[Editor's Note: Today's post originally published as one of my regular columns at Physician's Money Digest in 2016. Bonds become less and less attractive to people the further we move into a stock bull market, when in reality, the opposite probably ought to be occurring!]
It is well-known that the further we go into a bull market, the more frequently we will hear the question, “Why not just invest 100% of my portfolio in stocks?” There is a well-known trend of threads about 100% stock portfolios on the popular Bogleheads.org investing forum, for instance. These threads are a daily occurrence during bull markets, then go away completely in bear markets. In addition, I am seeing more and more articles in the financial press and the blogosphere suggesting bonds are unnecessary and even harmful.
Now, I am no bonds apologist by any means. I have never held more than 25% of my portfolio in bonds of any kind. But to ignore this important asset class completely is a mistake, in my opinion, for many reasons that should at least be understood before someone decides on a 100% stock portfolio for the long run. Worldwide, approximately $82 trillion is invested in bonds, compared to just $55 trillion invested in stocks. Ignoring 60% of the investments in the world gives up a lot of diversification.
Let’s look at five of the arguments being put forth against bonds, one at a time, along with the reasons why it may not be as clear-cut as you might at first think.
5 Arguments Against Bonds (And 5 Arguments For Them)
#1 Stocks Will Have Higher Returns
Stocks represent ownership in a company, while bonds represent a loan to a company, person, or government entity. When something goes bad with the borrower, the bondholders get their money back first, and only if there is anything left over do stockholders get anything. Bondholders are promised their principal back plus a certain amount of interest periodically. Stockholders aren’t promised anything. Thus, bonds are less risky than stocks.
This risk includes “shallow risk” or volatility — that despite good long-term returns you may have low returns at any intermediate point. It also includes “deep risk” — where permanent loss is possible. Stocks do not become less risky in the long run; they become riskier as there is a wider dispersal of returns and the likelihood of total loss becomes greater. Yes, that risk must be weighed against the risks of inflation and of your money not growing quickly enough to reach your goals, but to pretend that risk goes away if you can just hold on long enough is folly.
In addition, stocks have not historically always had higher returns than bonds. The experience of investors is often colored by that of investors in US stocks over the last 100 years. One of the best-known examples is Japan, where the Nikkei stock index peaked at 38,915.87 on December 29th, 1989. How long did it take to get back to that point? Well, we don’t know yet. After 32 years it is only at 28,730. Now, this is ignoring dividends, but also inflation, and is a good demonstration of just how bad things can be.
The experience of the US stock investor in the 20th century is rather unique in the history of the world. The future need not resemble the past. It is entirely possible for bond returns to outpace stock returns for 10, 20, 30, or even 50 or more years. When choosing an asset allocation, you are not only deciding what you think is most likely to happen, but also how sure you are that will happen. You must also consider the consequences of being wrong. I agree that stocks will probably outpace bonds during my investing career, but I’m not sure enough of that to put every investing dollar I have into stocks, especially given the consequences.
Bonds diversify stocks. Not only do they moderate the volatility of stocks, but they are entirely different. There is low correlation between the returns of the two different types of assets. Often when stocks zig, bonds will zag. Even if your bonds are only returning 2% or 3%, that sure beats the -30% return that stocks may see in a nasty bear market.
In addition, many types of bonds have returns similar to those of stocks. In general, the longer the term and the less creditworthy the borrower, the better the return. Peer to peer loans and hard money lending can have returns of 7% to 12% or more, for instance. Junk bonds can also have quite high returns.
#2 Stocks Are More Tax-Efficient
Some have argued to go 100% stocks because stocks are more tax-efficient than bonds. Not only is this allowing the tax tail to wag the investment dog (the most tax-efficient investments are those that lose money), but it is not necessarily even true. Many investors have most or even all of their investments inside tax-protected retirement accounts, where tax-efficiency doesn’t matter at all. Outside of retirement accounts, many stocks such as REITs and other companies with high yields are not particularly tax-efficient. Meanwhile, some bonds can be very tax-efficient, such as savings bonds and municipal bonds.
#3 I am Young and Have a High-Risk Tolerance
Investors in their 20s may argue that their youth and long time horizon allows them to take the additional risk of a 100% equity portfolio. In reality, the typical 25-year-old has LESS capacity to take risk than an older investor for two reasons.
First, their savings are not very large. It may not tide them over in the event of job loss or other personal financial catastrophe.
Second, they have limited investing experience. An investor who started investing at any point in the last eight years has never actually invested through a bear market. All the risk tolerance questionnaires in the world pale in comparison to the best indicator of risk tolerance there is — your own behavior in a real, honest to goodness, severe bear market.
Those who invested through the 2008 to 2009 Global Financial Crisis have a pretty good idea of their risk tolerance. They have an even better idea if they also invested through the 2000 to 2002 Tech Meltdown. Reading and understanding financial history is important. Estimating your risk tolerance is important. But it is far better to dramatically underestimate your risk tolerance than to slightly overestimate it and end up selling low in a bear market.
The truth is that for a young investor the savings rate matters far more than the investing return. So what if you eke out an extra 1% or 2% on your $10,000 portfolio? You can make that up with a little moonlighting on the side or skipping a single nice restaurant meal. Don’t lose the forest for the trees.
Young investors are also short-sighted in choosing a 100% equity portfolio. If they are truly risk tolerant and want to maximize their investing returns, why stop at 100%? Because it is a nice round number? It is not difficult to design a portfolio with 110%, 150%, or even more exposure to equities using leverage and/or options. Benjamin Graham, the man Warren Buffett looked to as a mentor, argued that you should never have a portfolio with less than 25% bonds (75/25) or more than 75% bonds (25/75.) There is a lot of wisdom in that moderation.
#4 I Am in it for the Long Run
Many investors not only assume that stocks will outperform in the long run, but that they can wait for the long run to spend their money. Job loss, divorce, disability, investment opportunities, career changes, family or personal illnesses, and death can all intervene and require some or all of your money in the short term. Experienced investors have learned that having some of your money outside the influence of the stock market can be very handy on occasion.
