Why Bother With Bonds?

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1 Why Bother With Bonds? KEY CONCEPTS: Stocks are much riskier. Bonds make risk more palatable. Bonds are a safe bet. Bonds are an attractive diversifier. The premise of the FinancingLife.org website is that the best way to manage your investments is so simple that anyone can do it. Simple, but not easy. In a nutshell, it is to buy and hold a diversified, risk-appropriate proportion of low-cost stock and bond index funds and rebalance regularly to stay on plan. Occasionally individual CD or bonds can play a helpful role as well. We ll show you why and how. If your goal is to have the amount of money you need when you need it, you face a difficult tradeoff as illustrated by this picture. The stock market will give you the highest growth, but is extremely volatile. You can count on cash, but it earns little usually less than inflation. The safest solution matches your investments with your needs. Bonds play an essential role in the mix. Unless you already have enough, you have the competing objectives of achieving real, inflation-adjusted, long-term growth while gradually decreasing risk as our investment timeframe decreases. It s not as simple as choosing which investment will give you the highest returns you can always find a higher-risk investment that promises higher expected returns. It s about selecting levels of risk/reward that match your various needs. The best strategy is to preserve the money you ve allocated to those needs coming-up soon, while achieving real growth in excess of inflation for those needs further out. CDs, bonds, and bond funds when chosen correctly are uniquely well-suited to help 1

2 us accomplish both. Four compelling arguments keep them vital for your investment portfolio: stocks are very risky, bonds make that risk more palatable, bonds are a safe bet and an attractive diversifier. Stocks are risky in the short-run, and the long run too! The fact is, while U.S. stocks have posted higher average annual returns than any other type of financial asset over long periods of time, they re a miserable place to put short- and medium-term money. That s because stock prices gyrate wildly in short periods of time. And sometimes stock prices can stay down for periods ranging from five to fifteen years. If the money you re investing is aimed at satisfying an important goal in the meantime, you re out of luck. 1 Funding retirement is usually the biggest financial goal for anyone who has thought about it. Time is our friend, for compound interest is the miracle that lets us obtain those goals that otherwise seem out-of-reach. But, time also increases risk. The closer we get to retirement, the greater the risk that a falling stock market (a bear market) will cause the catastrophic failure to meet our investment goals. In retirement, this is coupled with our decreasing ability to recover from such a loss. So the answer is to gradually reduce portfolio risk as income stream and preservation of principal become more important. This example illustrates the problem from stock market volatility. Example #1: An investor grows her investment portfolio over the years to $1 million which is her retirement goal. The stock/bond mix is 60/40 and the she is close to retirement. A bear market reduces her stock allocation by 50%. She is unable to retire as planned. A 50% loss of 60% equity allocation translates into a $300,000 loss in this case, leaving the investor with $700,000 on which to retire. The goal was $1 million. It will take the investor about 7 years to recover assuming a 6% annual return and no further contributions and, of course, it could take even longer. 2 Stock investments become riskier as your time horizon gets shorter and ability to wait out a bear market decreases. Also, as the portfolio grows, the loss that has to be made up becomes much greater relative to the investor's savings rate. Therefore, a strategy of reducing stock market exposure as time goes by is the prudent strategy to reduce the potential for catastrophic loss as retirement approaches. 2

3 The worst case is for a market crash to happen early in your retirement requiring depressed assets to be consumed before they have a chance to recover. The problem is that nobody can foresee these events. Nobody. The cost for increasing safety is lower returns. Look at the dramatically different compound growths of stock, bond, and gold investments over two centuries based upon the work of Dr. Jeremy Siegel (The Wharton School, University of Pennsylvania). $100,000, Total Nominal Return Indices $10,000, Stocks $13.24 mil $1,000, $100, $10, $1, Bonds Bills $31,188 $5380 $ $10.00 $84.68 Gold $19.15 US Dollar $1.00 $ Source: Jeremy Siegel, used with permission. Stocks also historically provided highest long-term real returns which is after inflation and what you really care about. John C. Bogle (founder of Vanguard) says that Siegel s chart shows that for two centuries, stocks have generated an average return of 7% in real, inflation-adjusted dollars. Bonds, over these two centuries, have generated average real returns of 3.5% half the 7% real return generated by stocks. In other words, stocks have delivered more than twice as much growth in purchasing power as bonds. 3 It isn t unusual to have extended periods where bonds generate negative real returns, something that stocks just haven t been prone to do. The difference between 7% and 3.5% doesn t sound like much, but it makes a huge difference when compounded over many years. That s compelling, and leads John Bogle to write, Although stocks are extremely volatile in the short run, the long-term investor cannot afford not to take those risks. 4 3

