One of the major building blocks of your portfolio is probably a bond mutual fund or ETF. The most popular bond benchmark is the Bloomberg Barclays Aggregate Bond Index (AGG), which basically tracks all U.S. taxable investment-grade bonds. These popular index funds all track some variation of this index:

• Vanguard Total Bond Market Fund (VBTLX/VBMFX) and ETF (BND). The biggest bond mutual fund. This fund is also inside all Vanguard Target Retirement 20XX or LifeStrategy All-In-One funds.
• iShares Core U.S. Aggregate Bond ETF (AGG). The biggest bond ETF.
• Schwab U.S. Aggregate Bond ETF (SCHZ).

What’s inside a Total Bond fund? A recent Vanguard Blog post provides some insight into the components that make up the Barclays U.S. Aggregate Index from 1977 to 2017:

• US Treasury. Bonds issued and backed by the US government, including Treasury notes and bonds. (Nominal only, TIPS are not included.)
• US Government-related. Securities issued by a Federal Agency or a government-sponsored enterprise like Fannie Mae or Freddie Mac. These are either explicitly or implicitly backed by the US government.
• Securitized (MBS). Mortgage-backed securities, backed by residential mortgages and packaged by Ginnie Mae, Fannie Mae, Freddie Mac, and others including private issuers.
• Securitized (ex-MBS). Asset-backed Securities, backed by things such as consumer auto loans, credit card debt, and home equity loans.
• US Corporate. Securities issued by corporations with investment-grade ratings from the major ratings agencies.

The first thing to note is that the bottom three layers are essentially all backed by the US government. When considered in this chart format, you can see that these bottom three layers consistently make up about 60% to 80% of the AGG. Thus, historically you can estimate that roughly 2/3rds of the index is backed by the US government and 1/3rd is privately-backed by securitized assets or corporations.

How much more does a Total Bond fund yield than a Treasury Index fund? Here’s how much the AGG Total Bond index yields above a Treasury index historically:

So the ingredients are little riskier overall than 100% US Treasury bonds, but you also earn a little higher yield.

Which is better? For the most part, I agree with this William Bernstein list of what kinds of bonds should be in an individual portfolio. I slightly prefer either 100% Treasuries, municipal bonds, or bank CDs – all depending on the after-tax yield. The idea is to pick the safest bonds that are hopefully the least correlated with your stocks. For example, the expectation is that Treasuries are more likely to go up when stocks are dropping.

But for the most part, I think a total bond fund is just fine as well. You can see it’s still pretty safe and you get extra interest in exchange for the extra risk that the market has decided is the proper compensation.

First things first – Buying a low-cost total bond index fund is very likely to return more over the long run than an expensive actively-managed bond fund. Choosing between Treasuries and a Total Bond fund is a secondary decision.

Bottom line. Lots of people own bond funds and ETFs that track the US Aggregate Index (AGG). These charts help show you what’s held inside such Total US Bond funds and how much more they yield than 100% Treasury bonds.

When you’re deciding where to invest your money, a good starting point is to consider every single business that you can invest in around the world. I still find it amazing that with a few clicks, you can own a share of Alibaba in China, Nestle from Switzerland, and Apple in the US.

Inside a post about investing in Emerging Markets stocks at Bps & Pieces, I came across this chart that tracks how all the investable stocks in the world could be broken down by total value (“market cap”) between the US, non-US Developed Markets, and Emerging Markets since 1990 (click to enlarge):

How much international stocks should you own? There is not a consensus amongst “experts” as to the optimal ratio, but I personally don’t deviate from this breakdown very much. My portfolio stock allocation has been set at 50% US and 50% non-US (including both Developed and Emerging Markets) for a while. Vanguard and Fidelity, which manage huge retirement funds, have settled on something closer to 70% US and the rest international.

Keep in mind that investable value is not the same as gross domestic product (GDP). China’s GDP is roughly 60% that of the US, but the total investable business value in China only makes up about 5.5% that of the US (about the same as Canada). Foreigners can’t invest in every public business in every country, and many countries don’t have stable public markets in the first place. In many ways, 50% US might even be too little if you really wanted to track the world’s business value.

Again, I go back to the classic Jack Bogle quote: “Don’t look for the needle in the haystack. Just buy the haystack.” I don’t know which companies will be the most successful in the future, or in which country they will be located. If it’s in the US, I will own them. If it’s not, I will hopefully own them as well. I hope that stable and transparent equity markets spread across the globe over time. I just want to sit back as a part-owner and earn a share of the profits.

If you care about valuations, you are probably aware that right now the US is “expensive” based on historical prices. Emerging Markets and Developed non-US are “cheaper”. But as usual, that is because US businesses are making lots of money (especially after tax cuts) and look strong, while the rest of the world has struggled on relative basis. Cheaper valuations could be taken as another reason to at least invest some of your holdings into international stocks.

