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In his classic work, The Intelligent Investor, Benjamin Graham suggested that passive investors, who do not actively research the best value stocks, may achieve their margin of safety against the likelihood at times of falling equity prices, by keeping a percentage of their liquid assets invested in bonds. Then, if stocks do fall substantially, they can be rebalanced with the bond assets.
For instance, if one begins with $1,000,000, half in bonds and half in stocks, but the stocks fall 20%, from $500,000 to $400,000, so that the total is now $900,000 (assuming, for simplicity, that the value of bonds has remained the same), a rebalanced portfolio would then have $450,000 in bonds and $450,000 in stocks. The $50,000 in new stock purchases would be made while stocks are relatively low in price.
Later, once equity prices broadly increase again, raising one's stock portfolio, for instance 22.22%, to $550,000, the assets can be rebalanced once more, with stocks being sold high to purchase more bonds, and restored again to the fifty/fifty ($500,000 each) relationship between the portfolios.
Although it might seem in the above example that nothing has changed, since one again has $500,000 each in bonds and stocks, actually one has achieved a major objective of investors, to buy low and sell high, and has, at the same time, maintained a relatively low risk total portfolio.
In practice, even in fairly weak equity markets, stocks tend over the long-term to go up a little more than they retreat. Thus a more likely scenario might be that, instead of going up just 22.22% in the next bull market, one's equity portfolio might rise 33.33%, to $600,000. At the same time, the bond assets would have been providing an annual yield and the stocks some dividends. If we assume the yield income was not required for expenses and was protected from taxes in a retirement account, it is reasonable to expect that, over a hypothetical three year period, these combined dividend additions would have added at least another $120,000 (4%, times the original $1,000,000, times three). Thus, even if the stock portfolio were very volatile, falling 20% the first year, rising 33% the second, and falling 20% again the third year, the total, including a combined yield of $120,000, would be about $1,063,000. In contrast, an all equity portfolio would have fared worse, ending at just about $913,300, including $60,000 in stock dividends over the period. (Note: assumes, again for simplicity, that stocks would average dividends of 2% and bonds 6% per year of the initial investments, through the three year period. At the time of writing, the "Value Line" yield is 1.9%, while the Aaa corporate bond average yield is 6.5%.)
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