In the bad old days, the market was a combination of the wild west and a P.T. Barnum inspired circus. Scams, deceits and overall anarchy ruled the day. To win in the market, a person had to either be lucky or criminal. Most honest folk, preferring the safety of interest-bearing bonds, turned askance when approached by a carpetbag-carrying salesman touting the latest elixir alongside the “next, greatest, railroad stock this side of the Union Pacific.” All this Tom-Foolery ended with a resounding crash on a Black Friday one ghoulish October.
Not only did the market crash of 1929 signal the end of the Roaring Twenties, but is also ushered in the most economically dreary decade America has ever seen. Try as he might, all of FDR’s horses and all of FDR’s men couldn’t put the economy together again. Yet, two actions taken early in his term set the stage for the vigorous return of capital markets – and the economy – following the close of World War II.
The first was the creation of the Securities and Exchange Commission to monitor the honesty of the agents of the markets. The second was a series of Securities Laws to level the accounting playing field. No longer were corporate financials held close to the vests of a precious few. Now, everyone got to read – and analyze – those fiscal tea leaves.
In the midst of this, a couple of young (not quite forty) Columbia Business School professors – Benjamin Graham and David Dodd – penned what is today referred to as “The Bible” by securities analysts. Titled, appropriately enough, Security Analysis, the book – still recommended reading today by serious investing students – advocates a fundamental of “value” approach to selecting stocks. While Security Analysis was written for professionals, it is Graham’s (a.k.a. “The Father of Security Analysis”) layman book The Intelligent Investorthat ranks #1 in Amazon.com’s Finance and Investments & Securities categories.
After the bad old days, Graham & Dodd ruled the day. Indeed, it wasn’t really displaced until the advent of Modern Portfolio Theory (MPT) with its efficient markets, asset classes and asset allocation. During the ascendency of MPT, attention moved from individual securities to asset classes. This, in turn, led to the proliferation of asset classes (which is still going on today, q.v., “alternative investments”). But let’s just focus on the two major investment classes for a moment – stocks and bonds (we’ll leave the third major asset class – cash – out of the mix for now).
Graham ultimately believed stocks must be valued against bonds. Only when the stock offered a greater reward than the steady income of (usually, a government) bond should the stock be bought. In the broadest term, he felt no portfolio should have less than 25 percent stocks (because you never knew when “Mr. Market” would grow fat) and never less than 25 percent bonds (for those unexpected deals Mr. Market would regularly – though unpredictably – offer).
But, when you got right down to it, Graham advocated measuring stocks and bonds against the “risk free rate of return.” Now, there might be some question as to what “risk free rate of return” means, but think of it as a guaranteed short-term bond. In his original portfolio strategy, what today we would call asset allocation came about organically. In other words, we didn’t say “buy 40 percent bonds to reduce the volatility of the portfolio.” Rather, we’d say, “I could only find enough qualified stocks (i.e., those that will beat bonds) to fill up just 60 percent of the portfolio, so the rest will be in bonds.” Same result. Very different philosophy.
Fast forward a few decades during the pre-eminence of MPT. No longer were portfolios built from the bottom up (i.e., security by security), by they were formed from the top down via an asset allocation overlay. This injected bonds into portfolios au naturel, whether or not there were enough “bond-beating” stocks to fill the portfolio. (Remember, we’re talking long-term portfolios here. In other words, these are retirement portfolios.)
Now, when the professionals were in charge, they presumably had the experience to know when to avoid overweighting in bonds. But with the creation of 401(k) plans, professional management gave way to employee choice. (This coincided with the proliferation of asset classes, making things virtually unbearable for employees.)
With a natural tendency towards risk-aversion – even when it is demonstrably against their best interests – employees tended to overweight bonds in their retirement portfolio. Despite the 2006 Pension Protection Act’s desire to reverse this trend, a recent study (see, “Bad News Bonds Could Increase 401(k) Fiduciary Liability,” FiduciaryNews.com, January 28, 2014) shows the problem remains.
I know we’ve tried to educate employees. And many insist education will work “if it’s only better.” But what it really comes down to is that plan fiduciaries giving employees enough rope to hang themselves. Sure, ultimately the employees’ remain responsible for their own actions, but doesn’t the enabling actions of plan sponsors and fiduciaries demand some form of culpability.
Perhaps we all need to consider removing bonds from 401(k) plan options. We can leave our stable value “risk free” options in, for their purpose is short-term. All other options have a long-term object. And in the long-term, we all know equities are the only place to be.
Ironically, old time students of Ben Graham would find this an odd issue. That anyone would force long-bonds into a portfolio for reasons of “safety,” is contrary to Graham’s original teachings. If a stock beats a bond, buy the stock. If not, buy the risk free equivalent and keep the cash safe until Mr. Market offers a better deal.
Towards the end of his life, Graham threw away his lifetime philosophy when he was quoted saying, “In the old days, any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.
“To that very limited extent I’m on the side of the ‘efficient market’ school of thought now generally accepted by the professors, Benjamin Graham in “A Conversation with Ben Graham,” Financial Analysts Journal, 1976)
In a strange twist of fate, now that most leading academics have replaced the Efficient Market Hypothesis with elements of behavioral finance, we’re seeing a growing number of professional returning to the original wisdom of the Father of Security Analysis.