Here are some charts from a Credit Suisse research report that you should keep in mind when reading articles about high valuations and future returns. I first saw the highlighting done by WSJ Daily Shot, but I can’t find the post anymore.

Here is a chart plotting the starting Forward P/E ratio and the subsequent 10-year annualized returns for US Stocks (S&P 500). As of September 2018, the Forward P/E ratio is approximately 17. As you can see, this is higher than the historical average, with the trendline suggesting that the average expected future return is about 5% annually. Chart like this explain why many articles warn of low returns ahead.

However, step back and you see that the historical range has varied from -1% to 8%. Over 10 years, that’s a big spread. It’s the difference between $100,000 turning into $90,000 or $215,000. Focusing on the line gives you a false sense of accuracy.

Here is a chart plotting the starting Forward P/E ratio and the subsequent ONE-year annual return for US Stocks (S&P 500). In the next year, just about anything could happen! You should shoot up 30%+ or drop 30%+. (There appears to be a typo with the vertical axis missing some zeros. I believe the range should be from -60% to +60%.)

P/E ratios are not reliable for market timing. Yes, P/E ratios are something to watch and consider, especially to keep reasonable expectations for long-term returns. But when people sell all their stocks, they feel a drop is coming soon, not 10 years out. That crash might happen. But it might not. As the John Maynard Keynes quote goes, “The market can stay irrational longer than you can stay solvent.”

In my opinion, it is a much more reliable bet to maintain broad exposure to stocks for decades. You can do some trimming around the edges if that helps you minimize regret.

Warren Buffett had his annual charity lunch today and was on CNBC for a short interview. As usual, he was asked about the current stock market situations and, as usual, he managed to sum everything up in a few folksy sentences. Here’s a direct quote from the full CNBC interview:

If you had your choice between buying and holding a 30-year bond for 30 years or holding a basket of American stocks, there’s just no question, you’re going to do better owning stocks. It’s more attractive than, considerably more attractive than fixed income securities. That doesn’t meant they’re going to go up or down tomorrow, next week, or next year, but over time, a bunch of businesses that are earning high returns on capital are going to beat a bond that’s fixed at roughly 3% or 30 years. And it’s not my field of specialty, but actually they look, stock generally (American businesses), they look cheaper than, generally, real estate.

[…] That’s what you have to do in investing. I mean, you’re sitting with some cash in your pocket. You have savings, and the question is what do you do with it? You can buy a duplex next door and rent it out to people and do fine over time or buy a small piece of farmland or something of the sort or you can put it into something fixed income, bonds, or bank deposits, or whatever it may be.

My interpretation is that you have invest your money somewhere, and if you have a 30-year time horizon and you don’t plan on timing the market in and out, then stocks are still your best bet. Over the long haul, stocks will still outperform bonds and cash (at current interest rates), and he thinks real estate as well right now. Timing the market is too hard to do. Predicting returns over the next 5 years is too hard to do. If you don’t have a long enough time horizon or can’t handle the swings, you shouldn’t be in stocks.

Long-term stock investors just have to take some lumps if prices drop for a while. Keep enough money in bonds and cash so you don’t panic and have money to spend in the meantime.

[I actually have an issue with the CNBC caption “Buffett: Stocks always more attractive than bonds”. He never said that. He specifically noted that the 30-year bond was paying 3%. In the past (1970s?), Buffett has invested in Treasury bonds when the rates were really high and the stock market was overvalued. If today’s rates were 8% instead of 3%, Mr. Buffett would be rational enough to adjust his opinion.]

I’ve read Jeremy Grantham’s quarterly letters and the GMO 7-Year Asset Class Return Forecasts for over 8 years. (Anyone can sign up at GMO.com for free.) Grantham gained successively more fame after avoiding the Japanese bubble, the Dot-com bubble, and the Financial Crisis. Given the recent talk about record bull markets, let’s take a look back and see how accurate the most recently applicable GMO predictions turned out to be.

Let’s compare the GMO 7-year return forecast with reality, in this case actual returns from January 1st, 2011 to January 1st, 2018. Below is the forecast chart as of December 30, 2010. I looked up the closest ETF or mutual fund that I would have invested in for each asset class, and then found the total return via Morningstar or ETF Replay for 1/1/2011 to 1/1/2018. According to BLS.gov and SmartAsset, the total inflation during that same period was 1.6% to 1.7 annualized. I added the actual 7-year real returns onto the old prediction chart below.

(The blurred-out asset classes are basically special investments that GMO was selling to their institutional clients that the Average Jane could not have easily bought via ETF or mutual funds. Since they didn’t make their position clear in the beginning, it’s hard to judge the subsequent results.)

Some quick and simple observations:

• US Large-Cap and US Small-Cap stocks did a lot better than forecasted. Compounded over the full 7 years, the difference was on the order of doubling your money vs. making nearly nothing.
• International Developed Large-Cap and International Small-Cap stocks also did significantly better than forecasted.
• Emerging Market stocks did significantly worse than expected.
• Bonds did about as expected across the board.

