Ideastorm #11
Rethinking conventional advice, the Buffett indicator, Challenges with private investments, and more...
Welcome to the latest Ideastorm. Market Sentiment curates the best ideas and distills them into actionable insights. Join 38,000+ others who receive curated financial research.
Actionable Insights
Contrary to conventional wisdom, a 50/50 allocation to U.S. and International stocks outperforms conservative portfolios and target date funds in all metrics, even in retirement.
Manager selection is vital in realizing the “market-beating” returns touted by alternative asset classes like Private Equity.
The latest research indicates that the Buffett Indicator has excellent forecasting abilities, and the best time to invest would be when the indicator is at its lowest.
Incorporating real assets, value/momentum tilt, and trend following in the traditional 60/40 portfolio can boost its risk-adjusted returns.
1. Rethinking Conventional Investment Advice
Conventional investment advice recommends holding more stocks when you are young and tilting your portfolio to bonds as you near retirement. A popular rule of thumb is 100 minus your age for the % allocation to stocks — so a typical 60-year-old will have 40% of their portfolio in stocks. Even sophisticated target date funds more or less follow this thumb rule for their portfolios1.
But is this the most optimal allocation?
To test this, researchers collected data from 38 developed countries from 1890 to 2019 and ran one million simulations for a U.S. couple’s lifecycle. They compared four critical parameters — Wealth at retirement, retirement income, conservation of savings, and bequest at death across four asset allocation strategies:
100% government bills
100% domestic stocks
50% domestic stocks, 50% international stocks
Traditional Target Date Fund (TDF)
As expected, the traditional TDF produces more wealth, higher retirement income, and a lower probability of financial ruin than investing 100% in govt. bills. What was interesting was that the (50% domestic stocks/ 50% international stocks portfolio) outperformed the TDF in all metrics:
32% higher average wealth in retirement than TDF.
TDF portfolio had a 16.9% ruin probability under the 4% withdrawal rate compared to only an 8.2% ruin probability for 50/50 US-International stock allocation.
The average portfolio size at death was 3.5x higher for the 50/50 portfolio than the TDF ($3M vs $0.86M respectively).
Source: Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice
2. Challenges with Private Investments
Private Equity seems to be all the rage now following the release of The Holy Grail of Investing by Tony Robbins2. Private Equity has historically given a higher return than the public markets. Most of this premium can be explained by the illiquidity premium — Private assets don’t trade regularly and generally have a lock-in period for investments. Investors are compensated for this illiquidity by receiving a premium over public investments.
In addition to the inherent complexities of the private investment universe, manager selection becomes vital in contrast to traditional asset classes. The difference in performance between the top and bottom quartile managers typically does not exceed 2% in the case of stocks and bonds. But for alternative asset classes, this figure routinely exceeds 10%, with U.S. venture capital reaching up to 30% spread between top and bottom managers.
These observations highlight that average returns touted in the Private Equity world should be taken with a pinch of salt. Deep expertise, due diligence, and access to the top investment managers are a must-have to gain an edge with private investments.
Source: Portfolio Implementation Guide for Private Investments (Morgan Stanley)
3. The Buffett Indicator
From 1964 to 1981, the Dow Jones Industrial Average (DJIA) only grew 0.1% compared to the 373% growth in GDP. However, over the next 17 years (1981 to 1998), DJIA increased 497% vs. a 177% growth in GDP.
This mismatch led Warren Buffett to create the market value of equity (MVE) to the gross domestic product (GDP) ratio. Buffett claimed this to be “probably the best single measure of where valuations stand at any given moment”.
MVE/GDP is exceptionally intuitive. When the price of equities (the total value of free cash flow the company can generate in the future) goes up without a proportional increase in economic output (GDP), equities become overvalued, and vice versa.
Based on this ratio, the best time to invest would be when the MVE/GDP ratio is at its lowest. To test this theory, researchers used data from 14 countries going back to 1973.