Bond to Equity Allocation Percentages

So you’ve decided that you would like to try and gain some volatility versus return free lunch via some Bonds mixed in with your Equities or Equities mixed in with your Bonds.  The next million dollar question to answer is then how much of your wealth should be allocated to each asset class.  This is a critical question as it will likely have a big affect on your long term portfolio return.

Unfortunately, as with many investing questions, I'm yet to find a silver bullet but considerations will certainly include your tolerance to volatility and risk.  Assessing this tolerance is of course easier said than done.  For example if you’re naturally risk averse you might choose to load up with more bonds as history suggests they might dampen volatility at the expense of some return however this adds absolutely no value if you then have a low probability of  ever achieving your long term goal.  Conversely there is then no point loading up with more equities to then sell at the first significant equity downturn.  On top of this there could also be age considerations.  For example every year that passes gives you less time to rebuild wealth before retirement.

So what do others have to say about bond to equity allocation percentages?

The granddaddy of value investing, Benjamin Graham, in his excellent first published in 1949 revised multiple times book, The Intelligent Investor, says “We have already outlined in briefest form the portfolio policy of the defensive investor.  He should divide his funds between high-grade bonds and high-grade common stocks.  We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.  There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.  According to tradition the sound reason for increasing the percentage in common stocks would be the appearance of the “bargain price” levels created in a protracted bear market.  Conversely, sound procedure would call for reducing the common-stock component below 50% when in the judgement of the investor the market has become dangerously high.”

Why I Hold Bonds in My Portfolio

I don’t think it’s too controversial to suggest, that at its simplest, a modern portfolio will contain bonds (whether government and/or corporate, domestic and/or international, index linked and/or otherwise) and equities (whether domestic, international developed and/or emerging).  I make this statement as bonds and equities are two asset classes that historically have exhibited different properties that when combined can work together to give some interesting characteristics.  Tim Hale describes the differences well – “Equities have an economic rationale for and history of delivering mid-digit real returns (after inflation) and are considered the engines of portfolio returns, but with considerable and sometimes extremes swings in returns...  High quality domestic bonds on the other hand, tend to have far smoother return patterns at a cost of lower returns, which come in the low single digits, after inflation.”

I probably make it more complicated than it needs to be but at its heart my portfolio is not much more than a 32% bonds/68% equities portfolio which at its conclusion will likely settle at a 40% bonds/60% equities portfolio.  In comparison I’ve recently starting noticing more and more personal finance bloggers who are holding far lower or even no bond allocations in their portfolios.  This has had me thinking:

1. has the significance of bonds in a portfolio disappeared;
2. is it correlated to us now having been in a bull market since 2009;
3. is it because my high savings rate encourages and allows me to live the Warren Buffet quote “Rule No. 1: Never lose money.  Rule No. 2: Never forget rule No. 1” where others might be chasing higher yields; or
4. is it just simply that I’m now nearing the end of my rapid wealth generating journey and others are a little earlier on in theirs.

To make sure it’s not number 1 let’s spend some time going back to fundamentals to understand if bonds combined with equities are still doing their thing.  I’ve been able to source 10 full calendar years (not quite for the bonds as I’ve only been able to go back to 29 March 2004 but close enough) of total return bond and equity performance covering the years 2004 to 2014.  The bonds are the Markit iBoxx GBP Liquid Corporates Large Cap Index and the equities are the FTSE 100.  Armed with this information I can calculate the annual return possible for everything from 100% bonds, through various mixed bond/equity allocations to 100% equities for each year.  I can then calculate the volatility (I’ve used standard deviation to represent volatility) for each allocation for the 10year period.  The 100% Bonds portfolio has volatility of 7.2%, the 40% Bonds/60% Equities has 10.7% while the 100% Equities has 14.8%.  This is all shown in my first table below.

Click to enlarge, Portfolio Annual Return if Bonds/Equities Allocation Rebalanced at Start of each Year

Australia, UK, US and the PIGS (Portugal, Italy, Greece and Spain) government 10 year bond yields – May 2010 update

I continue to monitor the 10 year government bond yields of three countries (Australia, United Kingdom and the United States) to try and understand when interest rates on savings and mortgages may start to rise with my datasets shown in today’s chart. In addition with all the excitement that is occurring with the PIGS I have decided to also dedicate a monthly chart to ‘Club Med’ (Portugal, Italy, Greece and Spain) also.

