Why Not 100 Percent Equities

A question that has long bugged me is: Why not 100% equities? If we agree that we should be very long-term oriented, and if we are convinced that over any 20-year interval stocks should outperform bonds, then why not target 100% stocks?

Well, the roller coaster ride of the stock market could be very upsetting. The worst eventuality would be if, at the bottom of a bear market, the stomach of some future investment committee weakened and the committee reduced the allocation to common stocks at that time. So how can we ease the roller coaster ride a little but not impair expected returns unduly? At this point, I would like to introduce my personal definition of the term "equities." By equities I mean all investments whose expected returns are generally as high as, or higher than, common stocks. I am big on diversification and believe in reducing the volatility of our aggregate portfolio through diversification. But I am convinced that strong diversification can be achieved without resorting to large allocations to assets whose expected returns we believe are materially below that of equities—such as traditional fixed income.

Judicious use of fixed income might let us boost our aggregate return per unit of risk, but unless we can leverage our overall portfolio (and that's tough to do), we can't spend risk-adjusted returns. If we are truly long-term oriented, why not accept a little higher volatility in exchange for higher returns?

Before relegating fixed income to oblivion, let's ask what purpose fixed income should serve in a portfolio, and how best we can fulfill that purpose. For an endowment fund or foundation, traditional investment-grade fixed income serves two key purposes:

1. Traditional fixed income lowers the expected volatility of the portfolio. This is the most common purpose of fixed income, and the purpose I would hope to achieve instead through the use of diverse asset classes that have materially higher expected returns than fixed income.

2. Fixed income gives the portfolio needed strength whenever interest rates decline and stock prices decline at the same time, as in a recession—or heaven forbid, in a depression. No asset class serves this function as well as fixed income.

So maybe there is a bona fide rationale for fixed income, after all. If we must use fixed income with a lower expected return to fulfill purpose 2 above, how can we do it most efficiently? The answer, it seems to me, is in long-duration high-quality bonds. This approach will (1) give us the maximum protection for the economic scenarios where we need protection most and (2) enable us to reduce materially the size of our allocation to lower-expected-return assets.8

For pension funds, bonds serve a further crucial purpose, which we shall cover in our final chapter, "What's Different About Pension Funds?"

8Another approach is to use interest-rate futures combined with market-neutral programs—programs that have little or no correlation with other investments in our portfolio. This approach is called Portable Alpha and will be covered in Chapter 5.

This discussion, however, focuses only on one aspect of asset allocation. Let's now describe a tool that can be immensely helpful as we approach that all-important decision about our fund's Policy Asset Allocation—a tool known as the "Efficient Frontier."

Your Retirement Planning Guide

Your Retirement Planning Guide

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