Monday, 9 July 2012

Sector Allocations: Will stocks or bonds outperform?

When I posted my June 2012 expenditure tracker I mentioned that Iwas quite heavily weighted towards my share portfolio at the expense of my fixed income portfolio.  I also mentioned that I was quite happy for this to be the case in the foreseeable future because of the expected returns that the market was showing.  I shall expand on this second point here.

This post will go through the arguments in favour of allocating funds towards the share market instead of investing it in a fixed income portfolio.  Note that this does not take into account your financial position - if you are likely to need the funds within the next few years then it becomes a completely different story as they market may not have recovered yet.  For those, like myself, who have a long time to invest though I think the story is fairly compelling.

Identify the types of each investment that you would normally invest in

The first thing to do is to identify the types of stocks / bonds you would normally invest in and use this as the basis of your comparison.  Don't compare the returns of securities you know very little about or are unlikely to invest in because this will give you a distorted view of what your sector allocations should be.

For fixed income securities / bonds I am going to assume that the investor is looking at investment grade bonds in high yielding companies, probably through both unlisted and listed bond funds, government bonds, high interest savings accounts and using funds in offset accounts (which are effectively fixed interest securities).  A quick side note - those who have read my expenditure tracker posts would be used to me referring to my home loan offset account - I view this as a fixed income security because the interest I save is effectively a return on this money.

I am further going to assume that investors are not  looking at investing in distressed bonds.  If you know how to invest in distressed bonds and are comfortable investing in these then this may be the perfect market for you.  There are bonds within Europe that seem rediculously cheap however you need to be really good at evaluating and pricing the risks associated with this.  This is not an area I know well so I tend to steer well clear of it.

Similarly you need to identify what stocks you are most likely to invest in.  I am comfortable with both cyclical and defensive stocks so both of these form part of my investment portfolio.  I don't mind small cap though prefer to avoid micro cap stocks so this forms part of my investment comparison.

Look at the relative forecast returns of stocks vs bonds

Over the last few years (i.e. post the GFC) the bond market has had an unbelievable rally.  You only need to look at the prices of bond funds, espeically those relating to 'safe' government debt to see this.  This has been driven by low official interest rates especially in the US and Europe.  The price of German government debt is at virtually zero percent and you don't get a whole lot of return by investing in US treasuries either.  Savings accounts (the other major form of fixed interest for investors) are also offering very low returns as well.

The above low yield environment has given rise to P2P lending (such as the Lending Club) which offer more attractive yields but you get none of the safety associated with a bank and if you want diversification benefits then it is very time intensive for quite a poor return (relative to historical returns). 

Conversely the stock market has been jittery over almost the whole period.  Most markets had a partiuclarly good run at the start of 2012 but then gave up most of their gains in the following months.  Companies have (by and large) degeared from the heady days of the GFC and most are better run and leaner though are suffering because of a poor economy.  There are plenty of companies who have actually increased their distributions (I may put up a list of good ones sometime in the next week or two) but are being penalised because of general disenchantment with the economy and stock market.

Note there are also those companies which are trading at premiums due to their percieved position in the markets.  Companies like Apple in the US are seen as being 'different' and somehow more imune to the environment.  When I am talking about relative returns on stocks - I am not talking about the Apple's of this world.  I'm talking about your regular S&P500 / FTSE100 / ASX200 company that makes steady earnings and is being punished by a market that seems to swing one way and then the other based on nothing more than whether sentiment is good or bad.

You should then look at what your own data is telling you.  What are the future expected returns for these companies.  Are they better than the bond returns that you are seeing (keep in mind that bond returns are far from certain as if interest rates go up the bond prices go down and unless you are holding to maturity you're going to lose out)

Assess the risks

When assessing sectors (rather than individual investments) you need to look at both what the upside and the downside risks are.  At the moment these seem to be the risks
  • Bonds: Limited upside (bond yields really cant go any lower and prices cannot go a whole lot higher) thus the upside is just the status quo.  Downside is if interest rates increase then prices go down and you're stuck recieving a very poor return with the potential for capital loss.  If you have gone for 'P2P' lending then you have more upside but also more downside due to larger risks that you have not structured your portfolio of loans correctly and risks of default etc.
  • Stocks:  Quite large valuation upside as prices seem depressed.  Also earnings for many companies seem stable so possible dividend upside.  Downside is if markets stay jittery and volatile for a while you will not be seeing your forecast returns.  Also further deterioration in the market could see stock prices decline futher.  If you invest in 'market darlings' like Apple then you have a more limited upside (quite a lot of growth is already priced into the stock) and more downside
Set your sector allocation

Having assessed all of the above you need to then set your sector allocations.  The hardest thing to do from a psychological point of view is to be a contrarian investor.  There is a certain comfort to going with the herd.

If you want to earn superior returns on investments then you need to be objective.  I am setting my investment allocations at 30% property / 50% stocks / 20% fixed income but each person needs to assess their own situation.  Talking to a financial advisor is definetely recommended for those who do not feel comfortable doing the above assessments for themselves.

No comments:

Post a Comment