What are the best long term asset allocation strategies? What level of dividend cover should I aim for? Is the science of Chartists worth studying?
What are the best long term asset allocation strategies and does frequent re-balancing make a material impact on the results?
Question: “When investing for the long term ( 20+ years), which of the following two strategies have historically had better results?
a) 100% equities (no re-balancing)
b) A small amount of bonds (10% to 20%) so that when the re-balancing happens you buy cheap stocks / sell expensive stocks.
Follow up: does the frequency of the re-balance make a material impact to results? ( monthly vs quarterly vs yearly)”
Over the long term equities almost always beat bonds. That means that for long-term investors, it's almost always best to be 100% invested in equity.
For the US market (diagram below), we have a long series of data. If we go back to the 1950's you can see the equity return, which is the total return including dividends and subtracting inflation, has been 7% and the volatility has been 12%. For treasuries for the same period it was only 2.5% in real terms and the volatility has been 6.4%. Therefore, over the long term, there is no question that equities outperform bonds.
If you are going to invest for a very long period of time it makes sense to have a very high equity allocation. That is why we talk about Life Strategies 20/40/60/80s.... the longer your investment horizon, the more you need to put in equity.
If you are only investing over a short period of time then put less money into equity because there is more chance of a crash in equity then there is in bonds. That is why the volatility of bonds is 6.4% which is about half the volatility of equity.
S&P 500 and ten-year US Treasuries
The minimum risk portfolio in the example below is actually about 21% equity and 79% bonds. This is called the minimum variance portfolio and this low level of risk is achieved because the portfolio is diversified. The beauty of diversification is that you can end up with a portfolio that has a lower risk than any of its constituents but this only works if the assets are not correlated.
As we increase the amount of equity the return increases but so does the risk. The second set of bars, in green, is where the risk adjusted return (the return divided by the risk) is greatest. This is the Maximum Sharpe portfolio and has the greatest number of units of return for the risk you take.
The third example is Risk Parity where both bonds and equity have an equal contribution to the risk. To achieve this in the example below you need 36% equity and 64% bonds.
The re-balancing question is interesting one and the short answer is that if there’s no trading cost, re-balancing frequency isn’t that important and once a year is probably enough.
What's a reasonable amount of dividend cover when looking for a sustainable yield in Investment Trusts and does this also apply to ETFs?
Dividend cover is the ratio of net income (earnings) over the dividend. For example If a company has £100 million profit and it is paying out £50 million in dividends then the dividend cover is 2.
Below is the example of the City of London Investment Trust (ISIN GB0001990497) which is a high dividend payer.
There are no hard limits, but a dividend cover of over two is high and less than one is worrying.
Dividend cover is not always a good measure of what will happen moving forward, this is because the numerator (net income) is very volatile. This means that even if dividend cover is high this year it might still not protect next year’s dividend.
Equity ETFs don’t usually have dividend cover because they contain hundreds of stocks so they are difficult to calculate. However because an index that an ETF tracks contains hundreds or thousands of shares the net income and dividend tend to be more stable than they are for single stocks. Of course the dividend for a whole country equity index can fall in synch if there is a recession.
Is the science of the Chartists worth studying? (e.g. Chartists – 100-day moving averages, Fibonacci retracement etc.)
- The Death Cross where the short term average trends down and crosses the long-term average.
- The Golden Cross where some bad news triggers a downwards trend and the short-term average rises above longer-term average and the upward trend continues
Personally I do not buy into these theories but an argument for them that could be true is that even if the pattern is not valid if enough people believe that these patterns forecast market movements then they will become self-fulfilling.
However the arguments against them include:
- Long-term trends are more predictable than anything short term (e.g. the rise of stocks and bonds long-term)
- Humans are good at spotting patterns in data, even if they’re not true!
If you were being cynical you may come to the conclusion that short term patterns just encourage people to do short term trading, which in the long run only benefits brokers.
Below is an example taken from Burton Malkiel’s Random Walk Down Wall Street. It illustrates what happens if you toss a coin many times. It appears to move in waves even though it is completely random and his point is that any statistician that looks at the stock market short term will tell you that the movement is just noise. There is no pattern over a short period of time, it is completely random but over long periods of time you can see a drift up in the stock market.
Many people do believe in these patterns, but i'm not one of them. There are a number of people who make jokes about the patterns you can get from Chartists and I do enjoy the comedy aspect of it. Below is an example from Katie Martin, who works for the Financial times and came up with a Vomiting Camel pattern for gold.
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