The Duration of Stocks

“Life is all about timing... the unreachable becomes reachable, the unavailable become available, the unattainable... attainable. Have the patience, wait it out. It's all about timing.”-Stacey Charter


For more experienced investors, the concept of duration in assessing the risk in bond investments is a simply executed yet vital tool. We can find clear explanations of "duration" in many places, but here is just one:

The concept of duration is straightforward: It measures how quickly a bond will repay its true cost. The longer it takes, the greater exposure the bond has to changes in the interest rate environment. The greater the exposure, the higher the risk.


Let's say that two bonds that each cost $1,000 and yield 5%. A bond that matures in one year would more quickly repay its true cost than a bond that matures in 10 years. As a result, the shorter-maturity bond would have a lower duration and less price risk. The longer the maturity, the higher the duration.

You can easily see that a bond's "coupon rate", the bond's payment, is a key factor in calculating duration. If two otherwise identical bonds pay different coupons, the bond with the higher coupon will pay back its original cost quicker than the lower-yielding bond. The higher the coupon, the lower the duration.

(Source: About.com)

Bonds have other risks of course, but it is the simplicity of calculations such as these that make bond investing somewhat more malleable to the blunt tool of a calculator in assessing risks than say, equities.

Or is that true? What if we were told that stock duration can be calculated as well? Wouldn't that be a huge help in assessing the risk from investing in that asset class? Let me allow John Hussman, economist and President of Hussman Econometric Advisors, to set up the discussion (found in his always informative Weekly Market Comment):

The relative performance of stocks versus bonds last year has had an important impact on durations, which investors should not overlook if they plan “rebalance” their portfolios in the weeks ahead. (Omit)

In order to understand the importance of the duration shift that we've observed over the past 15 months, recall that for a passive “buy-and-hold” investor having no view about short- or long-term market direction, the appropriate portfolio allocation strategy is to match the “duration” of the portfolio to the anticipated date that the money will be needed. So for example, an investor needing to use the funds in 5 years would tend to choose relatively shorter-term, less price-sensitive securities, while an investor having a 40-year horizon would typically choose longer-duration securities.

In 2007, the effective duration of a 30-year Treasury bond was just over 16 years. Meanwhile, the effective duration for the S&P 500 Index (which turns out to be essentially the price/dividend ratio) was nearly 60 years. At that point, in order for a passive long-term investor to achieve an expected long-term return of 7%, it would have been necessary to have a 60-year expected holding period, with a 100% position in stocks being the only passive investment allocation capable of achieving that result.

Equivalently, for an investor with only 20 years or so to invest, the largest appropriate allocation to stocks was only about 1/3 of the portfolio (i.e. 1/3 of 60 years = 20), provided that the balance of the portfolio was held in cash. For that investor, the reasonable prospect of 7% long-term returns was unavailable, without taking excessive risk. Even if one had no views about market direction, the extremely long 60-year duration of stocks in 2007 forced passive investors to accept a terribly limited menu of options, all with disappointingly low expected return prospects.

Why is this important now? Because with the recent surge in Treasury bond prices, the effective duration of a 30-year Treasury bond has climbed from just over 16 years to nearly 20 years. Meanwhile, the stock market's freefall plunge has collapsed the duration of the S&P 500 from nearly 60 years to just about 30 today.

For investors who rebalance their portfolios annually, this is essential information. Given the probable long-term returns that stocks and Treasury bonds are priced to deliver, an investor seeking a 7% long-term total return would currently require an allocation of about 60% in stocks and 17% in bonds, for an overall portfolio duration of about 21 years – only a third of the duration that an investor seeking that same long-term return would have had to accept just 15 months ago! Given the poor long-term returns that Treasury bonds are priced to deliver, an investor with any view at all about market direction would likely forego the 17% allocation to long-term bonds, opting for shorter-duration (and only slightly lower yielding) securities until the Treasury market normalizes.

Investors are sometimes urged to allocate a percentage of assets to stocks equal to 100 minus their age. In my view, this formula is terribly crude, because it ignores the impact of valuation on the duration of stocks. Again, at a dividend yield of 1.7%, stocks have a duration of nearly 60 years. At a dividend yield of 4%, stocks have a duration of just 25 years. Clearly – even for passive investors having no view about market direction – the appropriate allocation to stocks is inverse to their valuation. This point can be argued on the basis of duration alone.

For a 50-year old passive investor with, say, a 20-year investment horizon, the appropriate investment strategy isn't to plop 50% into the stock market regardless of valuation. At an S&P 500 dividend yield of 1.7%, as we saw in 2007, the duration of stocks was 60, so the appropriate allocation to stocks for that investor was no more than 33%. At an S&P 500 dividend yield of 4%, it could comfortably rise as high as 80% (20/25), provided the balance of the portfolio was in cash, which has zero duration. Given current valuations, the appropriate allocation – again for a passive investor with a 20-year horizon – could be as high as 58% in stocks, provided that the remainder of the portfolio is in fairly short-duration, low-volatility securities.

I can't stress enough the importance of Hussman's comment about time-frames for passive investments. In his view you have to match duration to an investor's needs for funds, i.e. the end of the investor's investment horizon. If you do not match horizons (for the investment and for the investor) you have recommended an inappropriate use of monies and misused the tools (duration calculations) at your disposal. A primary consideration? Absolutely! In fact I believe an advisor who hasn't considered this to be ignoring a vital source of market risk: the likelihood of the investment NEVER being paid back. We see this everywhere today with near retirees who have been devastated by the market's declines.

Read the entire piece CAREFULLY. A working knowledge of this important concept is essential to your investing health. As always, contact your advisor if you have further questions.