Should Individual Investors Follow Pension Funds Out of Stocks?

pexels pixabay 33786
pexels pixabay 33786

Pension funds are increasingly shifting their investments from stocks to bonds, spurred by rising interest rates and the desire to lock in recent stock market gains. Goldman Sachs estimates that pension funds will withdraw $325 billion from stocks in 2024, following a $191 billion withdrawal in 2023. While this strategy might seem logical given current market conditions, it could be misleading for individual investors to mimic these moves.

The Misleading Allure of Bonds

Higher bond yields may appear attractive, but it’s essential to consider the real, inflation-adjusted returns. The current 10-year Treasury Inflation-Protected Securities (TIPS) yield is 2.21%. Historically, investing in 10-year Treasuries has provided an annualized real return of about 3.01%, taking into account the risk of inflation.

Stocks, on the other hand, offer different prospects. The Cyclically Adjusted Price Earnings (CAPE) ratio suggests an earnings yield of about 2.91%. Adjusting for historical performance, this translates to an expected annualized real return of 2.73% over the next 10 years for the S&P 500, albeit with higher volatility compared to bonds.

The Pension Fund Dilemma

Pension funds face unique challenges that don’t necessarily apply to individual investors. Despite the appeal of bonds, pension funds need to maintain growth to cover their long-term liabilities. Cutting back on stock investments might stabilize returns in the short term but can jeopardize their ability to meet future obligations, especially given that expected returns on both bonds and stocks are currently below the average real return assumptions.

Interestingly, not all funds pulled from stocks are going into traditional bonds. Significant portions are being allocated to private equity, which carries equity-like risks, and private credit, which, despite bond-like features, also entails substantial risk. This diversification strategy aims to mitigate risks while still capturing growth, a balance that might be harder for individual investors to achieve due to limited access to private-market investments.

Lessons for Individual Investors

History shows that stocks have consistently outperformed bonds, even in periods when pension funds shifted towards fixed-income investments. For example, since World War II, when pension funds increased their fixed-income exposure, stocks delivered annualized real returns of 7.8%, compared to 0.3% for bonds. Conversely, when pension funds were reducing bond exposure, stocks still outperformed, though the margin was smaller.

Making Informed Decisions

Individual investors should be cautious about mimicking pension fund strategies. Unlike pension funds, individuals don’t have the same institutional constraints and can afford to take a more straightforward approach to asset allocation. The professional management and analytical resources available to pension funds might not translate well to individual portfolios, particularly considering the complexities of private equity and credit markets.

Instead, individual investors should focus on a balanced portfolio that considers their risk tolerance, time horizon, and financial goals. Diversification remains key, but with a clear understanding of the differences between institutional and individual investing needs. While bonds might offer more stability, the growth potential of stocks is crucial for long-term wealth accumulation.

In conclusion, while pension funds may be shifting from stocks to bonds, this strategy might not be suitable for individual investors. Historical data supports the continued inclusion of stocks in personal portfolios for their superior long-term returns. Balancing risk and reward, and tailoring investment strategies to individual circumstances, will be more beneficial than simply following the moves of large institutional investors.

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Ken Wells