Larry Swedroe is a principal and director of research for St. Louis-based Buckingham Asset Management. He has authored or co-authored seven books. Before joining Buckingham in 1996, he was a senior vice president at Citicorp and vice chairman of Residential Service Corp.
On Monday, IndexUniverse.com Managing Editor Murray Coleman caught up with Swedroe to discuss the plight of bonds and buy-and-hold investing, among other issues. (It should be noted that he and another Buckingham colleague, Joe Hempen, co-authored a book on bond investing in 2006.)
IndexUniverse: Did you recently suggest a portfolio of largely municipal bonds for investors?
Swedroe: That was a reference someone took from an example I was using concerning my own portfolio. I definitely wasn’t making a recommendation for everyone to use. There is no "right" asset allocation—or portfolio—for everyone. All of these cookie-cutter solutions people throw out are garbage. They’ve got about as much chance of being right as buying a lottery ticket.
It is important to note that my low-equity allocation does not reflect a negative view on stock returns. Instead, it reflects my own situation and that is that I have reached a point where my own marginal utility of wealth is very low. Therefore, I have little need to take risk.
IndexUniverse: What do you think about suggestions that bonds are now positioned as a less-risky asset class than equities over the long term?
Swedroe: People have recently conducted studies looking back at different longer-term periods and concluded that stocks aren’t likely to outperform bonds going forward. In my view, that’s nothing more than beta-mining. It’s just absolute trash.
IndexUniverse: Why is that?
Swedroe: Let’s start with Jeremy Siegel’s book, “Stocks For The Long Run.” It was a very dangerous book if people took the wrong message away, which many did. The book implied to some investors that stocks aren’t risky if your investment horizon is long enough. I don’t think that Siegel was trying to claim that as a fact. But clearly, that’s the message many people took out of that book.
If there’s no risk, then the expected returns of stocks over any extended period would be about the same as bonds. That’s insanity. Stocks have returned roughly 10% a year over the past 80 years. The average price-earnings ratio has been roughly 15. If people thought there were no risks in stocks, then the PE would be much higher. If the expected return over 40 years for stocks and Treasuries were the same, which would you buy? It’s just irrational to think that stocks and bonds over the longer term have the same risk profiles.
IndexUniverse: So such arguments about the outperformance of bonds are simply data mining?
Swedroe: What they were doing is going back to a period when bond yields were significantly higher and stock returns were significantly lower. From 1969 through 2008, both the S&P 500 and 20-year government bonds both earned 9% exactly. (And that's assuming someone would go back and repurchase the same types of 20-year government bonds as they expired.) We started that period with high stock prices and ended with stock prices at low levels.
On the other hand, you started that period with high bond yields and ended it with low bond yields. The 20-year bond at the end of 2008 was 3.05%. That meant the expected return over the next 20 years was about 3.05%. Do you think that stocks are going to give you a nominal return of less than 3% over the next 20 years? It can definitely happen. From the years of 1929-1948, stocks averaged a nominal return of 3.1%. That included the years of the Great Depression. But that period started with high stock prices. We’re starting this next period with relatively low PEs and low stock prices.
IndexUniverse: Do you think that the stock market is overbought right now?
Swedroe: Generally, I think the stock market is the best estimate of the right price. But we do know that high PEs predict low future returns. For example, when PEs were over 22, for the next 10 years stock returns were around 5%. On the other hand, when PEs were less than 10, stocks returned about 17%. When the PE was roughly between its average of 14-16, then stocks returned about 10%—their long-term average.
IndexUniverse: Where are PEs now?
Swedroe: Let’s look at the Vanguard Total Stock Market Index Fund (VTSMX). Its trailing PE is at around 12 right now. Then, let’s look at the Vanguard Total International Stock Index Fund (VGTSX), which is at 10.6. And Vanguard’s Emerging Markets Index (VEIEX), which is up almost 40% this year, is virtually the same. So stock PEs are below their long-term averages. That means stocks’ expected returns should be above their long-term averages. The equity risk premium is now greater than their long-term averages.
IndexUniverse: Is buy-and-hold investing dead?
Swedroe: Of course not. Buy-and-hold doesn’t mean you shouldn’t do anything at all, though. You need to buy, hold and rebalance. You’ve got to adhere to an investment plan. And that, by definition, means rebalancing it to adjust to the way markets flow. All along the way, you need to rebalance your portfolio. But time-based rebalancing doesn’t make any sense. You should do risk-based rebalancing. You set a band around each asset class.
IndexUniverse: What are your general thoughts about how people should rebalance their portfolios?
Swedroe: Each person has their own requirements. But any time you have new cash, you should rebalance. And people should remember that since time and costs are real considerations, you want to let your portfolio drift a little. But generally, I like to take a 5/25 approach. That means if an asset class has moved an absolute 5% or a relative 25%, you should probably rebalance.
IndexUniverse: How does that work?
Swedroe: You want to do a rebalancing test at three broad levels. The first is stocks vs. bonds. The second is domestic vs. international stock and then, thirdly, you’ve got to check by size and style as well as separate asset classes on the stock side. That applies to bonds, as well.
IndexUniverse: Can you provide an example of how that would work?
Swedroe: On the individual level, say you only want 4% in commodities. So I’d take 25% of 4%, which is 1%, and I’d rebalance once it goes beyond a 1% move—meaning below 3% or above 5%. But if you’ve got short-term capital gains taxes involved, then I’d wait to rebalance until you’d be triggering long-term capital gains. Or, you can use new money when it’s available to buy more of the under-performers.