Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
How Portfolio Construction Works (or Are Bonds Safer than Stocks) (S1 E13)
In this episode, we will build on what we learned about equities and bonds to uncover the principles behind constructing a resilient investment portfolio. Delve into the interaction of stock and bond returns with with me, Edward Finley, as I demystify the economic forces shaping their historical correlation. We're not just talking theory; I will share some practical wisdom on how to mix and match assets with varying expected returns and volatilities to either boost your gains for a given risk or trim the risk for your target return. Take a front-row seat as we use the quintessential 60-40 stock-bond allocation to demonstrate how a keen understanding of these assets' synchronicity can supercharge portfolio efficiency.
This episode is more than just a lecture – it's a journey through the shifting tides of stocks versus bonds, pinpointing the eras in which one asset class eclipsed the other and what that means for your money. I will dissect historical performances, from the tech bubble frenzy to the somber 'lost decade,' laying bare the wisdom in upholding a balanced approach amidst the capriciousness of markets.
By challenging the conventional notion that bonds are safer than stocks, I will invite you to redefine 'investment safety' with a long-term vision. So, buckle up and prepare for a masterclass in investment strategy, where empirical data meets economic theory to arm you with the knowledge to navigate the financial landscape's constant evolution.
Episode Slides: https://1drv.ms/p/s!AqjfuX3WVgp8uj9zHsJs3oRQ6lx4
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a Sum-Time Professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley. Well, we've covered now equities as an investment exposure to the productive economy and we've covered bonds as an investment. That is, primarily exposure to level and term risk. That is put another way, is exposure to the risk of changes in monetary policy and also risk in terms of changes in expectations on inflation and growth. I'm going to pause for a second now on asset classes in order to take a if you pardon the pun take stock of the situation and think about the relationship of stock returns and bond returns. Really, this is just a way to introduce the notion of portfolio theory, or how to build an investment portfolio. Well, in terms of thinking about the relationship between returns of stocks and bonds, the first question, of course, one might want to ask is who cares? Why is that an issue? There are a few reasons. First, as we'll see in the upcoming episodes on other asset classes, equity risk and bond risk, level and term risk. Equity and bond risk are really the two primary risks you can own in a portfolio. Virtually every other risk that one can own is a version of those two risks. We'll see that later on as we look at other episodes, but those are the two primary risks. If we return back to the notion of the capital asset pricing model, or the CAPM, you'll recall that we have this idea that it's not just the volatility and expected return that describes to us what an asset's value is. It's also how the assets co-move. The lesson from the capital asset pricing model is that you can mix assets with different expected returns and expected volatility in order to achieve a desired outcome either a desired return with the lowest level of volatility or a desired level of volatility with the highest return. This is the basic outcome of what we think about when we think about how assets' returns mix. That will be different than just earning a proportional amount of each asset's return and a proportional amount of each asset's volatility. If you have access to the slides that are in the show notes, you can take a look at the first image. It's the classic image of the efficient frontier, which is the basis of the capital asset pricing model.
Speaker 1:Let's just take a classic example of a 60-40 asset allocation 60% equity risk, 40% interest rate risk. If we ignore co-movement, or to put it another way, if we just assume that stocks and bonds are perfectly co-moving, they just do exactly the same thing at the same time. We would compute then a 60-40 allocation's expected return based on the last 30 years of returns and volatility. We would compute it in a very dummy sort of way as being 6.15% expected return and 12.83% expected volatility. Let's say that the goal that we have is that 6.15% return. That's really what we want to accomplish. If we take into consideration co-movement the fact that stocks and bonds don't perfectly co-move then we can construct a portfolio of stocks and bonds with an expected return of 6.15%, but it will have instead an expected volatility of 9.65%. So about 4% less volatility than just taking into consideration no co-movement. The information ratio on that portfolio that new portfolio is going to be 0.64. Recall, an information ratio is just return divided by volatility. It's an expression of return per unit, of one way to measure risk, namely volatility, with all of its flaws. The information ratio of our new portfolio, taking into consideration co-movement, is going to be 0.64. So we earn 0.64% for every unit of volatility in that portfolio compared to the dummy portfolio, where we think that the assets perfectly co-move of 0.48 or 48 basis points per unit of volatility. So the new portfolio, where we have taken into consideration co-movement, can earn that same 6.13% return, but with much lower volatility. So we would prefer that portfolio to the dummy portfolio.
