Portfolio Strategy and Expectations for the Defensive Investor

Key Insight

The defensive investor prioritizes safety and freedom from bother. A recommended policy involves dividing holdings between high-grade bonds and leading common stocks, with the bond component ranging from 25% to 75% and the common stock component inversely mirroring this. A simple strategy is to maintain a 50-50 proportion, rebalancing when market movements cause a shift of approximately 5%. Alternatively, the common stock allocation can be reduced to 25% if the market appears dangerously high or increased towards 75% if declining prices enhance their attractiveness.

In 1965, high-grade taxable bonds yielded about 4.5%, and good tax-free bonds yielded 3.25%. Leading common stocks, with the DJIA at 892, had a dividend return of only about 3.2%. It was suggested that at normal market levels, investors could expect an initial dividend return of 3.5% to 4.5% on stock purchases, plus an equal amount from appreciation, totaling about 7.5% per year. A 50-50 bond and stock portfolio would yield approximately 6% before income tax. This indicated a lower rate of stock market advance than the over 10% realized between 1949 and 1964, a period whose strong performance was often mistakenly regarded as a future guarantee.

Significant changes occurred after 1964, mainly a rise in first-grade bond interest rates to about 7.5% or more by late 1971, compared to 4.5% in 1964. Meanwhile, the DJIA dividend return at 900 was less than 3.5%. The change in interest rates caused a maximum decline of about 38% in medium-term bond prices. True 'cash equivalents' like U.S. savings bonds or short-term corporate issues proved better investments in 1964 than common stocks, yielding higher income with no principal loss. By late 1971, good medium-term corporate bonds offered 8% taxable interest, and U.S. government issues due in five years offered about 6%, making bond investment appear clearly preferable to stock investment, which yielded only 3.5% in dividends. Despite these yield differentials, a compromise policy of holding significant portions in both bond-type holdings and equities (25%-75% of either) remains advisable.