4 Further, John Bogle adds, The data make it clear that, if risk is the chance of failing to earn a real return over the long term, bonds have carried a higher risk than stock. 5 Indeed, as I write this in 2012 with interest rates extraordinarily low, many investors legitimately ask: Why would I invest in CDs or bonds? There s also no comfort from gold to provide inflation-adjusted returns over the long-run. It isn t a productive asset. Unlike owning a share of stock where you own a piece of a business that produces goods and/or services to customers, gold produces nothing. From a financial standpoint, gold has one purpose: rank speculation. It s interesting to those who want to gamble on government fiscal policy. What s The Catch? Stocks have been rewarding investors with substantial real returns that outpace inflation (by 7%) for two centuries! So, what s the catch? Stocks are notoriously risky, and speculative investments even more so! While stocks generally tend to outperform bonds over long-terms, a cautious rule-of-thumb is that stocks can also lose half of their value in any year. You should expect this to happen a handful of times during your investing lifetime. You need to plan for this. Bonds can provide you necessary funding during these times, as well as dilute and reduce the overall risk in your portfolio, approximately like this 6 : Choosing and maintaining your asset allocation is the key. You need to have your eyes wide open because abandoning your plan and selling during a decline is about the worst thing you could do you almost certainly would have been better off with a more conservative portfolio in the first place. Additionally, the bad experience might cause you to avoid investing in stocks altogether in the future. Bonds Are Risky Too But Keep It In Perspective! Bonds are volatile too, but an order of magnitude less volatile than stocks. While stocks might lose up to 50% in one year, for bonds 4

5 the volatility and chance of loss are very much smaller 7. You can minimize this risk by matching your needs with the duration of the bond, or bond fund. A good portfolio has a healthy and stable mix of both stocks and bonds. Just as predicting the stock market is impossible to do consistently, so it is with predicting interest rates which drive the bond market impossible. But you don t need to! Could What Happened In Japan Happen To U.S.? Excerpt from Riskiest Day by Larry Swedroe, June 25, 2012 Here in the U.S. we ve been lulled into thinking that the stock market crashes and recovers quickly. Stocks almost seem safe in the long run. Consider the case of the unlucky Japanese investors. In 1990, the Nikkei Index stood at close to 40,000. Twenty-two years later, it's close to 9,000. As Keynes might have said, markets can under-perform expectations for a lot longer than you can remain solvent. We can address this risk by not taking more equity risk than we have the ability, willingness or need to take, and diversifying the risks we do take as much as possible, avoiding concentrating assets in single (or small groups of) stocks or even asset classes (such as U.S. stocks). 8 Bonds Make Risk More Palatable The greatest benefit of a balanced investment program is that it makes risk more palatable. An allocation to bonds moderates the short-term volatility of stocks, giving the risk-averse long-term investor the courage and confidence to sustain a heavy allocation to stocks. 9 Bonds are not exciting like stocks. They are rarely in the news. They have always been boring and easy to ignore, yet have always been an important part of a good investment portfolio a stable mix of widely diversified stock and bond index funds held at the lowest possible cost. The highly respected and best-selling author William J. Bernstein once quipped: Bonds are the underwear in your portfolio unexciting and not much thought about, but select the wrong pair and you ll be surprised at just how uncomfortable you are. 10 It s a great metaphor. Comfort is one important reason every portfolio should include bonds. Too many investors expose themselves to more risk (i.e. stocks) than they should and then make bad decisions like selling when the stock market plunges. Yet other investors are too risk averse to own a healthy allocation of stocks, but by including 5

6 bonds, the overall investment becomes more palatable. Bonds Provide Ballast For Long-Term Investments Stocks and bonds are entirely different assets and behave differently over time. Some pictures are truly worth 1000 words. This picture shows the current value of $10,000 invested in a total stock market index fund back in 2006 compared to the same investment in a total bond market fund. I ve added an arrow to highlight the differences in a particularly bad year (2008). There is little debate that stocks are risky in the short run, and recent experiences validate that. The history of large company stocks supports the rule of thumb that stocks can lose half of their value any year. Small company stocks are even more volatile. Bonds Can Be A Safe Bet CDs, bonds, and bond funds are ideal for addressing those shortand medium-term goals for a couple of simple reasons. Ninety percent of the return on a fixed-income instrument comes from the coupon, or the interest paid on your initial investment, not from price appreciation as with stocks. 11 The risk of losing invested principal is dramatically lower than with stocks. And they are perfect if you have an important goal that must be satisfied with a set amount of cash on a known date or timeframe. The highly respected author, Larry Swedroe, asserts that risk is more highly rewarded in the stock market and so the bond allocation should be very high quality and safe. John C. Bogle recently wrote another terrific book 12 differentiating investing from speculating. Investing with the common sense principals I describe in my first book 13 is the surest path towards meeting your financial goals it s hitching your wagon to the great 6