#5 Bond Yields are at Historic Lows
Some people argue for a 100% stock portfolio based on the current low expected returns of bonds. The best estimate of future bond returns is their current yield, at least for very high-quality bonds. For example, the Vanguard Intermediate Term Treasury Bond Fund currently yields just 1% (0.48% in 2021). Corporate bonds of the same duration are yielding about 2.75% (1.60% in 2021). These yields seem really low, and they are. However, inflation is also quite low. In the 1970s and 1980s inflation was often in the double digits. In the 1990s, it was mostly between 3% and 6%. In 2015 it was 0.12%. It hasn’t even been 2% since 2012 (1.24-2.44% since original publication of this article). So the real, after-inflation, yield of bonds is not nearly as bad as it might at first appear. Corporate bonds are currently besting inflation by around 2% (equalling inflation in 2021). That isn’t the 4% real yield you could get in 1990, but it isn’t that different.
[Update for 2021 Republication: It's interesting to go back, read, and correct the above paragraph, originally penned in 2016, and reflect on bond returns between 2016 and 2021. Despite bond yields being very low in 2016 (and everyone saying “interest rates have to go up”), you can see that interest rates did NOT have to go up and that bond returns were actually quite good over the last 5 years. Take a look:
There's a good lesson there that actual returns are not always anywhere near expected returns.]
Choosing an asset allocation is a very personalized decision. The “100% stock portfolio” is always going to be controversial and perhaps may even be right for you, but be very careful choosing that allocation if you are relatively new to investing. The consequences of a slightly overaggressive portfolio are dramatically worse than a slightly under aggressive one.
Do you invest in 100% stocks? Why or why not? Comment below!
Have owned individual munis for 30yrs
A very recent 30 yr rolling period had bonds returning 8.7% average annually
TRUST ME-In or near retirement most will go more conservative if their ret plan assets and personal assets are their sole source of income
Look at the millions near retirement when the last crash occurred and they were heavily into equities
THEY ARE WORKING, NOT RETIRED
Ken, considering that markets are now at/near all time highs, the only way those who were heavily into equities when the last crash occurred could have to be still working is that they sold out of the market during/after the crash, (a behavioural issue), or had insufficient liquity. It is not a problem with equities.
I hate bonds. They bore me. I am trying to read why bother with bonds but it bores me. I am nearing retirement so I have 36% allocated to bonds mostly muni bonds in a taxable account. The next true bear market like 2001 or 2008 will show you the importance of having a few bonds. Also look at Bernstein’s work on the efficient frontier and you will discover that a portfolio with some bonds does better over time than one with 100% stocks. Just hold your nose and buy a few bonds. One day you will be glad that you did.
Two things that need to be pointed out about your comment, subtle but important.
First is your use of the word “does better.” That should read “did better.”
Second is the fact that that statement isn’t true. Adding a lower return asset class lowers your expected and actual returns in most cases and adding bonds to a 100% stock portfolio is no exception for most reasonably long historical periods in the US. I don’t recall ever seeing Bernstein argue anything different and would like to see a link where he did.
There is no doubt adding a dollop of bonds reduced risk quite a bit, but at the expense of reducing returns, at least a little. No magic there.
It’s not Bernstein’s work, but she may be thinking of the 100% stock portfolio having a slightly lower likelihood of lasting 30 years than a portfolio that contains your preferred ratio of a 25% portion in bonds, as the Trinity Study concluded.
https://retirementresearcher.com/the-trinity-study-and-portfolio-success-rates/
I beg to differ on this one. Adding a low percentage of bonds to a 100% stock portfolio reduces your risk and increases your return as you move to the peak of the efficient frontier.
Which period of time are you using to make that assertion? Apparently we need to do this exercise because you’re not the only one who mistakenly believes this. There is no rebalancing bonus. In any reasonably long term scenario, rebalancing into a lower returning asset lowers risk, but does so by lowering the return. Your risk adjusted return might be higher, but that’s not the same thing. The efficient frontier describes the maximum return for a given level of risk. Adding bonds moves you left on the chart, not up.
You are confusing risk adjusted returns with returns. Risk adjusted returns are the returns per unit of risk (in this case volatility) as measured by the Sharpe ratio. As the saying goes, you can’t eat risk adjusted returns, only returns. Intuitively, if you add a low expected return asset class (bonds), to a high expected return asset class (stocks) you’d expect the returns would be less. The efficient frontier graphs show the best risk adjusted returns occur with 20% stocks/80% bonds, but clearly that asset allocation would give you lower expected returns compared to a 100% equity portfolio.
Absolutely correct. Rick Ferri’s All About Asset Allocation has lots of charts that demonstrate this well.
How do you safely invest into bonds in the current environment, with increasing rates resulting in sell-offs and depreciation of capital? After getting halfway through Ferri’s book, I see the merits of not being 100% stock. Analyzing portfolio of total US stocks, ex-US developed and emerging, small value, these all still have correlated at ~0.85+, REIT slightly better at 0.7, but nothing coming close to bonds with VTI vs BND at -.17 for past 11 years. But now that I am looking at which bond fund to get in, I see the capital value is depreciating with the expected interest rates on the rise. Not to try to time the market, but with the feds pretty much assuring several more hikes in the coming year is now potentially not the right time to be buying in? Or is there some way around this, or just really don’t try to overthink it and set an allocation and buy, even with expected capital losses? How long do you typically expect it to take for the interest payouts of a total bond fund to start to reflect the increasing interest rates in our economy?
What do you mean safely? Your question suggests that somehow bonds are going to evaporate in value if rates rise. In reality, value falls by various values depending on duration. If duration is 5 years, and rates rise from 3% to 4%, then you lose 5% of your value, but you now have a bond that yields 1% more, breaks even in 5 years, and after that comes out ahead.
Now if you’re in a bond fund and worried that everyone will head for the exits at once, then buy individual bonds so you’re in control there.
If you KNOW the value of bonds is going down because rates are going up, wait until you KNOW they’re not going up any more and then buy them. In my case, I don’t know any of that, so I just follow the stupid know nothing written investing plan I drew up as a resident and that made me a multi-millionaire.
As a general rule, keeping duration short helps protect against rising rates, but there is a price paid for that protection – lower yields.
