Another new thread-- Bernstein's asset allocation

[Nords]

OK, I get it. Bernstein's "Intelligent Asset Allocator" recommends adding bonds to reduce portfolio volatility while adding return. What I don't get from "AA" is the bias for 10-20% bonds (at any cost) and the admonition against small-cap growth (SCG). He spends the entire book teaching asset allocation and not chasing performance or momentum. He freely admits that the last 70 years are not necessarily prologue. Then he shoots down SCG on its dismal record but doesn't temper this by admitting that a SCG hedge might not be a bad idea. And as someone has already pointed out, this is where the next Microsoft is coming from.

But has his AA plan been examined in today's interest-rate environment? Where "Interest rates can't possibly get any lower"? Where bonds are going to be crunched by the next rate increase? (Stand by for the day after the Nov elections.) I'm partway into "Four Pillars" without finding any solutions, but the history is more interesting than the analysis. Maybe I should just hold my criticism until "Birth of Plenty" comes out.

I could let these questions pile up if he offered alternatives. For example, let's go back to the bond-allocation question. I have a govt COLA pension now and spouse will get her own in 17 years. She'll work part-time for the next three-five years (very low portfolio withdrawal rate) and then we'll step up the burn for 12-14 years until her pension kicks in. At that point we'll be sixty and presumably blessed with another four decades of longevity (and Tricare Retired). Our retirement portfolio burn rate never exceeds 5% during the low-income years and it'll drop below 3% after the second pension kicks in. Even if it rises to (*shudder*) 8% for 10 years we'll still survive.

So, with two COLA pensions and a portfolio expected to survive the worst we've seen in this millennium, why start owning bonds? We keep two years' expenses in cash (CDs & MMs) and that worked well during the 2000-2003 "trial period". We're replenishing that cash stash from 2003's runup and we'll draw it down again during 2004-5 if necessary (not so far). I agree that bonds could tamp down the volatility but with low withdrawal rates it hardly seems necessary. And with bond funds ducking every time Greenspan burps... I'm really afraid to put 10% of ANYTHING into them.

Our retirement portfolio allocation is more chunks than slices. The tax-deferred portion is less than 20% of the total, spread among two conventional IRAs (Roth conversions coming soon), a tiny 401(K), and two tinier Roths. Aside from the two years' cash, the portfolio is 37% Tweedy Browne Global Value (TBGVX), 30% Berkshire Hathaway (BRK.B), 28% iShares S&P600/Barra Small-cap Growth ETF (IJT), and 5% iShares Dow Jones Select Dividend Industrials ETF (DVY). Most of the tax-deferred is TBGVX and a couple percent is IJT but the rest of the portfolio is all taxable accounts. Everything else is spoken for-- the kid's college fund is on track and contributed to from expenses. Roth contributions are part of our budgeted expenses. We don't do REITs since we own a rental and might buy more.

My point is that this portfolio is already heavily weighted toward tax-efficient value, mostly large-cap but a significant minority of small-cap. Intelligently allocating assets would seem to endorse 28% in hard-core small-cap growth, even despite Bernstein's prejudice against this category. (It didn't hurt a bit last year!) I wouldn't want to go 100% value for the same reason that he doesn't like growth-- value has underperformed for significant periods and may do so again. SCG has been a long-term laggard and may also be due for reversion to the mean. Our portfolio withdrawals will have the flexibility of harvesting whichever category has had the better year.

And while bonds would tamp out volatility, why bother? The volatility is breath-taking but we operationally tested 40% and survived with only minor emotional scarring (healed by 2003). With a two-year stash of expenses, and withdrawal less than 5%, you'd think that the portfolio would weather another bear-market correction without needing to risk losing money on bond funds during rising interest rates.

I'm deeply prejudiced against mutual-fund expenses/management, and I am a Buffett-head. That subjectivity aside, has anyone else noted Bernstein's inconsistencies? Anyone have a better solution?

 

[Cut-Throat]

Re: Another new thread-- Bernstein's asset allocat

And as someone has already pointed out, this is where (SCG) the next Microsoft is coming from.  

I don't think there are any inconsistences at all.

Remember that you are investing in asset classes not individual stocks. So if there is another Microsoft in SCG, but the overall asset class does poorly - what have you gained?