Speaker 1:Well, turn it around. Let's take the inverse example. Let's say I didn't have a return goal, I just knew that I'm a very long-term investor and I can afford to have 13% volatility risk, which is about what the dummy portfolio had. Well, if I take into consideration the co-movement of stocks and bonds is not perfect, then I can construct a portfolio with 81% stocks and 19% bonds and that will have the expected volatility of exactly 12.83%, like the dummy portfolio. But the expected return on that portfolio will be 7.43%, not 6.15. So fully about 130 basis points more. Another convenient way to compare it is that the information ratio on that portfolio is 0.58 versus the dummy portfolio of 0.48. So we would prefer that portfolio to the dummy portfolio. And so why we think about the relationship between stocks and bonds is because it matters. It really, really matters a lot whether stocks and bonds co-move and, if so by how much? Because then the whole exercise of building a portfolio of stocks and bonds is either going to be potent or less potent, and so that's really the focus of our consideration.
Speaker 1:Let's turn our attention, then, next to some theoretical explanations of what we should expect stock bond correlation to look like, and, as a reminder, in this podcast we'll always start with the theory. We'll sort of understand the theory from a sort of high level. Then we'll turn to the empirical data. Does it hold up? And if it doesn't hold up, we'll come back and reevaluate our theory. All right, so let's look at stock bond correlations. What should we expect?
Speaker 1:Let's start with economic theory. So economic theory tells us that the returns for interest rate, risk level and term risk should generally have an inverse relationship with the returns on equity risk. Why? Well, let's consider when we are in economic good times. The economy is growing, equity turns should be rising. Equity is exposure to the productive economy, and the productive economy is growing, so we would fully expect equity returns to be positive.
Speaker 1:However, inflation will be rising, which tends to erode the value of coupon payments on bonds. Moreover, we would probably expect soon the next couple of years that the Fed will probably raise interest rates in order to prevent inflation from becoming overheated. That would transmit across the yield curve. Both of those items higher inflation, making the coupons less valuable, and expected Fed changes in the monetary policy that will affect the slope of the yield curve, shifting the yield curve up, both of which will result in bond yields going up. But remember, yields and price move in the opposite direction with bonds, so bond yields go up, bond prices go down and so the returns would go down. So again economic good times economy is in growth mode. We would expect equities to have positive returns. However, simultaneously, we would expect to see inflation on the rise. That's gonna erode coupon payments. That's going to make us expect Fed rising of rates, both of which will have the effect of pushing bond returns down.
Speaker 1:Okay, what about economic bad times when the economy is already in a recession? Equity returns should be falling because it's exposure to the productive economy and the productive economy is shrinking, or at least not growing as fast. Simultaneously, inflation will be falling. That's making the future coupon payments worth more, so people be more interested in owning those bonds. The Fed will probably, over time, start to lower rates to stimulate the economy. That's gonna transmit across the yield curve as well, shifting the yield curve, and that's likewise going to put upward pressure on bond prices. Yields go down, bond prices go up, and so when we put those two together for bonds, that situation economic bad times should result in bond returns rising.
Speaker 1:So we can think of it in economic theory as sort of a relationship between the two. That has very much to do with what the current state of the economy is, what inflation expectations are and what growth expectations are, and we can see how they should move in the opposite directions. We can also see the same dynamic between stock and bond returns If we think about it purely from a preferences perspective, or what's sometimes in investing called risk on, risk off. This just me is talking about the behaviors of investors. Under certain circumstances, investors are going to have an emotional reaction, a behavioral reaction to something. We can see the same dynamic. Stocks and bond prices should move in the opposite direction. So let's take an illustration.
