My BS talking on asset allocation

Recently a friend asked me which investment portfolio will be better, stocks only or stocks with other asset classes. This is a good asset allocation question and here is my response: This is basically a asset allocation question. Most of people won’t realize it but appropriate asset allocation is considered the most critical factor determining the effectiveness of wealth growth. Of course there is always exception that few gurus only put money in very concentrated few stocks and still be very successful. But for the vast majority of people, a diversified asset allocation is always better than narrowly concentrated portfolio with much less risk involved for long term investment. So at a high level to answer your question, I would certainly suggest to avoid stocks only investment but investing in major assets like stocks as well as bonds, real estate, precious metals etc. Life insurance may not sound like an investment but personally I treat it as an alternative to bonds. As you may know I personally don’t like IUL but CV focused WL. Asset allocation is a big and complex topic with a lot of personal touch involved. I’ll write more later to share my personal view on it.  

As I said before, I have never expected my opinion will be agreed upon by everyone as I often disagree with many others. Sure enough, I immediately see some criticism on my asset allocation philosophy and this time is it even a bit harsh: I’m considered to be talking BS.😒😒 For one reason, it is said all assets will go down together when the market is crashing. For another, one should not put money into bonds when the interest rate is going up. It is not an unreasonable rebuke actually but as I said, asset allocation is a very complex topic and the details involved are critically important to fully assess whether a diversified asset allocation makes sense. So let me add a bit more flavor to my BS to see if it makes my asset allocation philosophy less BS. 😜😜Joking aside, let me start with the following chart that compares S&P vs Gold (GLD), gold stocks (GDX) and Treasury bond (TLT) during the worst market crash in 2008-2009 in the recent history.

  Do you see an all-together crash among the four? Apparently not! When S&P stocks plunged 30-50% during 2008-2012, gold shot up 150%, gold stocks and bonds jumped up 20-30% as well.  This is one real life example to demonstrate why a diversified asset allocation for your portfolio could be very important to stabilize your asset value during a bear market. Having said that, I do agree nowadays most assets, if not all, are more and more intertwined and correlated to each other to various degrees. A total separation from each other is not always possible, especially at a random given time point. But over time, the tendency is still there that stocks tend to go inversely with bonds and precious metals may tend not to go together with stocks. Even when they go down together at a time, the degree of decline may be very different, hence lessen the pain of a drastic devaluation of a diversified portfolio.

Now comes to the point of bond investment. This is even more complicated and therefore let me spend a bit more time to explain. But first of all, let me be very clear upfront that I have been bearish for bond in general for quite some time already and have talked against buying bonds purely for investment purposes. Here is what I said a few months ago: As a general rule, you don’t want to buy bonds, especially long term bonds just for higher interest income as you will be hurt more when the underlying bond values decline. Of course, as part of asset allocation for your whole portfolio, bonds should always be part of it and for that reason, buying some bonds is reasonable. Personally I don’t want too much of it. I highly suggest you read this blog again for a more comprehensive understanding about my view on bonds.  Having said that, keeping some money in bonds as part of asset allocation for your portfolio is a wise strategy in my mind. At least there are three ways one may consider.

• Short term Treasury bonds. While it is critically important that one should not commit to long term bonds as they are subject to sharp devaluation due to increasing interest rate, the risk of investing in short term bonds is quite low and virtually none when talking about short term Treasury bonds. Why so? Well, for Treasury bonds, it is a legal obligation for the US government to pay the interests and the principle fully back at maturity. The chance for the US government to go broke and not to meet the obligation for the next few years can be considered zero. That’s why the US Treasury is often treated as equivalent to cash. It is very easy to open an account with the U.S. Treasury at its Treasury Direct website ( link to the Treasury Direct website). It just takes a few minutes to complete the forms and then you can link this account to your bank account. When this is set up, you can look into pre-schedule bids in any bill auctions that interest you.  Let’s say you are interested in the four-week auctions (as I’d suggest to go for short-term bids) and get them.  You should see the Treasury Bills in your account with the corresponding interest rate and maturity date. Four weeks later, the bills get redeemed, and the principal plus interest is deposited back into your bank account. If you don’t need the money right away, you can schedule the bills to roll over for another four weeks. The interest rate keep changing of course at each bid. As of now, the 4-weeks Treasury yields about 1.5-2% annually, a much better interest than your bank account for sure.

Of course, you won’t get rich by investing in such short-term Treasury bills but it is extremely safe and secured with zero downside risk regardless how badly the stock and bond markets may go as long as you hold them to maturity for 4 weeks. The idea is to keep portion of your portfolio in such super safe bonds to ensure the overall downside risk is reduced to the extent you want. It is a personal preference regarding the portion size for your portfolio; the bigger, the less downside risk. This short term rollover strategy is especially favorable in an increasing interest era, since you will get higher interest rates along with each bid if the overall interest rate is going up. If the stock market indeed crashes at some point (trust me it will come and probably more severe than the 2008 crisis), your money in this portion is not only kept safe and intact, it can also be used to buy lows when everything is on sales in the stock market. That’s the beauty of an appropriate asset allocation with some low risk bonds like short term Treasury bills. Just note, 4 weeks term is just an example and there are many different time duration like 6 months, 12 months or 24 months etc. In general, bonds for 5 years and below have less impact from the interest rate hike and the key is to find a duration that you feel comfortable to hold on for the whole period. Then your downside risk is minimized.   