Of course, the risk you face with bonds is tiny compared to the risk you face with stocks and don’t let anyone fool you otherwise.
Does the expected value change per interest rate change hold true to aggregate bond indexes like SCHZ, or is that more applicable to single bonds? (hence the comment on bond funds?) I would rather be in a single diversified fund for simplicity, but could buy individually at various durations or even just put into t-bills with different terms if that is the smart move that blends a priori know-nothing approach with current information about feds stated further interest rate hikes and their anticipated effects balanced on the risk of that information being wrong.
The only real issue you could run into with a bond fund over individual bonds (at least related to this issue) is if the bond fund holder en masse head for the exits and force selling.
I still use funds for the usual reasons (liquidity, diversification, professional management.)
I think in your case just keeping your duration short (i.e. a short term bond fund) will accomplish your purposes.
For corporate bond funds, yes, forced selling is an issue. But for most of us who hold either an intermediate term government bond funds, or an aggregate bond fund (which is mostly government bonds) to smooth the ride, that is a non issue. The only time we’d be wanting to sell these funds is to rebalance in a crash, when due to the “flight to safety” investors are rushing to buy these funds, so pushing up the price.
I think it’s also a mistake to buy short term bond funds just because you think interest rates are going to rise. You’d only do better in that scenario, anyway, if interest rates rise more than expected, as interest rate expectations are already priced into the yield curve, which is the best predictor of future interest rates, anyway.
The long term investor is better off to simply own intermediate term government bond funds, or an aggregate bond fund, and forget about what interest rates might do. Over the long term you’ll get a better return than short term bond funds, and any price drops are temporary – you’ll get your money back by the duration of the bond fund.
I came across an article challenging the idea of a bond fund and the indexing approach to bonds based on the idea that frequent turnover and transaction costs that result from indexing majorly inflate the costs associated with a fund, which is not represented accurately in the expense ratio. Does this idea have validity? I prefer the idea of holding a simple fund over the complexity of individual bonds. The article for reference is here, forgive the click-bait-ish title (https://seekingalpha.com/amp/article/4237221-dark-side-john-bogles-legacy)
I wasn’t impressed with the reasoning of the article. I mean, what is the actual turnover of the Vanguard Total Bond Fund? It’s not a secret.
It was higher than I thought- 60%. But the turnover of most bond funds is much higher than stock funds. Look at the turnover of all the Vanguard bond funds:
https://investor.vanguard.com/mutual-funds/list#/mutual-funds/asset-class/stock-attributes (click on stock attributes)
They range from 25% to 620%. By the way, the lowest ones are the muni bond funds.
It is true that additional costs from turnover are not reflected in the expense ratio, but they are reflected in the return. So how does TBM stack up against other bond funds? Let’s go to the tape:
Morningstar says TBM has outperformed 47-76% of its peers in the last 5-15 years. Not bad, but maybe nothing to write home about other than that 10 year figure (76%).
http://performance.morningstar.com/fund/performance-return.action?t=VBTLX®ion=usa&culture=en_US
But clearly it isn’t “indexing” that is causing TBM to suck. Because it’s still whooping the actively managed funds which have just as high of turnover anyway.
Now if you want to build your own treasury ladder and hold to maturity in an effort to boost returns, I think that’s fine. I think it’s folly to go buy your own corporate bonds and try to run your own bond fund. Since TBM owns corporate bonds, you now really have to ask yourself whether you want to own corporate bonds or not. If so, I think you should use a fund. If not, then either buy a fund or ladder treasuries. Personally, I only own treasuries and munis, but I’m not opposed to corporates. Corporates do have higher long term returns than treasuries. 5.82% to 2.71% for intermediates over the last 10 years per the Vanguard funds.
Good luck with your decision. No right answer. But the article states the wrong conclusion considering its findings. It says:
after a whole article whining about turnover costs and then pointing out that TBMs turnover costs are way lower than those of active funds. No sir, John accomplished exactly what he set out to do by creating a bond fund with much lower turnover and lower costs, including both the visible ER and the invisible turnover costs.
Hatton, I think you have mis-remembered Bernstein’s discussion of the behavior of multi-asset portfolios (refer to chapter 3 of The Intelligent Asset Allocator). Historically, adding a small amount of stock to an all bond portfolio both reduced risk and increased return, however this did not occur at the other end of the spectrum with an all stock portfolio.
You make some good points, but for the average investor, they think they can control points #2-4. The most important reason in my eyes was missed, and it’s something I learned from reading the website road map for investing success (recommended website here, I’m alluding to chapter 2). Having bonds substantially reduces losses in bear markets to a much greater degree than they reduce potential returns. I’ll refer to that website for examples of portfolios with numbers. It’s like having insurance for your portfolio. It’s also an insurance most people will use multiple times in their investing career.
I was going to leave this story alone, but just had to ask: how does owning bonds substantially reduce losses in a bear market? This is like saying guns kill people. People kill people using guns. If you don’t pull the trigger, there is no loss.
Permanent loss in a diversified equity portfolio is always a human achievement of which the market is incapable.
Your portfolio value decreases less. The caveat, and I wish WCI had addressed it, is that it depends on the types of bonds you own. US treasuries tend to go up in bear markets, but most other types of bonds go down as well, though perhaps to a lesser degree than stocks. That is a lesson many people learned the hard way in 2008.
I get your point that you don’t lock in the losses until you sell, but still, most people have a difficult time watching the value of their assets drop in front of their eyes.
That happened in 2008, but not all bear markets. Corporate bonds, it can be argued, are mostly high quality bonds with a dollop of equity. That’s Swedroe’s main argument against them. He would rather have you own more equity and just keep the bonds shorter term and higher quality.
1. That analogy doesn’t make sense.
2. You missed the point of my comment by ignoring the second part of that sentence, which is the key. I’m just reiterating a concept I picked up from the “road map for investing success” website chapter 2. Owning bonds reduces losses in a bear market MORE than they reduce gains in a bull market. He lays out a couple nice examples in more detail than I’ll go into here.
1. Bear markets don’t cause losses, investors cause losses
2. Sorry – I ignored it because if there is no loss, the rest of the sentence is moot.
It is possible to use logic and reason when investing for the long term but these arguments are based upon the premise that it is not. You don’t have to let emotions control a properly invested and managed portfolio. Behavior is a choice, is it not?
