#$bond

Here is a sobering statistic for you: While the S&P 500 has generated annualized returns of 9.9% over the past 20 years—and a boring old asset allocation of 60% stocks and 40% bonds has managed to return a solid 8.7%—the average investor has eked out a measly 2.5%. 

Inflation has averaged 2.4% over the past 20 years, meaning that in real terms the average investor has returned pretty close to zero. And this during one of the best periods in this history of the U.S. stock market.

Source: JPMorgan

How are returns that bad even possible? If the Efficient Market Hypothesis is to be believed, investors should roughly track the S&P 500 over time, not underperform it by 75%. 

There are a myriad of answers, including everything from overtrading to underdiversification, but the biggest contributing factor is peformance chasing. Investors don't park their cash in the stocks or sectors promising the best value. They jump on whatever is trendy in a perpetual case of closing the barn door after the horse has already bolted.

Late last year, veteran financial writer Mark Hulbert crunched the numbers and found that following the investment newsletter portfolio that performed best during the previous calendar year resulted in annual losses of more than 17% per year. Not just underperformance, mind you, but actual losses. 

In looking at mutual fund performance, the numbers get a little better but are still remarkably bad. In a study done by Vanguard, a strategy of buying the top-performing large blend mutual funds over a rolling three-year period underperformed a naive buy-and-hold strategy by 34%. And while the numbers varied slightly across mutual fund market caps and styles (small-cap value, mid-cap growth, etc.), a naive buy-and-hold approach outperforms across all. Though we see these words so often we become blind to them, experience proves them true: "Past performance is no guarantee of future results." To be more accurate, the data here more or less guarantees that past performance is a guarantee of future results...it just so happens that the future performance in question turns out to be terrible. 

So, what are we to do about this? Buy an S&P 500 Index Fund, hold it forever, and wash our hands of the entire investing process? 

Well, we could do that. But there are better ways to skin this cat. 

Take a second look at the chart at the top of this article. You'll notice that a 60/40 portfolio of stocks and bonds came awfully close to matching the performance of the S&P 500, but what you don't see here is that it did so while taking far less risk. This is the essence of asset allocation: Essentially sprinkling "a little of everything" into a portfolio and regularly rebalancing with the understanding that there will be years when some pieces of the portfolio perform very well and others perform very poorly. 

There is an important catch that a lot of people seem to forget these days: Asset allocation works well when the constituent parts all have reasonably high expected rates of return and--importantly--returns that are not highly correlated.

Asset allocation is going to look a little different today than it did in years past because we are in a very different interest rate environment. I think you can make a very good case for eliminating most bonds altogether or at least for replacing a traditional long-only bond allocation with a tactically-managed one. This is what I have done in portfolios that I manage for clients. And for those clients that qualify, I've been incorporating low-volatility, absolute-returns strategies into the mix. 

For a simple and easy-to-execute asset allocation, consider something along the lines of the following ETF allocation: 

Domestic U.S. Stocks (45%)

17% Cambria Shareholder Yield ETF (SYLD)

11% iShares Select Dividend ETF (DVY)

11% Vanguard Dividend Appreciation ETF (VIG)

6% iShares Core S&P Small Cap ETF (IJR)

International Stocks (21%)

7.5% Cambria Foreign Shareholder Yield ETF (FYLD)

7.5% PowerShares International Dividend Achievers ETF (PID)

3% EG Shares Emerging Markets Consumer ETF (ECON)

3% Cambria Global Value ETF (GVAL)

Real Estate / Infrastructure (24%)

12% Vanguard REIT ETF (VNQ)

12% JP Morgan Alerian MLP ETN (AMJ)

Fixed Income / Cash (10%)

5% PIMCO Total Return Active ETF (BOND)

4% iShares TIPS Bond (TIP)

1% Cash

There is nothing sacred about any of these specific ETF positions. I chose them because I believed them to be a solid proxy for the risk/return exposure I was looking for, but I periodically swap out ETF positions when newer, better alternatives come along. The takeaway is that, while the specific vehicles may change, the asset classes remain pretty constant. 

For another perspective, check out The Gone Fishin' Portfolio. Alex Green chooses a few asset classes that I would avoid--such as gold miners--but his recommendations are solid and simple to implement. And if you really enjoy digging into asset allocation strategies, check out Meb Faber's latest, Global Asset Allocation. It's a short read and worth many times over the $3 price tag. 

There a million different ways to allocate a portfolio well, but most poorly-allocated ones have one point in common: They chase whatever has been recently hot.

Don't do that.

