Continued from Part 04 . . . Standard Deviation (“How sure am I to get it?”)
The standard deviation (SD) straddles the mean (the “average”), with half the SD on one side and the other half on the opposite side.
The SD for the Total Stock Market (per portfoliocharts.com) is 17%. That is, the range containing two-thirds (rounded) of the investors likely return runs from 17% beneath the mean to 17% above it: in this case, from minus 9.4% (7.6% less 17%) to positive 24.6% (7.6% plus 17%).
In some years, the market rose (or fell) more than one standard deviation. In 1995, the market increased 33.5%; in 2013 the increase was 26.5%. There were also big downside years that exceeded one SD. In 2008 the market fell 33.8%.
So gains and losses can exceed one standard deviation, but 2/3rds of the time yields cluster on both sides of the mean (the “average”). The SD expresses the investment’s risk.
As we’ve seen, not many people can accurately forecast what the market is going to do over the short term. Historically, however, the real return of the stock market has been 7.6% per year over the long term.
Takeaway 1: Stocks are volatile. People that make short term investments in volatile markets are called speculators, and few experience much success.
Stocks are more appropriate for the long term investor, the investor that can wade through inevitable market declines (sometimes very serious declines) without losing her composure and turning a temporary market decline into a permanent loss of capital.
Takeaway 2: On the other hand, there is historical data suggesting that the unleveraged real return on stocks might be at least comparable to income properties. Many people find that surprising.
Make a Different Investment, Get a Different Return
the purposes of this article, the wise investor is defined as (a) one who knows how to recognize sound individual stocks, or failing that, (b) one who just gives up and buys the market (possibly through a low cost ETF). Either extreme on the investor’s radius of competence will do. The saying is, “If you can recognize good alternative.
What if the investor put only 2/3rds of her stock funds into a Total Stock Market fund (total return estimated at 7.6%) and 1/3rd into a Small Cap Value fund (total return estimated @ 11.4%). In that way the majority of her stock portfolio would be in larger companies with a smaller SD (and thus safer), and a smaller portion would be in more volatile (riskier) “higher return” companies. The numbers might look something like this:
Total Stock Market Stocks @ 7.6% CAGR / SD 17%.
Small Cap Value Stocks @ 11.4% CAGR / SD 19.7%.
The blended portfolio compares very favorably, in both CAGR and SD, with the return from the TSM (only) investment we saw in the above. The return is a full 130 basis points higher (8.9% minus 7.6%). The SD is only 90 basis points higher. Yet the initial principal grows 36% more. Sometimes taking a little greater risk is worth it.
This is why an investor in stocks / bonds should have a competent professional advisor. There are some good advisors that have had no formal education, but many have earned the CFP or CFA designations.
Interest Rates Drive the Economy
A developed nation’s economy is driven by its long term (secular) interest rate. When interest rates are low the demand for goods and services increases. People buy larger houses, nicer clothes, and go on more vacations. Businesses adjust to their improved prospects by borrowing money to purchase machinery, lease more space, and hire more people. It works the other way, too.
When interest rates are high, the economy declines because consumer demand for goods and services wanes. Businesses must now decrease their costs just to remain solvent. They no longer extend their leases. They lay off employees. All that new machinery rusts in the corner.
Most (but not all) financial advisors seem to have an increasing anticipation that the next portion of the interest rate cycle will be a period of rising rates. It probably won’t happen immediately, though. The Federal Reserve will struggle to support the economy at least until after the 2020 elections, but there’s a limit to how much more rates can be reduced. The Federal Funds rate (that’s the interest rate banks charge for lending to other banks) is currently very low. At the beginning of this cycle, in June 1981, it was at 18.49%. Back then, the Fed had a lot of room to lower rates, and it has taken full advantage of the situation, aggressively reducing rates a total of 16.37% in 38 years, or an average of about 43 basis points every year. With the Federal Funds rate now at 2.12%, how much remaining room does the Fed have?
The Largest Asset Class: Interest Bearing Bonds
The bond market is larger than the stock market. There are roughly $30 trillion dollars currently invested in stocks, and $40 trillion in bonds. The bond market is 33% larger than the total capitalization of the stock market. It is a liquid market, and it contains a number of different types of bonds, some of which are:
Municipal bonds are free of federal taxes and often, for state residents, exempt from state and local taxes as well. Due to favorable tax treatment, municipals typically are offered at lower interest rates than taxable bonds. Municipal bonds are issued to pay not only for day-to-day expenses, but also for capital expenditures like water treatment plants, schools, civic improvements, etc.
