Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
8:30 AM EST, Thursday, April 12: "Harry,
you're nuts. My bonds let me sleep at night."
I replied: "Warm milk is more effective, and cheaper."
phone have been ringing off the hook since I started questioning the value of
retired classmate of mine calls, "I've never questioned my bonds --
until now. I'm thinking it through. Maybe I don't need them, as you suggest?
Or at least as many." We chatted for half an hour. 30% of his portfolio
was in bonds, yet his children were out of college and his living expenses were
low. It was clearly one of those moments when you re-think long-standing assumptions.
buy bonds for ten reasons:
Bonds are safe and predictable.
2. Bonds return a steady income stream.
Bonds add diversification. When stocks do awful, bonds do good. Bonds reduce
4. People need the income from the bonds to live on.
5. Peoples' brokers and/or their financial advisors tell them everyone needs
bonds, especially as they get older.
6. Bonds don't go lose 90% of their value as stocks did in the depression, or
50% in the Tech Wreck of 2000-2002.
7. Learned economists who know zip about investing, write stupid stuff like
are Riskier the Longer You Hold Them."
8. Some investors keep their money temporarily in bonds, while they await a
new deal. They'll make up their lost opportunity cost with the huge returns
on the next deal.
9. Investing in bonds is a "no-brainer."
10. Bonds are liquid.
Have I forgotten
Here are arguments
against the arguments for owning bonds:
1. No one in their right mind would sit idly by and watch their portfolio of
equities fall 90%. We have this inviolate rule -- 15% drop and we're out.
And we stay out until things get better.
can pay your living expenses with dividends from equities and selling gains
from your equities (or other asset allocations) from yesterday's column.
3. You can lose with bonds. With interest rates rising, bond prices
are falling at present. Idiots like me have bought bonds a premium. If I hold
those bonds to maturity, I will lose my premium.
4. There are better
things to invest in -- including real estate. And those things add better diversification
to your portfolio and reduce its volatility. But you got to put time and work
into improving your deal flow.
5. Brokers and financial advisors don't typically have real estate, hedge funds
or alternate assets to sell you. They sell you what they have to sell. And --
guess what -- they make much higher commissions today on bonds than they do
on equities. In fact, I challenge you. Find out how much your broker made on
your most recent bond purchase. It's a big black secret.
Last night I'm
researching bonds. I pick up "The Intelligent Asset Allocator"
by William Bernstein. On page 143, he writes:
versions of the book, I allowed the most risk-tolerant investors 100% equity
exposure. At the present time, however (the book was dated 2001), it appears
that expected stock and bond returns going forward may not be all that different,
and a dollop of bonds is recommended for all investors.
Two more essays from The Yale Endowment 2006 report:
"there ain't no such thing as a free lunch." While explicit and
implicit costs permeate the field of economics, financial markets contain
a marvelous exception. Harry Markowitz, pioneer of modern portfolio theory,
maintains that portfolio diversification is that exceptional free lunch.
assets that vary in response to forces that drive markets, well diversified,
more efficient portfolios can be created. At a given risk level, properly
diversified portfolios provide higher returns than less well-diversified portfolios.
For a given return level, well-diversified portfolios produce returns with
lower risk. A free lunch indeed!
pioneered diversification into alternative asset classes like absolute return,
real assets, and private equity. Today the University boasts one of the most
diversified institutional portfolios, with allocations to six asset classes
with weights ranging from 4 percent to 27 percent. Yale's allocations of 12
percent to domestic equity and 4 percent to fixed income cause only 16 percent
of the University's assets to be invested in traditional U.S. marketable securities.
In contrast, the average endowment has nearly 50 percent of assets in U.S.
stocks, bonds, and cash.
has paid handsome rewards. In the late 1990s, significant exposure to private
equity helped the Endowment keep pace with other endowments despite the University's
relatively small allocation to the booming U.S. equity market. After the Internet
bubble burst in 2000, strong performance by the absolute return and real assets
portfolios, which had lagged overall Endowment performance in the late 1990s,
bolstered the Endowment. In fact, despite the collapse of the domestic stock
market, Yale continued to generate positive returns; in the three years following
the collapse, Yale returned 6.1 percent annually, while the mean return of
a broad universe of college and university endowments was -1.6 percent per
year. In the last three years, remarkable performance by Yale's real assets
and foreign equity portfolios, combined with solid results from absolute return
and a resurgence in private equity, enabled the Endowment to generate annualized
returns of 21.5 percent. These breathtaking returns were generated in an environment
where domestic equity returns were in the low double digits and bond returns
were barely above zero. Diversification has been an important factor in helping
Yale generate an extraordinary long-term investment record.