Speaker 1:If equity markets are up, it means that investors are gonna see those positive returns and they're gonna be inclined to earn those positive returns. How they're gonna do that? Well, if they're fully invested, they're gonna sell bonds and buy stocks. That's gonna have the effect of further pushing up the price of stocks, and that's gonna have the effect when, if I'm selling, lots of people selling bonds of pushing down the price of bonds and that will, in turn, result in higher equity returns and falling bond returns. How about the opposite? How about when equity markets are down? Well, when equity markets are down, investors don't like that. They've experienced declines in returns and so they're anathema to those. So what are they gonna do? They're gonna sell equities and buy bonds Again. As they sell equities, that puts further pressure downward pressure on price, and they're gonna buy bonds, which is gonna put upward pressure on bond prices. That has the effect of making bond returns and stock returns again move in the opposite direction.
Speaker 1:All right, so two really, I think, logically intuitive ways of understanding the relationship between stock bond returns, and I hope, as you listen to it, found yourself nodding along Like, yeah, that makes perfect sense. Okay, so let's look at the empirical data. What is the empirical data? Well, it turns out that for most of the last 50 years, bond returns and stock returns have been basically independent of each other, that is, they had a correlation of only 7%, and you'll recall from our discussion of statistics that when we look at correlation, 100% correlation means they perfectly co-move in the same direction, and negative, 100% means they perfectly co-move in the opposite direction, and zero means that they're absolutely independent of each other. Well, the correlation is positive 7.42. So, first, it's positive, not negative. That's not consistent with the theoretical ideas we just built up. And it's very, very small, so very close to zero, and so they seem like they are independent, and that just doesn't fit with our theory.
Speaker 1:So why? What could possibly explain it? And the answer is that the correlation of stocks and bonds has to do with investors' inflation expectations and growth expectations. And when investors doubt the Fed's ability to manage inflation, then growth expectations take a backseat to inflation expectations when pricing assets all assets and if inflation expectations are driving asset prices, that's going to make stocks and bonds move in the same direction. Why would they do that? Well, if what you're really worried about are not growth expectations but inflation, inflation is going to necessarily make bond coupon payments worth less in the future and that's going to make bonds be much less desirable. And inflation, if it's endemic and lasts a long time, is going to make it increasingly difficult for firms to be profitable. Firms can pass along some of the inflation of their costs, but not all, and so as a result it has a hit on firm revenue and firm profits. So it would seem that when inflation expectations predominate, what we're going to expect to see is positive correlation between stocks and bonds. But when investors have confidence in the Fed's ability to manage inflation so they're not too worried about the future inflation, then growth expectations will predominate in asset pricing and when that happens we would expect stocks and bonds to negatively co-move. And those are the stories that we gave ourselves before, where growth expectations are what predominate.
Speaker 1:Looking at the period for the last, say, 50 years, we see that from 1971 through 2000,. Every decade exhibited moderate positive correlation. So the 1970s saw positive correlation of 17%, 1980s positive 36%, the 1990s positive 24%. The Fed during those years really couldn't be counted on to adequately manage inflation. This is the period of the great inflation of the 1970s. That meant inflation expectations and monetary policy surprises are driving asset prices for both stocks and bonds, and when investors expect the long-term rates are going to be higher than changes in long-term prices. That's that point I made before about how firms can't pass along all of those costs. They're going to expect economic activity and growth to decline. That's going to push stock prices down. They're also going to expect that the coupon payments on intermediate bonds will be worth less in the future, and so therefore, current bond investors are going to demand higher yields, and that's going to push down bond prices and so, as a result, bonds and equities both experience falling prices. Okay, that's a period of an illustration in the past where there were about 30 years where investors' inflation expectations predominated and we see this positive correlation between stocks and bonds.
