AN IDIOTIC TALE – THE IDIOT SON – 50% STOCKS 50% BONDS

16 Aug AN IDIOTIC TALE – THE IDIOT SON – 50% STOCKS 50% BONDS

This is one of my favorite tales because it involves my father, his friends and investments. In this tale I am the idiot son. I left Legg Mason in 1990 and started my own advisory firm. I no longer wanted to dish out conflicted advice as a commission compensated advisor and had to focus my energies on succeeding as a fee-driven advisor. For those that are unfamiliar with the 1990’s, they were a very good period for stock market returns.

I started managing my father’s money professionally in 1987 and have continued to this day. However, I was under the umbrella of a large firm until 1990. This gave my father a sense of security. He was apprehensive when I told him my plans for starting my own firm and though he didn’t say it our show it, I assumed that he also had some hesitancy about me managing his money on my own. He was 64 years old, he was going to place his trust in a 32 year old and the bulk of his money was going to some discount broker named Charles Schwab. I know he had to feel that way because many of my clients at Legg Mason were reluctant to transfer their portfolio and entrust me with their money under these new circumstances

What happened and why was I the idiot son? I was the idiot son because I allocated 50% of my father’s money to stocks and 50% to bonds. Of course I am no longer the idiot son but from 1990 to 1999 I sure was, at least according to his friends. I would rebalance his portfolio every time it reached a disproportionate percentage and get back to the 50/50 allocation. Because the stock markets performed so well during the period I was forever selling stocks when they were going up and watching other riskier allocations make returns that were superior to my father’s. Amongst his friends I was the idiot son that didn’t know we were in a bull market that would last forever. What was wrong with me?

By the end of 2002 I was no longer the idiot son. Everything that I had left on the table with my diversified, conservative and systematically rebalanced portfolio I more than made up for by the losses I avoided during the 30-month bear market that devastated most high risk oriented portfolios. I was vindicated and it only took about 13 years. You see, my father’s situation called for a 50/50 allocation in my opinion, even though with other clients including my brother for example, I had a 100% allocation to stocks. Please note the stocks we owned for both my father and brother were approximately the same, because advisors can’t customize their purchases and if they do they won’t be in business very long. However, they can customize the allocation.

How was I vindicated? How did I go from “idiot” son to “maybe he might know what he is doing” son? To understand we have to look at some data for the 13-year period from 1990 through 2002. The table below will explain what happened. Let me explain what the table says. Column A shows in percentage terms the rate of return that an investor would make if they invested in the stock market in each of the years. Column B shows the same thing for bonds. Column C shows what $100 would have grown to if a person would have invested all of their money in the stock market at the start of 1990 and kept it their until the end of 2002. We can see that $100 grew to $328.75 in the 13-year period. Column D shows what $100 would have grown to if a person would have invested half of their money in the stock market and half in the bond market at the start of 1990 and kept it their until the end of 2002. We can see that $100 grew to $308.80 in the 13-year period. Column D shows what $100 would have grown to if a person would have invested half of their money in the stock market and half in the bond market at the start of 1990 and rebalanced at year end whenever either stocks or bonds represented more than 55% of the total portfolio until the end of 2002. We can see that $100 grew to $335.72 in the 13-year period

Column AColumn BColumn CColumn DColumn E
YearStock Market

Return

(%)

Bond Market

Return

(%)

Invest all

In the Stock

Market.

($)

Invest half

In the Stock

And Bond

Market

($)

Invest half

In the Stock

And Bond

Market &

Rebalance

($)

100.00100.00100.00
1990-3.066.2496.94101.59101.59
199130.2315.00126.24124.21124.21
19927.499.36135.70134.66134.66
19939.9714.21149.23150.92150.92
19941.33-8.04151.21145.77145.77
199537.2023.48207.45190.37190.37
199623.821.43256.86216.31216.31
199731.869.94338.69265.96261.52
199828.3414.92434.67328.37319.67
199920.89-8.25525.45364.59339.86
2000-9.0316.66477.99357.83352.82
2001-11.855.57421.35336.13341.74
2002-21.9815.12328.75308.80335.72

 

What can we learn from this? Let’s examine Column C. We can see that at its’ peak $100 grew to $525.45 by 1999. However, when it dropped to $328.75 by the end of 2002 it had lost 37.43% from the peak. We can see from Column D that the peak was neither as high at $364.59 nor the percentage drop as high at 15.30%. Looking at Column E we can see why by 2002 someone that practiced a methodology of diversification, a conservative allocation and rebalancing was no longer an idiot. We can see that not only did the person that invested this way have more money than an all-stock portfolio, $335.72 vs. $328.75, when they lost money they lost substantially less. The worst decline we see in Column E is a 4.85%. There is very little doubt that though a person that chose to invest using the Column E approach would have appeared to be an idiot for almost the entire 13 years by the end of the 13th year he was a genius. This is the way with investing. Idiots become geniuses and geniuses become idiots.

I don’t want to leave anyone with the impression that a portfolio where you invest half in stocks and half in bonds and rebalance every time the percentage of stocks or bonds exceeds 55% is a superior way of building wealth it isn’t. It is however a superior way to preserve wealth and it absolutely is if the investor is taking a monthly draw or salary from their portfolio. It is what it is. It is neither superior nor inferior. It is simply a tool that the good advisor recognizes is essential in order to determine the proper asset allocation.

To that end I did a little study that cover 68 13-year periods starting in 1928 and ending in 2007. So the period of this tale, 1990-2002, would represent just 1 of those 68 13-year periods. What did I find? I found that the all-stock portfolio outperformed the rebalanced portfolio 59 of the 68 times. It just so happens that the period I chose for this tale was one of the 9 times where the rebalanced portfolio outperformed. I of course did it on purpose to illustrate a point. I also found that the rebalanced portfolio had a superior draw down meaning that it lost less during bad periods 60 of the 68 times. Lastly, in not one period did the untouched portfolio where I put half in stocks and half in bonds portfolio rank as the top performer in either rate of return or in minimum drawdown. It’s clear that rebalancing has its advantages and disadvantages compared to an aggressive all-stock portfolio but it is without a doubt a superior strategy to doing nothing and why I call it “The free breakfast” and we all know that diversification is “The free lunch.”

CONCLUSION:

What can we learn from this tale? We can learn that an all-stock portfolio is often a superior way of building wealth but that at times it loses the investor a lot of money. We also learn that in the case of my father, it took 13 years to recognize that I was implementing a low risk, as defined by low drawdown, strategy that would under-perform in strong stock market s but would protect capital in a weak stock market. In investing it takes a long time to see if your strategy is successful and why I devote an entire section of these tales to the understanding of advisors and the relationship that you must foster.

Carlos Sera is a Financial Advisor in Annapolis, Md.

Carlos Sera
carlos@seracapital.com

Carlos Sera Founder of Sera Capital Management, LLC Co-Founder of Chicago Wealth Management, Inc. Registered Investment Advisor Speaker on Financial/Investment Planning Fluent in Spanish – First Generation Cuban/American Author of Financial Tales Blog Education Johns Hopkins University – BA – Natural Science – 1980 University of Rochester – MBA – Finance and Applied Economics – Honors – 1982 Find me on:  LinkedIn | Twitter

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