Suggested Stock Allocation By Bond Yield For Logical Investors

Recommend stock allocation by bond yield for logical investorsWith interest rates rising across all treasury bonds, there comes a point where owning bonds becomes more attractive than owning stocks – where you’re willing to have a greater than 50% weighting in bonds in your portfolio. After all, treasury bonds offer a guaranteed return if held to maturity and they are state income tax free.

Even with the 10-year bond yield rising to ~3.25% on October 10, 2018 from just 1.46% on July 1, 2016, is 3.25% a high enough risk-free rate for investors to make a shift mostly towards bonds? Probably not.

In a research report written by Savita Subramanian, Head of US Equity & Quant Strategy at Bank of America Merrill Lynch, she believes the 10-year bond yield has to reach 4.5% – 5% before US equities start to look less appealing than bonds.

Take a look at this chart.

Historical Stock Allocation By Bond Yield

Average allocation to stocks by interest rate

Subramanian says, “based on several tested frameworks, 5% is the level of the 10-yr Treasury bond yield at which Wall Street’s average allocations to stocks peaked, and is their expected return of the S&P 500 over the next decade.”

I get why the bar charts would fall (lower stock allocation) after the 5% level. But it’s interesting to see how the stock allocation is lower when rates are between 1% – 4.5%. It’s also interesting to see how there was an uptick in stock allocation once the 10-year bond yield surpasses 9.5%.

My guess is that at several points between 1985 – 2018, despite low risk-free rates, investors were simply too afraid to invest aggressively in the stock market because there was some type of financial catastrophe going on. In other words, investors preferred holding a bond that yielded just 1.5% versus potentially losing 10% – 50% of their money holding stocks.

The Bond Yield Level Where I’d Switch

It has generally been OK to invest in stocks in a rising interest rate environment up to a point. A rising interest rate environment means there is inflationary pressure due to a tight labor market and strong corporate profits. Given corporate profits are the foundation for stock performance, a rising interest rate environment is an epiphenomenon.

Stock performance in a rising interest rate environment

I’ve currently got about a 60/40, stocks/bonds asset allocation in my House Sale Fund with the 10-year bond yield at ~3.25%. 60/40 is interestingly slightly more aggressive than the BOAML chart would dictate at similar rates: 57/43.

At a 3.5% 10-year bond yield, I would go 50/50. At 4%, I would go 40/60. At 4.5% I would go 30/70. And at 5%, I would go 20/80. I’ll stop at 5% since there is no way we’re getting above 5% again in my humble opinion. America is too smart and too efficient to allow inflation to runaway.

We know that based on history, a 50/50 weighting has provided a healthy 8.3% compounded annual return. That’s pretty darn good if you ask me, even if the returns are slightly lower going forward.

But remember, you’re not me. I’m more conservative than the average 41-year-old because both my wife and I are unemployed in expensive San Francisco with a son to take care of now. I cannot afford to lose a lot of money in our after-tax investments because I’m determined to stay unemployed until our boy goes to kindergarten in 2022.

At a 4% 10-year bond yield, we’re now at the popularly espoused withdrawal rate where you will maximize your take and minimize your risk of running out of money in retirement.  If you can earn 4% risk-free, that means you can withdraw 4% a year and never touch principal. Therefore, a 40% equities / 60% fixed income portfolio that has returned a historical 7.8% compound annual return since 1926 sounds quite reasonable.

Balanced portfolio historical performance

 

See: Historical Investment Portfolio Returns For Retirement

Suggested Stock Allocation By Bond Yield

Eventually, higher rates will slow down borrowing and make borrowing more expensive. As a result, corporate profits and the stock market will decline, all else being equal.

Based on historical Wall Street stock allocation data and the current economic environment we’re in, here is my suggested stock allocation by bond yield to consider for logical investors in a rising interest rate environment. Preferences will obviously vary, so use the chart as a gut check and make your own decision.

The goal is to always balance risk and reward in what I believe will be a permanently low interest rate environment. The investor who tends to blow themselves up generally underestimates their true risk tolerance.

Suggested Stock Allocation By Bond Yield For Logical Investors Chart by Financial Samurai

Bank of America Merrill Lynch believes we shouldn’t worry until the 10-year bond yield hits 5%. I say you absolutely should worry about your stock investments if the 10-year bond yield hits 3.5% – 4%.

I assign a 40% chance of the 10-year bond yield reaching 3.5% within the next 12 months, and a 25% chance the 10-year bond yield will hit 4%. If the 10-year bond yield hits 3.5%, I expect up to a 10% sell-off in stocks, and up to a 20% sell-off in stocks at 4%.

The more likely scenario is that the 10-year bond yield stays at 3.25% or less, and the yield curve resumes its flattening as the Fed raises rates further. In such a scenario, stocks are also capped as a recession usually ensues within 18 months after the yield curve goes flat or inverts.

At a 4% risk-free rate, a 30-year fixed mortgage rate will be at around 6%, choking off the housing sector. In such a scenario, I don’t see much incentive to take more risk in stocks anymore.

I’m confident the vast majority of you have seen your net worths double or more since the financial crisis. As a result, the return on your larger net worth no longer needs to be as great to return the same amount of income or principal appreciation.

I was aiming for a 4% – 5% rate of return on my after-tax investment portfolio when I left my day job in 2012. With a larger net worth today due to some fortuitous investments and hustle, all I need is a 1% annual return to match the absolute dollar amount I desired in 2012. But by the power of Greyskull, I can now get a 3.25% risk-free return so I’m pumped!

All of you should go through the exercise of figuring out your asset allocation at different 10-year bond yield levels. I highly recommend you run your investments through an Investment Checkup tool to see what your current asset allocation looks like compared to what you want. Asset allocations can shift dramatically over time.

Good investing is all about understanding different scenarios and managing your risk. With interest rates rising and such a huge run up in stocks and real estate, it’s only logical to dial down risk and enjoy life more.

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Related: The Proper Asset Allocation Of Stocks And Bonds By Age

Readers, at what 10-year bond yield are you willing to shift to greater than a 50% weighting in fixed income? Where do you see the 10-year bond yield going from here? Anything interesting you notice from the BOAML chart?


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