As far as bonds, yes they will get crunched when interest rates rise, but that is why Bernstein and others always recommend going short.

So, with two COLA pensions and a portfolio expected to survive the worst we've seen in this millennium, why start owning bonds?

When you get to the last part of 4 Pillars, Berstein recommends that you take Pensions and SS and value them as a Bond - He shows you how to do this. - So in essence you may already be overweighted in Bonds.

even despite Bernstein's prejudice against this category. (It didn't hurt a bit last year!)

Bernstein fully admits that some asset classes will do better than others, but cautions you to not pay attention to individual asset classes, but to the overall portfolio. Also he says don't even pay attention to the last 10 years. He tends to think in 30 year periods, as stocks may not do anything for periods of 20 years.

Finish the the 4 pillars book and see if you still see any inconsistences.

Also remember that Bernstein is human, and is just proposing a plan. His is better than mine, so I'm going with him - In 30 years , I'll know whether it was a good one or not.

 

[unclemick]

Re: Another new thread-- Bernstein's asset allocat

Nords
Take the following with a grain of salt:

1. If you 'operationally tested 40%' - you're allowed to humm the opening stanza of 'The Ballad of The Green Beret' about the 100 men we'll test today- or old Bogart- bonds we don't need no stinking bonds.

2.Bernstein is a math/stat guy and does a great job of explaining where current financial theory lies. And he stuggles to improve growth and damp volatility thru asset class selection - difficult and sometimes opposing forces. And asset classes sometimes depart from historic trends for periods(like as much as 20 +yrs)

3. I'm in two camps - Bogle's buy the whole thing (total stock,bond,international) and let the asset classes 'move' within the balanced index as they will. NO slice and dice. And then, and then try to 'pick' with my hobby stocks - I also monitor what Buffet owns.

4. Accept the paradox as best I can - ie you only have to be 'right' once in a lifetime (whether it's one or a few good stocks). On the defense - diversify, low expense, yes even some bonds. I'm amazed how many ways the posters to this forum have worked this out.

5. 80/20 plan - my 20% will capture the holy grail( a few good stocks) and the 80% remains the horse I rode in on (defense, defense baby, the old balanced index)

6. I always find the 'better solution' in hindsight - but I plan to keep reading and listening.

 

[wabmester]

Re: Another new thread-- Bernstein's asset allocat

Your asset allocation should reflect your tolerance for risk. You have to have a helluva lot of tolerance for a 100% stock portfolio, but if the swings don't bother you, go for it.

I don't really understand your love of stocks and aversion to bonds, though. Bernstein should tell you two things that might make you question this strategy:

1) Stocks historically have outperformed bonds, but there's no guarantee that they will in the future. And, in fact, you should expect some long-term RTM in stocks as well as a lower risk premium going forward.

2) The only bonds he recommends are short-term. Why, because they basically behave like variable rate instruments. You don't need to sweat the potential loss of NAV in a rising interest rate environment because funds will be investing in the new higher yield bonds as soon as their current (short maturity) inventory matures.

 

[John Galt]

Re: Another new thread-- Bernstein's asset allocat

I must once again repeat. I don't care what stocks
have done historically. What I want is predictability.
And, the NAV bouncing around is not a problem either
since I never intend to sell, but rather hold to maturity.
There are plenty of ways and places to invest without
ever owning common stocks.

John Galt

 

[ats5g]

Re: Another new thread-- Bernstein's asset allocat

Nords,

On SG growth, two EF links:

The Investment Entertainment Pricing Theory (INEPT) - Stocks, Bonds, Bills, and Lottery Tickets

The Cross-Section of Expected Stock Returns:
A Tenth Anniversary Reflection

SG is an asset class that has not rewarded investors for taking on added risks. Note, however that Wall Street and its brokers love to dangle the "next microsoft" in front of investors, without telling them that the likelihood of this is quite small. IPO's as a group have the worst returns. Now of course we can identify individual cases where this doesn't apply, but that's just data mining pure and simple. Just like we can identify high cost actively managed funds that seemed to have outperformed.

Are either of these a good strategy? Benjamin Graham said no. Buffet says no. F&F say no. Bogle says no. Who are the only people saying yes? Wall Street. The people who get access to the stock of the IPO's before it begins to get traded, and who make billions in investment banking fees. See any conflict of interest there?

