Thu, 18 Oct 2012
Portfolio Solutions' Rick Ferri expects stocks to return 7% and bonds to yield 2% during the next decade, and he also offers tips on how investors should handle their fixed-income positions.
Christine Benz: Hi, I'm Christine Benz for Morningstar. I recently traveled to the annual Bogleheads event where I had the opportunity to sit down with financial advisor and author Rick Ferri.
Rick, thank you so much for being here.
Richard Ferri: Thank you.
Benz: Let's start out by discussing your forecast for the stock and bond markets, over the next decade. You recently published some forecasts on the website, let's just run through them and talk about how you arrive at them--7% equity return--but how do you get there?
Ferri: Well, the equity return is a formula based on gross domestic product growth, and let's assume we have 2.5% of GDP growth. Let's assume that we have 2.5% of dividends, but the dividend is derived by not only cash dividend, but stock buyback that gets us to 5%, and then the other 2% is inflation. And that gets us to a 7% return, and that's where [we get] the equity return of 7%.
Now, if you get a speculative bump in the market where the P/Es go from roughly 14.5 where they are right now up to 15.5, then we will see more than 7%, but I'm not putting that into the formula right now. I think that will happen by the way, but I am not putting it into the formula.
Benz: You are less sanguine about cash and bonds, expecting a 1% return on cash, about what people are earning right now, if they are lucky, and 2% for fixed income. And that's simply looking at where current yields are I imagine?
Ferri: That's correct. The cash component, the 1%, if we get that far, just looking at over the next 10 years and looking at a rather slow economy that's growing at a 2% GDP growth rate or 2.5% in that area--that's what the Fed is looking at--and thinking what would Treasury bill yields be and cash-equivalent yields be in that environment, it's about 1%.
Then I looked at the 10-year Treasury bond yield and other bonds, mostly the 10-year Treasury, which is around 1.7% today. And pretty much whatever the Treasury yield is today, the total return of Treasuries over a 10-year period is within a very close range of what Treasuries are today. So, that gives you 2%. Plus if you think about it, it works out where equities generally return as a premium about 5% over Treasuries, and so you get to 7% on equities. So, in all the numbers work out.
Benz: If people are coming into year-end and thinking about doing some rebalancing in their portfolios, if they haven't done anything for a while and we have had a quite a good year in the equity market so far in 2012, that might call for lightening up on stocks and moving money into bonds.
Benz: But yet investors have a lot of trepidation about bonds right now. What do you say to them?
Ferri: Well, actually a lot of individual investors are selling their equities.
Benz: That's true. Buying bond funds, we have seen that.
Ferri: I mean, yeah, a lot of money has been going into bond funds.
Ferri: I think there are two reasons to go ahead and rebalance. Number one, you have to maintain your discipline. That's one of the keys to investment success is to maintain your discipline. So, if you are going to rebalance, you should rebalance, but also right now if you are selling stocks at a gain, and they're in your taxable account, you are going to pay a maximum of a 15% capital gain. I can't say that next year you are going to be paying 15% capital gain tax, it maybe more than that. So, I think, for that reason alone, [if the assets are in a] taxable account is good idea to do it anyway.
Benz: Many people who are looking at fixed income, though, might say, "Well we've had three very good years in the bond markets, so our asset-allocation models call for X percent in bonds." Are they really looking at past data that may not be that relevant in the years ahead? What do you think about that?
Ferri: The bond position in a portfolio is not so much to get a large real return. I know we've had some very large real returns from bonds mainly over inflation; they've given us very high returns. But it's more of a hedge against the downturn in the equity market. So, it's rebalancing your portfolio and having a mix between stocks and bonds as a risk-control measure because even if interest rates do go up, and you are in a portfolio of intermediate-term bonds your portfolio will go down some, but over the next couple of years it will come back up. It won't go down as much as the equity market.
And if we have a recession, if there is a fiscal cliff and we do have a recession, then the equity market is going to get hurt more than the bond market. The bond market is not going to get hurt because interest rates will stay very low and maybe even go lower. It wouldn't surprise me if a 10-year Treasury bond got down to 1% even though it's at 1.7% right now if we have another recession going into 2013 or 2014. So, I am still OK with doing the rebalancing and being in a balanced portfolio.
Benz: How about bonds versus bond funds. Some investors think, "Well, I'll just buy the bond, hold it to maturity, and it doesn't matter what happens with interest-rate fluctuations between now and then." What about investors attempting to build diversified portfolios that consist of individual bonds? Are there impediments there?
Ferri: Sure. I mean, there are advantages and disadvantages to doing a bond ladder or matching the maturity of a bond to a certain cash liability that you have coming due in the near future; there are certainly benefits to doing that. In fact, I would say that if you do have a cash liability coming due, you know what it's going to be next year or the year after and you did individual bonds or individual certificates of deposit; that's a fine strategy.
But if it's a retirement portfolio where your liabilities stretch out over 20-30 years, then a bond fund is actually still better because first of all the interest that comes into a bond fund is automatically reinvested. Unlike the individual bonds over here where the money flows into a money market fund that's yielding basically nothing. So, you're losing out on that cash drag and the portfolio.
But in the bond fund, it automatically gets reinvested, and if interest rates go up, bonds are always maturing in the bond fund. They automatically get reinvested, and you'll follow interest rates back up. It might take a couple of years, but you'll follow them up.
It's a better strategy, in my opinion to have a bond fund that is fully managed in a retirement account. Whereas an individual bond portfolio is good to hit specific liabilities, that you have coming due in the next few years. So, they are both good, but it's a question of which strategy do you use for your particular situation.