Bonds For The Long Run?

Wharton professor Jeremy Siegel wrote a very popular book in the 1990s called Stocks for the Long Run, in which he made a case for building equity-centric portfolios. Professor Siegal's thesis is that stocks beat bonds over long periods of time by so much that investors must have meaningful exposure to stocks in order to accumulate sufficient wealth for retirement. The fact that stocks have beaten bonds on average by more than 3% per year from 1871 through 2008 would seem to support Siegal's point of view. Further, Siegal maintains that the recent horrendous performance of stocks is exceedingly rare and that investors need to maintain substantial buy-and-hold exposure to equities.

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!

It's the Government Stupid!

Public opinion appears to blame the free market system for the current state of affairs in which we find ourselves. Voters have turned overwhelmingly to the federal government for answers to the economic malaise that exists throughout the 50 States. The Obama administration has spent hundred of billions of dollars already and pledged trillions more in an effort to get consumers spending and the economy expanding once again - to the applause of a majority of U.S. citizens. Yet, it is the misguided fiscal and monetary policies of the last 50 years (with the exception of a brief period in the 1980s) that have culminated in the worst recession since the Great Depression. It is the continued application of those policies that will almost certainly lead to more economic pain in the coming decades. Americans must get a clue! It is the Federal Government which bears overwhelming responsibility for the current mess. It is the Federal Monster that must be reigned in and subjugated to the will of the free people of the United States of America, or most of us will die poor.


Not interested in politics? You should be. Politics is the process by which groups of people make decisions, among the most important of which are how to allocate scarce economic resources. Politics, when left to run amok, can ruin an economy, as has happened in Zimbabwe, where inflation is running at 11,200 percent per annum. The United States is not immune to hyperinflation and, in fact, may be barreling head on into just such an environment. Highly inflationary environments are not typically good investing environments. Wealth preservation becomes problematic to say the least, never mind wealth creation.


Right now the markets are running nicely and many economists and political pundits are declaring victory over the recession that has been with us now since sometime in 2007 (the precise start of the economic contraction is still open to debate and will likely be moved back closer to 2006 (once the government is finished massaging the data for political purposes and the academics move in to correct the record). The folks at ECRI say that their leading indicators are pointing toward a very strong recovery in the economy; they are far less sanguine about the chances of a sustainable recovery.

The problem is that the Obama Administration is not addressing the underlying structural problems with our economy, choosing instead to simply stimulate the economy with additional credit, which may have positive short term consequences, but is unlikely to provide a lasting source of economic expansion. We have too much debt; the government is loading more debt on at a furious rate. We have too little manufacturing; the government is doing nothing to address the hollowing out of American industry, which has occurred over the last 30 years. We are fighting two wars, but do not have the money to pay for either. The cold war is over. We need to pull out of most parts of the world. We are not the world's policeman; there is no money in our Treasury for it and the world does not reward us for it.

Get the Federal Government out of state and local affairs. Shut down the giant spending machine that is increasingly sapping our national vitality and robbing us of our individual initiative. Get government out of business so that businessman can compete against one another, rather than having to compete against a government that can change and manipulate the rules at will to ensure supremacy. Let American ingenuity have free reign once again. Let small businesses grow unfettered by government interference! Job growth will follow. Real income growth will follow (Real income is currently below 1973-1975 recession levels.)

The stock market isn't likely to keep its gains. The consumer is 70% of the economy and the consumer has no money to spend other than what the federal government is handing out. The economy is highly likely to slip back into recession more or less as soon as the federal government stops giving people money to spend. The profit recovery implied by the stock market rally from the March lows is unlikely to materialize. We are entering silly season in the stock market - that period where the boys on Wall Street underpin the market in an effort to maximize year-end bonuses. The most likely outcome of this secular bear market rally is a nasty sell-off sometime early next year, perhaps around the March time-frame.

We are maintaining our price discipline by refusing to pay up for businesses that are no longer undervalued, and by taking profits on companies that are up 40% or more since the March lows (business valuations do not change so rapidly as that in the real world). We are acknowledging the lunacy of our federal government's (this isn't a Democrat/Republican thing by the way - both parties are responsible) fiscal and monetary policy by favoring tangible assets over financial, and international assets over domestic.

We strongly urge investors to tread with extreme caution over the next six months as the government's massive spending winds down and the underlying structural problems reassert themselves. The piper has not yet been paid for 30 years of over consumption, over spending, and easy credit.

