With interest rates rising, are you starting to wonder if you should incorporate individual government bonds into your portfolio? Especially if you are targeting dividends, are you starting to feel concerned when comparing them to dividend percentages? At the very least, I am.
“But even at the same interest rate, stocks offer capital gains, and since stocks still have momentum, it feels like a waste.”
Actually, which one is the correct choice is not determined by the yield figures, but by your entire portfolio, which is determined by your risk tolerance.
In fact, you can calculate the ratio of stocks to government bonds relatively easily, and above all, clearly. (Of course, it is fine to diversify into REITs, alternatives, etc., but this time we are limiting it to stocks and government bonds.)
Even with the same 2% interest rate, the contents are completely different.
First, let’s briefly review the differences between risk assets like stocks and government bonds.
In particular, you need to be careful with investment trust distributions. There are cases where a portion of the distribution is a “return of principal (special distribution),” meaning it is just your own money being returned to you. In other words, this comparison is between a “nearly certain 2%” and an “uncertain asset that aims for 2% + alpha.” You cannot find the answer just by lining up the yields.
Conclusion 1: The answer is determined by risk tolerance.
“Government bonds or stocks” is not a question of choosing a single product, but rather “how much risk you are willing to take within your total assets.” question.
And the answer to that is determined by your own risk tolerance.
The main factors that determine risk tolerance are the following four:
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Investment horizon: How many years until you need to use the money?
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Income stability: Can you maintain your lifestyle and savings even during a downturn?
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Emergency fund: Do you have several months to a year’s worth of cash separate from your investments?
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Psychological resilience: Can you refrain from selling even if the valuation drops significantly?
Let’s calculate it concretely.
Suppose you have 10 million yen in financial assets, 50% of which is in stocks. If stocks fall by 40%, the stock portion decreases by 2 million yen, and the total assets become -20% (8 million yen). If you can withstand this, 50% in stocks is a candidate. If you cannot, reduce stocks and increase government bonds. By calculating the ratio of stocks to government bonds backwards from “how much of a loss can I handle in the worst year,” the answer to “2% government bonds or 2% stocks” will naturally emerge.
Conclusion 2: Determine allocation using the efficient frontier and rebalance periodically.
A method you can use to determine the ratio is the efficient frontier.
This is a curve that connects “combinations of assets that provide the highest return for the same level of risk.”
When you combine assets with different price movements (for example, domestic stocks and foreign stocks), the relationship between risk and return becomes a curve rather than a straight line. The upper-left side of this curve is the efficient frontier. To this, we add government bonds, where the principal and interest are almost guaranteed if held until maturity. Government bonds can be considered “risk-free assets” with almost zero risk. The point where a straight line drawn from the government bond point touches the stock frontier is the tangency portfolio, and that line is the Capital Market Line (CML).
All points on the CML are combinations of “government bonds + tangency portfolio.” And for the same level of risk, the CML is above the frontier of stocks alone. In other words, mixing government bonds and the tangency portfolio is the most efficient approach at any level of risk.
An important conclusion follows from this.
The composition of the stock portion (the tangency portfolio) is the same regardless of risk tolerance. What changes from person to person is only the ratio between government bonds and the stock portion (this is called the separation theorem). The answer to the question of “what is the correct ratio of stocks to government bonds” is precisely this ratio. However, it is difficult to accurately estimate the tangency portfolio. In practice, it is realistic to use a global stock index or similar as a substitute for the tangency portfolio.
I will explain how to actually calculate this yourself in the next installment.
Until then.
AFP | Asset Formation Consultant Ritsuki