Disclosures: Long AMJ, BOND, DVY, ECON, FYLD, GVAL, IJR, PID, SYLD, TIP, VIG, VNQ

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

Twenty-five year old bond traders need to be reminded why the Federal Reserve started it zero interest rate policy in December 2008.  A lot has changed since they were freshman in college.  The recent bond rally and stock bust over the past several weeks saw the 10-year T-note yield touching 1.87%, (IEF) or (TLT), and the 2-year T-note, (DTUS) or (DTUL), yielding 0.25% on Wednesday, October 15, 2014.   That might make you might suspect that there is a lot of data suggesting that the Fed must shelve its plans to end its third program of bond buying program, quantitative easing, better known as QE3.  You would be wrong.  Actually all the recent data and trends points to an economy where the Fed is close to hitting its twin targets of 5.4% unemployment and 2.0% inflation.  That is why Fed funds rates will likely rise above 1% in 2015.

Figure 1:  The Unemployment Rate Has Been Falling by about 0.1% per Month in 2014 and is Below the Unemployment Rate when the 0% Interest Rate Policy Started.

Source:  St. Louis Federal Reserve

                The unemployment rate hit 10% during the Great Recession, but after six years of zero interest rate policies it is below 5.9%.  That is the lowest unemployment rate since before the zero-rate policy started.  Unemployment has been falling by about 0.1% per month for the last year.  If present trends continue, that indicates that the Fed will hit its 5.4% unemployment rate target in February 2015.  At the ends of QE1 and QE2—March 2010 and June 2011—the Fed was no-where near a 5.4% unemployment target.

Figure 2:  The Fed Has Had No Trouble Hitting Inflation Levels Above 2.0% Since the Great Recession Began

  Source:  St. Louis Federal Reserve, Oxriver Capital

                One of the myths of the current bond bubble is that the Fed will have a lot of trouble hitting the 2% inflation target, because of the after effects of the Great Recession of 2008-2009.  Yet, as you can see, the 12-month increases in the inflation rate, CPI-U, have been over 3% for substantial time periods since the 0% interest rate policy began.  The feared debt-deflation has not occurred even during the depths of the recession.  It is unlikely to be a legitimate concern in 2015.  The University of Michigan surveys consumers about their inflation views.  At last reading they expected 2.8% inflation next year.   On average, that reading overstates the next twelve months’ inflation by 0.3%.  Thus, that forecast is probably consistent with inflation of 2.5% over the next 12 months. 

Figure 3:  The dollar rose much more during the bull market of the 1990s.  Today’s dollar rise is very modest by historic standards.

Source:  St. Louis Federal Reserve

                One of the stories for why the bond market has started accepting such low yields all of the sudden is that the rise of the dollar is pushing down inflation.  Yet, from 1995 to 1998 the dollar index rose from 90 to 120 or about 33% percent while stock market rose by 20% plus per year and the Fed set Fed funds targets at between 4.75%-6%.  This year the dollar index is only up 4% since the start of the year.  That is a puny rally compared to other time periods and is unlikely to significantly impact inflation as it stands now.

                Other measures of the labor market also point to a strong and improving job outlook.

Figure 4:  Non-Farm Payrolls Have Been Increasing at a Strong 200,000 for the last Several Years

Source:  St. Louis Federal Reserve

                Figure 5:  Jobless Claims Keep on Falling

Source:  St. Louis Federal Reserve

                  The drop of jobless benefit claims may have helped the stock and bond markets realize that there is little or no data to suggest a slowing U.S. economy right now.  While a couple regional Fed presidents said they would be willing to discuss pausing or restarting QE infinity, neither said that was the expectation or the most likely scenario.  They both said, in so many words, that more QE would depend on data that is more pessimistic than they have seen thus far.  St. Louis Fed President James Bullard’s comments were the most interesting because he is seen as an inflation hawk and his comments coinciding with the market turnaround—(SPY), (VOO), (IVV), (IEF), and (TLT).  His comments appeared to have the effect of calming markets.  Further, after his comments, bond market prices moved closer to levels implied by the FOMC’s Fed funds interest rate forecast of 1.375% at the end of 2015.  Moreover, what was ignored was that his rate forecast was unchanged based on the larger interview.

The market prices of the 2-year T-note and Fed Fund Futures are a long way from the Fed’s expectations.  The Fed’s forecast should put the 2-year yield, (DTUS) or (DTUL) at closer to 100 basis points according to Oxriver Capital’s analysis, than the 38 basis points it was at on Friday, October 17, 2014.  That means the bond bubble is still in full swing, and many twenty-something bond traders may be out of work when it bursts.  

My advice to 20-something bond traders is to take the GMAT.  There is a great education to be gotten down in Cajun country, and it beats applying for unemployment benefits!

  Disclosure:  I am long DTUS and VOO.  I manage Oxriver Capital and am a finance professor at the University of Louisiana.