Since 2009, both the S&P 500 and the US aggregate bond market have performed well. In fact, both stocks and bonds are sitting close to their all-time highs. The questions we should now all be thinking about are: 1) What’s next? 2) Why are both stocks and bonds at near record highs? 3) As I age, what should my asset allocation be?
In this article, I want to not only show you recommendations of different asset allocations. I want to also teach you the why. The more you can understand why these asset allocations makes sense, the more you can invest with confidence. Don’t blindly do something without understanding the logic, especially when it comes to investing your money.
What’s Next For The Stock And Bond Market?
Nobody knows for sure what’s next. What we do know for the stock market, as represented by the S&P 500 index, is that the long term trend is up and to the right. We also know there are bear cycles to watch out for every 5 – 10 years. For example, if you invested all your money at the top of the market in 2000, it would have taken 10 years until you got your money back if you held on. But if you bought at the bottom in 2009, you’re up well over 150%. The Brexit fiasco has now heightened the chances of another multi-year bear market.
Given it’s extremely difficult to time the market, it’s a good idea to deploy a consistent dollar cost average strategy throughout your life. In the beginning, because they make up a larger portion of your overall investment amount, contributions are extremely important. However, over time, contributions become less important compared to investment returns.
The bond market, as represented by the Barclays Aggregate Bond Fund ETF, acts a little differently. Whereas the S&P 500 declined by roughly 50% during the last downturn, the Barclays Aggregate Bond Fund only declined about ~15%. In other words, during times of despair, bonds are much more defensive. On the flip side, since its 2009 lows, the Barclays aggregate bond index is only up about 25%.
During times of uncertainty, investors rush to the safety of bonds, pushing down interest rates. Savvy borrowers will take advantage by refinancing their debt to lower their costs. After Brexit, the 10-year bond yield collapsed to 1.46%.
Given we’re near all-time highs and the stock market moves much more violently than the bond market, the logical conclusion is to shift some of our investments out of stocks and into bonds. If we are wrong, then we simply make less than we could have. If we are right about a downturn, then we will either make more or lose less than we could have. Although many are warning we are in a bond bubble, in finance, everything is relative.
It’s also important to observe the dividend yield for both asset classes. Consider the annual dividend yield as the income you’ll earn while waiting for things to play out. The dividend yield of the S&P 500 at 2.6% is higher than the dividend yield of the Barclays aggregate bond fund at 2.3%. When this occurs, there’s a tendency for money to flow towards equities given the opportunity cost to invest in bonds is so low.
The dividend yield can also be considered a performance buffer. For example, if the S&P 500 declines by 10%, your total return is really -7.4% if you hold for one year (-10% + 2.6%). When investing in either stocks or bonds, always think about the total return = principal performance + dividends.
Inflation Is Important To Understand
Just like how inflation is a natural tailwind for real estate investors, inflation is also a natural tailwind for stock market investors. The stock market performs based off corporate earnings growth, which inflation helps. The more corporate earnings grow, the higher the stock market if valuation multiples stay the same. The stronger the expectations for earnings growth, the higher the stock market tends to climb as well as valuations expand.
Between 1926 and December 31, 2015, the annualized total return for a portfolio composed exclusively of stocks in Standard & Poor’s Composite Index of 500 Stocks was ~10%. The average inflation rate for the same period was 2.93%. Therefore, the real rate of return was 10% – 2.93% = 7.07%.
Meanwhile, during the same period, the average annual return for investment-grade government bonds was 5.72% for a real rate of return of 5.72% – 2.93% = 2.79%.
Given we all want to beat inflation by as wide a margin as possible without taking undue risk, we tend to favor stocks over bonds, but hold both because we don’t know the future. Take a look below at the historical performance of stocks and bonds versus inflation.
There’s also something else worth mentioning. One of the key reasons for the widening wealth gap is because the rich invest their savings, while the not rich tend to spend. If you combine consistent savings with compound investment growth, it’s easy to see how huge the wealth gap becomes over an extended period of time.
