Have Everything In Stocks Now? Here’s Why You’ll Want To Rethink That

April 16, 2018

Have Everything In Stocks Now? Here’s Why You’ll Want To Rethink That

  • As crazy as it sounds, one shouldn’t have everything in stocks.
  • Perhaps the best counter option right now is short term bonds.
  • We’ll discuss Graham’s take and apply a contemporary perspective on it.



Introduction

Today, we’re going to continue our review of Benjamin Graham’s The Intelligent Investor with a discussion on the fourth chapter, General Portfolio Policy: The Defensive Investor.

Graham clearly differentiates between aggressive and defensive investors where an aggressive investor spends a lot of time on research while a defensive one enjoys life. No matter whether you’re aggressive or defensive, this chapter is crucial for this environment as being defensive might be the most aggressive thing one can do.

Let’s see what Graham had to say about the stock and bond allocation in his time, and whether it still applies to this environment.

Opposite View On Risk

The common view on risk is that low risk equals low returns but Graham, like me, sees things from a different perspective. For him, a well-researched bargain is much less risky than a bond because bonds lose a lot if interest rates increase and if there is inflation, thus they are also risky.

The Basic Problem Of Bond Stock Allocation

Graham’s view for the defensive investor is to have an allocation between bonds and stocks between 25% and 75%. When stocks are cheap, one should have 75% in stocks and vice versa. This is against human nature and we saw in 2017 that, after an 8-year bull market, stock market inflows were the highest. However, this human trait of buying high is exactly the reason why one should do the opposite and buy low when others are selling low.

Another problem is that stock bond allocation is personal and this is where the problems start. If you had been just 25% in stocks for the past 3 years, you would have missed out on the 25% run the S&P 500 has had since, while your returns would be around zero given the returns on bonds and their recent decline.

Figure 1: S&P 500 in the last 3 years. Source: CNN Money.



As the current situation is relatively similar to 1972, we can certainly get value from Graham’s advice. He didn’t like the high levels at which stocks were trading in 1972, but he also didn’t feel comfortable with saying that one should have had just 25% in stocks so he went for the neutral 50/50 where the defensive investor constantly rebalances their portfolio between bonds and stocks where if the stock market part becomes 55% of the portfolio, the intelligent defensive investor sells one eleventh of their stock holdings.

However, I’ll quote Graham “if he can act as a cold-blooded weigher of the odds, he would be likely to favor the low 25% stock component at this time, with the idea of waiting until the DJIA dividend yield was, say, two-thirds of the bond yield before he would establish his median 50-50 division between stocks and bonds.” Let’s first dig into what Graham has to say about bonds and then see what the current perspective is on what he is saying.

Bonds

The main question with bonds now is whether one should buy short term or longer term bonds.

The issue here is that if you own longer term bonds, you are exposed to potential price fluctuations where higher interest rates lower their values and lower interest rates increase their values. At current interest rates, I must say the odds for higher interest rates over the long term are bigger than lower interest rates as the debt governments across the world have will lead to inflation in case we see another round of monetary easing. In case we don’t see more monetary easing, we could really see higher interest rates, especially in Europe where what has happened in the U.S. is only about to happen there now.

I will be touching more on that tomorrow when I discuss the yield curve which is an important thing to look for when investing. Nevertheless, if you are a defensive investor, short term bonds might be the best option as long term bonds don’t offer much higher interest rates.

Figure 2: Short term interest rates went up but long term much less. Source: Bloomberg.



Graham dissected various kinds of bond investment opportunities at the time where what I would touch on are high yield or junk bonds which offer attractive yields but are also extreme risks. You should really know what you are doing if you invest in high yield bonds and then be ready to buy more in the case of a crash. But for that you need forensic accounting knowledge and to understand the risk such companies or countries run in a different financial environment.

Current Problem

The current problem is that stocks are overvalued from a valuation perspective but bonds are also not the place to be as bond values decline with higher interest rates and bond investors haven’t had a great time over the past few months.

The key takeaways from this are that each one of us has to properly check what our financial goals are and whether the investment vehicles we use will lead us there.

The point of investing isn’t to maximize the returns in the short term, but to achieve the best risk reward returns over the long term and I know this is hard to grasp when stocks have been going up for 8 years, but it is crucial to understand.

In order to really work on this extremely important matter, I’m going to write about the yield curve tomorrow and on Wednesday, about how we think we know what we are doing in the stock market but how that perception changes when stocks go down which leads us to doing the wrong thing at the wrong point in time. Keep reading.



By Sven Carlin Benjamin Graham Bonds Investiv Daily Stocks Share: