However, not everyone agrees that investors should heavily weight their portfolios toward equities. Boston University professor Zvi Bodie believes that equities are simply too risky over the long run and the core of a retirement portfolio should be Treasury Inflation Protected Securities (TIPS). He contends that a portfolio of stocks doesn't become less risky the longer you hold it because, historically, there have been multi-decadal periods in which bonds have beaten equities (periods long enough to encompass an individual investors entire investment life). Furthermore, Bodie claims that stocks are a poor way to hedge against an investor's future income needs - which is, after all, the main reason for investing in the first place. Bodie believes that inflation-indexed bonds are the best asset for matching future liabilities.
Now facts are facts and the S&P 500 has outperformed bonds by about 3% over the last 137 years. Why on earth would anyone not want maximum exposure to the stock market if they had a sufficiently long time horizon? Well, that turns out to be the rub - the time horizon. As pointed out by Bodie, bonds have outperformed stocks for long periods of time in the past. In fact, bonds beat stocks over the 68 year period ending in 1871. Bonds outperformed stocks from 1929 to 1949 - a 20-year stretch that saw the stock market lose some 89% of its value at its nadir. Currently bonds have outperformed stocks over a 41-year period going back all the way to 1968! And now comes the $64,000 question: Do you really care that stocks are likely to outperform bonds by about 3% over the very long run if you happen to be the poor slob investing in them during one of those horrible, multi-decade long stock market debacles? After all, average returns are all well and good, but you only get to live your life once! There are no redo opportunities!
But how likely is it that you will be one of those unfortunate investors living through a down period in the stock market? Well, there is a 1-in-20 chance that the S&P 500 will underperform a broad U.S. bond index by 130% over a ten-year period. There is a 1-in-5 chance that stocks will underperform bonds by 50% cumulatively over a ten-year-period. Knowing that, on average, the S&P 500 will outperform a broad bond index by 50% over a 10-year period is of small comfort to those investors who don't happen to get the average stock market return during the period that THEY are invested in the stock market. The fact that the shortfalls in stocks vs bonds over 10-year periods are much greater than the shortfalls generated over a single year is also exactly why Bodie argues that stocks are not less risky over longer periods of time. His point made another way is simply that looking at average returns does not address the question of the magnitude of a shortfall when one does occur. In Bodie's own words from his original 1995 paper, "But as has been shown in the literature, the probability of a shortfall is a flawed measure of risk because it completely ignores how large the potential shortfall might be."
What then to do with your investment portfolio. The reality is that most of us do not have an investment portfolio big enough to stick 100% into bonds - we need the extra capital appreciation kick that will come to us from stocks over 10 and 20 year periods... on average. Yet it seems apparent that heavily overweighting stocks is far too risky as well. Put another way, meaningful exposure to assets other than bonds increases investors chances of successfully funding their retirement by reducing longevity risk - the probability of outliving your assets. Building a diversified portfolio of stocks, bonds, commodities, and real estate increases the likelihood of creating a sufficient, sustainable income stream during retirement while still being able to withstand a worst-case scenario in the stock market - a worst-case scenario that seems to come along all too frequently!
One last comment: we are writing from the point of view of buy-and-hold investing, which is the same point of view that Professor Siegel has in his book. Biechele Royce Advisors is not a buy and hold investor on behalf of its clients. We add value and control stock market risk by refusing to overpay for a business. We buy good companies at great prices and great companies at good prices. We sell those same companies when they return to fair value. Our price discipline and focus on stockpicking gives us a big advantage over buy-and-hold investors during secular bear markets!