7 economic engine of capitalism and sharing a small part of the value that gets created by everyone s hard work and creative energies. In contrast, Bogle defines speculating as betting on shortterm fluctuations of market prices. This is how much of the huge financial services industry makes money off of you because the costs associated with active investing make this a loser s game for all but a few (and you can t predict those in advance). Even with bonds, many are tempted by high returns and take unwarranted risks. It s better to stay with high quality bonds that add stability to your investment portfolio. In many years, bonds outperform stocks. They too are volatile, but much less so compared to the stock market. Many characteristics affect the value of a bond, but for the highest quality bonds the dominant factor is the market s interest rate for similar loans. The relationship preserves the time value of money. This makes bonds highly predictable compared to stocks, whose value depends primarily on forecasts of future profits. Protect yourself from changing interest rates One key concept that you probably already know is that if you hold a bond to maturity you get exactly the return promised (assuming no default). Rising interest rates diminish existing bond values. But in the longterm, investors benefit from reinvesting dividends at the higher rates. Smart investors don t attempt to predict interest rates but rather match their bonds to their needs. The key concept to learn is that if you hold a either an individual bond, a collection of bonds, or a bond fund for the length of time called its duration after interest rates change, then you would be indifferent to those interest rates changes. Protect yourself from inflation As big as the risks are in the stock market, this risk is dwarfed by the risk of inflation in the long term. If you are saving money to enjoy during retirement 40 years from now, an average 3% inflation rate means your hard earned dollar will only be able to purchase what 30 cents can buy today. 14 The challenge is to grow our investments faster than inflation. The rate-of-return that exceeds inflation is called the real rate of return. Inflation expectations are factored into current market prices for both stock and bonds. However, bank savings, money market funds, and short treasuries (T-bills) do not. So while these may be appropriate places to park money for our short-term needs, they are 7

8 inappropriate for our long-term needs and these long-term needs dominate most of our portfolios since our needs during retirement are so great. An Attractive Investment Diversifier Bonds can be a good diversifier in your portfolio. Not only do bonds dilute the amount of the portfolio at risk in the stock market, but the portfolio is strengthened by bonds that are poorly correlated (go up when stocks go down). Note that not all bonds are, so it is important that you learn the concept of correlation. Short-term U.S. Treasury bond returns have almost no correlation with stock returns adding valuable stability to an investment portfolio. Being uncorrelated (or, near zero) means their values move independently from each other but that doesn t preclude that sometimes they move in the same direction. There is no cause and effect. For instance, US Treasury bonds generally (not always) do well when the stock market does poorly. Lower quality bonds are more positively correlated with the stock market. This has the undesirable consequence of the bonds performing poorly at the very time you need their stability. Ideally, we would like perfect negative correlation so every downturn of one asset would be offset by an upturn of the other. Treasury Inflation Protected Securities (TIPS) have a slightly negative correlation with the stock market. This is highly desirable and ultimately means that the same portfolio return can be achieved for less risk or a smaller allocation of stocks. Or alternatively, for the same level of risk, the portfolio can contain a higher allocation of stocks, thereby increasing the expected return. Combining poorly correlated assets both reduce risk and increase return. Bonds are an attractive investment diversifier precisely because they are so very different from stocks. Bonds, are called fixed income because their characteristics are fixed when a bond is first issued. Stocks are ownership permanent shares of an enterprise. They are normally called equity investments. Very little is pinned down. This makes them both simple and complicated. In contrast, bonds are debt with very specific repayment terms. To illustrate how different bonds are from stocks, consider being offered these two alternatives. The first is a businessman who looks you in the eye and says Loan me money and I ll sign a legal contract to pay you exactly $500 every year and exactly $10,000 8

9 on March 9th, He is saying something very different from Hey, buy a share of my business. If it does well, you ll do well. 15 Equity ownership is forever. Bonds are very different. They are simply loans. They are not forever; they have a term. Ultimately, the role of any fixed income investment is for safety that money you are relying on is there when you need it. They are much simpler in concept. Almost anyone could describe the bonds they sell at banks and credit unions that are called certificates of deposit, or CDs. Watch the FinancingLife.org website as I address some of these other common questions that arise as people add bonds to their investment portfolios: Should I use a CD, or a collection of CDs (also called a ladder)? Should I consider individual bonds, or bond funds? How do I judge a good bond or bond fund? If interest rates rise suddenly, how long til I get my money back? Note From The Author: Thank you for visiting our website and subscribing to periodic updates. There are many questions about how to invest in bonds and CDs. This is an important topic. I expect to explain this further with short videos, and possibly a short book. Watch your or my website at FinancingLife.org. Rick Van Ness (19Dec 2012) 9

10 Footnotes: 1 Kathy Kristof, Investing 101, John Wiley & Sons, 2008, p $700,000 x (1.06)^7 = $1,052,541. (Thank you Adrian Nenu for this example.) 3 John C. Bogle, Common Sense on Mutual Funds, John Wiley & Sons, Inc., 1999, p Ibid., p Ibid., p Larry Swedroe, The Only Guide To A Winning Investment Strategy You ll Ever Need, 2005, St. Martin s Press, p Since 1976 the total annual return for Barclay s U.S. Aggregate Bond Index has ranged from -2.92% to , with only two years with negative returns. 8 Link to Larry Swedrow s blog posting: 9 John C. Bogle, Common Sense on Mutual Funds, p Link to William Bernstein s blog posting: 11 Ibid., p Clash of Cultures 13 Rick Van Ness, Common Sense Investing: Ten Simple Rules to Finance Your Dreams, $1.00/(1.03)^40 = $ Many thanks to Nisiprius for this useful observation he/she shared in a forum discussion at Bogleheads.org. 10