Yale continues to expect superior results from its diversified approach to
investing. The University's target portfolio produces an expected real (after
inflation) return of 6.9 percent with a risk (standard deviation of returns)
of 11.8 percent. Using Yale's standard capital markets assumptions, the average
college asset allocation produces an expected real return of only 5.8 percent
with a risk of 12.1 percent. Yale's diversified portfolio promises higher
expected returns with lower risk, providing the University with a reasonable
expectation of a free lunch.
portfolio diversification can be painful in the midst of a bull market. When
mindless momentum strategies produce great returns, market observers wonder
about the time and effort expended in creating a well-structured portfolio.
Consider the recent stock market bubble. For the five years ending June 30,
2000, the S&P 500 returned an amazing 23.8 percent per year, trouncing
the mean educational endowment return of 16.9 percent. Simply owning the S&P
500 would have generated a wealth multiple of 2.9 times, while the average
endowment lagged with a multiple of 2.2 times.
During a roaring
bull market, diversification seems to punish investors. Indeed, institutional
investors who sought Markowitz's free lunch by holding foreign equities saw
those diversifying assets lag terribly. During the five years when the S&P
produced 20-percent-plus returns, developed foreign markets, as measured by
the MSCI EAFE Index, generated an 11.3 percent annual return, while emerging
markets, as measured by the MSCI EM Index, returned 1.0 percent annually.
Alternative asset classes like absolute return and real assets, which generate
equity-like returns with low risk, fell hopelessly behind the blistering U.S.
By the late
1990s, many investors questioned the wisdom of owning any assets other than
U.S. equities, especially high- flying technology stocks, asserting the inherent
superiority of American companies and the inevitable dominance of hightech
businesses. Making the mistake of extrapolating future returns from a strong
historical base, investors picked the absolute worst time to abandon diversification
and increase allocation to U.S. equities, as the stock market's remarkable
run had brought valuations to unprecedented heights.
U.S. equity markets eventually collapsed. In the five years following June
30, 2000, the S&P 500 returned -2.4 percent per annum and the formerly
popular technology stocks did even worse, with the NASDAQ Composite Index
returning -11.9 percent annually. Each asset class that had dampened returns
in the late 1990s-bonds, foreign equities, absolute return, and real assets-drove
the Endowment to a series of positive returns in the face of an equity bear
In spite of
the opportunity costs of diversification in the late 1990s, the University
continued to believe in the importance of a properly diversified portfolio
with superior risk and return characteristics. When the bull market in U.S.
equities finally came to a halt in the spring of 2000, Yale was in an extremely
strong position to generate handsome returns. In fact, the University's discipline
of sticking with a diversified portfolio contributed to the Endowment's achievement
of the top longterm record of any college or university endowment.
can read The Yale Endowment's entire 28-page annual report online.
Ignore the error message.
we look forward to -- #1
A senior citizen was driving down the highway. His phone rang. His wife was
calling to warn him, "Herman, I just heard on the news that there's a car
going the wrong way on I-95. Please be careful if you come home that way."
"Heck", said Herman, "It's not just one car. It's hundreds of
What we look forward to -- #2
Two elderly women were out driving in a huge car. Both could barely see over
the dashboard. As they were cruising along, they came to an intersection. The
stoplight was red, but they just went on through.
The woman in the passenger seat thought to herself: "I must be losing it.
I could have sworn we just went through a red light."
After a few more minutes, they came to another intersection and went right on
through it, too. And again the woman in the passenger seat was sure again that
the light had been red and was getting really concerned.
Finally, when it happened yet again, she got really nervous. So, she turned
to the other woman and said, "Mildred, did you know that we just ran through
three red lights in a row? You could have got us both killed!"
Mildred turned to her and said, "Oh, crap, am I driving?"
What we look forward to -- #3.
Two dear old ladies had been friends for decades. Over the years, they had shared
all kinds of adventure, but lately, their activity had been limited to a few
card games each week. One day when they were playing, one looked a the other
and said, "Now don't get mad at me... I know we've been friends for a long
time, but I just can't think of your name. I've thought and thought. I'm so
embarrassed. Please tell me what it is."
Her friend looked at her. She just stared and stared. Three minutes later, she
said, "How soon do you need to know?"
This column is about my personal search
for the perfect investment. I don't give investment advice. For that you have
to be registered with regulatory authorities, which I am not. I am a reporter
and an investor. I make my daily column -- Monday through Friday -- freely available
for three reasons: Writing is good for sorting things out in my brain. Second,
the column is research for a book I'm writing called "In Search of the
Perfect Investment." Third, I encourage my readers to send me their
ideas, concerns and experiences. That way we can all learn together. My email
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