• Distressed corporate bonds. This is a more specialized investing arena and more for experienced bond investors. In a nutshell, during panic selloff everything will be on sales. Then savvy investors may find gems in the rocks as some corporate bonds with little chance of default may also be sold on huge discount. Have you heard Howard Marks? He is a legendary distressed-debt investor, a truly maestro of distressed debt! He started his high-yield debt investment career back in 1978 and he has made his funds' investors average annualized gains of 19% over the past 25 years. You can hardly find anyone one who can do this even in the stock market, let alone in the bond market. You may find more details about him here.  I personally also know some gurus who made 30-50% consistently from distressed bonds during 2008-2009. As I have alluded to before, we may start to see a huge run on corporate bonds within the next 5 years. Actually it may start as early as next year. Why? There are trillion dollars of corporate bonds that will be due to rollover in the next 2 years. Probably half of them are issued by those companies that have no cash flow to support the debt. They will be in big trouble to rollover their debt when the interest rate is going up. We are going to see real fireworks to play out when more and more companies cannot serve their debts and go defaulted. That will be the Lehman Brothers moment that may likely trigger a domino fall in the bond market and then the stock market. And that will also be the thriving moment for the savvy distressed debt investors.
• Life insurance. I have talked about the great benefits of life insurance many times (see here and here). But you may wonder what’s the deal to link life insurance to bond investment? Well, to me a good and cost-effective life insurance is a great alternative to bond investment and as such, could also be treated as part of the asset allocation in lieu of the direct investment in bonds. You see, for the vast majority of folks, bond investing is not an easy job in the interest-increasing environment. The short-term Treasury bills, while extremely safe, are rather low in return. Distressed bonds are too technical and challenging for most people. But life insurance companies are basically doing bond investment for their business. They hold tens of millions of funds and have top bond experts to manage and carry out various sophisticated and safe bond investment strategies that cannot be done by individual investors like you and me. The key is to find good insurance companies with long term track records and to set it up with reasonable cost. And for safety reason, I’m only interested in non-stock based permanent life insurance that will guarantee a base return via increasing cash value in addition to death benefits. Here are a few key points that convince me to include life insurance as part of my overall asset allocation strategy.
  • It is my firm belief that we are going into a long lasting interest increase era. If history is any indicator, it tends to last for decades. In this environment, it is very difficult for retail investors to make good returns from bonds. But history has demonstrated that insurance companies are generally doing well in high interest/inflation era as they do have the needed expertise for bond investment. By setting up a life insurance, I’m basically hiring an bond expert to invest for me with guaranteed tax-free minimal return (5% for my policy as of now with 4% fixed plus 1% floating dividend). If I’m right, the return could be much higher in the future as historical dividend return (1% for now) could go up to 10% as they did in the last peak interest time (80s-90s). So I’m really expecting 5-10% total tax-free return in an extremely safe bond investment from my life insurance during the time the bond investment is typically not performing well for general people.
  • Of course, I could be wrong and interest rates could just stay as low as now. But regardless, I’m still at least getting a 5% return tax-free (equivalent to 7-8% before tax for my tax rate). Should I complain for this asset allocation portion that will keep my portfolio very safe?
  • Another very important factor for me is to know that this type of cash value (CV) growing life insurance is almost like a high yield saving account that I can use the CV anytime and for any purposes, even since day one. It is my money to use with no credit impact whatsoever! As a side note, our family has just got two living examples of using CV: my son is using his CV to pay for his tuition for his MBA (it is not a small amount) and I’m using my CV to pay off my second home mortgage with a 5/1 arm that has come to its end. The process is extremely smooth and just like withdrawing money from my saving account without any headache.
    As you know I’m holding a very bearish view of the stock market in the next 5-10 years. I think the chance is very high that we will be hit by another major financial crisis down the road due to historically high debt burden that has been piled up for decades, especially in the past 10 years. If this reckoning unfortunately comes indeed, everyone’s stock portfolio will be hit significantly to the downside, but my life insurance will stay intact regardless how bad the market goes. Even more beautifully, I can use the big chunk of my CV accumulated safely in the policy to buy good stocks on huge sales. I wish I could do more buying during the 2008/09 crisis but my money was largely tied up with stocks already and I couldn’t be doing much more than what I had wished. But I’m mentally and monetarily ready now for the moment to come to do more aggressive bottom fishing when such kind of historical moment presents itself!