returns (see his comment for details) in a portfolio with equities.

I think the point about rebalancing made by another commentor John accounts for part of the shortfall and thanks to John for saying that since I did not mention it in the original post. Gibson's modeling rebalanced the portfolios annually, which in effect implements an automatic program of "sell the asset when high and buy the other which is low". This boost returns. But that only accounts for part of the return gap noted by Michael.

So, Ok, Michael, let me back off a little. First, the portfolios modeled by Gibson consist of various non-bond combinations. The other asset classes of international equities, commodities and real estate returns have been close enough to that of an all-equity S&P 500 portfolio to do exactly what was stated - higher returns at lower volatility. But with respect to bonds, Gibson himself states that when fixed income is mixed with equity in a portfolio ... "the large difference between the returns of fixed-income and those of equity investments obscures the increase in portfolio return attributable to the diversification effect." In other words, you are strictly correct: with bonds it is unlikely that portfolio returns will actually increase in a combined portfolio. However, there will be a large decrease in volatility/risk that more than compensates for the slightly lower return. The common way of expressing this is the Sharpe ratio, which divides the equity return (net of the risk-free T-bill rate) by the standard deviation (i.e. volatility). I daresay you will never find a study/data in which a portfolio of bonds plus equities has a lower Sharpe ratio than an equity-only portfolio.

I found this interesting article "Do You Need Bonds?" by Duncan Hood in Canadian Business. Apart from the "can-you-stick-with-it-when times-get-tough" argument, he outlines differences in returns using an example of the TSX over 30 years and indeed the portfolio with bonds does have a slightly lower return of 11.5% annually vs 12.1% for one of TSX index-equity only. The annual return ups and downs are much less for the combo portfolio.

The additional element introduced by the article is taxes, which can result in net returns being higher with equities plus bonds when the money is in an RRSP or with equities only in a taxable account for long holding periods due to the differences in taxes on bond interest income, on RRSP withdrawals (taxed as income) and on capital gains and dividends from equities (lower rates).

Thanks to Michael for his sharp eyes and brain. To quote Keynes again, "There is no harm in being sometimes wrong — especially if one is promptly found out."


CanadianRetiredGuy said...

I believe that increasing the bond component in a portfolio as one ages is akin to a train slowing as it approaches the station.

The ride tends to be much smoother.

Preet said...

Numbers, statistics, theory and research are trumped by results. While what has been determined is true, investor behaviour negates the findings as it pertains to real world results (for the average investor) - as you allude to with the "stick to it-ness" reference.

Jean, you have been writing some really excellent posts as usual - and Michael James, I think I'll be adding your feed to my reader!


Michael James said...

The Sharpe ratio results are only relevant if you are willing to borrow (use leverage). If you don't use the optimal amount of leverage, then you don't get much benefit from the lower volatility (apart from emotional benefits). Another problem is that if you choose to use leverage, to take full advantage of the Sharpe ration you must be able to borrow at the risk-free rate. All loans I have had have been at interest rates above the risk-free rate. This complicates the analysis and reduces the benefit derived from lower volatility when holding some bonds. All my attempts to work through this have lead to the conclusion that bonds don't help. But, this is dependent on assumptions about expected returns and variances of the various asset classes.

It is true that for most investors, all of this concern over tenths of a percent in returns each year are trumped by emotions. I haven't had this problem so far, and I am comfortable with my current portfolio which is 100% in stocks for money that I won't need for 3 years or more.

John said...

The post mentions that “Gibson's modeling rebalanced the portfolios annually, which in effect implements an automatic program of "sell the asset when high and buy the other which is low".”

If you use TD e Funds you can rebalance (if necessary) weekly during times of great change. That way you really are buying during drops and selling as the assets rise

Brian Poncelet, CFP said...

Hello DIY,

When you get corporate class funds which have bonds and cash as well as stocks any distributions are treated as capital gains.



Michael James said...

I was inspired to work on this question about bonds. I wrote a post on my blog that explains my thinking:


CanadianInvestor said...

Brian, that's fascinating .. how do the funds turn the water (income from bonds) into wine (cap gains)?

Anonymous said...

Very interesting discussion. An all-stock portfolio assumes the historical premium on stocks (3% to 5% over government bonds) will continue into the future. That’s an excellent assumption but it is based on induction, and as John S. Mill said, the problem with inductive reasoning is that black swans do exist. Some black swans over the next 5 to 25 years could be wars and revolution (events responsible for Russian and Chinese stocks not having the same equity premium as U.S. stocks). One also wonders if the current state of the U.S. economy – with its huge and growing structural imbalances – is ahistoric and allows one to make extrapolations from the past with as much certainly as before.

John said...


What a great link to the “black swan” article.

The percentage of bonds in a portfolio is insurance against the existence of black swans, black Fridays, 911, Nortel, Enron and other non linear events.

Michael James said...

I agree with John who said that holding bonds in a portfolio is a form of insurance against poor stock returns. However, this insurance is expensive.

Based on John Norstad's historical figures in the US from 1926 to 1994, the median outcome of investing $100,000 over 30 years in just stocks is $730,000 in real dollars (inflation accounted for). The same investment with a 60/40 split between stocks and bonds has a medain result of $470,000 in real dollars.

This result takes into account the wars and stock bubbles that occurred from 1926 to 1994. The insurance from bonds is too expensive for my taste.

Anonymous said...

Would John Norstad's figures from the US experience be the best estimate of the cost of insurance? Perhaps an average of the equity premiums from several countries might be a better representation of past and future events -- in which case the "cost of insurance" would be noticeably lower (since premiums were lower in other countries and decidedly so in Russia and China)?

Michael James said...

An anonymous poster asked whether the US experience is the best one to use. I would say tht the best country to use is the country (or blend of countries) where you intend to buy your stocks and bonds.

If anyone can recommend a good source of data on stock and bond returns for various countries, I'd be willing to run the analysis again.

brian Poncelet, CFP said...

Hello Canadian Investor,

Fund companies like Fidelity allow investors to switch and rebalance non-registered investments without triggering immediate tax consequences.

How this happens is when they (investor buys) one of these funds, they are essentially buying into a group of funds rather than the single mutual fund. Since all of theses funds are part of the same corporate structure, investors are able to switch from one fund to another, plus any distributions are treated as capital gains (this includes bonds, and cash)



Michael James said...

I've finally made it through the 4th edition of Roger Gibson's book. It's excellent in some respects, but lacking when it finally comes to choosing an asset allocation. I wrote up my analysis on my blog: link

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