Last Updated on 27 January 2021 by F.R.Costa

Over long periods of time stocks clearly outperform bonds, but in the long-run we are all dead, right?

John Maynard Keynes was interested about the short-term economic fluctuations because, even if the economy tends to an equilibrium in the long-run, the long-run is often too far away for us to forget the meantime and do nothing about it. In the world of investment, time also plays in our favour, even though the ride towards the long-term is often a bumpy one. The best we can do is to invest in a cheap broad-based stock index and do nothing more. While it sounds boring, this is the best way of achieving the best long-run returns.

However, even in within the scope of passive investing, there’s something we can do. In the world of the Modern Portfolio Theory (MPT), the best portfolio is built with two assets: a broad-based stock index and bonds (or cash). The exact choice depends on expected returns for bonds and stocks and on our individual preferences of risk and return. In any case, the decision is always about the exact proportion of a broad-based stock fund and bonds. But, for some of us, the optimum lies on a 60/40 stock-bond holding, while for others the proportion may be 80/20 or even 120/-20. That’s not an error. The best way of of pursuing higher returns than offered by the market is by means of borrowing money, which corresponds to selling bonds (borrowing cash).

Now, let’s think about periods of high enthusiasm. At times, stocks just see their prices pushed out of bounds due to overconfidence. When that happens, price ratios like the price-to-earnings, the price-to-book value and the price-to-sales rise to unsustainable levels. This happens because price rises faster than the fundamentals of a company. However, price ratios do not follow an explosive process. They instead revert to a mean. And for reversion to happen, either prices need to fall or earnings growth needs to accelerate and overcome the rise in prices. Unfortunately, price is a much faster adjustment mechanism than earnings and at the slightest sign of smoke in the market, it is through a sudden price decline that price ratios revert to their mean, or to more reasonable levels.

According to the WSJ, the P/E ratio for the S&P 500 is now at 40.40, up from 25.53 one year ago. This is an increase of 58% in a ratio that was already high. Even worse is the fact that we are talking about an average ratio for 500 stocks, which means that the disconnection from reality needs to be very large for many of these stocks. It’s unreasonable to expect return rates for stocks in the same order of the recent past. But, if we slash the expected returns for stocks, then the best option available is to reduce the proportion of our broad-based stock index in the portfolio and increase its bond proportion. Bonds have a much lower volatility than stocks. If the market crashes, bonds are a way better protection against the backdrop.

The chart below depicts two broad-based ETFs from Vanguard: the Vanguard Total Stock Market (NYSEARCA:VTI) and the Vanguard Total Bond Market (NASDAQ:BND). These index funds are good proxies for a stock-bond portfolio. As you can easily spot, the volatility of VTI has been a lot higher than the volatility of BND. Because the correlation between these two ETFs has been just 0.22 for the period running between 31/Dec/2019 and 7/Jan/2021, investors have an advantage of mixing the two in a portfolio. That feature is easily observed in the chart. When the turbulent lockdown period occurred between February and March 2020, VTI declined more than 30% while BND dropped just 5%.

When stock prices are too high, there’s some short-term action you can take while still keeping your focus in the longer-term, which is reducing your exposure to stocks. It doesn’t hurt to hold more bonds as they are like cash. If the market drops in the meantime and you need money, you can easily sell the bonds without having to do it at a heavy discount, as it’s usually the case with stocks. At the same time, you can use bonds to raise cash to buy more stocks later, when they are cheaper.

As a summary, what I mean is that you should keep your focus in the longer-term. Eventually, the best portfolio you can hold is made of just two assets: one broad-based stock fund and another broad-based bond fund. However, there’s scope to manage the exact proportions among them. When the stock market is near record highs and price ratios are on high two-digits, then reduce your stock holdings and use the cash from the sale to purchase additional bonds. Then, when the opportunity arises, you can easily convert a part of the bonds into cash and use it to purchase more stocks. You shouldn’t adjust these proportions too often but you can revise them from time to time, instead of boringly wait for the long-term! And, at this point, if there’s an adjustment to be made is in the direction of increasing the bond part of the portfolio.

About F.R.Costa

Filipe has more than 20 years experience with financial markets. He holds a degree in Economics with a specialisation in Finance and he's currently finishing a PhD in Finance. He used to work as financial consultant and research associate but then decided to return to academia five years ago. Since that, he has been an Invited Lecturer, teaching courses on Investments, Financial Markets, and Monetary Economics. He is also a regular contributor writer at The Master Investor Magazine.

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