Speaker 1:The next two decades are the other story. So, from 2001 until 2020, every decade exhibited a moderate negative correlation between stocks and bonds. So in the 2000s it was negative 35%. In 2010s it was also negative 35%. So now we have that kind of negative co-movement between stocks and bonds. Well, what was happening was that inflation expectations and monetary policy surprises seemed less likely. The Fed seemed, by 2001, to have tamed inflation and so therefore, growth expectations could take over, and risk preferences as well, to dominate asset pricing. Well, if expected growth and risk preferences are dominating asset pricing, then expected growth is going to drive equity prices higher, precisely because we know that it's a growing economy and you own a share of the productive economy and it's going to cause the Fed to raise interest rates in order to avoid inflation. Raising interest rates is going to lower the returns for bonds. So we see that negative, that one is up, the other is down movement. Likewise, if we were in the middle of an economic contraction, a recession, that's going to drive equity prices down for the reasons we mentioned before, but the Fed's going to lower rates and that's going to spur economic growth and increase the returns for bonds. And so for that period from 2001 through 2020, we saw a relationship between stock and bond returns that's more like what our theory predicted.
Speaker 1:One thing that's important to note when we talk about positive correlation and negative correlation is you shouldn't imagine that what that means is that the returns have the same or different signs. So if there's positive correlation, you don't necessarily expect stock returns and bond returns both to be positive, and if there is negative correlation, you don't expect one to be positive and the other to be negative. Instead, it's really about relative returns. So if we look in every decade the 70s, 80s, 90s, et cetera, except this decade that we're in now returns were positive for both stocks and bonds. So in the 70s, stocks earned a little less than 10%. Bonds earned 3.5%, in the 80s, 13% and 13%, et cetera, but they were all positive for both stocks and bonds. Even though in the 70s, 80s and 90s there were positive correlations and in the 2000s and 2010s negative correlations, still all returns were positive. In the current decade, the correlation between stocks and bonds has been very high 60% 6.0. And still stock returns are positive 9% and only bond returns were negative. And so, even though we have positive correlation, we see positive returns for equities 9%. Negative returns for treasuries negative 8.3%. And so, again, really be careful when thinking about correlation, not to equate that with the returns. Have a different sign.
Speaker 1:It's really to talk about the way that stocks and bonds prices are co-moving. The last 10 years has been quite varied in terms of stock bond correlation. As I mentioned just a minute ago, it has been, roughly speaking, leaning toward the negative side, but when we break that down, we can see that there's some real variation. There have been periods when stock and bond returns were positively correlated, for example, in 2014,. There was the so-called taper tantrum. The Fed had signaled to the market that they were going to start to reduce their quantitative easing programs that were launched during the financial crisis and the markets reacted very negatively. That had moderately positive correlations at around 15%. More recently, in the period of the rapid rise of inflation following COVID in 2022 and also into 2023, we see positive correlations that are really off the charts 58% in 2022 and 77% in 2023. Both of those examples in the last decade show us the taper tantrum and then the rise in inflation following COVID, when inflation expectations really predominated. Asset pricing, when we thought that Fed moves and what inflation is going to look like, would make us think that the Fed's not going to be able to control inflation somehow. It's going to cause us to then see asset prices for stocks and bonds move in the same direction. There have also been, though, lots of years during the last 10 years in which stocks and bonds were negatively correlated. During the whole post-global financial crisis recovery from 2015 to 2020, we saw negative correlations that varied between negative 22 and negative 49.
