A New Mental Accounting for Equity Exposure
Common Method of Allocating Between Equity Securities and Debt Instruments
Portfolio design customarily begins with a decision regarding the percentage to be allocated to equity securities versus debt instruments[1]. Allocating and rebalancing to a percentage is simple; but the percentage to be allocated is typically nothing but a rudimentary judgement call, based upon ill-defined risk tolerance and age of the investor.
This method lacks specificity and is more art than science. The traditional 60/40 portfolio may seem cautious to one person, and quite risky to another. An advisor can communicate the volatility of a portfolio in terms of historical deviations of returns, but investors typically do not understand the magnitude of dollar losses until they experience them.
The time horizon of an entire portfolio is also problematic. Certain accounts or holdings are commonly earmarked for distinct purposes, each with its own time horizon. This leads to making exceptions to the overall portfolio equity percentage. For example, an investor with a 100% equity portfolio might hold a short- term bond or cash equivalent that is earmarked for an upcoming withdrawal and exclude it from the overall equity allocation.
As a result of this imprecision and lack of quantifiable rationale, the justification for the percentage allocated to equity securities and debt instruments are often less than satisfactory.
Best Use of Equity Securities and Debt Instruments
The superior long- term returns and higher price volatility of equity securities over debt instruments is well established. Because of this, the odds that an equity portfolio will produce excess returns over debt instruments is little better than a roll of the dice over very short periods, but with increasing time, higher returns become more and more likely. There is no historical precedent for a period exceeding 15 years in which the US stock market did not fully recover to its former high- water mark.[2]
Over the 95 -year period in which we have reliable empirical data, the US stock market[3] has achieved an average annually compounded return of 10.3%. The return of short-term, high-quality debt instruments[4] over that same 95-year period has been 3.3%. In nominal terms then, US equities have had a rate of return over three times that of debt instruments, and the real inflation adjusted difference in returns is even more pronounced.[5] The undeniable conclusion is that for long periods, investors will almost certainly achieve better results with a diversified portfolio of equity securities. The conclusion holds whether the portfolio consists strictly of U.S. stocks, or a portfolio diversified by region into domestic, international and emerging market equities.
Conversely, the lower returns and volatility of debt instruments are clear. If the goal of an investment is to be fully available without loss to fund an upcoming withdrawal, the price stability of debt instruments makes them more dependable than equity securities. The conclusion is that near-term withdrawals are best funded by investing in debt instruments.
It might be helpful to summarize the utility of equity securities and debt instruments this way: The best use of equity securities is long term growth, and the price paid is the distress and loss experienced in bear markets. The best use of debt instruments is price stability, and the price paid is lower long- run returns.
A New Mental Accounting
With these concepts in mind, we can change the method to determine equity exposure. Rather than relying upon the fuzzy concepts of risk tolerance and the age of the investor, we can allocate both equity securities and debt instruments to their best use. This is accomplished by funding near-term withdrawals with debt instruments and allocating the remainder into equity securities to achieve longer term, indeterminate goals. In other words, debt instruments are for specific, short- term needs, and equity securities are for long-term, indeterminate goals.
This method starts by determining the dollar amount required to invest in debt instruments to fund net withdrawals over a set number of years. For example, an investor with a $1 million portfolio who wishes to reliably fund planned withdrawals of $80,000 per year over five years would allocate $400,000 to debt instruments, with the remaining $600,000 invested into equity securities. There is comfort in knowing that the withdrawals over the next five years can be met strictly with debt instruments. In the event of a bear market, equity securities have five years in which to fully recover, avoiding any loss due to forced sales of equities during that period. This is a reasonable rationale for a 60/40 portfolio.
A more cautious investor may want to fund withdrawals over a ten-year, or even a fifteen-year period. Regardless, this concept makes sense, and is not based upon an ill-defined risk tolerance or time horizon.
This article is designed to serve as philosophical discussion, not as advice for any specific situation. Asset allocation between equity securities and debt instruments is a complex topic that is not fully addressed here. Before making any decisions regarding portfolio design, consult with a CFP® professional who is knowledgeable about your specific financial circumstances.
[1] Herein the term “debt instruments” refers to short duration, high quality bonds and cash
[2] From the 1929 Crash, the S&P 500 Index didn’t fully recover until late 1944. Source: Dimensional Matrix Book 2024, page 12.
[3] S&P 500 Index, 1926 – 2023. Source: Dimensional Matrix Book 2024
[4] As measured by One-Month US Treasury Bills; Source: Dimensional Matrix Book 2024
[5] In the period from 1926 through 2023, the nominal annually compounded return in the one-month T Bill was 3.3%, while the CPI rate was 2.9%, leaving a real return of just .4% per year. Source: Dimensional Matrix Book 2024, pages 34 & 48.