Most muni bonds are historically safe investments, but there are always some that will never be repaid. Imagine a developer who buys cheap land way out past Fort Mudge and talks the local authorities into issuing municipal bonds for the streets, utility extensions and hookups, street lights, and maybe an elementary school, common area hardscaping and all the other desiderata of a marketable housing development. The issuing authority will have no obligation to service the bonds. The burden will lie exclusively upon the (not yet in evidence) home buyers. Further imagine that no buyers show up. Henry! Henry, do you know how far this is from Costco?” If no buyers, then there is no money to service the bonds and the bond holders lose bigly.
Currently, top rated municipal bonds are offered at 1.24% (two year term). Given 35% Federal and 10% State tax, this is equivalent to a taxable bond yielding 2.25%
- Using the 2.25% taxable rate, $100,000 in these bonds would in 25 years be worth $174,400 (net of inflation).
It shocks the conscience, but it is nonetheless a fact that a surprising number of corporations, including some major ones, are capitalized in excess of 50% by bonds. While that may be manageable when rates are 1.62% (current rate on 2-year AAA corporate), it becomes worrisome when rates eventually rise towards their long term mean. Even if current rates only tripled (i.e., to 4.86%), they would still be below their long term average.
Since bonds are a contractual claim against earnings and must be paid before dividends (which are not contractual claims: dividends are discretionary) are released, it is not unreasonable to anticipate that in some cases all or most of current dividends may have to be repurposed to service bonded indebtedness. In some cases, even that might not be enough.
- Using the 1.62% yield, $100,000 in these bonds would in 25 years be worth $149,000 (net of inflation).
Yes, U.S. Treasury issues are among the world’s safest investments, but only if they are held to maturity. At maturity, the government will just crank out whatever dollars are due to the holder. But if they are sold before maturity, they are subject to market risk. It may well be that interest rates have gone up since purchase, and the price of the bond might have to be discounted to compensate.
Those people who seek the security of Treasuries but think they may have to sell their bonds before they come due have the option of buying shorter term bills (maturity is one year or less). Some folks divide their bond portfolio into four buckets and invest in four-week bills.
Investing one bucket every seven days in four-week bills means (a) in four weeks the entire bond allotment will be placed, and (b) after that, every week one-quarter of the portfolio will mature. Think you’ll need early-money? This might be something to consider. If you don’t need it, it can be automatically reinvested in then-current 4-week bills.
- 2.10% (the current annual yield of four-week Treasuries,) $100,000 in these bills would in 25 years be worth $168,000 (net of inflation).
Data Source and Inflation
The data source we’ll use is https://portfoliocharts.com/portfolio/annual-returns/. There are other sources of data. Some people like Portfolio Charts, some don’t. It might depend on whether they are buying bonds or selling them. A seller might find it useful to refer buyers to a data source that includes inflation in the “return”. That might be a useful sales tool. A buyer, on the other hand, may wish to use figures that are net of inflation. PortfolioCharts.com data is inflation adjusted (a highly desirable feature). Many others are not. This is often overlooked, but can be significant. Right now Iranian banks offer 18% interest (payable in Iranian rials), while the official inflation rate is reported at 52%. So the saver puts 100 rials in the neighborhood bank and a year later receives 118 rials (includes interest and the return of principal). Over the same period the price of a given quantity of rice rose from 100 rials to 152.
Clearly, one would expect a major difference in reported returns between a data service that adjusts for inflation and one that doesn’t.
With all of this, why buy bonds?
Proper diversification between asset classes enhances portfolio growth because, as someone once said, “When one asset loses, another gains”. That only happens when there is an imperfect correlation between assets. Bonds are the classic asset used to offset
potential losses in stocks. After all, a company has the option of distributing dividends or not. But bonds have contractually obligated interest payments and maturity date. If the issuer doesn’t abide by the terms, the company falls into default. A company doesn’t do that lightly.
The recommended (liquid) portfolio is often quoted at 60% stocks and 40% bonds. The reason for the heavy bond component is obvious: losses hurt more than gains help. For example, if one starts with a single asset portfolio valued at $100 and the asset loses 40% (the investment is now down to $60), it would take a 67% gain ($40) just to get back to the original $100. It takes a big gain to offset a small loss. One object (not the only object, but one of several) of good portfolio management is to minimize losses through a selection of imperfectly correlated assets. Bonds can be an important part of that.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email info@KlariseYahya.com.