Investing in Stocks

We wrote about portfolio diversification a while ago - we related how a 15 - 25 stock portfolio can give you 90% of the benefits of diversification and how a 40 stock portfolio can give you 99% of the benefits. (Diversifying away non-systemic - company specific - risk is important in achieving the highest possible return for the amount of risk taken). We work hard educating our clients on the importance of building properly diversified and appropriate portfolios consisting of stocks and bonds. Properly diversified to us means eliminating all unnecessary risk while appropriate means putting our clients at a risk (and return) level that works for their financial situation and temperament.


But what about individual stock selection? If strategic asset allocation (the percentage of a portfolio allocated to stocks, bonds, real estate, commodities, and cash) accounts for most of the variation in returns over the long run (and it does), why even bother with individual security selection?


A very good question indeed!


Because we can add to returns with careful security selection and reduce taxes through tax loss harvesting. The empirical evidence overwhelmingly shows that we can outperform the market using a common sense approach to investing - buying businesses when they are trading for less than a knowledgeable buyer would pay for the entire company in an arms length transaction. In other words, buying companies when they are trading cheaply. It only makes sense! An investor should outperform the market over the long run by purchasing undervalued businesses and avoiding overvalued businesses - and the academic data supports that view.

How is it possible that the market is inefficient enough to give value investors a known edge over other types of investors? Economics 101 teaches us that excess profits in a capitalistic system are eventually competed away. Why don't the majority of investors recognize that value investing brings superior returns and join the gravy train?

The answer lies with some well-known investor biases that endure, despite wide recognition that they exist. People will be people! It is estimated that only about 10% of investors are value investors while the other 90% chase growth and momentum. Value investors are able to take advantage of investor biases which create excess profit opportunities for them. For instance, investors routinely associate good companies with good investments and are willing to pay a premium for them in the stock market. The Behavioral Finance term is "representativeness". Good companies are usually widely recognized as such and are highly priced as a result - and on average they under perform the market going forward. Likewise, investors routinely associate low growth (bad) companies with poor investments and shun them, creating a profit opportunity for the savvy value investor.

As well, a majority of investors expect stocks with poor liquidity (thinly traded) to have lower returns, yet the empirical evidence shows otherwise. Also, investors expect lower returns from stocks that are not widely followed by the financial analyst community, yet the evidence contradicts that expectation. Less widely followed stocks actually tend to outperform.

It really isn't rocket science. Rather, it is having the patience and discipline to buy a good company at a great price (or a great company at a good price) and waiting for the herd to recognize that it was overly pessimistic. It is also about having the discipline NOT to buy a stock just because the entire stock market it rising. We will not pay up for an investment - ever! Price discipline makes for successful investing and we never forget it at Biechele Royce Advisors. Although we aren't willing to market time per se, we are willing to let cash build up in our client accounts if we can not find good businesses at great prices or great businesses at good prices. Price discipline is risk management and risk management is a must during a secular bear market.

Mutual Funds and Benchmarks

Many people are invested in mutual funds. Most people have no clue how to tell if their mutual funds are better or worse than average. Many people allow their financial advisor, planner, accountant, or fee-based advisor (broker) to put them into mutual funds but must take their advisors word for the "best-in-breed" claim. Unfortunately the reality is that actively managed mutual funds do not out perform their unmanaged benchmarks on a risk-adjusted basis after taking fees into account. Furthermore, the mutual funds that do outperform their benchmarks on a risk-adjusted basis over trailing five and ten year periods are unlikely to outperform going forward. In other words, the top ten performing mutual funds in a market segment - say large cap - over the trailing ten year period are unlikely to be the same funds that out perform over the following ten year period. Bottom Line? There is no way to know in advance which funds will outperform their benchmarks on a risk-adjusted basis, net of fees, over five and ten year periods.

Now stop and think through what I just wrote. Most financial advisors tout their mutual fund picking ability as a primary reason to hire them (never mind the fact that their advice is often skewed by which funds pay the best commission!). Yet the brainiacs ensconced in the ivory towers of Wharton, the University of Chicago, and Harvard will tell you in excruciating detail why it is impossible to know a priori which mutual funds will out perform their benchmarks. John Bogle of Vanguard has it right! Index funds will beat the majority of actively managed mutual funds over long periods of time and, therefore, are above average!