Why Are Stocks And Bonds Both Near Record Highs?
The S&P 500 is close to a record high because corporate earnings are also close to record highs. We’ve also seen the P/E valuation multiple slowly start to increase for the S&P 500 as well.
Valuation multiples tend to increase when confidence in corporate earnings certainty and growth increases. Investors are willing to pay up for future earnings that may or may not come.
The historical mean and median S&P 500 P/E multiple is around 15X. Therefore, at 24.27X, stocks are expensive, but not yet as outrageously expensive as they were in 2001 and 2009. But now that we have massive global uncertainty with Brexit, it is logical to conclude that earnings growth will decelerate and valuations will decline over the coming years.
The bond market is at close to a record high because inflation is close to a record low. When inflation is low, investors buy bonds to gain yield. But as investors bid up bond prices, the yields come down e.g. $10 dividend payment on a $100 bond = 10% dividend yield, but if the bond gets bid up to $200, the dividend yield is only 5%. Remember we are looking at snapshots in time. The markets are fluid.
Notice how the 10-year bond yield has been coming down since it reached 15.8% back in 1980. We’re at under 1.5% today and will likely stay around the 2% level for a long time. This is one of the reasons why paying a higher mortgage rate for a 30-year fixed is a suboptimal choice. Why pay more when you can pay less with an ARM?
Unless you think coordination among global central banks will become weaker, technology will become slower, and there will be no more global upheavals like Brexit, it’s unlikely that inflation in the US will spike higher. Think about how much technology is displacing jobs. Think about how globalization is creating cheaper labor and goods.
Low inflation and low interest rates are here to stay.
As a well-rounded investor, you must look at this collapse in interest rates as an opportunity to invest in rate sensitive sectors like REITs and physical real estate. It seems clear to me the US dollar will continue to strengthen as global money chases safe-haven US foreign assets. Rental property can be considered a type of bond. But we’ll get to this in a future article.
Recommended Allocation Of Stocks And Bonds By Age
Given what we know about the stock and bond market, we should conclude the following:
1) If we want to beat inflation, it’s wise to invest in both the stock and bond market. Cash loses its purchasing power over time given money market returns are minuscule. But cash is also a fantastic temporary store of value during times of uncertainty.
2) Time in the market is better than timing the market. The longer we can invest, the higher the probability we will make money. Employ a disciplined dollar cost average strategy.
3) Market cycles force us to diversify between stocks and bonds. We never know for sure when we will retire, when we will need our funds, and what our future cash flow will look like.
Below is my updated recommendation of stocks and bonds by age for most investors. The formula simply takes 120 minus an investor’s age to calculate the stock allocation percentage e.g. 120 – 40 year old = 80% in stocks. I use 120 because we live longer. The “New Life Model” is the base case asset allocation for the general public.
Age 0 – 25: You’ve got nothing to lose. Your earnings potential is high and your energy is strong. Perhaps you’re paying back student loans. Do so with vigor, but make sure you are at least contributing to your IRA or 401k up to your company’s match. If you don’t have a company match, then try and save and invest as much as possible until you feel financial pain.
Age 26 – 40: You’ve still got a lot of energy and earnings potential, but you’ve got to start thinking about others as well. Large purchases such as a house or vehicle will significantly draw down investable assets. Perhaps there’s a marriage to pay for or a partner’s debt to assume. Despite additional financial responsibilities, you’re now maxing out your 401k and investing whatever is left in real estate to get neutral inflation.
Age 41 – 60: Your prime earning years should allow you to aggressively save and invest. All those net worth target charts a younger you scorned now make a whole lot of sense due to compound returns. At the same time, there may be growing bills to pay such as private school tuition for high school and college. Burnout risk at your job is now highest.