Once again, you’re arguing not only that shallow risk doesn’t matter, but also that deep risk doesn’t exist.
Permanent loss is not always a human achievement. Consider the handful of stock markets that have disappeared in the history of the modern world. Crazy bad things can and do happen and bonds can protect your portfolio against some of them.
Just to be nit picky, wouldn’t you agree that (apart from devastation and confiscation, which would also affect bonds), permanent loss in a globally diversified equity portfolio is always a human achievement?
I think when Johanna discusses human achievement in this context, she is referring to behavioral choices made by that particular individual investor, not Putin launching nukes.
WCI is correct.
Imagine this: what if you, as a doctor, could tell your patients that a optimal healthy life was totally under their control. You could take away any influence outside of their control – environment, genetics, the actions of others and make that guarantee if only they will follow the directions you give them to have good health for the rest of their lives. Don’t you think they would want to know what to do?
Of course, you can’t make that claim. Fortunately, I can. This is not arrogance – anyone can do this. The plan is quite simple but divorcing yourself from your emotions is quite difficult. I believe that is why it is discounted.
Part of the reason is that people just view an annualized return number and think it cant be bad if X% long term. However, due to the dependent nature of returns making them geometric and not average, you can have a great looking annual return and poor overall total return as volatility makes the gap between actual and average return ever larger.
Bonds increase your “risk adjusted” returns.
Forget the fancy terms. They mean nothing in this context. I stand by my statement, which was not referring to “disappearing markets”.
Show me any well-diversified equity fund portfolio, rebalanced annually, that has disappeared. Or even lost money over the long term. That portfolio would be an equal weighting in LCV, LCG, SCV, SCG, Int’l, and REITs (optional).
Whether the terms are fancy or not, I’ll leave it up to you. But they do apply in this situation; absolutely they do.
Shallow risk is volatility. Not only does this have effects on behavior (investors and their advisors bailing out at market lows) but it also comes up when an UNEXPECTED short term need for money rears its head. Your plan, to just use bonds for EXPECTED needs in the next five years, ignores both of those aspects. While it is possible that a disciplined investor, with or without the help of a disciplined advisor, can hold a 100% stock portfolio throughout a deep bear market and still sleep fine, I would estimate that is a relatively small percentage of investors. Whether it is worth running the risk of a possible unexpected short term need in return for a higher expected long term return is a judgement each investor must make.
Deep risk is not volatility. Deep risk is defined by Bernstein (well known for his stance of “when you win the game, stop playing”) as Inflation, Deflation, Devastation, and Confiscation. This is when stocks go down and don’t come back. i.e. the real risk of stock investing. i.e. the risk of permanent loss. In addition to reducing volatility, bonds also help protect against some of these risks.
I try to be humble when it comes to taking past data and applying it going forward. Even if we take all of our known stock market data, even the low quality stuff, and analyze it, we only have five independent 30 year periods, and that’s basically for a single country, the most successful country in the history of the entire universe. Any statistician will tell you that is basically nothing. Practically anecdote. Just because something hasn’t happened in the past is hardly a guarantee of what will happen in the future. Do I put a lot of my portfolio in stocks for just those reasons that you use 100% stock portfolios? Absolutely. Is someone investing a significant portion of their portfolio in bonds a fool? I hardly think so. There’s a reason the difference between stock and bond returns is called a risk premium. Sometimes the risk shows up.
Excellent point and part of the reason Wade Pfau is so down on the sustainable withdrawal rate being for sure 4%, as it turns out this only worked in the US and a couple other countries (NZ, Austr..) in many other countries it led to premature failure.
However, I guess we still live in america which still has quite a few of those advantages.
As an example for geometric returns and that volatility matters, between 1929-1940 small caps returned 8.1% but turned a dollar into $0.52.
We can make plans not upon everything that has not happened, only on what we know. That is true for bonds as well as stocks.
“Your plan, to just use bonds for EXPECTED needs in the next five years,…” That is not my plan (and you know better). Clients loan money (via bonds) only for short-term planned needs. Otherwise, short-term needs, such as emergency funds, are
in money market or other liquid accounts.
“..when an UNEXPECTED short term need for money rears its head.” Can you name an example that would force me to sell off a portfolio at a loss within the context of a financial plan so I can respond?
‘…basically for a single country, the most successful country in the history of the entire universe. ” Which is where we live and invest – helps to make my point.
I’ve been thinking about your previous comment: “Consider the handful of stock markets that have disappeared in the history of the modern world. Crazy bad things can and do happen and bonds can protect your portfolio against some of them.” Can you name one of these disappearing markets where bonds of the same protected “investors”?
Again, show me any well-diversified equity fund portfolio, rebalanced annually, that has disappeared. Or even lost money over the long term. That portfolio would be an equal weighting in LCV, LCG, SCV, SCG, Int’l, and REITs (optional).
Sorry. I didn’t realize you were keeping 5 year needs in cash. That has its own issues obviously. Didn’t mean to misrepresent your position on bonds.
Short term needs, according to the plan. Are you saying you invest your emergency fund in the market?
A sliced and diced portfolio and REITs haven’t even existed for a generation. You have lots of faith in precious little data to assume that what has happened in the relatively remote past will continue to happen. Reasonable way to bet? Sure. I just prefer to hedge my bet more than you do.
I’ll respond to both of your comments in one:
1) Short term needs according to the dictates of the plan, of course. Are you telling me you keep your emergency fund in a stock portfolio?
2) I know I don’t have to spell this out for you, but here goes: A generation ago, all we had were pure equities (actually, longer ago than that), which made up diversified equity portfolios. With the creation of mutual funds, the theory is still the same but the risk is greatly reduced. I am using data back to 1926, same as you.
I am retired with 18% in equities and my bonds provide all my income and the portfolio continues to grow and I sleep like a baby. Rates will go up as I have been told for the last 10yrs but its much slower than changes in the stock mkt. I have seen the gamut of int rates swings from buying a six month CD for 16.5% to the present paltry rates. I cannot see any reason wealthy individuals should not own individual munis
AS BOGLE SAYS AGE IN BONDS; a pretty bright fellow
1/3 of money now being indexed!!!!