Reading the commentary is always illuminating and helps me better understand their forecasts. Grantham has addressed these results here and there, but basically he still thinks a reversion to the mean will happen eventually. Here’s a quote from one of his recent quarterly letters:

“Relative to what we were thinking [in 2010], emerging equities have done surprisingly badly, and the U.S. equity market has done surprisingly well,” said Grantham. “Was that the luck of the draw, which has no bearing on future returns? Was it a temporary phenomenon that will soon reverse? Or does it tell us something important about emerging being a value trap and/or the U.S. being extraordinary that we need to take into account in our forecasting of the future?”

The short answer to these questions is that while emerging markets “deserved” some of their bad luck over the last several years and the outperformance of the U.S. has made some sense, we do not believe that emerging is a value trap, nor do we believe that the U.S. has proved itself particularly extraordinary.

Here’s GMO’s most recent forecast as of July 31st, 2018:

I understand the fundamentals behind these numbers, but I can’t help but think that if you keep calling for a drop long enough, it’ll happen eventually. There’s a reason why market timing is hard and why it’s called a “risk premium”. You never know exactly when the drops will come. All you might really be able to say is that a drop is more likely now than when people were worried in 2014, 2015, 2016, 2017… The rubber band is stretched, but it’s been stretching for a while and it could still stretch even longer.

Bottom line. Forward-looking stock return forecasts can be off. By a lot. Most of them rely on a reversion to historical average valuations, which doesn’t always happen in a timely fashion (who knows, maybe not ever all the way back?). Forward-looking bond return forecasts are made differently, and more likely to be kept within a tighter range. I sitll believe in simple diversification between stocks and high-quality bonds.

After my last quarterly portfolio update, I rebalanced back to my target asset allocation this week. I sold some US stocks and went from 70% stocks/30% bonds back to 67% stocks/33% bonds. (I bought a little Emerging Market stocks as well.) In preparation for living off my portfolio, I also recently increased my separate “emergency fund” to two years of household expenses.

This is all part of my normal investment plan, but current prices do show a market valuation that is pretty darn optimistic. If we get Vanguard’s expected asset class returns along with their projected inflation of a bit under 2% annualized, I’d be actually be fine with that.

Of course, the real fear is something much worse – a severe recession and extended bear market. I like to imagine this ahead of time and give myself a mental “stress test”. This is more about imagining your future behavioral responses than running fancy computer simulations.

A simple version of such a crash scenario is to imagine the following:

1. Your stock holdings drop by half over a short period.
2. Your bond holdings have zero total return for the same period.

Below again is a chart including multiple 50% drops.

In addition, here is a JP Morgan AM slide that shows that sharp intra-year drops are much more common than you might think from just looking back at annual returns:

My personal portfolio is basically 33% US Stocks, 33% International Stocks, and 33% Bonds (33/33/33). In the crash scenario above, my portfolio balance would drop by 1/3rd and my new asset allocation would be 50% stocks and 50% bonds.

Based on past experience, I will probably find it difficult to keep buying stocks as they keep dropping. However, I will probably find it tolerable to hold on without selling. This might be a hoarder thing, although I actually don’t do that much with physical stuff.

How long could I hold out in a crash scenario? I think in term of “years of expenses”. First, I have my two years of expenses in cash. My withdrawal rate is 3%, so if I didn’t want to touch my stock holdings, I could withdraw funds out of my bond holdings alone and still have another 11 years of expenses (33% divided by 3). This would be my form of “rebalancing”. Instead of selling bonds and buying stocks, I’d just gradually sell bonds and buy food. 😉

In addition, my stock holdings would still distribute dividends. Right now the dividend yield is about 2%, but maybe in a severe recession the total dividend also drops to half of the original amount. Taking the cash, bonds, and depressed stock dividends together, I could go about 17 years without selling a single share of stock.

Hopefully, stocks will rebound well before 17 years pass. People like to point out that to get back to even after a 50% drop, you’d have to have a 100% rise. True. But look at the chart above again… 100%+ rises happen more frequently than 50% drops. It’s easy to forget how crazy the swings can be in both ways. Staying out of the market at the wrong time hurts too.

There are other options that are less fun and harder to count on. I could spend less money. Cutting back might come more easily when everyone else is cutting back as well. I could get more work. It might be harder to find a job in a severe recession, but even a lower-paying job would help.

Bottom line. This is my rambling stress test as someone planning to live off their portfolio for another 40+ years. Hopefully, you’ve gone through something similar that fits your situation. If you’ve got a good steady job, maybe it’s most important to ignore the noise and ABC (Always Be Contributing). Some retirees put 5 years of expenses into cash or bank CDs so they “know” that they can last 5 years without having to take money out of a depleted portfolio. If that sounds like a good idea, I’d do it sooner rather than later. There are many bank CDs earning around 3% APY right now.