For at least the last 70 years or so, there have been two guiding principles of portfolio management. The first is that you should spread your risk between different asset classes, with the general consensus being that those should be principally equities and bonds. The second principle is that, as you get older, you should gradually reduce your exposure to equities and increase your exposure to bonds.
These two principles are easy to understand and are now so deeply ingrained in us that they are hardly ever challenged. But what if it's time for a rethink? Indeed, what if these sacred principles weren’t such great ideas all along?
A paper published later last year explores optimal asset allocation and suggests that a portfolio holding 100% stocks and no bonds at all is generally best, even if (wait for it) you’re already in retirement.
The paper is entitled Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice, and it was authored by three finance professors in the United States — Scott Cederburg from the University of Arizona, Aizhan Anarkulova from Emory University, and Michael S. O’Doherty from the University of Missouri. (1)
A million simulations
Using market data going back to the 1890s, the researchers simulated the financial lives of one million couples from 39 countries, who start saving 10% of their salary from the age of 25 until their retirement at 65. When they retire, each couple withdraws 4% of their savings, indexed to inflation, until the death of the second spouse. The simulations take into account market fluctuations, mortality risk and the risk of redundancy, as well as the buffer provided by state pensions.
Cederburg, Anarkulova and O’Doherty compared five different investment strategies, both pre- and post-retirement:
- 100% government bonds
- 60% stocks, 40% bonds
- 100% stocks at age 25, with a gradual shift to bonds over time
- 100% domestic stocks
- 50% domestic stocks, 50% international stocks
The success of each strategy was evaluated on a number of criteria, including, most importantly, the risk that a couple outlived their money.
On average, the researchers found, a 100% exposure to stocks produced some 30% more wealth at retirement than stocks and bonds combined. To accrue the same amount of money at retirement, an investor gradually blending into bonds would need to save 40% more than an all-in equity investor.
Of course, we shouldn’t be surprised that an equities-only strategy performed best since stocks have substantially outperformed bonds over that period. However, some may be surprised at how significant the difference in outcomes is.
Even more eye-opening is what Cederberg at al. found when they measured the likelihood of each strategy resulting in so-called ruin, or running out of money in retirement.
A portfolio that transitioned from stocks to bonds over time came with a 17% chance of ruin. For domestic equities, the risk was very similar. But investing 50% in domestic equities and 50% in international stocks produced a relatively much smaller 8% chance of running out of money. One explanation, say the authors, is that international stocks have provided protection against domestic inflation. But, yes, that’s right, investors were less likely to suffer ruin if they didn’t invest in bonds at all.
Three reservations
I do have problems with this study — three in particular. The first is that, although a 50% allocation to domestic equities is perfectly reasonable for U.S. investors, a similar allocation to U.K. stocks for investors in Britain is far too high.
Secondly, though it’s true the research is based on very long-term data, there is always a risk that the future will look very different to the past. Who knows? Although it’s unlikely, stocks could conceivably underperform bonds for several decades.
The third, and most important, reservation I have with this study is that it doesn't account for human emotions. The superior returns achieved by an equities-only approach assume that investors stick to their chosen strategy through thick and thin. In the real world, most people simply wouldn’t have the intestinal fortitude to resist the pressure to capitulate, or at least reduce their exposure, when markets crash, if all of their money were invested in stocks.
Food for thought
All that said, I do think that Cederberg et al. have provided useful food for thought.
We need to be honest with ourselves — and financial advisers need to be honest with their clients — about the case for investing in stocks. If (and it’s a big if) you can manage to ignore the noise and stay the course, you will almost certainly be better off with a larger allocation to equities.
That especially applies to younger investors, but it also applies to older ones. In fact, the older and wiser I get, and the more market history I read, the more willing I am to embrace the risk of long-term equity exposure.
Winning the Loser’s Game author Charley Ellis, who is far wiser and far more steeped in financial history than I am, is still 100% invested in stocks at the age of 86. (2)
“I have never owned bonds and never expect to,” Charley writes. “All my adult life, I’ve earned enough to cover all of our family’s expenses. Still do. Most of my investments will be converted into spending not by me, but by family members, particularly my grandchildren. My investments will be spent many long years from now.”
Of course, not everyone has that level of financial security. But, for those who do, all-in equity investing certainly had its merits, even when you’re Charley’s age.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products.
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.
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