Buffett versus Asness on Bonds: Terrible Investment or Good Diversifier?

/Buffett versus Asness on Bonds: Terrible Investment or Good Diversifier?

Buffett versus Asness on Bonds: Terrible Investment or Good Diversifier?

By | 2017-08-18T17:08:37+00:00 February 27th, 2014|Tactical Asset Allocation Research, Macroeconomics Research|10 Comments
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(Last Updated On: August 18, 2017)

Financial news TV shows are a great place to wage philosophical battles, particularly with respect to investing, which tends to gets people’s juices flowing.

Warren Buffett went on CNBC back in May of 2013, and had some choice words for those who would consider investing in bonds:

 “In terms of…bonds, some day they will sell the yield a whole lot more than they’re yielding now…I don’t know…when it’ll happen…the question is always when…but you could have interest rates very significantly different than what they are now, in some reasonable period in the future.

 

…I like owning stocks. I do not like owning bonds now. There could be conditions under which…we would own bonds, but they’re conditions far different than what exist now.

 

…You shouldn’t be 40% in bonds…I would have productive assets. I would favor those enormously over fixed dollar investments now, and I think it’s silly to have some ratio like 30 or 40 or 50% in bonds. They’re terrible investments now…I bought bonds back in…the early 80s…We made a lot of money and we bought zero coupon bonds…The price of everything determines its attractiveness…You’ve got some guy buying $85 billion a month…and that will change at some point. And when it changes, people could lose a lot of money if they’re in long-term bonds.”

 

Got it, Warren. Don’t buy bonds.

Fast forward five months to October of 2013, when Cliff Assness sat down for an interview with Consuelo Mack, host of WealthTrack, a New York-based business news program that airs on public television:

Consuelo Mack:

[What is] one investment for a long-term diversified portfolio? What would you have us all own some of?

Cliff Asness:

“I am going to be very counterintuitive, and this is not a forecast. I am actually picking an expensive investment, one more expensive than stocks. I’m going to pick the bond market. And I don’t want anyone to listen to your show and go ‘god, Asness’s forecast – he loves bonds!’ Having said that, people understate the power of diversification.

 

Take the 1970s. The 1970s was a disastrous period for bonds (the decade). A portfolio that took equal risk in stocks, bonds, and commodities, something like we might prefer, did better than all stocks, and it had way more bonds.

Consuelo Mack:

In the 70s?!

Asness:

In the 70s. One thing: commodities were strong, which helped, which in an inflationary period, …when you’re really going to see your bond disaster, is not a certainty, but is not a bad bet, I think.

 

Second, the power of diversification is that strong…having three different horses even if one doesn’t work. You know, if you commit yourself to diversification…the glass is half empty way to view it is you’re always in the worst thing, but the glass is half full way is you’re always in the best thing. Turned out to be commodities that decade.

 

If you look over the long term, we think balanced risk [can make sense], even when rates mildly rise. We look at periods from the 40s to the 80s. You know your interest rate[s], they mildly rose, and then they shot up in the 80s, and they’ve been coming down ever since until very recently. Even over that rising period, having a relatively equal amount of risk in bonds, not even dollars, worked better than traditional approaches. So this is not a short term forecast. I am certainly not sitting here telling your viewers, ‘here is an undervalued asset – bonds.’

Mack:

But don’t abandon bonds, and always have a portion in your portfolio.

Asness:

Exactly. And I love it because it’s counterintuitive, and it gives me a chance to beat to death what is almost always our most important theme: diversification beats timing.

 

So who is right? Is it silly to have some portion of bonds in your portfolio, or does diversification beat timing?


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About the Author:

Mr. Foulke is currently an owner/manager at Tradingfront, Inc., a white-label robo advisor platform. Previously he was a Managing Member of Alpha Architect, a quantitative asset manager. Prior to joining Alpha Architect, he was a Senior Vice President at Pardee Resources Company, a manager of natural resource assets, including investments in mineral rights, timber and renewables. He has also worked in investment banking and capital markets roles within the financial services industry, including at Houlihan Lokey, GE Capital, and Burnham Financial. He also founded two technology companies: E-lingo.com, an internet-based provider of automated translation services, and Stonelocator.com, an online wholesaler of stone and tile. Mr. Foulke received an M.B.A. from The Wharton School of the University of Pennsylvania, and an A.B. from Dartmouth College.
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  • Remmelt

    Great debate topics, thank you.

    Can’t help but think that Buffet’s approach makes more sense to me in terms of return over decades. Buying overvalued asset classes to diversify comes at the price of being less concentrated in picks which you think will have outsized returns on average. You’d be wasting valuable research you’ve performed by diluting your portfolio with mediocrity, with GMO forecasts in January putting the real return of 10-year treasuries at 0.4% (https://www.gmo.com/Europe/CMSAttachmentDownload.aspx?target=JUBRxi51IIBwJ2T4%2bJCs9Qg7VfMu4dotg%2b22LcIdPrIo8v%2fyh4TgeNXPsL5MBFxlK1FrYHJU0pwQ5AQrWzV9MOANJHNzOirB8m1VG%2fV4FI%2b%2b7zTZUG8D6g%3d%3d). Though I could understand having some portion in short-term bonds in order to be able to buy cheaper asset classes in the future as they mean-reverse (I mean CAPEs, Tobin’s Q and GMO asset forecasts are putting stock returns at below -1%). Another exception would be buying statistically cheap distressed debt, which is less dependent on interest rate movements and more on recovery of principal.

    Leveraging medium to long term bonds would compound the problem in my opinion.

    My further view is that Asness’ focus on diversification would be suited for less volatility (or perhaps a higher Sharpe or Sortino ratio) and make fund investors less scared over the short term (you could argue you’d be helping certain clients grow their capital by reducing the chance of them fleeing at what would quite likely be the wrong time). It might be beneficial for people that need immediate access to their capital, but not for long-term compounding of capital.

    Would I be given the choice, I would go for the Buffet approach. There’s enough to buy (foreign stocks, carefully selected US stocks, diversifiers like gold which is less bubbly now, certain currency hedges and short / put positions on high-flyers, etc.) that will reduce the risk of long-term permanent capital loss, without having to resort to the mediocrity of medium to long-term bonds.

    Then again, I’m biased, not very knowledgeable about quant investing, and would like to read arguments for Asness’ case.

  • Remmelt

    For example, I think the Quantitiative Value approach is a great method to get outperformance over the long run.

    Deciding to have 80%QV and 20% bonds especially at current valuations, in case the stock market implodes but bonds stay intact, would be a waste of that research.

    However, I think that if having moving part of your portfolio in short-term treasuries depending on how overvalued a combination of CAPE, Tobin’s Q, Stock Market/GDP is, historically would have outperformed QV, that likely would be a good idea. Or if moving into short-term treasuries if there are no more stocks available below a certain absolute limit of P/EBIT, would have outperformed historically. Or even if returns would have been approx. the same, as you are taking less risk with treasuries.

  • Marc

    The answer to the question is driven by their ultimate view of risk. Buffett is a value investors who sees risk as a permanent loss of capital, is benchmark agnostic and holds a concentrated portfolio. Asness is an institutional investor more interested in outperforming a benchmark and holds a diversified porfolio (391 stocks in the lastest Core Equity Factsheet).

    It seems clear which is more interested in performance and which is more interested in gathering assets. The track records of investors with each style is also very clear. I know who I am siding with.

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