Now stop and think about THAT for a moment. You can actually outperform the majority of mutual funds over the long run simply by indexing. Furthermore, since an index fund merely matches its benchmark's risk (average risk) yet outperforms the majority of peer group funds, you are able to know in advance that you are investing in a fund with a favorable risk/reward relationship (average risk and above average reward). And you didn't even need a Morningstar report to figure it out!

But since many of you are determined to speculate on mutual funds much in the same way that many of you speculate on individual stocks, here's the appropriate way to measure your actively managed fund's performance. You must compare your fund to the asset subclass in which it invests. A large cap growth fund should be bench marked against the Russell 1000 growth index and a large cap value fund should be bench marked against the Russell 1000 value index. In both cases, you should adjust for risk. Unfortunately, even then it isn't quite so simple since most fund managers cheat. Large cap fund managers will add small and mid cap stocks, or foreign stocks to their portfolio in an effort to beat their benchmark by going outside the appropriate universe of stocks. Of course they will sell those stocks before the required reporting period so that no one is the wiser - the practice of cleaning up the portfolio prior to reporting holdings is known as window dressing and is a common Wall Street practice.

To recap: Investors who use mutual funds should index. The academic case is overwhelming. Index funds outperform the majority of their actively managed peer group with only average risk. You don't need a fee-based financial advisor (aka broker) to pick actively managed mutual funds for you, since he's whistling in the dark anyway, while collecting commissions on those A, B, and C shares. What you need is someone to help you arrive at an appropriate strategic asset allocation and then implement that allocation with index funds. Better still, seek out a financial advisor that employs Chartered Financial Analysts capable of building low-cost stock portfolios chock full of businesses purchased at less than their fair market value, because the same academic research that categorically shows it is better to index than attempt to pick mutual fund outperformers, also shows that value investing outperforms the market over the long run!

Diversified Portfolios

Many people believe they have too little money in their investment portfolio to own individual stocks. They feel that mutual funds give them the "safety" of diversification. I often review portfolios for prospects and find that they are invested in five, six, ten different mutual funds. The prospects believe they are adequately diversified; after all, they own multiple mutual funds which hold one hundred plus stocks each on average. They are often surprised when I tell them that they are not very well diversified at all. They are down right disbelieving when I tell them they could get almost the same diversification with a portfolio of 25 carefully chosen stocks. The reality is that 15 to 25 well chosen stocks provide 90% of the benefits of diversification and that a 40 stock portfolio can provide 99% of the benefits of diversification. The hundreds of additional stocks owned by the mutual funds in which our prospects are invested provide almost no additional diversification benefits. Have $100,000 allocated to equities? More than enough to build a 25 stock portfolio that will adequately diversify away your non-systemic (company-specific) risk. However, you aren't properly diversified just because you own a properly diversified stock portfolio.

A properly diversified stock portfolio provides nowhere near the diversification benefits of investing among different asset classes. Small, large, domestic, and international stocks are sub-asset classes, not truly separate asset classes. After all, stocks tend to move together because companies tend to prosper or suffer together as economies expand or contract. Rather than limiting oneself to a single asset class, investors should build a properly diversified portfolio containing all four major asset classes (the historical data indicates that a four asset class portfolio composed of stocks - domestic and international, bonds, real estate, and commodities provides high levels of return per unit of risk).

The famous Brinson, Hood, and Beebower (BHB) study done in 1986 indicated that approximately 92% of a portfolios' variation of returns is due to the mix of asset classes chosen. BHB used stocks, bonds, real estate, and cash in their study. Simply put, the percentage of each asset included in your portfolio will go a long way in determining your returns and the volatility of your returns over the long run. Individual security selection and market timing are not major determinants of long run returns and variation of returns relative to the asset classes in which you choose to invest. (Importantly, the value style of investing does outperform so-called growth and momentum styles over the long run and therefore does add to an investor's returns).

Consider that approximately 80% of actively managed stock mutual funds don't beat their benchmarks. Most large cap funds don't beat the S&P 500 index (large cap). Most small cap funds don't beat the Russell 2000. Furthermore, the funds that do beat their benchmarks vary from year to year and there is no evidence whatsoever that a savvy financial advisor can pick a priori (in advance) which funds will outperform (Connecting the dots - your financial advisor or planner is blowing smoke when he confidently informs you that he'll only put you into the best mutual funds, since he can't possibly know which ones those will be. Unfortunately, too many financial advisors put their clients in mostly, or only, stock mutual funds and they tend to use the ones with the highest commissions!)

