Age Based Asset Allocation
Why Cycles Are Important and
Why Bonds Are Not Always The Best Investment For Retirees

We have all seen charts like the one below. It seems intuitive doesn’t it? Obviously you want to have more stocks in your portfolio when you are young and more bonds when you are retired. Stocks are risky and bonds are safe. That’s the way it is, isn’t it?

Chart 1 Source: CIS

Unfortunately for millions of retired Americans, they may well soon find out that isn’t the way it is.

Risk - What Does It Mean To You?
Let’s first look at the term “risk.” What does it mean to you? What does it mean to Wall Street? You would be surprised to find out that they are not always the same answer.

Risk to an individual investor might mean the possibility of losing money. Wall Street many times defines risk as an abstract mathematical concept called Standard Deviation.

Standard Deviation (SD) is the amount of volatility in a series of data points. (The Miriam-Webster Dictionary defines it as “a measure of the dispersion of a frequency distribution that is the square root of the arithmetic mean of the squares of the deviation of each of the class frequencies from the arithmetic mean of the frequency distribution.” Investopedia defines it this way: “1. a measure of the dispersion of a set of data from its mean. The more spread apart the data is, the higher the deviation. 2. In finance, standard deviation is applied to the annual rate of return of an investment to measure the investment's volatility (risk).”)

Did everybody get that? Simple, right?

Let’s take it apart. First, SD is a mathematical measurement of the volatility of a series of numbers. It is not a measurement to tell you how much money you could lose on an investment. It is not a measurement to tell you if the investment is a good risk or not. It is not a measurement to tell you if the investment has the potential to do what you expect or blow up in your face. It tells you nothing about the fundamentals of an investment.

Since SD only measures volatility, you could have a very low volatility stock (read low risk in Wall Street talk) drop 50% because the fundamentals stink. Since SD doesn’t tell an investor anything about the poor fundamentals, they would not have been prepared for the decline, nor would have expected it.

How Far Can They Twist Things?
The worst application of SD is the last definition, where SD is used to measure the volatility of the return itself. This is defined as risk. Really? The volatility of the annual return is now the risk? So by this definition of risk, risk is getting a return of only 10% when you expected 12%. This is interesting and not at all what investors expect from their definition of risk.

This is how it works. If mutual fund A has trailing 5 year returns of 10%, 15%, 10%, 15% and 10%, it would be considered more risky than mutual fund B with returns of -5%, -6%, -5%, -4% and -5%. Mutual fund B was an obvious loser, losing money in all 5 years, but because the annual numbers were closer together than mutual fund A’s, A is considered higher risk than B. Foolishness. Standard Deviation told the investor nothing about the potential for loss of money, and to an investor, that is the most important risk.

Real Life Proves SD is Not a Good Measurement of Risk
Here’s a real life example: According to Rydex Investments, bonds had virtually the same Standard Deviation (Risk) in the 1970’s and 1990’s, at just under 9.00%. What did this tell investors about the potential for bonds during those time periods? Absolutely nothing, because in the 1990’s bonds gained an average of over 5.00% per year while during the 1970’s they lost about 1.00% per year. (Click here to see the link to the Rydex piece and all related disclosures.)

An interesting twist is that during the 1980’s bonds had a Standard Deviation of almost 15% (over 50% more volatility than the 1970’s) yet early in the decade interest rates peaked and then a new bull market in bonds was born, leading to returns of over 7.50% annually. (Bull market in bonds, what is that? More later…)

Standard Deviation told investors nothing about the potential of investment return or the potential for loss of money. It can’t tell the difference between a bull market and a bear market. But luckily, we can.

Which Is Riskier, Stocks, Bonds or Truisms?
The other widely held belief we need to question is the acceptance that stocks are always riskier than bonds. We at Cornerstone believe this is a truism promoted by Wall Street that doesn’t hold up to its own data. Using their measurement of risk, Standard Deviation, according to research by Rydex, bonds were riskier in the 1980’s than stocks were in the 1990’s. The SD for bonds in the 1980’s was around 15% while stocks in the 1990’s had a SD of about 14%.

Observation of the two time periods tells us that obviously stocks were riskier in the 1990’s than bonds were in the 1980’s. The 1990’s had the dot com bubble and the crazy speculation that ended in the first quarter of 2000 with the beginning of a horrendous bear market. Bonds, on the other hand, continued to perform well in the 1990’s.

What this means is that bonds, by Wall Street’s measurement, can be riskier than stocks. But more importantly, we can see that Standard Deviation, as a measurement of investment risk failed miserably to warn investors about potential loss of money.

Fundamentals Determine Risks
We at Cornerstone prefer to look at the fundamentals of an investment, the markets and the economy to determine risks. And our perspective is from the same perspective as most investors - how much money can be lost. This means that sometimes bonds can be riskier than stocks, depending on the macro economic conditions and market environment. And most importantly is that these risks can shift. Risks can go up and down. An investment that was risky last year might have less risk this year, because of changing fundamentals.

