Those who track mutual fund investment flows tell us that, based on flows out of bond funds and into stock funds, the individual investor is beginning to join the party---although just barely beginning. In terms of market implications, the "just barely" part is music to the bulls' ears. There's this widely-held view---one I sympathize with---that heavy retail (individual investor) participation is a classic warning sign that the party's nearing its end. But, honestly, that's not what troubles me most about individuals reallocating their long-term money. What troubles me is the switching from fixed income assets to equities, when it's done for reasons other than periodic rebalancing.
I've maintained, for an embarrassingly (in that I've been wrong till recently) long time, that bonds are no place to be when interest rates are at record lows. One of the few things we know for sure about markets is that when interest rates rise bond prices fall (we just don't know how long interest rates will stay low [or how long the Fed can successfully keep them low]). Hence, my concern for the individual investor who tracks the track records displayed on his quarterly 401(k) statement. When the government bond fund that served him so well after the drubbing he endured in 2008 delivers a negative 4% year-to-date return, and the U.S. equity fund posts a 25% gain, he can't help but wonder if a change is in order.
While I entirely understand how the individual investor with a day job can come to that wonder, I'm less understanding of investment advisors, Princeton professors and best-selling authors who suffer the same temptations. In a recent CNBC interview, Burt Malkiel (he's all three rolled into one) offers an alternative allocation for those who've stuck with the traditional 60% stocks/40% bonds mix to this point. While he and I are on the same page when it comes to bonds, we go to entirely different places when it comes to what to do instead. He recommends the following:
27.5% Dividend growth stocks, emerging market bonds and tax-exempt bonds
12.5% Real Estate Investment Trusts (REITs)
That, in my view, is in no way a reasonable alternative for investors who wish to maintain a moderate risk profile. It's like taking what was a traditional bond allocation (the 40%) from the frying pan and throwing it into the proverbial fire.
Here's how those "bond substitutes" performed (according to Morningstar) during a recent period of rising interest rates (5/22/13 - 6/30/13):
Dividend stocks (S&P 500 Dividend TR Index): -12%
Emerging market bonds (BofA ML Glbl Emerg Mkt Credit Index): -4%
Tax-exempt bonds (S&P Muni Yield TR): -5%
REITs (MSCI U.S. REIT PR Index): -12%
And here's how the remaining two asset classes performed during the same period:
Stocks (S&P 500 TR Index): -4%
Ironically, during that brief period, three of the four asset classes replacing the conservative allocation declined further than the not-conservative allocation.
As you can plainly see, trading bonds for other interest rate sensitive asset classes in no way mitigates potential risk. In fact, when you consider the economic (and business) risks inherent in stocks, real estate and emerging markets, it exacerbates it.
Here's my suggestion:
60% Stocks (diversified globally and across sectors)
40% Simple, safe, CASH
Rest assured, there will come a day when bonds once again make perfect sense. In the meantime, a zero rate of return (on the "safe" part of your portfolio) is a beautiful thing.