Sunday 18 December 2011

A Random Walk though 'Income' Portfolios

You may have heard of Burton Malkiel as the author of the best-selling book 'A Random Walk Down Wall Street', popularising the Random Walk theory of the stock market - the basic message being that the markets are (pretty) random and trying to forecast them is pointless. The answer to this randomness lies in diversifying your portfolio between different asset classes.

In a new article in the Wall Street Journal he sets out his thoughts on portfolio mix for the future.

The main benefit of diversifying asset classes is that these are then relatively uncorrelated - so don't all 'go south' at the same time. The main asset classes are cash, shares, corporate bonds and government bonds ('gilts' in the UK).

Over the 2000s, bonds have been an excellent diversifier by performing particularly well when the stock market declined and providing stability to an investor's overall returns.

But - as Malkiel point out - bond yields today are unusually low. In fact he sees the current low yields on government bonds, coupled with high inflation, as a kind of taxation.

He suggests two 'reasonable' strategies that investors should consider:
  • look for corporate (or, in the US, local tax-exempt State bonds or local public agency bonds) with moderate credit risk where the spreads over government bond yields are generous
  • consider substituting a portfolio of dividend-paying blue chip stocks for a high-quality bond portfolio.

He points out that yields for many companies' shares are now often higher than the yields on their corporate bonds - giving the example of AT&T: the dividends yielding close to 6%, almost double the yield on 10-year AT&T bonds, and AT&T has raised its dividend at a compound annual growth rate of 5% from 1985 to the present. Whilst the interest payments on bonds are fixed, AT&T's earnings and dividends should rise with inflation - making the stock/shares perhaps even less risky than the bonds.

He also like Australian corporate bonds, with Australia having (in his view) bright future prospects with its low debt-to-GDP ratio (about 25%), relatively young population and abundant natural resources.

The above thoughts fit in very easily with the DIY Income Investor approach, which suggests such a range of asset classes, and also suggests looking at the relative yields (and risks) in choosing what to invest in (beyond the basic emergency/reserve funds). However, I don't recommend investing outside your home currency - as I don't think many of are good currency speculators.

As noted in previous posts, yields of up to 9% or 10% are available in the UK for what I feel are reasonably safe investments.

(Thanks to Monevator for spotting the original article)

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

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