The lottery affect. Yet another behavioral finance mistake many, many people make. The odds are you don't know what the odds are.

On interest rates rising. Do you think that they're only going to affect bonds? Wrong. Interest rates rising also affect stocks. Remember 1994? Stocks could also get crunched.

Which maturity bonds are least affected by either falling or rising interest rates? ST bonds. Hence, Bernstein and others (like DFA) recommend them b/c ST bonds have virtually zero correlation w/ equities, while longer term bonds have had periods of high and low correlation to equities. And when times got bad, longer term bonds' correlation to equities rose - which was at exactly the wrong time.

People have been screaming that interest rates are going to rise for what, 2 or 3 years now? The fears and thoughts of everyone is already reflected in the prices and yields of today's bonds. That's why the yield curve is so steep. How sure are you that this will actually happen when it's been "a sure thing" for the last three years?

Nords, you obviously have a low need to take risks b/c of your cola'd pension and that you've done such a good job saving. Personally, I don't consider stocks to be safe long-term investments, no matter how well diversified your portfolio is. I consider risks a necessary evil that I must take to reach my retirement goal.

I also believe firmly in declining marginal Utility of Wealth - that I don't value the next $ as much as the previous $. Also, given that I could get as much as 5-5.5% on things like 5-7 year CD's, the hope of getting 8% return from equities doesn't thrill me all that much.

- Alec

 

[cute fuzzy bunny]

Re: Another new thread-- Bernstein's asset allocat

I was going to say the same things - - stocks arent going to enjoy rising inflation or rates either and while bonds might take a dinging, some of that dinging is already built in and it will only hurt if you sell shares in the bond fund. Staying the course will result in a NAV rebound eventually and higher dividend payouts as a function of newer bonds carrying higher rates entering the portfolio.

While I wouldnt be shocked if the fed dialed in a quarter or half point raise this year as a defensive move to give them some space to lower if the economy came to a stop again, I cant see them going a full point or more until the economy was really chugging and some markable inflation became evident.

Sure, it could go up 3 or 4% in time, maybe even 5 or 6%, but unless some really great stuff starts happening, thats going to be spread out over a period of many years, which should buffer the effects to both stocks AND bonds.

With regards to the "next microsoft" in SCG, wouldnt such a company fairly quickly join the mid-cap index ranks and leave the SCG index?

 

[Bob_Smith]

Re: Another new thread-- Bernstein's asset allocat

I prefer the Total Stock Market. It just seems to be slightly less risky in the sense that if I veer from the TSM, I'm getting into a zero sum game. That's great if I win; I just don't think I can know enough to be reasonably assured of not being on the losing end. I have no faith in myself, or anyone else, when it comes to beating the market. Far too many brilliant minds have tried and failed. I guess this is a long way of saying that I too am a Bogle disciple. Perhaps my logic is flawed, but that's how it strikes me.

 

[Cut-Throat]

Re: Another new thread-- Bernstein's asset allocat

I prefer the Total Stock Market. It just seems to be slightly less risk in the sense that if I veer from the TSM, I'm getting into a zero sum game. That's great if I win; I just don't think I can know enough to be reasonably assured of not being on the losing end. I have no faith in myself, or anyone else, when it comes to beating the market. Far too many brilliant minds have tried and failed. I guess this is a long way of saying that I too am a Bogle disciple. Perhaps my logic is flawed, but that's how it strikes me.

Bob,

I agree that I cannot beat the Market either. The only reason that I don't take the TSM approach is that it leans too heavily towards Large Caps. That is why I lean towards Bernstein and am a 'Splitter'. Historically it will increase returns and reduce some volatility. Especially when including International Stocks. The only extra task is a mindless rebalance every couple years, when things get out of whack.

Have you read the Four Pillars yet by Bernstein?

 

[Bob_Smith]

Re: Another new thread-- Bernstein's asset allocat

Have you read the Four Pillars yet by Bernstein?

Not yet, Cut-throat. It's on my "to-do" list.

 

[charlie]

Re: Another new thread-- Bernstein's asset allocat

Amen brother Bob. I totally agree with you.

Cheers!

Charlie

 

[Cut-Throat]

Re: Another new thread-- Bernstein's asset allocat

I must once again repeat.  I don't care what stocks have done historically.  What I want is predictability.

johngalt,

We live in an unpredictable world.

