Whenever stocks have a great year, I become the recipient of criticism for owning bonds. So, it was no surprise I took a lot of flak in late 2024 and early 2025 after US stocks had gone up 25% a year in both 2023 and 2024.
For some people, it is challenging to stay the course with their investment plan when markets go down. They don't like losing money. Others find it just as challenging to follow their plan when markets go up. They feel like they need to “take money off the table” or that they should only own what is doing well, whether that be the latest meme stocks or real estate or whatever. I know it's kind of boring to stay the course, but it really does work well over the long run.
Katie and I have had bonds in our portfolio since the beginning. We've stayed this course for over two decades. So, there probably isn't much someone can say to us or that can happen in the markets that are going to cause us to change our plan. In this post, I thought it might be interesting to review some of the reasons why $1 out of every $5 in our portfolio is invested in bonds.
#1 Simple to Understand
Some people find bonds hard to understand. I'm not sure why. I find them to be just about the simplest financial instrument to understand. A bond is a loan. If you loan someone or something money, they pay you interest on your money. That's it. Over the long run, that interest is the primary driver of your returns. At times of high interest rates, bonds have high (nominal) returns. At times of low interest rates, bonds have low returns.
Bonds have three main risks:
- Default/Credit Risk: The risk that the borrower won't pay you back
- Term Risk: The risk that interest rates go up and cause your low interest rate loan to be worth less if you have to sell it early.
- Inflation Risk: The risk that inflation will be so high that your principal will be worth much less by the time you get it back.
I find that list of risks to be very short and easily understood compared to all of the things that can happen to a stock or real estate investment.
#2 Stock Markets Go to Zero
There is a common assumption out there that is not quite 100% accurate. That assumption is that if you buy all of the stocks, you won't lose all of your money. That's a pretty good way to invest in stocks, but it isn't 100% true. Sometimes the value of all the stocks does go to zero. A few historical examples to consider:
- Russian Stock Market of 1917
- Nationalization of Egyptian stocks in the 1950s
- Nationalization of many US companies, particularly around WWII
- Confiscation of Jewish assets and companies all over continental Europe during World War II without compensation for at least 50 years afterward
Ninety-nine percent of US stocks that have existed are no longer traded on US stock markets. Since 1996, 43% of US stocks have disappeared in some way through consolidations or going private. While those situations often result in investors being compensated in some way, the idea that the stock market remains very static over the decades-long investment career of a typical retirement investor is not accurate.
Stocks are not “safe.” Not even if you buy them all. Not even if you hold them for a long time. The reason stocks are supposed to have higher returns than bonds in the long run is because they are riskier. And we're talking about real risk of loss to inflation, deflation, confiscation, and devastation—not just volatility to tolerate.
More information here:
Bond Allocation: Fixed Amount vs. Percentage
How to Determine Your Ratio of Stocks to Bonds
#3 The Future Might Not Resemble the Past
People love to point out that equities have had higher returns than bonds in the past, at least over long time periods. While that is certainly true, especially in the United States, one needs to be careful extrapolating the past—especially the recent past—into the future. Many of us remember that US bonds outperformed US stocks during the lost decade of the 2000s. But that isn't exactly an isolated period. Bonds beat stocks over 20 years from 1964-1984 and shorter time periods, including:
- 1890-1896
- 1906-1922
- 1927-1941
- 1997-2012
Professor Edward McQuarrie looked at a larger international database than had been considered in prior studies for his 2023 paper, Stocks for the Long Run? Sometimes Yes, Sometimes No. He found that while stocks far outperformed bonds between 1942-1981, stocks and bonds produced about the same wealth accumulation during the 150-year period before 1942 and from 1982-2019.
The point is that it is possible, no matter how unlikely it seems to us today, for bonds to outperform stocks over your investment horizon, whether that is 10 years or 60 years. While I don't think I'd bet 100% on bonds for long time periods, it seems wise not to bet the farm on stocks either.
#4 Bonds Can Be Indexed to Inflation
Stocks are generally thought to keep up with inflation over the long run, but they don't reliably do so in the short run. There is no such thing as an “inflation-indexed stock,” but you can buy both TIPS and I Bonds to index your bonds to inflation. That seems like a feature worth including in a portfolio, especially considering that serious inflation may be the biggest risk that non-indexed bonds face.
#5 Bondholders Are First in Line
When things go bad, bondholders generally make out better than equity owners. This has been reinforced to me with some bad real estate investments I have owned. While I was cleaned out as the equity holder, the “bond holder” (lender) got back all their principal and interest. Bondholders really do have first claim on a business's assets.
#6 Reduce Portfolio Volatility
Adding bonds to a portfolio has historically reduced the volatility of the portfolio. Reduced volatility is a good thing. Even with the same average returns, a less volatile portfolio has higher annualized returns, which are the only ones that matter in the long run.
#7 Help People to Stay the Course
Perhaps the biggest benefit of reduced portfolio volatility is the behavioral aspect. When it comes to investing, the investor matters more than the investment. Your behavior affects your return. Investors classically buy high and sell low repeatedly. The less you do that, the better off you will be. When your portfolio doesn't fall as far in a bear market, you're just more likely to stay the course. There's a whole crowd of people who think that a 100% equity portfolio is the best portfolio. In reality, there's nothing special about 100%. With a plethora of ways to increase equity exposure to more than 100% using options and leverage, what are the odds that 100% is exactly right for anyone, much less everyone? They seem pretty low to me. And for most of us, less than 100% is probably ideal.