Speaker 1:When we think about designing a portfolio of equity risk and interest rate risk, it's important to remember that, yes, there is a benefit of combining assets that do not perfectly co-move. We can build portfolios with a target return that has lower volatility, or we can get a target volatility with higher expected returns, but we've got to remember that, while that's useful the correlation of assets, time varies quite a lot, and they're going to be periods during which that combination of assets is going to be more or less effective. Well, as I like to say to my students, it's important to remember that, while building a more efficient portfolio is great, at the end of the day, investors have goals, and those goals usually are described in terms that require a certain rate of return, and so, while combining stocks and bonds in a portfolio can be useful in creating a more efficient portfolio, higher return for the same level of risk, and that's driven by these different correlations between stocks and bonds we have to pay attention to what the expected return of each asset is going to be as well, because we have to make sure that we hit our goals. It won't matter very much if the portfolio is efficient if, over the long term, we don't meet our investment goals. So let's take a look, therefore, at how the performance of a stock bond portfolio has done over time in order to get a sense for how building a portfolio helps, and does it help all the time? So, over the entire period, we can see that stocks outperformed bonds, and not only did stocks outperform bonds. So over that entire period we earned something like 11% return on stocks and 5% return on US Treasuries. Not only was the stock return greater, but it was also the case that over that entire period, the stock return was probably sufficient for most investor's goals. Maybe the Treasury return wasn't sufficient, but that's a reason to mix stocks and bonds.
Speaker 1:But when we dig a little more deeply, we see that there are decades when bond returns significantly lagged equity returns, and vice versa. So, for example, bond returns were way better during the lost decade of the 2000s, as the global financial crisis caused a very low equity return and the Fed once again engaged in aggressive monetary policy that lowered short-term rates. The Fed, by the way, during that period took the overnight rate from 5.3% in April of 2007 to 0.2% in April of 2009. That's a huge reduction in the overnight rate and, if you remember our discussion of level risk, that has the effect of shifting the entire yield curve down, and falling yields means higher prices, so higher returns. So in that decade that we're talking about, of the sort of quote, unquote lost decade of the 2000s, bond returns were almost 4% a year. In contrast, equity returns were 2.5% per year, and that's why we call it the lost decade.
Speaker 1:Now, in both cases, those returns are well below most investor's goals. Even if you had the complete foresight to own only 10-year treasuries, you probably would have not met your goal. In contrast, during the 1980s, stock returns underperformed bonds by a slight margin a very slight margin as the central bank began an aggressive policy of lowering the Fed funds rate to encourage economic growth. Remember, the Fed had raised the overnight rate in order to combat inflation during the 70s, and so in December of 1980, the Fed funds rate was 22%, and the Fed, over the course of the 1980s, lowered the Fed funds rate so that by December of 1990, 10 years later, the Fed funds rate had fallen from 22% to 5.3%. Again, this has the effect of creating a very strong positive bond return.
Speaker 1:But unlike the lost decade, where something else was affecting equity returns, here, when we look at this decade, we see that bond returns in the 1980s were almost slightly bigger than equity returns. Bonds earned 12.9% a year during that decade and stocks earned 12.6% a year during that decade. During the dot-com bubble period of the 90s and the more recent decade, we saw that equity returns far outstripped bond returns. So in the dot-com period we saw equity returns were earning 17% just a little shy of 17% and bonds earned half of that around 8%. And in the 2010s we saw equity returns of 13.8% and bond returns of 2.2%. And in the first three years of the 2020s we've seen stock returns be 9% and treasury returns be negative 8%. So in all of those situations we saw that when we have economic growth dominating asset prices, we see stocks outperforming bonds by quite a lot.
Speaker 1:But it is not necessarily the case that owning just stocks or owning just bonds is the answer to the problem of achieving your goals. So how would this have worked out if we had that 60-40 portfolio we discussed earlier, this very efficient portfolio of mixing stocks and bonds in the correct proportion so that we could achieve that expected return of 6.5%, but with the lowest level of volatility? How would that have worked out? Well, from 1997 to 2023, that portfolio did about as well as we might have expected it to do in the long run. It earns 6.9% annually and it had volatility of 9.3%. That's an information ratio of 0.75. And you'll recall, that's very close to what our expectations were for that portfolio. So our portfolio's expectations were met for over a period of roughly 30 years. But if I look at the last three years so 2021, 2022, and 2023, the returns of the portfolio over the last three years were 2.2%. That's well below our target of 6.15%. And the portfolio it's not that it earned very little, but thank goodness it wasn't very volatile. The volatility was higher than the long-term volatility. It was 13% over the last three years, giving us an information ratio of 0.17, well below the targeted return that we need for a given level of risk.
