Famed World War II General Douglas MacArthur said “Old soldiers never die. They just fade away.” The same can be said about old theories.
In 1986, three professors named Brinson, Hood, & Beebower (BHB) published a research paper entitled “Determinants of Portfolio Performance.” They showed 93.6% of a portfolio’s performance was determined by the asset allocation. (A similar 1991 study showed a 91.5% correlation.) Asset allocation refers to the allocation between stocks and bonds. For example, a 70/30 allocation refers to a portfolio with 70% allocated to stocks and 30% allocated to bonds. The theory was simple enough to become widely accepted, and it was very widely accepted, indeed!
The theory seemed to work well enough until 2008, when the Great Recession crushed the economy. To support our economy, as well as the stock market, the Fed crushed interest rates. In effect, our “free market” economy then became managed capitalism, which has no room for the BHB theory of asset allocation. Remember: bonds lose value when interest rates increase. That means you lose money, unless you hold the bond until maturity. Conversely, the value of a bond increases when interest rates decrease.
With interest rates at historic lows, that means bonds are already at historic highs. The Fed is expected raise interest rates within the next twelve months. That’s why Warren Buffett recently warned “bonds are not the place to be these days.” He famously invested his wife’s inheritance 90/10 or ninety percent invested in stocks and ten percent in cash.
Until interest rates are normalized and we return to a less-managed economy, I’ll listen to Warren Buffett and avoid bonds.