Morningstar Advisor - February/March 2010 - 47

much about where stocks would go in the interim. You could be comfortable that your terminal value wasn’t going to depend enormously on the ups and downs of the stock market over your holding period. On the other hand, as we got into the high levels of valuation up to the 2000 peak, the dividend yield was about 1.25%, which meant that the duration of stocks was about 80 years. In other words, if you were drinking from a sippy cup at the time, it may have made sense to have all of your assets in stocks and still have some confidence that it wouldn’t matter where stocks went over the lifetime. But if you had a horizon of less than that, it mattered enormously. People found that out the hard way, not only in 2002, but in the decline that we’ve recently had. You want to match the overall duration of your assets to the lifetime over which you expect to use the money. RL: Gus, do you think that John’s analysis that the overall allocation of a portfolio may have to change dramatically with the underlying valuation of the market is appropriate for advisors and investors? GS: In concept, yes, absolutely. We could Applying that to the individual investors is more difficult, because your liabilities aren’t just changing with interest rates. It’s the fact that you can’t afford the same level of volatility as your time horizon is shortening. So an asset allocation should be derived based on the circumstances of the individual, and it should be adjusted as those circumstances change. GS: You’re assuming that the payout ratio is constant, and in fact … JH: No, I haven’t said anything about earnings. GS: But you can easily get to a different dividend yield just by changing the payout ratio without changing … JH: That’s why I said that I’m assuming that An Algebra Concept RL: Does moving the glide path of targetdate funds with duration make sense? Right now, the glide path of a 2055 fund would be exactly the same if equities had a 40 P/E ratio or a 10 P/E ratio. GS: I am not familiar with any work that says we won’t have a substantial variation in dividends, which we’re really not observing in terms of the relationship between dividends and normalized earnings. That payout ratio is not highly variable at all. GS: Payout ratio has gone down, and stock buyback has gone up. that the volatility of equities goes up as dividend yield goes down. That’s really the important thing that investors need to solve. They need to moderate volatility of their portfolio. JH: But duration is, in fact, strictly a mathematJH: But stock buybacks are a way of reducing perhaps come up at different endpoints using different methodologies, but the idea that as your time horizon shortens you need to adjust your portfolio is absolutely recognized by all investment advisors. When we measure the duration of a bond, what we’re really seeing is the volatility relative to changes in interest rates. The best example of using duration is for something that’s truly liability-driven, like a pension plan, because there we know that the liabilities are driven by changes in interest rates; therefore, you want to make your investments very sensitive to changes in interest rates as well. A lot of corporations are moving to liability-driven investing, and it makes all the sense in the world. ical measure of volatility. It’s the elasticity of the security price to changes in the underlying rate of return. Let’s put it this way. If you have a 100-basis-point increase in a 2% dividend yield, by definition you’ve lost a third of your value, because you’ve gone from a 2% dividend yield to a 3% dividend yield. On the other hand, if you go from a dividend yield of 4% to a dividend yield of 5%, you’ve lost a much smaller percentage of your assets. It’s just a strictly mathematical relationship. You take the old dividend yield divided by the new dividend yield and subtract one. GS: Well, that holds with bonds. JH: No, it’s a mathematical fact for stocks, too. the float as a result of corporate insiders handing their earnings over to themselves and not wanting it to appear in the float. We can argue about the notion that buybacks are a distribution to shareholders, which I would strongly argue against. But the fact is that you’re not seeing an enormous amount of retained earnings less buybacks, which is actually what investors are going to get outside of the dividend yield. If you were, you would see book values expanding much faster than you’ve observed over the past decade or two. GS: You don’t see that high a correlation between dividend yield and price/earnings ratio, and you also haven’t seen that high of a correlation between dividend yield and volatility of equities. JH: The reason you don’t observe it in the price/ If the dividend yield on the S&P 500 goes from the current 2% to 3%, an investor, barring massive dividend growth, is going to lose about a third of his money. It’s not a bond concept; it’s an algebra concept. earnings ratio is because earnings year to year have enormous amounts of noise. You have to normalize these things. For example, right now we’re looking at a trailing 12-month figure for S&P 500 earnings of something around $7. That’s certainly not anything close to the normalized level of earnings that would be expected to be sustained over the MorningstarAdvisor.com 47

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Morningstar Advisor - February/March 2010

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