Speaker 1:How about if we sort of lengthen our time horizon a little and start looking at decades? Let's say we'll just break it into three decades 97 to 2006, 2007 to 2016,. 2017 to 2023. Decades are roughly equal in size. The most recent decade, 2017 to 2023, the portfolio would have earned a little less than 7.5%. That's better than our goal, with 11.2% volatility, also a little higher than our goal, but still a reasonably good, reasonably good performance. How about the decade just before that, 2007 through 2016? That we would have earned 5.7%? That's a bit less than our goal, with 8.7% volatility, again in the same general vicinity of what we would expect to see in long-term performance. And how about the decade before that 1997 to 2006? Well, that portfolio would have earned 5.7% return with 9% volatility, and so, again, better than our long-term expectations and better than our risk-adjusted expectations. So what's the takeaway? Well, the takeaway is that if we expect a stock bond portfolio to deliver the benefits of the diversification in any one year, or even, it would seem, on any three-year period, it's unreasonable to expect because of the time variation in those correlations. As we saw earlier, the long-term correlation of sort of independence doesn't hold in shorter sub-periods, but over decades, and really decades in which the correlation was positive, the correlation was negative. What we see is that over decades, we will achieve our goals, and so I think the real takeaway from understanding portfolio theory in this sense is that you've got to think in ten-year time horizons, not much less than that.
Speaker 1:There's another question that comes up when we think about stocks and bonds in portfolios, and that's the following statement that I've read in newspaper articles many times. I've heard people say it many, many times, and the statement is bonds are safer than stocks, and I put the word safer in quotes Bonds are safer than stocks, and I want to take up that question. Is that true? Are bonds safer than stocks? And I think, if you want to answer that question in the affirmative, you're implicitly saying that the only risk that matters is volatility, and I don't think that's true. I don't think that's the only risk that matters. In fact, I'm not even so sure it's the most important risk that matters. So let's unpack that. Why do I say that? You're implicitly saying that only volatility matters?
Speaker 1:So I've put in the slides a chart. You don't need the chart if you don't have it handy, but it just sort of lays out the recent Treasury yield curve, everything from the one-month Treasury yield out to the 30-year Treasury yield, a 10-year Treasury. This was all as of January 2024,. A 10-year Treasury had a yield of 4.13% and it had a modified duration of 9.6%. Remember from our discussion of bonds modified duration is really a way of measuring a bond's sensitivity to changes in prevailing interest rates. And so if a bond's modified duration is 9.6%, then we would expect that an increase in prevailing yields of 1% would result in the bond's price falling by 9.6%. And vice versa, if there were a decrease in yields, we would expect the bond's price to increase by 9.6%. So it's a measure of sensitivity, so that we can kind of eyeball what the return might look like for a bond like that. So a 10-year Treasury duration of 9.6% with a yield of 4.13%. A 30-year Treasury had a yield of 4.3%, so just a smidge more, and had modified duration of 28.75%.
Speaker 1:What does that tell us? Well, currently we have expectations of a recession happening in the near term. That's what's currently in the news. If you're listening to the podcast, the week or so that it's posted, that's what's currently everybody is talking about If you're listening to this. In the future, that is where we are right now is great question mark about whether we're going to see a recession in the near term. If we, the bond market at least, thinks a recession is coming in the near term, how do we know this? Well, again back to our bond's discussion. The yield curve is inverted. The one-month yield, 5.4%, is higher than the two-year yield, 4.3%, and so whenever we have the shorter term yield higher than the intermediate term yield, we say the bond market thinks that a recession is coming. We also see that the yield curve is monotonically decreasing as maturities rise. So all longer maturities, out to about five years, are going down. So if we have inflation, if that happens, so if we have a trade dispute, if we have a spike in oil prices, etc.