But, As Berstein says the Stock Market is very predictable over the long haul. It always goes up eventually.

The Market is like a man walking a dog from Point A to Point B with a 100 foot leash. Everyone always focuses on the Dog, which is zipping wildly around the owner up, down and sideways. However the dog always ends up going where the owner goes and eventually ends up at point B!

Just don't watch the Dog!

 

[wabmester]

Re: Another new thread-- Bernstein's asset allocat

But, As Berstein says the Stock Market is very predictable over the long haul. It always goes up eventually.

This is the assumption upon which all of this MPT stuff rests.   And I can't come up with any reason it should continue to be true in the future, can you?

I think it's a safer bet that inflation will always go up.

And I think it's an excellent bet that real interest rates will also be going up throughout the entire baby-boom retirement bubble.   Even if social security is fixed, and you can be sure that it will be, the one thing that *has* to happen when all of our generation retires is that assets will have to be liquidated on an unprecedented scale to provide their cash flow.  Not just nest-egg assets, but social security trust fund assets (i.e., treasuries) and pension assets.

 

[Lohengrin]

Re: Another new thread-- Bernstein's asset allocat

on Today at 10:08pm, Cut-Throat wrote:But, As Berstein says the Stock Market is very predictable over the long haul. It always goes up eventually.


This is the assumption upon which all of this MPT stuff rests. And I can't come up with any reason it should continue to be true in the future, can you? wabmester

This is the buy and holder's version of "data mining". It ALWAYS goes UP? They always pick whatever time frame is most advantageous to the point they're trying to make at the time. Or they assume you're 20 yrs old and will work a long time and never take any money out during that time, and when you get to the end point the market will have GONE UP. Or they do the 20/20 hindsight thing and tell you "yes but if only you had had X % in bonds or some other ratio of stuff you'd have done just fine" Whatever that's supposed to mean.

What if I dont have 40 or 50 or 60 or 75 yrs? Or what if I guess wrong at the RIGHT ratio of stuff? What if I die after 20 yrs.. twenty BAD yrs? For me the market NEVER went up. Of course then it wouldnt matter so I wouldnt figure into their stats of successful vs unsuccessfull investors

 

[wabmester]

Re: Another new thread-- Bernstein's asset allocat

Well, to be fair to the MPTers, those are two different questions. You're right that there's no guarantee that the market will go up in the timeframe that matters to you. That's a good reason to hedge with TIPS -- the closest thing you can buy to a guaranteed income with COLA increases.

But more fundamentally, the MPTers believe that stock prices grow as earnings grow. So the "always go up" assumption is really an assumption that earnings will always grow -- forever! This has been true in the US for the last 100-something years, but it is true in no other country, and there's an excellent chance it will stop being true in our lifetime.

 

[Nords]

Re:  "Stocks for the Long Run?"  (Maybe not.)

When I look back over two decades of investing, it's clear that our ER is founded on cutting expenses & savings, not on brilliant investing. (All of those deployments and sea pay.) But Quicken's IRR of the whole portfolio between 1985-2002 shows that we've netted 11% before taxes (with some unrealized gains). That includes a whole zooful of what could tactfully be called "experiental investing", including bonds & CDs & MMs. So maybe we're accustomed to volatility.

I can't say that a 40% hit was a voluntary or an enjoyable experience. It happened while I was busy working (not a good time for the military workload) and it sure was a potential ER breaker. But I ran FinancialEngines after dinner on 17 Sep 2001 (the day the markets reopened) and got the little ">95%" lightbulb. If that worked two years ago, it'll probably keep working.

I've read all of the investment classics but Bernstein is making a big impression-- especially his analogy of walking the hyperactive dog. There are some inconsistencies and I'll give him a chance to explain them before I finish "Four Pillars".

I agree that stocks are risky. I agree that they're volatile, and that volatility is on the rise. However, I'm not sure that those are issues if you can control the emotional reactions (someday I will), have a cash stash to ride out expenses during a big bear, and keep a SWR. (I especially appreciate Bud Hebeler's "Analyze Now" approach.) In ER, bear markets are only a hazard if you have to sell-- they're great for buying! I'm willing to trust Tweedy, Browne & Warren Buffett, but I'm watching that SCG ETF with a fairly tight sell stop.