The PIGS or should that be the UPIGS

PIGS are an acronym for Portugal, Italy, Greece and Spain. Unlike the BRICS the PIGS have high government debt levels and high government deficits when compared to their GDP’s. Let me take a moment to explain debt and deficit because given that the UK is currently letting governments get away with saying ‘we will halve the deficit’ without really being challenged I don’t think most people understand the difference.

Are we heading towards a series of sovereign crises around the world?

It appears to me as though governments around the world have just about maxed out their credit cards as they continue running massive fiscal deficits. I’m starting to wonder if we might not see one or two sovereign debt crises in the near future. This is just some of the highlights from the news that I have seen today (not even this week but today).

Australia, UK and US government 10 year bond yields – April 2010 update

I continue to monitor the 10 year government bond yields of three countries (Australia, United Kingdom and the United States) to try and understand when interest rates on savings and mortgages may start to rise with my datasets shown in today’s chart.

Are we back to blowing asset bubbles already?

Last week saw Alan Greenspan interviewed as part of the Financial Crisis Inquiry Commission. The Times reported that during this interview “Mr Greenspan denied his policies encouraged the type of risky lending that spurred the financial crisis. The long-time Fed Chairman - whose reputation has been deeply undermined by the crisis - denied low interest rates and loose regulation had encouraged lenders and borrowers to take ever greater risks."

Australia, UK and US government bond yields – March update

I continue to monitor the 10 year government bond yields of three countries (Australia, United Kingdom and the United States) to try and understand when interest rates on savings and mortgages may start to rise with my datasets shown in today’s chart.

UK government bond yields continue to rise – February update

I continue to monitor the 10 year government bond yields of three countries (Australia, United Kingdom and the United States) to try and understand when interest rates may start to rise with my datasets shown in today’s chart.

Since June of 2009 the 10 year Australian bond prices have actually fallen by a relatively small 0.5%. In contrast the US 10 year has risen by 7.4% and the UK 10 year by 13.8% to be 4.20% today.

I’m going to update why I think the United Kingdom bond (gilt) yields continue to rise:
Reason 1. The Bank of England have now made clear that they are going to hold interest rates at 0.5% even though inflation is well above target. They have even mentioned that they could yet perform more quantitative easing (QE) which must be inflationary. In the letter to the Chancellor the Bank of England claims that ‘the direct effect of the short-run factors on inflation should be only temporary’ and that ‘although it is likely to remain high over the next few months, inflation is more likely than not to fall back to target in the second half of the year...’. I can’t help but feel that the Bank will ignore their inflation target of 2% and that it’s a case of do as I do not as I say given that the Bank of England’s pension fund has 88.2% of its assets devoted to Index-linked gilts. The market is starting to think the same thing and so to ensure a sensible real (after inflation) yield the prices have to fall and yields rise.

Reason 2. Alistair Darling has forecast government borrowing to be £178 billion. On Thursday last week yet another record was set when it was announced that in a month when tax receipts usually flood in the government still had to borrow £4.34 billion. This is the first time since 1993 that the government has had to borrow in a January. Punters are now starting to suggest taht at current trends the government deficit could be £10 billion more than forecast. Supply and demand principles should hold. More supply of debt for purchase should reduce the price of debt.

Reason 3. The UK government are still yet to explain how they are going to reduce the levels of borrowing. The levels of borrowing are heading to 13% of GDP and may even exceed that of Greece which we have seen so much of in the press lately. How long until the credit worthiness of the UK is downgraded. This will depress prices meaning yields will have to rise.

Reason 4. Those who already own government bonds and can see what’s happening will start to sell their holdings. This combined with the Bank of England now out of the market and no longer buying debt through QE has to reduce the number of buyers. Again supply and demand should prevail pushing yields higher.

So what does this mean for my retirement investing strategy? Exactly where I was last month. If I owned gilts I’d be considering selling. I don’t own fixed interest gilts so I’m ok here. I do own index linked gilts but with inflation kicking off I’m comfortable with this and following the Bank of Englands pension fund.

I also will continue watching house prices carefully. The interest rates on mortgages have to rise as those wanting to borrow for a house will effectively be competing with the UK government for funds. I can’t see how house prices can continue to rise with increased borrowing costs and this could turn out to be the catalyst that brings on a reduction in house prices.

As always DYOR.