Age 61 – unknown: Hopefully you’ve achieved financial independence. Your investment income from stocks, bonds, real estate, and alternative investments should be covering 100% of living expenses. Your main goal is principal protection rather than principal growth.
The above chart assumes that you live and work a more traditional lifecycle.
But what if you’re a little more unorthodox than the general public? Here’s the Financial Samurai stocks and bonds asset allocation model, which is appropriate for folks who build multiple income streams and get out of the rate race sooner due to an aggressive accumulation of capital.
Age 0 – 30: You’ve also got nothing to lose. This is the period where to get ahead you are working way more than the conventional 40 hours a week. Due to your strong performance at work, your pay and promotion schedule is accelerated. You’re maxing out your 401k and investing an additional 20%+ of after tax, after 401k money through a digital wealth advisor or DIY broker. Even if the stock market craters by 20%, your contributions continue to buoy your investment portfolio as you buy during bad times times.
Age 31 – 40: After firmly cementing your position as a valuable employee, you begin to use your free time to build additional income streams beyond the stock market: bonds, rental properties, crowdsourcing investments, structured notes, venture debt, venture capital, private equity. Your goal is to diversify your net worth by making public equity investments equal to no more than 50% of your net worth because you realize the value of various asset classes. You also long to be more independent after working diligently for the past 15 – 20 years. Therefore, the only way is to really create multiple income streams.
Age 41 – 60: Not only do you lower your exposure to stocks to 60%, you also increase your exposure to dividend paying stocks with less volatility. Your main goal is to extract income from your investments instead of shooting for the next multi-bagger growth stock. By this time, you’ve broadened your net worth into at least five different asset classes. Further, you’ve developed your side-hustle into a stand alone business where you can be your own boss, pay less taxes, and generate a powerful income stream. If you can get a guaranteed 5% annual return, you’ll take it.
Age 61 – unknown: Your main goal is to protect your assets so they can provide for your friends and family indefinitely. With a 50/50 ratio, your investments are playing both offense and defensive. You’re aiming for a 4% annual return. You have more than enough, which means you have a greater ability to donate your time and money to others. Any wealth accumulated over the estate tax level will be aggressively given away because the government is inefficient.
Point of clarification: These asset allocation recommendations are pertinent for those who have a majority of their net worth in stocks and bonds. However, my sincere hope is that everybody diversifies their net worth so that public equities makes up no more than 50% of their net worth. Hence, if you are 40 years old and follow my 70%/30% stocks/bonds allocation, stocks and bonds actually may only make up 35%/15% of your entire net worth.
Invest Early And Often
Technology has made investing easier and cheaper. In the old days, you had to call your broker to make a trade and pay a $100+ commission for each trade. Can you imagine spending $1,000 to build a portfolio? It’s no wonder the buy and hold principle was established.
Today, you can build a portfolio by simply owning SPY (the low cost S&P 500 ETF) and AGG (the low cost Barclays Aggregate Bond ETF) in the above ratios through a brokerage like Motif Investing. It will only cost the investor $9.95 to buy or rebalance up to 30 positions and you get $150 of credit free. If you have a smaller portfolio or if you really enjoy following the markets, I recommend this route.
Or, you can let a company like Wealthfront build multiple asset classes within stocks and bonds and automatically rebalance for a fee of just 0.15% a year. The positions they build for you are all Vanguard ETFs and index funds. If you aren’t really interested in following the markets and find that you can spend your time making money elsewhere more efficiently, I recommend this route.
If you haven’t already, max out your 401k and your IRA. Keep your portfolio simple and invest in the lowest cost index ETFs possible. Follow a recommended asset allocation model as you age. Feel free to take 5% – 10% of your portfolio and swing for the fences too, especially before age 40.
If you need liquidity and can’t max out your 401k, then consider contributing at least up to the company match and investing in an after-tax account. If you keep up your investing schedule, in 10 years you’ll be surprised at how much you can accumulate.