I guess the reason we're in stocks is for their historical returns (conjecturally those days could be over) and because we haven't put it all into real estate. I can also appreciate the contrarian's possibility of SCG reverting to a mean (as if last year wasn't enough!) and I'm willing to give it a few years. I'm also encouraged by the recent resurrection of dividend investing.

OTOH I also appreciate the "If you don't need them, why the heck are you holding stocks?" query. This is a symptom of a bigger issue for spouse and me-- we don't easily pass by money that we don't need right now but might just possibly need "someday". It's not just that we don't spend it, it's also that we're reluctant to give up the control or the opportunity unless it's for a purpose that we deem truly worthwhile (or valuable). I'm not sure how much we'd have to have in our portfolio before we loosened up, if we even COULD loosen up, but I've read that's a common problem with retired investors. So IMO stocks are still the best and easiest way to guard against inflation risk while having the opportunity of greater returns. 30 years from now I'd hate to think that I didn't have the foresight to take the risk "just in case" it was necessary. And before someone trots out the "repeating history" of the S&P500's 0% return between 1966-1982, let me point out that little factoid has ignored the effects of reinvesting dividends. We can be patient for at least two or three decades, especially if I go back to work. (Ug!)

Another thing I've learned is that, while I'm not a brilliant investor, the harder I work the luckier I get. ats5g, while I agree that IPOs as a sector suck a lot of wind, I don't buy the ones that suck. I've read thousands of pages of prospectuses (prospectii?) and while I still have a lot to learn, the results have been gratifying. My IPO experience has been Kraft in 2000 (up over 25% in the following year), Netgear last fall (up over 25%), and Texas Capital Bancshares (up 45%). I set the sell stops and rode them until they broke down; my biggest complaint is that I couldn't get a decent share allocation. I also shorted Red Envelope's IPO as soon as my broker could get the shares-- I could see from the prospectus that one was going to have a miserable holiday. And speaking of holidays, I just unloaded last fall's K-Mart purchase and the kid's Disney shares. I've also profited from shorting Janus, SCO Group (more to come on that short!), Sirius, and the NASDAQ QQQs. (Need some more time on the QQQs. Maybe another year, maybe not.)

While all of the above sounds just ducky, I worked darn hard over the last three years to gain the brains & experience before finding the guts to commit real cash to building up that record in the last year. It's being done with a small separate account, and if I tried to do it with our retirement portfolio then the scale-up & monitoring would be a horrific workload. It's quite likely that I just succeeded on a rising tide, and the real test will be the NEXT bear market (I was too ignorant to handle this one). While it might only pay for longboards & family vacations, this has been a relatively cheap way to satisfy my investing curiosity and to find out if this is something worthy of greater effort. Until I get tired of it, I think stocks are the place to be.

But while I don't agree with his SCG opinions, I'm sold on Bernstein's short bonds. I think we'll be doing something similar with laddered I-bonds or PenFed CDs over the next few months. Hopefully it won't distract me from Google's IPO!

 

[Cut-Throat]

Re: Another new thread-- Bernstein's asset allocat

This is the assumption upon which all of this MPT stuff rests.   And I can't come up with any reason it should continue to be true in the future, can you?

Wabmester,

And I also cannot come up with a good reason why the Sun will come up tomorrow, other than past history.

The Sun will burn out some day, but I'm not looking for another place to live right now.

 

[ats5g]

Re: Another new thread-- Bernstein's asset allocat

But more fundamentally, the MPTers believe that stock prices grow as earnings grow.

Wab,

Stock prices do not go up b/c earnings go up. Long-term earnings do not grow exponentially, they grow at the rate of long-term GDP growth (which has been around 3% real). It is economically impossible for corporate earnings to outpace GDP growth long-term. I would say that stock prices go up when the risk premium decreases (or when people become more certain of future corporate earnings), and go down when the risk premium increases (or when people become more pessimistic about future corporate earnings).

Nords,

Actually the real return for the S&P 500 from 66-82, including dividends, was 0%. However, the real return for Large Value was 4.45%, and the real return for small value was 9.42%. Even if a person put a quarter in each LG, LV, SG, SV, his/her real annualized return was still 4.32%. Value stocks are better stocks to hold as inflation heges, in my opinion, not growth. Although, you do have the COLA'd pensions, so you probably don't need a whole lot of inflation protection.

