We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with consequent inverse range of between 75% and 25% in bonds
This sensible advice from Benjamin Graham is aimed at what he called ‘defensive investors’:
The defensive (or passive) investor will place his chief emphasis on the avoidance of serious mistakes or losses. His second aim will be freedom from effort, annoyance, and the need for making frequent decisions.
Similarly Graham defined what an ‘enterprising investor’ was:
The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort in the form of a better average return than that realised by the passive investor
As a standard rule the Thomas Value Report has a mix of both stocks and bonds which is reflected in the model portfolio and subsequently my SIPP.
But striking a balance between stocks and bonds on a 25/75 basis is not a hard and fast rule for me.
Since I’m an enterprising investor I take advantage of discrepancies between price and intrinsic value regardless of what the value of the general market may be.
January’s investments saw a purchase in IG Group (LSE: IGG) as well as a UK government bond fund simply to start the portfolio off but I’m finding – even at market highs – stocks selling well below their intrinsic value.
Returns from stocks have outperformed returns from bonds over the long haul when stocks have been consistently purchased at sensible prices.
It follows that portfolios made up of stocks bought this way tend to lose less in bear markets than their benchmarks and return more than their benchmarks in bull markets.
But that’s for me.
If you are a defensive investor or very new to investing then at market highs (which we are experiencing right now) Graham’s advice of having 75% of your portfolio in bonds and 25% of your portfolio in stocks is good to follow until you gain enough experience to be more selective in your stock purchases and increase your allocation towards them.
In other words, as the PE ratio of the S&P 500/FTSE 100 rises so does your allocation of capital towards bonds, as the PE ratio falls your allocation is weighted more towards stocks.
Chart of the PE Ratio (TTM) of the S&P 500
As can be seen from the above chart from 16 December 2015, the PE ratio of the S&P 500 is high when you consider the historical ups and downs from the chart.
You can also clearly make out what happened to the S&P’s PE ratio at the time of the 2007/2008 financial crisis – the PE ratio was literally off the chart.
It’s almost the same story with the dot com bubble of 2000; the S&P PE ratio was historically high.
It is clearly more art than science to correlate the PE Ratio of the S&P 500 to a sensible allocation of your portfolio between stocks and bonds but at least it gives you a good idea of how to go about doing it.