Assumptions:
- All yields are month end except February which is 18 February 2010

Free Asset Allocator Website

I am running my entire retirement investing strategy including expected annual returns and projected retirement dates from an excel spreadsheet. Today though, I stumbled upon a nice little tool that looks to be written by Morningstar which provides a quick way of mixing up simple asset allocations to project expected returns. Additionally if you enter the portfolio value, annual investments, desired years to retirement or similar and your total financial goal it provides a probability of reaching the goal. Link here.

The website states “Asset Allocator helps you assess the likelihood of meeting your financial goals based on your current financial situation. If you find that you are not on track to meet your goals you can adjust certain criteria and immediately see the effect of your portfolio's growth potential.”

I entered my retirement investing strategy into the site which included a Portfolio Value which is currently at 40% of my Financial Goal. My Annual Investments were based on me investing around 60% of my gross annual earnings and I entered my time to retirement (Years) as 7 years. Asset Mix was entered as my Desired Low Charge Portfolio as I describe regularly on the site including here.

The Expected Return was provided as 8.99% with a 3 year standard deviation of 13.18. An Expected Return of 8.99% seems a little bullish for my tastes. Using my models I have a current expected annual return after inflation of 4.2%. The UK arithmetic mean of the retail prices index (RPI) since 1987 is 3.5%. Totally these would give an expected return of around 7.7% before inflation which is a variation of 1.29%.

What is also provided by the website is a Probability of [reaching my] Goal. In my case this was provided as 91%. I’ll take those odds...

As always DYOR.

Government Bond Yields are Rising

I monitor the government bond yields of three countries (Australia, United Kingdom and the United States) and they are all rising. My chart today shows the month end (except the last point which is the 08 January 2010) 10 year bond yields since 2007.

Why are they rising? Comparing Australia and the UK I think for different reasons.

As an outsider I think Australian bond yields are rising because the country is being run relatively prudently by the Reserve Bank of Australia and is raising interest rates as they are serious about keeping inflation at 2-3% over the cycle. The cash rate set by the RBA is now 3.75%. Savings account interest rates are also rising and without too much difficulty it is easy to find an instant access bank account paying 4.25%. So it makes sense for Bond yields to be rising to the 5.76% today.

I think United Kingdom bond (gilt) yields are rising for very different reasons:

Reason 1. I have shown previously that inflation is rising and it appears to me as though the Bank of England is going to hold interest rates at 0.5%, ignore their inflation target of 2% and start to let debts be inflated away which I discussed here. This seems to be reinforced by the Pension Fund of the Bank of England who have 88.2% of assets devoted to Index-linked gilts and other government guaranteed index-linked securities and 10.9% to fixed-interest gilts and other government guaranteed fixed-interest securities. This is up from 70.7% and 22.3% respectively in 2008. Buyers of government debt will however expect a real (after inflation) return on their investment and so if inflation rises then gilt yields must also rise.

Reason 2. The 2009 pre-budget report stated that UK government borrowing would be 12% of gross domestic product (GDP) in 2010/2011 and still a crazy 9.1% in 2011/2012. The Office for National Statistics reported on the 22 December that Q3 2009 GDP was £315.5 billion. Extrapolating this indicates that borrowing in 2010/2011 will be £150 billion and in 2011/2012 will still be £110 billion. To find buyers for all this debt (particularly if the Bank of England stops quantitative easing) you are going to have to attract them with increased yields.

Reason 3. The UK government are yet (and for that matter the Conservatives also) to explain how they are going to reduce the levels of borrowing. So far they have done nothing more than rearrange the deck chairs on the Titanic. If this continues the credit worthiness of the UK is going to be downgraded meaning yields will have to rise.

Reason 4. Those who already own government bonds and can see what’s happening will start to sell their holdings putting yet more gilts onto the market. This issue is real with the world’s biggest bond investor , Pimco, has started to sell off its holdings of gilts. More gilts coming to the market will mean gilt prices falling which will then mean rising gilt yields.
So what does this mean for my retirement investing strategy?

Firstly, if I owned gilts I’d be considering selling. As I’ve described previously I don’t own fixed interest gilts so I’m ok here. I do own index linked gilts but with inflation kicking off I’m comfortable with this.

Secondly, I’ll be watching house prices carefully. The interest rates on mortgages will have to rise as those wanting to borrow for a house will effectively be competing with the UK government for funds. I can’t see how house prices can continue to rise with increased borrowing costs and this could turn out to be the catalyst that brings on a reduction in house prices.

EH3BAY54PUKX