Asset Allocation

SEED weighs the current reality of rates and other value measures along with the customized requirements of each individual.

Historically, simply investing and rebalancing to a pre-set equity-to-fixed income split has resulted in much reduced volatility for only a modest reduction in returns relative to just stocks. The Vanguard Balanced Index Fund, as a real example, maintains a 60/40 domestic equity to fixed income split and has only underperformed the S&P500 by less than 2% from 1992 through 2022 with much less volatility. Equally impressive, by managing their tax lot when selling, they have paid out only a minimal amount of capital gains.

But a word of caution is in order: given a 10 year treasury rate near 3.5% in early 2023 versus over 7% at the start of 1992, common sense implies a 5-6% return for bonds again in the near future is highly unlikely. In other words, past performance doesn’t translate into future results, and given current rates, it is very unlikely to now. If we use The Putnam Income Fund, one of the nation’s oldest aggregate fixed income mutual funds, as a working proxy for the fixed income index, starting at the end of 1955 when rates were last even close to these levels, it would have taken over 31 years for an investor to capture even a slight positive return — in nominal terms! No amount of rebalancing would have made a difference. On the flip side, the Japanese 10yr yield went through 2% in 1997 and has never looked back, closing 2019 at a near 0% yield and holding steady from there.

The point isn’t to market time. Just as low dividend yields (to pick one measurement) signal lower expected returns for stocks in the future, low yields imply lower expected returns for bonds. Yet, because bond prices typically go up when the stock market goes down and vice versa, fixed income coupled with equities can dampen volatility while still providing positive returns. Bonds are thus still a valuable component to a portfolio. Longer term bonds also are the least risky way to hedge a known future expense.

Many alternative investments add little to diversification but do offer very high fees, so they have a much higher hurdle in our mind. Either way, when making asset allocation decisions, rather than relying on just historical returns, we weigh the current reality of rates and other value measures along with the diversity advantages of various asset classes, then tailor this reality to the specific needs and desires of the individual: their time horizons, cash flow needs, risk tolerance, current asset exposure, availability of tax-deferred accounts, etc. It’s not complicated math; it’s rather just common sense.