Okay, to review: a 25 stock portfolio will get you 90% of the benefits of diversification and a 40 stock portfolio will get you 99% of the benefits (assuming diversification is your goal). But is that a properly diversified portfolio? Stock portfolio - yes, investment portfolio - NO!

Multiple-Asset-Class investing offers demonstrably superior results to investors, providing high rates of return with less volatility than one, two, and three asset class portfolios. For instance, an equally weighted four asset class portfolio (composed of domestic stocks, international stocks, bonds, and commodities) returned 11.24% per annum from 1972 through 2008 with a standard deviation of only 14.11%, resulting in a Sharpe ratio of 0.46 (high). What that means for us individual investors is that we want to create portfolios containing stocks (domestic and international), bonds, real estate and commodities for the long-term. Importantly, we can adjust volatility by adjusting the mix. Also importantly, we can add additional return by using value investing (paying less for a business than its worth) rather than growth investing (paying a premium for a business) or momentum investing (buying a stock simply because it is going up).

The Really Big Picture

I had a prospective client ask me the other day how we were handling the current stock market rally. He wanted to know if we planned on raising cash as the rally progressed or whether we thought this was the start of a new bull market. My prospect's question certainly isn't unusual. In fact, CNBC and the other popular media outlets spend hours debating those same questions. Speculating on where the stock market is going, what interest rates will do, whether commodity prices will rise once again this year - these are the questions to which people want answers. And, Wall Street provides those answers in abundance, although many of the answers contradict one another and most of the answers turn out to be wrong - predictable once you realize that it is all just speculation about an unknowable future.

Yet most individuals are so indoctrinated into the Wall Street mindset of prediction that they view it as a normal part of investing. Buy a stock because it may go up in the next six to twelve months - that's what the typical mutual fund manager tries to do. Look at ways to predict that a stock will rise in the short term - for surely six to twelve months is the short term. Upside earnings surprises, stock price momentum, rising earnings estimates, beating revenue forecasts - all designed to capture a short term stock price move. The problem? Not much in the way of business valuation gets done by the majority of investors, which is the core of any true investment methodology. Successful investors buy businesses for less than they are worth and sell them for more than they are worth. Business valuation is the core and price paid is the THE key.


I did answer my prospects questions. After all, I have just as much fun as the next guy trying to predict what the economy and the stock market will do next. It's fun, fascinating and endlessly entertaining, but I don't forget for one instant that it is still speculation and I make very sure to use my forecasts only as a backdrop for our core investing discipline in order to help us with risk management. For the record, I don't think this is the start of a new bull market; the economy is not yet on the mend, despite all of the cheer leading now emanating from the government and the talking heads on the Street. As well, any expansion is likely to be short lived once the economy does begin to respond to the massive fiscal and monetary stimulus that has been applied. The United States has simply taken on too much debt and has an insufficient ability to earn enough to pay it off. In short, the economy will continue to founder for years (perhaps decades) under the weight of the ever growing mountain of debt our government and corporate America have assumed.

Enough of the macroeconomics though. Now I want to answer my prospects question on how we are handling the current rally in the hope of passing along something useful to you.

We buy businesses when they are selling for substantially less than what we think a knowledgeable third party would pay for the entire business in an arm's length transaction. Bear markets create plenty of opportunities to buy good companies for great prices and great companies for good prices. We are currently buying hand over fist because we are finding plenty of bargains. Conversely, bull markets make for far fewer opportunities to make great investments, which means we will often end up holding cash toward the end of a bull market because we can't find a worthwhile investment.

We do adjust our buy discipline for macroeconomic factors. It was obvious to us in late 2007 and early 2008 that the financial sector was toast. The red flags were everywhere. We will not buy a business at any price if we don't think the business is viable, which means the balance sheet must be strong enough to allow a company to survive. The banking system is currently insolvent as a whole and the rules of the game change daily as the government attempts to salvage it - we will not buy into the banks at any price right now.

Likewise, we adjust our sell discipline for macroeconomic factors. During the great secular bull market of the 1990s it was reasonable to hold businesses longer than we normally would as the bull market pushed valuations further than justified. Rather than selling a business as it returned to fair value, we commonly held them a bit longer if the chart indicated that the uptrend was intact. However, price risk is not something you want to take during a secular bear market, which means we are currently much more aggressive selling investments as the market pushes them back near fair value.

