All across America, retirees and near-retirees are reeling. They were assured by simplistic “McMoney” financial advisers that bonds were “safe,” that bond returns were steady and predictable, and that a portfolio balancing stocks and bonds would be fine in all circumstances.
And in the first half of this year they have discovered to their shock that none of these things is necessarily true.
So it is timely that James Montier and Martin Tarlie, strategists at white shoe money management firm GMO, have produced a paper showing why these assumptions are wrong, why they may be endangering our retirement plans, and what we can do about it.
“If the financial planning industry had an anthem, it would probably be ‘Let’s Do The Time Warp Again’ from the Rocky Horror Picture Show,” write Montier and Tarlie in “Investing For Retirement II: Modelling Your Assets.” Financial planners, they say, are building portfolios for clients by rehashing hopelessly outdated and debunked models. “To put a finer, more brutal, point on it, managers construct portfolios using anachronistic technology from 1952 and then have the temerity to check the results using assumptions from 1970. The unsurprising result of a process stuck over 50 years in the past is portfolios that burden future retirees with an unnecessarily high risk of financial ruin.”
Those out of date techniques? So-called Monte Carlo simulations, efficient market hypotheses, and “random walk” assumptions. In other words, the idea that the performance of the stock and bond funds in your portfolio will be unrelated to what has gone before. Like flipping a coin, the next result will be unconnected to the last one.
And it is, as Montier and Tarlie point out, untrue. Future returns are heavily influenced by valuations, which are largely the result of previous returns. So what goes up must come down. Or: Buy low, sell hgh.
“If you don’t have orange and brown shag carpets or an avocado green bathroom suite or wear bell-bottom jeans or sport pork chop sideburns, why on Earth would you choose to believe that a random walk is a good description of the reality of asset returns?” they ask. Good question.
If stock prices have risen much faster than earnings, dividends or economic growth for a decade, common sense says brace yourself for a period when they will perform worse. And, most obviously, if bond prices have risen through the roof following a generation of Federal Reserve manipulation, be prepared for disappointment.
It has been dismal to see so many red-faced financial commentators and analysts “shocked, shocked” that bonds have fallen so far this year. Broad-based bond index funds like the iShares Core U.S. Aggregate Bond Index ETF
AGG,
have lost 10%. Inflation-protected Treasury bonds (such as
TIP,
and
VAIPX,
) have lost about 9%. Long-term Treasury bonds
EDV,
have crashed as much as 30%. It’s the worst bond market since the 1970s, say some. It’s the worst the 1840s, say others.
(Combined with the crash in stocks and the so-called “60/40” portfolio of 60% stocks, 40% bonds, long considered a benchmark of investing, has lost a devastating 16%.)
But should we be surprised? Bonds work like seesaws: As the price rises, the yield or interest rate falls. And after a generation of skyrocketing bond prices and collapsing yields, bonds came into 2022 more expensive than at almost any other time in their history. Buy a 10 year Treasury bond with a yield or interest rate of 1.6%, which was what they were offering on Jan. 3 this year, and I can tell you exactly how much you will earn on that bond if you hold it until it matures in 10 years’ time: 1.6%.
It doesn’t matter if 10 year Treasury bonds have earned 5% a year on average in the past (that’s the data). The only way to get a 5% annual return for a decade from a 10 year Treasury bond is to buy one with a starting yield or interest rate of…5%.
TIPS are, if anything, even simpler. Their annual returns (though a complex formula) are effectively adjusted to reflect the consumer-price index, so that you are guaranteed a “real” inflation-adjusted yield on top of inflation. At the start of the year 10-year TIPS sported a “real” yield of minus 1%. So if you bought that bond and held it for 10 years you were guaranteed to lose 10% of your purchasing power. (Before taxes and fees, of course.)
There was no mystery about this. No uncertainty. Such assets might have offered short-term trading profits if you could sell them to someone else for even more money. But no investor can or should have been surprised that such things would end up losing money, sooner or later.
TIPS with a negative “real” yield were even less interesting than cryptocurrencies. In the case of TIPS there was literally no chance whatsoever that these assets would make you wealthier if you held them until maturity. It was a mathematical impossibility.
In January, “investors” were buying 1 year Treasury bonds yield 0.4%, 10 year bonds yielding 1.6%, and 30 year bonds yielding 2%. The official inflation rate at the time? Er… 7%. You might just as well have set fire to your money.
As it happens, around that time a friend of mine was launching a business as a financial adviser. I told him one of the simplest ways to add value was just to avoid any such “certificates of confiscation.” Yes, the stocks have gone down as well, but at least that is somewhat less predictable. Bonds weren’t even interesting.
As for stocks: Montier and Tarlie point out that “returns to investing in a broad universe of stocks are created by three potential sources: changes in valuation, growth, and yield. These elements completely define the drivers of return.” This is mathematically obvious. But they also demonstrate its truth using historical data for U.S. stocks dating back to the 1890s. U.S. stocks, in particular, have benefited from a massive inflation of valuations over the past 15 years. This, too, should at least produce some caution among investors.
Finally, Montier and Tarlie raise a point about risk that is often ignored by financial planners. Risk isn’t volatility: It’s the danger of running out of money in your senior years, which they call “the probability of ruin” or the risk of “not having the money you need when you need it.”
Put all this together and you end up with a brutal critique of the way the financial planning industry is helping people prepare for retirement, including the simplistic so-called “glide paths” offered by an industry whose main incentives aren’t to help you retire in dignity, but to gather assets and, by doing what everyone else is doing, avoid being sued.
The challenge is what to do instead, or as well. Montier and Tarlie offer two ideas.
The first is a “glide path” that varies asset allocations much more based upon valuations, so that it avoids stocks or bonds when they are expensive. The problem with that is timing: GMO itself has been warning for years about the overvaluation of U.S. stocks, and it has been at best far too early in doing so (and at worst plain wrong). Their second idea may be of more practical use. It’s in general to own fewer long-term bonds than conventional wisdom suggests, replacing them instead with more stocks and more “short-term bonds,” presumably including Treasury bills or near-cash. Short-term paper may be less risky than bonds, especially when bonds are expensive.
Interestingly, this echoes the advice of two investing legends: Warren Buffett and British financial consultant Andrew Smithers, both of whom have argued that Treasury bills or short-term bonds, not regular or longer-term bonds, were the better counterweight to stocks in a portfolio.
I might add that one thing we’ve learned this year is that a small dose of commodities (whether through a futures fund like
DBC,
or a resource stocks fund such as
GNR,
) can go a long way toward diversifying a portfolio as well, because these typically do well just when everything else is doing badly.
But one thing is clear: Beware of relying too much simplistic models based on flawed or naive assumptions.