Thanks John
I have a small portion of my portfolio in bonds. I fully anticipate the returns on that portion (non-junk) to be lower than equities. I have paid for a lot of things that may not make sense from a ROI: I don’t really expect to use that box of silver dollars to barter for goods, the case of ammo to defend my family, nor do I ever want to use my malpractice or disability policies. Of course if you are never in a position to liquidate your portfolio, you will never lock in the loss, but I have bonds in case I *do* have to sell.
The only reason you would “have” to sell is if you are investing without a plan. A real financial plan will negate that possibility and pay for itself multiple times over the long run.
I am investing/living/working/insuring/saving/spending as part of a “grand” plan–a plan which does not anticipate selling assets until required by The Man (barring calamity and not counting my accelerated mortgage payoff scheme or “play money stocks”). That plan also involves some of my portfolio in investments outside of equities, a portion of which is bonds. We’ll have to agree to disagree.
And herein lies the scenario I have not addressed: that some folks make a purposeful decision to accept lower long-term returns within the confines of a “real” financial plan. It is illogical in my universe. but to each his own. Other than that, I am not sure what our disagreement is.
Sometimes things happen that you cannot plan for. Bonds are good for some of those.
Whats ur opinion on bond funds? My “3 fund” portfolio consists of majority in $ITOT, then $AGG for bonds and $IXUS for foreign. I also have a small amount of a reit fund, $FREL.
Funds are functionally identical to the bonds they hold. Look at the risk level of the underlying holdings and the average duration for an understanding of credit risk and interest rate risk of the underlying bonds.
Sorry, haven’t memorized all the tickers in the world. Post fund names, ERs, and a description of what’s in the fund if you want an opinion.
I love when young MD investors who have never suffered through a bear market make macho statements to the effect that they can handle the volatility of being 100% in stocks. I certainly made those remarks in the late 90’s! By the time my second big bear market came around in 2008, in my early 40’s, I was 20-25% in fixed income. When the next bear market strikes, I will be 35% in fixed income, maybe even a bit higher.
My thoughts exactly
I’m a young MD investor with poor risk tolerance. I use the 3 fund portfolio with nearly 33% into Vanguard’s intermediate term muni fund since the bulk of my retirement savings are in taxable.
I agree I’m waiting for the next big bear market to assess whether I am willing to change my asset allocation and what my risk tolerance is truly like.
For now, I’d rather work a little harder, save a little more, spend a little less, and plan on working just a bit longer.
I was once seduced by the dark side (100% equities) but a few smart folks and calculators have brought me back to reason.
If one were to use historical data looking at every possible rolling 15 year period from 1972 to the present and pick a portfolio with just 4-5 asset classes, equally proportioned, with the goal of obtaining a greater than 6% real 15 year CAGR while minimizing volatility and worst year drawdown (which has damaging effects on sustainable withdrawal rates), you might be surprised at the results.
Take a test drive over at Tyler’s site at portfoliocharts.com, and head to the portfolio finder calculator. Try as you might, bonds always end up in the results, at either 20% or 40% of the portfolio. Now granted, long term treasuries and intermediate term bond indexes prove much more helpful than short term bonds or TIPS, which may cut against the grain for some folks, but a portfolio with 20-40% bonds will achieve similar long term real returns to a 100% equity portfolio with less volatility and here’s the kicker, while ACTUALLY INCREASING THE SAFE AND SUSTAINABLE WITHDRAWAL RATE OF A PORTFOLIO. Seems hard to believe but the numbers bear it out.
Interestingly the optimized portfolio might be something like equal parts
Mid cap value, international small cap, REITs, and long term treasuries. Each plays a diversifying role and the overall lower volatility of the portfolio maximizes safe withdrawal rates, far exceeding say a 100% equity (70% US, 30% international) index portfolio.
I think research like this will continue to show that frowned upon asset classes such as long term bonds, and even gold still have a place in most portfolios.
While true for the last 44 years, due to the tremdous bond bull market since 1981, we will not likely see a repeat during the next 44 years.
I think trying to predict the future performance of bonds or confidently predicting that yields will remain as they are now is a dangerous assumption. All the more reason to own a small amount of bonds as part of a truly diversified portfolio.
If someone has any kind of debt at all, be it for their house, their practice , or their vehicles, why would you invest in bonds? Id much rather get a guaranteed return and reduce my leverage. It seems like bonds in that case are vastly overrated, but a small portion of bonds in a portfolio , especially inflation linked bonds, makes a lot of sense I’ll concede
M Moola, your statement is very misguided. Most folks take debt for business and homes b/ they don’t have the lump sum to begin with. Secondly, due to many reasons / including taxes and litigation it is prudent to have “smart debt”. Now car loans / credit cards, I agree its best to pay them off before investing in EITHER STOCKS OR BONDS.
You say bonds are overrated. Well, you will learn few hard lessons before you leave this earth. One of them will be that it is debt / bonds and not equities make and preserve real wealth. Equity / stock wealth is 40 – 60% speculation. That is why folks jump out of windows during stock crashes.
>>Equity / stock wealth is 40 – 60% speculation.<< Is that opinion or research? Would like to see the resource you took that figure from.
Great deal of research on it. If economy as a whole grows at 4%, and stock market gain 10 %, the 6% premium paid is speculative part. Historically, folks have paid anywhere 10 x to 35 x per dollar of earning.
Aside from liquidity and volatility tolerance, no good reason. Certainly doesn’t make a lot of sense to hold something paying you 2% while you have a 6.8% loan.
I avoid bonds at this point because of their higher administrative fees, within my employer’s 401K plan. We’re lucky enough to have a handful of Vanguard stock index funds to choose from, with very low administrative fees. So, couple the low fees with the better long-term return, and I’m not missing bonds at all. I choose to diversify with four single-family home rental properties, and indirectly, the international business captured within the index funds, for global US companies.
Agree with the overall. Although I do understand the concern for bonds, not necessarily that they are low yield but because they are low yield their risk/reward is heavily skewed to the downside. I do myself have the great majority of my taxable account in muni bonds, but the yield is much better and after considering the tax effects theyre pretty great.