And that is how we're handling the current rally. We are aggressively buying good businesses at great prices and great businesses at good prices but with the expectation of selling them as they approach fair value because we do not think that the next great bull market is anywhere close at hand.

Medicare Supplements

Medicare isn't the end all and be all of medical care for seniors. The truth is that most seniors need supplemental insurance if they can't afford to reach into their pockets repeatedly as they grow older and require increasing amounts of medical attention. In fact, practically everyone needs a Medigap or Medicare Supplement policy. The only folks who probably don’t need a supplement are those who qualify for Medicaid or another government assistance program. It is important to sign up during the 6-month window provided by law after turning 65 to avoid having to qualify medically. The six month window allows you to enroll in any plan you like; you may lose that freedom of choice if you miss the window and your health is questionable.

You need to understand what Medicare is and isn't to understand the value of a supplemental policy. Medicare is a federally funded health insurance plan for citizens of the US who are age 65 and above. Medicare Part A is an automatic enrollment and costs nothing. This is the “Hospital” coverage portion of Medicare. Individuals must enroll in Medicare Part B which covers out of hospital charges; doctor’s visits, lab work, outpatient surgeries and the like. Part B coverage is paid out of your social security benefit and currently costs $98.00 per month.

One of the most misunderstood things about Medicare is how it pays benefits. Many seniors think that it will pay for all their medical expenses and that can be a costly error. The reality is that Medicare comes in two parts. The 2009 Part A Deductible is $1068.00 annually and is for hospital stays. The 2009 Part B Deductible is $ 135.00 annually and is for non hospital expenses. Now here is the IMPORTANT part. Medicare does not pay 100% after the deductible is met, instead paying only 80% of the costs. And that is very important to understand because if an individual with Medicare parts A & B goes into the hospital and generates a $100,000.00 bill from their stay, then that individual would owe approximately $20,000.00 to the provider. Yikes!

But that is where Medigap policies enter the picture as they are designed to pay one or both deductibles and the 20% remaining balance that Medicare does not pay. Remember that $20,000 bill we generated with our single hospital stay, even after Medicare had paid its portion? Your bill would drop to $0.00 with a Medigap policy.

Now you do have choices to make regarding which plan is right for you. There are 10 STANDARD Medicare supplement plans (standardized by the federal government a few years back). Pricing and the actual plan details are the key as every insurance company must provide an identical standardized plan by law. Of course, the financial strength of the insurance company is also a front and center issue. One important attribute of the standardized plans is that they allow policyholders to go to any doctor/hospital that accepts Medicare assignment. It is critical that prospective buyers understand that Medicare Select policies and some of the newer policies such as the "Advantage Plans" severely restrict your access to doctors and hospitals and also require you to make co-payments for services, as well as limit some benefits. Non-standardized plans are not necessarily wrong for you, but you do need to make sure you understand what you are and aren't getting for your money.

Seniors who currently have a plan can shop for another, cheaper one as long as they qualify by answering a few health questions. There are no lengthy exams and the underwriting decision is usually made within a few hours. Premiums for Standard plans are determined by age, take into account whether you are a smoker, and sometimes are adjusted based on medicines prescribed. You should expect to pay around $100.00 per month for age 65 up to around $240.00 per month for a 90 year old depending on the plan you choose.

It is worth while talking to an agent when shopping around for a plan. Agents are paid a commission from the insurance company so no direct fees to the client are involved. Of course, the insurance company will seek to recoup those commissions with a portion of the premiums paid. A knowledgeable agent should be able to help a senior with the choice of a supplemental plan that makes sense for the senior while also advising on an Rx plan under Medicare Part D (the prescription drug portion of Medicare that currently offers 75 different options). Another service that an agent can provide is accessing a clients qualifications to see if they are eligible for free or discounted medications. Any agent you choose should have some experience in the insurance industry, the ability to review part D for you, have an understanding of low cost Rx plans, and also be able to advise the client on other senior products, such as long term care planning.

In summary: Medicare Standard plans allow the owner the most flexibility and best coverage. They are a commodity product though so shop price. While Select and “Advantage” plans may be less expensive, you are restricted in choice of providers and may have poorly disclosed co-pays for each service. It is important that you understand exactly what you are and aren't getting in these non-standard plans. And don't forget that you may replace your current plan for less benefits, more benefits, or a lower price.

(I'd like to thank Bob Dorman of Dorman Benefit Consultants for providing invaluable help with researching the article.)