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Todd -

As I've said before, I've put a significant fraction of my portfolio into real-return bonds, so in some ways you're preaching to the choir. But I do have a few thoughts.

1. For investors, two competing goals are preservation of capital and desire for growth. To oversimplify, a real-return bond likely has little risk of loss of capital (at least for government bonds) but substantial risk of lost opportunity cost due to real economic growth. A diversified stock portfolio, on the other hand, has substantial risk of loss of capital but smaller risk of lost opportunity cost due to real economic growth.

A person's tolerance to these two risks differs according to individual circumstance. For example, my mother, age 69, has little tolerance for lost capital risk, but a high tolerance for lost growth opportunity cost risk. On the other hand, my nephew, age 4, has plenty of tolerance for lost capital risk, but needs not to expose himself to the risk of lost opportunity cost due to real growth.

Similarly, a person's tolerance to these risks changes as circumstances change. Assume that there is a specific amount of money that one needs to live for the rest of their expected lifespan. Once a person's wealth (which for these purposes should include expected income from one's labor) rises above that amount, he should see no risk from giving up real growth, but significant risk of any loss of capital. If a person's wealth is significantly below that level, however, capital preservation must take a backseat to the possibility for real economic growth.

Oddly enough, in the market of the past several years, many investors seem not to have behaved in this manner. That is, as their wealth grew, they chose not to reduce their risk of loss of capital in exchange for real economic growth. In my profession, I ran into a number of people who rued the day they sold their Microsoft stock, a few years too early. Many of them proceeded to ride the internet-stock wave all the way up and all the way down. In economic terms, they adjusted their goals so that they required a larger amount of wealth to live in their desired standard of living.

Your point is that in the view of experts, the risk of loss of capital by investing in stocks is above average at this time, while the risk of lost opportunity cost from real growth is below average. Given that, one's natural predilections toward avoiding one risk or the other should be skewed to some extent toward capital preservation. But as jrr7 points out, this does not necessarily mean that a given person should completely eschew stocks as an asset class. For my nephew, even a small risk premium is enough to justify choosing stocks over a real-return bond.

2. If you define the "US Stock Market" as the S&P 500 or the Wilshire 5000, then US GDP is not necessarily the correct measure of economic growth. If companies can direct investment toward countries with higher GDP growth rates, then their stock values should be more closely correlated with the GDP of those countries. Obviously, US GDP is a substantial fraction of world GDP, and many other countries' GDP figures are strongly positively correlated to the US. But this is still a factor to remember.

3. Because of tax preferences for stocks over bonds, investing in stocks as an inflation hedge may have smaller frictional costs than investing in real-return bonds. If the difference between ordinary income and capital gain rates is 15% (e.g., 35% v. 20% in US), then using real-return bonds to hedge against an eventual 10% inflation rate will cost you 1.5% more annually than using stocks. Of course, if tax-advantaged accounts are available, the problem goes away.

4. I suspect the frictional costs of short-selling are far higher than those available for long stock investors. I may be mistaken, as I have little experience with short-selling.

5. Your model assumes a cyclical reversion to "underlying value". While I happen to believe that such cycles exist, I also admit that premiums to underlying value can persist for relatively long periods of time. To the extent that I value being able to make use of my investments during my lifetime, it does me no good if I correctly identify such a premium but it fails to revert in time.

Thoughts and responses are much appreciated.

dan
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