The problem people appropriately see is that if rates start to rise, the capital loss will be tremendous and offset any coupon you recieved. Also, remember that since the great majority of us are talking about funds when we say bonds, and not individual bonds, your principal is actually at risk. This isnt the case with individual bonds, you only have interest rate risk, in a fund you have both and that is the huge risk most are worrying about.
However, of course we dont know anything about where rates are going, I mean they had the same concern in Japan in 89 but bonds turned out to be the superior investment until even today. Tomorrow could be different, but as usual we dont know for sure so it makes sense to follow your plan.
I dont have any bonds outside of muni funds, but they fit within the overall plan.
zaphod,
You are over thinking it.
Recent bond outperformance has been due to increase price of bonds (45% bond price/rest dividend). Historic bond return is 90% due to coupon payment. No one can predict the future. However, lets suppose we do a mirror image analysis of interest rate behavior over past 15 yrs (so it exactly tracks but in reverse), even then in 5yrs / indexed bond fund will give you 3.5% return (worst case scenario). After 5 yrs bonds will do much better due to increased coupon payments.
Now, what if rate stay low for next 20 yrs (look at japan / look at negative yield offered by many soverign debts). US cannot unilaterally raise rate and ignore attempts at devaluation by other countries (It could, but will have to reverse course to prevent super strong dollar)
Its not a linear curve though, as rates go up the price of the bonds will drop tremendously at first. However, I agree with you that in any likely probability the overall loss over time is not as bad as its made out to be, and I think your 3.5% is exactly in range of what Cullen Roche has pointed out.
Just pointing out where I think people fear bonds and their return at this particular point in time. If rates do start to go up, I will accumulate them faster.
Zaphoid, when interest rates rise, there is a temporary loss of capital that is recovered over the duration of the bond fund due to maturing bonds being reinvested in bonds with the higher interest rates. So your principle is not at risk. With individual bonds, yes, you do get your principle back at maturity, but you are stuck with the lower interest rate of the bond as interest rates are rising. There is no difference between individual bonds and bonds, with regard to these issues, which is not surprising seeing bond funds are just a bunch of individual bonds.
“Tremendous” probably isn’t the right word to use for that. Have you actually run the numbers on what to expect from your bond portfolio in the event of a 1-3% rise in rates? It’s probably much less than you imagine if you’re using words like tremendous. Or you’re taking on a great deal of interest rate risk.
Just describing the shape of the curve and how it acts near zero, not the nominal move itself. I agreed with the prior poster on the overall long term damage is not too bad. Its the initial move up that will have the biggest effect, especially when combined with sentiment change. Over an investing lifetime though, and this is whats important, it doesnt matter and you should stick to your plan.
@Grant, there is no guarantee, and in no way should one assume the time frames of when that will come back in balance will coincide with your accumulation/draw down phases and work out in the end. True of all asset classes of course.
Again, I dont know where interest rates will go, and my current view is that there is no compelling reason for them to go up greatly just because thats what people assume is “normal”. They may, but they certainly dont have to, and I suspect one day they will go up, but maybe their highs are lower than in the past. Could be wrong, I dont pretend to know for sure.
I was 40 – 50% in bonds even during my 30’s
Now close to retirement, 50 – 70% bonds
I use leverage with stocks, as well as bonds
I have crushed stock market returns decade after decade
I am hoping and preying for another stock crash, thats when the real money is made
I was A bit more then usual in equities because I loaded up on MLP’s few months ago, they have doubled in price, and I have locked in 24% dividend which will grow for decades to come.
Bonds are beautiful / give you options when you really have opportunity to make money
Sorry to doubt you but there is no way that you have crushed stock market returns with the portfolio you describe. And your feelings about the beauty of bonds are irrelevant within the framework of proper investment principles.
I understand your concern. I stand by my statement b/ it is a fact. What has helped me is leverage ability and science of prudent call writing and patience. Every decade I get one to two opportunities to pick up great stocks at bargain prices. This decade the only new stocks I have purchased are MLP’s. Additionally, this decade I am behind the sp500 total return by 6 percent (as of aug 2016). But, I have few hundred calls expiring in 2 – 6 weeks. So should catch up. If stoke market goes down and I hope it goes down big, I will do even better
Ahhh…Lake Wobegon…where all the women are strong, all the men are good-looking, and all the children are above average.
I resemble that comment.
Here is the way my acceptance of the need for bonds in my portfolio grew/changed over the last several years:
1. Ken’s constant comments about munis got me interested in learning more about bonds. One thing that is great about this site is that if you let it, it will challenge your ideas and help them develop.
2. I read DeMuth’s The Affluent Investor. Thanks again, Phil! He discussed how some jobs have stock-like qualities and some have bond-like qualities. I liked the idea of thinking about not just the AA of my portfolio but also of the income stream that goes into it. Bogle thinks about Social Security this way. When I was younger and less knocked around by life, the income stream from our careers in medicine seemed like bonds so a high stock allocation in the portfolio made sense to me. With time and life, that perception changed. The income stream began to feel more stock-like which meant perhaps it was time to place bonds into the portfolio mix.
3. I read all of Graham’s The Intelligent Investor. I no longer met his criteria for a 100% stock allocation, although my kids do. He also discusses tactical asset allocation. I realized that having such a high percentage of stocks made sense in 2008-9 for us. But, as market conditions have changed, it no longer does. If you have made it this far in the comments and have not read this book, you really need to read it, especially if you are at 100% stock.
4. I then began to play with different asset allocation calculators (Firecalc is my favorite) and realized that we were at a point where cutting our stock allocation didn’t change the success rate of meeting our goals. I won’t repeat any of the wisdom of the above commenters except to say, I realized that our time frame may not correspond to the length of the time period needed for stocks to outperform bonds. Best wishes!
I also credit Ken with pounding the muni bond table, and have loved them since looking and finally starting to invest into that space, like usual only wish I started earlier.