The Market Doesn’t Know How Old You Are…
Let’s look at the other Wall Street truism in Chart 1. It says that as an investor gets older, they should have more money allocated to bonds. This seems sensible, but what if bonds are going into or are in a bear market? What then? (It also assumes that stocks are the only alternative. This is not the case. Wall Street would like investors to believe they are limited to a choice of stocks and bonds, but the truth is that there are many other investment alternatives. We implement them daily at Cornerstone. We do not limit our clients to just stocks and bonds.)

Are bonds always a good idea all the time for every retiree? Are bonds suddenly good investments just because you are retired?

Chart 2 Source: Federal Reserve; Format: CIS

If this were true, then bonds would always be a good investment because there are people retiring every single day of the year. Are bonds always a good buy? As Chart 2 shows, obviously, no.

Let’s assume Larry retires at age 65. But it is 1973, not 2007. Like a good student of the markets, he listens to what Wall Street says about his retirement asset allocation and plunks $100,000 into Government bonds. Since he needs income, he decides to only take 5% out each year. But considering the effects of inflation, he increases the income by 5% each year.
(See disclosures below Table)

By age 67, he has lost 10% of his portfolio. But fortunately for Larry, he listened to the smart people on Wall Street that assured him to hold on for the long term. By the time he was 69 years old, his portfolio was up almost 10%.

Then the long term kicked in. From age 69 through age 74, Larry watched his bond portfolio lose almost 40% of its value. Bonds were supposed to be safe. Bonds were what retirees were supposed to buy. What went wrong?

Long term, bonds had been in a multi-decade bear market when Larry retired. Interest rates had been rising for about 30 years. And that trend was about to get ugly. Inflation had started to take off, oil was rising and the stock market had already been in a multi-year bear.

Cycles Matter Most
What we are skirting around is the issue of market and economic cycles. This is a concept denied by many on Wall Street and in the offices of those in power. Regardless of their opinions, plans and propaganda, history shows that cycles exist and have repeated themselves throughout history. Bull markets have always been followed by bear markets and good economic times have been followed by recessions. No manipulation by governments has been able to change that. (Ask the Russians and the Japanese how successful their attempts at centralized planning faired.)

To show we didn’t cherry-pick the retirement date, we tracked the hypothetical retirements of several others, all with the same investment parameters, $100,000 invested in the bond market, 5% income with a 5% annual increase for inflation. Here’s the results:

It’s the Cycle, Not Your Age That Matters Most
All of the above participants in our example did the exact same thing. They retired at the same age and took out the same amount each year. Yet the results were vastly different.

Why did Tony do so badly and Bart do so well? Why did Steve start out so poorly, but finish strong? What did Martha do right and Linda do wrong?

Since they all invested in the same investment, with the same amount of money and took the same amount of income out, the only variable left was the market cycle. What the retirees prior to 1980 hadn’t considered was that the bond market was in a bear market. Tony, Linda, Jake, Ralph and even Steve were victims of being in the wrong part of the cycle. Rates were rising and killing their bond portfolios.

Bart, Tommy and Martha all benefited from being in the bond market as interest rates were declining. Their portfolios did very well. Yes, they did have some declines, but nothing compared to the earlier bunch.

And what about Lou? We threw him in as a control. Instead of taking 5% out each year, he took only 1%. This meant he had a much better chance to let reinvestment work for him. As you can see, it helped, but not much. By age 75, he had made only about 1.60% annually on his investment. The worst his portfolio was ever down was 17.27% though. And after 1982, when interest rates peaked and the bull market in bonds took off, his portfolio performed much better and he never ran out of money. (He was still only taking out the original 1% with the 5% inflation kicker.)

This Time Is Different! No, it isn’t…
The common complaint from the nay-sayers is that today’s economy is vastly different than that of 70 years ago. And they are right, there are many differences. But there are also many similarities. The differences are in the micro economics, the similarities are in the macro.

The first and most important is that economic collapses are many times the result of too much debt. In the late 1920’s, debt to GDP ratios almost hit 300%. There was 3 times more debt than economic activity. The current Japanese deflation, which has lasted more than 17 years, was because of too much debt.

And debt is today’s problem as well. The US has a debt to GDP ratio of over 400%, well above the previous peak in the late 1920’s.

Chart 3 Source: Federal Reserve; Format: CIS

Other similarities include stock market manias, housing booms and international trade. Sound familiar? The problems they had in the past are the same problems we have again today. The cycle keeps repeating. Different players, but the same game.

Extraordinary Popular Delusions and the Madness of Crowds
The only constant throughout history has been human nature. It seems it is man’s nature to go to extremes, from extreme greed creating manias and bubbles to extreme fear creating panics and bear markets. Until we remove the human element, this cycle will probably continue.

Mr. Market Doesn’t Care How Old You Are
Since there are apparent and repeating long term cycles, investors are better advised to base their asset allocation on these cycles instead of their age. The market doesn’t know how old you are. To base your asset allocation on your age denies the existence of market cycles and forces one to believe that just because you are a certain age, a certain investment class is now the best investment for you. That would not be investing, it would be gambling.

...And not a good gamble.

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