I can distinctly recall late 2008 and early 2009 and how happy I was to have some of my money in bonds. I can recall thinking, “At least everything I own isn't going down in value.” That helped me to stay the course. By March 9, 2009, at the nadir, I recall thinking that my 75/25 portfolio was just about right for me.
I often run into young investors who want to be or think they should be investing in 100% stocks. I suggest they adopt a less aggressive asset allocation until they go through a bear market or two and discover their actual risk tolerance. Plenty of us intellectually have high risk tolerance. We've looked at compound interest charts over the last 100 years, and we're sure we can stay the course. Well, that intellectual knowledge is little help when you realize that all that money that you didn't spend on a kitchen renovation to invest in stocks is now gone. That's not an intellectual experience. It's a visceral, emotional one. And you'd better have a portfolio you can stick with when you have that sort of emotional experience. We're not all Spock-like automatons. Overestimate your risk tolerance at your own peril.
More information here:
Should I Hold Bonds In My Portfolio? Here’s Why I Don’t
The 90/10 Warren Buffett Portfolio?
#8 Facilitate Rebalancing
Portfolio rebalancing helps maintain the risk level of the portfolio. When stocks go down, you sell bonds and buy more and vice versa. But if all you own is one thing and it goes down, there's not much to rebalance.
#9 The Classic Buffer Asset
You know when owning more than one thing REALLY matters? When you're retired. Imagine all your money is in stocks and they tank for two, three, five, or more years. What are you going to do? You're going to sell stocks low so you can eat. But if you own something else, anything else, you can sell that or borrow against it and eat without having to sell low, giving those stocks time to recover and reducing the Sequence of Returns Risk (SORR).
These assets are often called buffer assets, and they include things like classic cars, whole life insurance, and home equity accessed via a HELOC. But you know what the classic buffer asset is? Bonds. The shorter the term and the higher the quality of the bonds (i.e., the more cash-like they are), the more they can function as a buffer asset, even when stocks and bonds fall in value.
#10 Gentlemen Prefer Bonds
Andrew Mellon, a famous financier from the early 1900s, said, “Gentlemen prefer bonds.” They're just a much more civilized, predictable way to invest. Kind of like how a lightsaber is a more elegant weapon from a more civilized age.
#11 Groucho Marx Owns Bonds
Another famous quote about bonds comes from Groucho Marx. The story goes:
After having achieved great financial success as an entertainer, Groucho Marx went on a tour of the New York Stock Exchange. As he was walking around the floor, one of the traders asked him, “Groucho, how do you invest your money?” He answered, “I keep my money in Treasury bonds,” to which the trader replied, “But Groucho, they don’t make you much money.” And Groucho responded, “They do, if you have enough of them!”
When I have been ridiculed for having any of my money in bonds, I often console myself by considering the financial situation of the person doing the ridiculing. Often, I have more money in equities than they do, despite the fact that 100% of their money is in equities. It's pretty rich for a poor person to be telling a wealthy person how to invest. I'm not saying the poor person is never right; they often are. Surely, you don't expect a 25-year-old financial planner to be wealthier than a well-advised 60-year-old doctor, but I try not to spend too much time criticizing people who have met their financial goals, no matter their strategy.
We have a wealthy, but elderly family member who did most of his investing long before index funds were invented. I often have to remind my wife that the way he invested (and still invests) was completely rational for somebody who started investing in the 1960s when mutual fund loads and expense ratios were ridiculously high. Changing now and realizing capital gains with a step up in basis coming soon probably isn't wise.
#12 Don't Take Risk You Don't Need to Take
Way too many people are taking on more risk than they need to take to make money they don't need to buy things they don't want to impress people they don't care about. Stop doing that. When you've won the game, stop playing. If you don't need a leveraged 100% stock portfolio or a bunch of rental properties mortgaged to the hilt to reach your goals, why are you taking on all that risk? Dying the richest person in the graveyard doesn't seem like a very worthwhile goal, much less a way to spend your limited time, health, and motivation on this planet.
You don't need to carry this idea to extremes and put 100% of your portfolio into a TIPS ladder just as soon as you hit enough, but adding a few bonds to your portfolio seems wise, doesn't it?
More information here:
Best Investment Portfolios — 150+ Portfolios Better Than Yours
The 15 Questions You Need to Answer to Build Your Investment Portfolio
#13 Fewer Margin Calls
There are other risks you can be compensated for besides market risk. There is small stock risk, value stock risk, leverage risk, illiquidity risk, and more. Instead of betting your entire financial plan on market risk, maybe look into some of those other ones while you're at it. Depending on the source and terms of your leverage, it's possible that it might make sense to leverage up a balanced portfolio rather than taking on a more aggressive asset allocation.
One benefit of a margin account that includes bonds is that you are much less likely to get a margin call due to the lower volatility of bonds. Obviously, you have to watch the interest rates. It's not common to have margin interest rates lower than bond interest rates, but it does happen. As I write this post, margin rates can be found as low as 5%, and Vanguard's Long Term Corporate Bond ETF is yielding 5.62%.
Bonds are one of the main asset classes, and most investors ought to own some of them. If you've decided that 100% stocks or 120% stocks or 50% stocks and 50% real estate is right for you, try to resist the urge to ridicule the rest of us for it. There are lots of good reasons to own bonds.
What do you think? Do you own bonds? Why or why not? What percentage of your portfolio is in bonds?