Speaker 1:What might we expect the Fed to do? Well, we might expect the Fed to further raise the Fed funds rate, say, by 50 basis points. That will probably result in about a 1% increase in the 10-year yield. And because the 10-year has a duration of 9.6%, if there's an increase in 10-year yields of 1%, the bond's going to lose 9.6% in price. Well, if you've got a current yield of 4% and a loss of 9.6%, that means that the net for your bond is going to be a 5.5% loss. Likewise, it could result in a similar or maybe even higher rise in 30-year yields. And so if we have a 1% rise in 30-year yields, that will mean that the price of our bond will go down by about 29%. With a current yield of 4.3% on that bond, that would result in a net loss of nearly 25%.
Speaker 1:And I don't know about you, but the possibility of a 5% loss or a 25% loss feels pretty risky to me, feels pretty risky. In contrast, what would happen if that kind of economic surprise occurred? Well, there might be a 20% or more loss in equity markets. And so here we see a sense in which why some people say bonds are less risky. If I look at a 10-year bond and I might lose 5.5%, but in equity markets I might lose 20%, you can see why someone would say ah, I see. Therefore, bonds are less risky.
Speaker 1:But even in a world in which we're talking only about risk-free assets, there's still a meaningful risk in owning bonds. Let you still have a loss of 5%. That's not like there's no loss. But there's another risk. It's not just that we understand that bonds would lose less than equities lost if the environment were to go inflationary at the moment. There's another risk as of January 2024, as I mentioned, the 10-year Treasury pays a yield of 4.13%, the 30 years paying about the same 4.34%, even if you're prepared to hold that bond to maturity.
Speaker 1:If you're a retiree and you need to make sure that you don't run out of money, and so your annual return goal is 6%, so you can support your spending and make sure you don't run out of money. If your bonds are only paying you a yield of 4% and you hold them to maturity, that's going to be your return. That's not consistent with your goal of 6%, so is that really less risky? Likewise, if you're a middle-aged person and you're saving for retirement. You need to make sure that you have enough when you retire so that you can live out the rest of your years. So your annual rate of return goal might be more like 8% a year, so that your savings can compound as you're working and adding more to it. Well, if your return goal is 8% a bond that you hold to maturity earning 4% is that really less risky? In other words, volatility isn't the only risk when we're investing. Achieving your goal is the much more important risk, and earning 4% on an asset might make that goal less likely.
Speaker 1:And so when we think about the mixture of stocks and bonds, we want to make sure we take into consideration First, it's not always going to be an inverse relationship. Second, we have to remember that stocks and bonds, even if they have an inverse relationship, doesn't mean that the returns are going to have different signs. They might have the same signs, but their returns might be very different. Third, we shouldn't necessarily imagine that we're going to have a portfolio that behaves like it does in the long term at any shorter interval. Only 10 years is the most reliable way to evaluate your portfolio's performance and reaching your goals, and historically it does a pretty good job of it.
Speaker 1:So articles we see in the newspaper these days about the death of the 60-40 portfolio, I think are just nonsense. We just had a year in which it didn't work, and that's typical. If we look historically and then last, are stocks riskier than bonds or are bonds safer than stocks? I think that only makes sense if the thing that you care about is volatility. If you take volatility into account but you also add in the notion that I have certain goals for my portfolio, then you have to look very closely at what your expected return will be on the bonds, and if the respected returns are far lower than your goal, it may not matter that you should, in the long run, own bonds, because failing to meet your goal will be much more painful than, say, having a less efficient portfolio. That's all I've got for you now.
Speaker 1:Next time we're going to come back to asset classes and we're going to introduce probably one of what I think is the most important asset classes to understand and maybe even one of the most tricky, and that is hedge funds. It's important enough that we'll do several episodes on hedge funds, breaking it down into pieces. Next time we'll just introduce hedge funds and we'll talk about the biggest segment of hedge fund strategies, namely equity long short. Thanks for listening and we'll look forward to talking again next time. You've been listening to Not Another Investment Podcast hosted by me, edward Finley. You can find research links and charts at NotAnotherInvestmentPodcastcom, and don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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