Dr. Mom – your posts are always thoughtful and interesting. I love reading what you have to say and always pay attention. In the above, you are very right – for most of the investing public. The Intelligent Investor was written in 1949, decades before financial planning was a discipline, much less a profession (and we’re still evolving). Both of the books you mention are written from a “portfolio as the plan” mindset. For most people, that is the only way they will view investing and, yes, these books are very important educational tools. But a plan does not start with a portfolio – it doesn’t even stop with one. It may incorporate a portfolio as a tool to meet the goals articulated by the plan, but, of course, that is not even necessary.
Fortunately, most of the doctors and professionals posting on this site can afford to give up long-term growth and will never know the difference. That is not the case for many investors; having a plan in place to as their financial lighthouse can make a huge positive difference in retirement. In my world, though, I want everyone to have the opportunity to maximize wealth, no matter their tax bracket.
I have written much about the importance of financial planning and how the plan should be the roadmap upon which all financial decisions are made. I’ve even explained the process in detail in a 2-part post on PhysicianOnFIRE. Everybody who disagrees feels the need to provide me with their personal theory of investing. That’s fine but, to date, I have not been given a reasonable argument – actually, any argument – explaining why my process would not work if applied to their finances, even by WCI. If nobody can do so, don’t you think it might deserve consideration?
I have read your posts and comments. We disagree and that’s okay with me. I feel no need to argue my point with you. I put it in the category of parents who don’t want to vaccinate their kids. I am not the right pediatrician for them – just as I would not be the right client for you. Instead of arguing endlessly, I just prefer to take a pass. You know, separate realities and all. But thank you for your writing as it helps me clarify why how I think works for me! As WCI often quotes, many roads to Dublin.
While I enjoy the conversation and don’t consider it an argument, we can absolutely agree on many roads to Dublin 🙂 Your perspective is always valuable to me.
DrMom as you so eloquently stated bonds are important. I find it hard to believe that this is a controversial topic on this blog. The question should be what percentage of my portfolio should be in bonds and what type not do I need them at all. I have often heard it referred to as the ballast of the portfolio. They help you when stocks are sinking by 50%.
have LOVED my muni bond income for 40yrs
What beats unearned income?
Hi Ken, I have always loved your “Kennisms”. A question – how often do you rebalance your portfolio? Thanks.
Maybe we should do an entire post of Kennisms. I could include the emails he often sends me, which are often just as short and cryptic as the comments.
You’re going to make me buy bonds at age 25? That will be the most boring decision I’ve ever made. I’d rather be 25% TSLA!!
(what bonds would you recommend? Im seeing a Vanguard Bond with a since inception yield of >8%, am I missing something…, also any links to good reading on bonds)
4+ years and 1500% later, I’m curious whether or not you actually went with 25% TSLA.
Wondering what folks think of using cash flow real estate instead of bonds in portfolio for the stability? Thats what i do and it is about 50 percent of my portfolio as i near retirement.
I like real estate as an asset class. It doesn’t replace bonds.
Wow. Who knew bonds were so controversial? 35 comments and growing in one day. Bonds are boring but that is how investing should be. It is like watching paint dry. Let’s get our excitement somewhere else. My asset allocation is 40:40:20. Stocks/bonds/other. It seems to work great for me. I have growth of assets with solid cash flow and minimal volatility.
If you were retired and long term bonds were paying double digit returns as in the 80’s, you would be HEAVILY INTO BONDS. Those who bought 30yr treasuries at 12-13-14% were very happy campers
So I use the David Swensen allocation (which means I’m 15% TIPS and 15% intermediate treasuries and so “only 70%” in stocks). And I think there’s another reason for using bonds that’s not explicitly mentioned above though it is alluded to in the 3:35PM comment by WCI…
Swensen suggests as a guiding asset allocation principle that you want enough in each category to make a difference to the portfolio if the category does well, but not so much that you get killed if the category does abominably.
My thoughts about my treasuries and TIPS flow from this. If things really melted down, I’d have my treasuries.
Great post with lots of interesting comments. I like Cullen Roche’s take on this “We own stocks to protect against loss of purchasing power and bonds to protect against permanent loss of capital”, (to reduce volatility so we don’t panic sell in a crash).
Predictions are hard to make, especially about the future. I’ll keep a few bonds just for fun 🙂
Mr/ms. philospher, predictions are hard to make, but thanks to folks like you I can predict with certainty that this decade I will buy stocks at much much cheaper prices then today, as people panic and sell during next bear market. I look forward to taking shares from you at bargain basement prices. In the interim, I am very happy with 30 / 70 stock/bond portfolio.
Perhaps you want to rethink you plan of I’ll keep a few bonds just for fun”. At this point of the bull market, even a new born baby should have 30 – 40% bonds. Reversion to means is coming, and I hope it is tomorrow.
And there, my friends, you have a perfect example of someone who believes that they can predict short term market moves.
Bear markets have occurred, on average, every 5.5 years since the end of WWII. That’s a statistic that anyone can look up. Therefore, anyone who predicts a bear market in the future will, at some point, be correct – even you. The fact that we are overdue for a bear by that stat doesn’t mean one is around the corner.
“We have long felt that the only value of stock forecasters is to make fortune-tellers look good.” Warren Buffett
Please review my post again. I am certain of another bear market this decade , I do not mention or know if it will be this year or in 4 yrs.
As far as warren bufett goes, well, he hasn’t done much over past 12 yrs. I still respect him and still own class A shares since early 80’s, 3 shares to be exact.
“Please review my post again. I am certain of another bear market this decade , I do not mention or know if it will be this year or in 4 yrs.” And your point is…?
“As far as warren bufett goes, well, he hasn’t done much over past 12 yrs.” Even if I agreed with you, so what? Buffett quotes are timeless.
Here is my interpretation of Buffett quote
“We have long felt that the only value of certified financial advisor is to make fortune-tellers look good.” Sam from Lake Wobegon
WCI (and everyone),
What do you think about international bonds as a means to diversify both shallow and deep risk?
Great conversation all. I had no idea bonds would be so controversial. I’m in my young thirties and love holding 30% bonds.
Thank you,
Ben
Hedged or unhedged? If unhedged, you’re mostly just playing around with exchange rate risk. If hedged, then there is an additional expense there. I don’t hold international bonds, but I don’t think it’s necessarily a bad thing to hold. I just have so many asset classes already.