If you want to invest in individual stocks, go right ahead. I'll stop lecturing But, I still think that they're a suckers bet, and not a good long-term strategy. I had a good laugh at "I don't buy the ones that suck." No one does, do they? To each his own. Personally, I'd just go with low-cost tax, efficient ETF's in my taxable account and use that time to make money the guaranteed way, work (but I guess that defeats the purpose of retirement). For me, the opportunity costs of individual stock investing are just way too high. They're a great way to win, but also a great way to lose and lose big.

Although, they'd be an interesting experiment for a small (like 5%) portion of your portfolio. Indulge yourself for a couple of years, or a decade or so, and then see how well you faired after taxes and investing costs as compared to some relevant benchmarks.

There is some interesting reading, if your "interested".

Two books by John Paulos:

A Mathematician Plays the Stock Market and

Innumeracy: Mathematical Illiteracy and Its Consequences

One book by Nassim Taleb:

Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life

and Terrance Odean's (prof at Berkeley) website. Very eye opening. His webcasts are good as well. They pretty much distill his research into one presentation.

- Alec

 

[Telly]

Re: Another new thread-- Bernstein's asset allocat

Quick question - What does the acronym "MPT" stand for?

Male Pipe Thread?

More Power To ya?

I know when somebody tells me, I'll probably say "duh... I knew that!", but I'm sure drawing a blank now!

 

[wabmester]

Re: Another new thread-- Bernstein's asset allocat

And I also cannot come up with a good reason why the Sun will come up tomorrow, other than past history. The Sun will burn out some day, but I'm not looking for another place to live right now.

Physics can help you calculate the sun's future behavior -- you've probably got over a billion years before you have to go solar system hopping.

Economics and demographics can help you calculate when the stock market might burn out -- I expect we've got a couple years before before we see the Japan/China/Greenspan effect and about 30 years before we see the baby-boomer effect.

Stock prices do not go up b/c earnings go up. Long-term earnings do not grow exponentially, they grow at the rate of long-term GDP growth (which has been around 3% real). It is economically impossible for corporate earnings to outpace GDP growth long-term. I would say that stock prices go up when the risk premium decreases (or when people become more certain of future corporate earnings), and go down when the risk premium increases (or when people become more pessimistic about future corporate earnings).

Most like to decompose stock price growth into earnings growth, dividend growth, and P/E growth. The risk premium is reflected in P/E. But you're right that ultimately it's GDP *growth* that limits earnings growth, and there's nothing that guarantees continuous GDP growth. It's a function of increasing productivity gains, increasing salaries, increasing value of goods produced, and increasing value added to raw/cooked materials.

 

[wabmester]

Re: Another new thread-- Bernstein's asset allocat

Quick question - What does the acronym "MPT" stand for?

Modern Portfolio Theory -- you know, the efficient frontier and the rest of that historical data massaging.

 

[Telly]

Re: Another new thread-- Bernstein's asset allocat

Duh! Thanks wab!

 

[cute fuzzy bunny]

Re:  "Stocks for the Long Run?"  (Maybe not.)

and it is a big BUTT for me

Hey, can we have this conversation without talking about ANYONES big butt?

Once again I'm fascinated with the range of experience, knowledge, techniques and approaches. Just reading this thread is a learning experience.

But I think Bogle has bitten me. Because reading all this makes me inspired and encourages me to do all sorts of different things. But instead I'm going to go skating, and the dog is telling me to ignore the fact that her brother is out cold sleeping on his back, its time for a walk!

 

[sgeeeee]

Re: Another new thread-- Bernstein's asset allocat

I was kinda hoping for More Pork Tacos  :-/

That reminds me . . . I head a recipe the other day that explained how to make taco shells out of old dryer sheets.

 

[cute fuzzy bunny]

Re: Another new thread-- Bernstein's asset allocat

Darn it, you guys are doing this all backwards!

We NEED to figure out how to make dryer sheets out of taco shells, not the other way around!

Just think about it, the luxury of using an ENTIRE sheet for each and every load.

My dryer would exude softness!

A fine alternative would be finding a way to make beer out of dryer sheets. Or taco shells.