Benjamin, to piggy back on WCI statement, that “I just have so many asset classes already”, I would say that this is true for most investors, b/most investors are misguided by financial advisors. From publicly traded assets classes, you just needs stocks and treasuries. You can further complicate your portfolio and buy gold (which I am guilty of, bit I buy billions for reasons of my own), commodities, and emerging markets, and reits and this and that. But, all you really need is a whole market index stock fund and treasuries. Now, once you have gone through many seasons of investing then consider using leverage and art of writing options (be extremely careful)
As mentioned below, I believe that WLI is an excellent assett class
I also invest in private LLC’s (after stocks and treasuries, best asset class which not too many know about or care). Although equity p2p real estate lending may change that. I also invest in lending club (have done so since 2008. I am pleased with results, but have no ideas as how to classify this investment. Based on 2008/09 performance, this assett class may go down 5 – 10% due to defaults, but who knows.
Private LLCs isn’t an asset class. It’s a business structure. I’d say the asset class you’re referring to is private equity.
Technically you are correct. What I have invested in LLCs are assets such a leasing equipment companies, timber land, and NNN real estate funds with less then 20% leverage. These funds are LLC’s / pass through entities with excellent tax benefits (like running your own business). It turns out that lack of liquidity is a good thing for these types of funds. They really do well, even during market crashes. Nice / consistent tax favored cash flow.
On the other hand, some partnerships / private equity funds are very speculative and not tax efficient.
First and foremost, why do you hold bonds?
If they are for diversification and to decrease magnitude of draw down of your portfolio when market crashes then you can do one two things:
1. Buy all purpose bond fund (has around 40% treasuries of long / short duration, state and corporation issue bonds as well as 8 – 15% exposure to foreign bonds (depends on which fund you are buying. During huge bear market this type of fund may go up by 3 – 5 % or go down in 3-5%. For most part these funds will give you a return bit more then intermediate term treasures. Not Bad.
2. However, nothing beats treasuries during panic. The best asset class to mix with stocks for best risk adjusted returns. If you have enough experience to do some tactical rebalancing besides annual rebalancing, you will love and appreciate how easy and beautiful investing really is.
I have always been very conservative investor. Even during my early years. around 50% bonds even in my 30’s. I have done well / better then market as a whole by learning how to write calls, and us leverage.
Big proponent of WLI (if you ever going to get it, soon the better, also ingest rate hedge, but no one knows what rates will do)
Another thing I have done besides owning RE is to invest in non publicly traded LLC’s/ partnerships. These investments have paid b/ 6 – 12 %. They pay on tax advantaged basis. Large chunk in early years is non-taxable, return of investment due to depreciation / business expenses. Later on, and especially during liquidation phase, you end up paying some taxes, but still at much less rate then ordinary income.
Since these funds issue K-1, and if you have passive investment losses you can write them off $ per $ (passive investment losses are typical for real estate investors).
After educating myself about investing recently, I’ve started giving advice to my sister who completely ignores her portfolio. She had all her assets in equities (and a huge overrepresentation in Apple). She took my advice to put 20-25% of her assets into bond funds. Because she is 37 and has a long investing horizon, we decided to go with mostly longterm bond funds (VBLTX). She made the move about 3 months ago and has subsequently lost 10% of the money she moved. I am still convinced the general allocation change was the right move, and nobody can predict market timing for which she was very unlucky, but I can’t help feeling guilty.
In retrospect, maybe we should have picked a total bond market fund. Do we wait to recoup the losses and then switch over, or just trust that over the next 30 years the long term bond fund will outperform the total bond fund? And what exactly were the forces that caused the longterm bond market to drop 10% in the last few months–I imagine it has to be more than just impending interest rate rises? And is there any reason to think that it won’t rebound?
Lots of issues here.
# 1 There is family risk of helping family members with their money. Maybe she blames you, maybe she doesn’t, but at a minimum you feel guilty.
# 2 Long term bond funds have extreme interest rate risk. Just looking at the Vanguard index funds, the long-term fund is down 10% in the last 3 months (although still up for the year), the intermediate fund is down 4%, and the short term fund is down 1%. That’s the way bonds work. You get a higher yield for running that risk. When rates drop, the long term fund gets more benefit. When rates rise, it gets more of a penalty.
# 3 Many smart investment gurus recommending keeping your bond duration/maturity on the shorter side to protect against that risk and taking your risk on the equity side where it is more efficient. Your sister, on your advice, chose not to do that.
# 4 Your sister lost 10% of capital but also now has an investment with a higher yield. For example, if a fund has a duration of 10 years, a yield of 3% and rates go up 1%, then it loses 10% of its value and now has a yield of 4%. After 10 years, you break even for that particular interest rate change. After that, it’s all gravy. In the long run, higher rates cause you to have a higher nominal return on the bond fund.
# 5 Whether or not it bounces back is highly dependent on interest rates. Your chosen fund has a duration of 15 years. If interest rates don’t change in the next 15 years, it will take a decade and a half to get back to where she would have been if interest rates had not changed. If interest rates rise more, she will get another capital loss (and a higher yield.) If interest rates drop, she will get a capital gain and a lower yield. So she could “make it up” in 2 months, in 15 years, or in 30 years. I can’t tell without a crystal ball that shows what interest rates will be in the future.
# 6 Selling now is classic buy high/sell low behavior. Obviously that’s a terrible way to invest. If you/she are committed to this portfolio for the long term, then stay the course. You chose a long term fund for a reason, right? That reason hasn’t changed, right? So why would you change your strategy now?
# 7 Waiting to recoup the losses and then changing is a classic behavioral mistake. Either you’re in the right fund and you should stick it out long term, or you’re not in the right fund and should get out now. That’s the sunk cost fallacy to stay in it until you get back to even. As noted above, that might be a very long time or it might be next month.
# 8 Diversification works, even when you don’t want it to.
You will never regret owning individual Munis assuming you will never touch them till maturity
I would buy the longest term a rated or better from my state
Nothing beats that monthly tax free income
tax free income. Nothing!!!
What an odd statement. It makes me wonder about the state you live in. Beyond that it’s an opinion you cherish, what makes this true and why did you feel compelled to post that?