Bonds: What are they good for? Part 1

[jfoxcpacfp]

Thought some of you might be interested in a guest post that PoF kindly asked me to share. Before you get too riled up, remember that Part II is coming out next week. 

[The White Coat Investor]

For those who are unaware, this is a long-term disagreement Johanna and I have. The counterpoints are best explained in Rick Van Ness's excellent Why Bother With Bonds.

It's definitely a controversial area of investing, but the basic arguments for bonds include:

1) Diversification - bonds are different from stocks and so perform differently in various market conditions

2) Return - While bonds are generally lower risk/lower return vehicles, there are bonds with expected returns similar to those of stocks

3) Decrease portfolio volatility - It turns out that very few investors (and their advisors) can tolerate a 100% equity portfolio in a severe downturn

4) Decrease deep risk in important ways - Volatility is "shallow risk" that can be ignored by a long-term investor with a stomach of steel. Deep risks, which Bernstein defines as inflation, deflation, confiscation, and devastation, are much more significant. Bonds provide significant protection against some of these. Bottom line- it is possible (even if perhaps unlikely) your bonds will outperform your stocks for long periods of time, perhaps your entire investing career.

Moderation in all things, including portfolio design.

[Zaphod]

Absolutely agree that long term government treasuries have a poor risk:reward profile here. All the coupons have been pulled forward in capital appreciation limiting a long term scenario where its a great outcome. Volatility dampening I understand.

I hold muni bonds as a significant portion of my portfolio, but really theyre about volatility and tax free income from savings. I did buy some high yield funds in February and will continue to hold. Though bonds are really about risk adjusted returns, and that is where their value lies. However, as noted above, contrary to the 30 years before now, they even have a pretty poor risk/reward profile thus unlikely to give much risk adjusted return value. They might even be a significant portion of that risk and could make a good argument as such. Or, we could go on a path like Japans, but we're much different and our demographic destiny is much different than theirs at this time.

Good arguments can be made either way. The past of course doesnt exactly match the future either. This is a very interesting time in portfolio construction to be sure.

[jfoxcpacfp]

The White Coat Investor wrote:

For those who are unaware, this is a long-term disagreement Johanna and I have.

Click to expand...

A gentle(wo)man's disagreement, to be exact.

The solution is interactive, collaborative financial planning. For people who choose not to engage in financial planning (which is far riskier than volatility, which does not equate to risk), then, yes, bonds are a (poor) substitute. So is a large sum of cash.

[conniebird]

I enjoyed reading the article and waiting for part 2

[PhysicianOnFIRE]

This is an outrage! How dare you talk trash about my bonds!!!

 Thank you, Johanna for your insightful post(s). I've been intrigued by your seemingly anti-bond stance, and I wanted to give you the opportunity to more fully explain your position and rationale. There is some good discussion & debate in the comments section. Thanks again for participating.

Best,

-PoF

 

[DarrVao777]

Copied from WCI's reply on PoF's blog

"Benjamin Graham recommended you maintain your stock:bond split between 75/25 and 25/75. I think there is great wisdom there. Moderation in all things.

If you need the extra kick of having 100% stocks in your portfolio to reach your goals, perhaps you should save more, work longer, and/or spend less in retirement rather than making such a big bet on equities."

Agree wholeheartedly. Admittedly I'm still in the early phases of attendinghood where savings % means more than asset allocation. I've still opted for a 67:33 stock:bond split for my retirement savings as I don't know how I'll react the first time I encounter a bear market. I truly don't check those accounts but for once a month to make contributions. Still, I'd rather be more cautious and adjust accordingly.

I've compensated by attempting to save > 50% of gross, anticipating on working a full career (for now, I like my job now but I realize how quickly the winds change), and spending ~20% of gross (which admittedly is still way more luxurious than living like a resident)

I do have a separate account that's 100% equities and it is more of a "icing on the top" account. Doing well? We'll get that big house and luxury car we always wanted. Not doing well? Stay the course, keep dumping in any extra funds (after fully funding retirement accounts, 529, backdoor Roth), and wait for sunnier days.

[Hatton]

I have always had some bonds.  I now have a 62/38 asset allocation.  I am nearing complete retirement and I have been trying to increase the bonds.  It is painful since I like stocks and feel I understand them better than bonds.  I am trying for the classic 60/40 split.  I  notice less volatility with increased bonds.  The highs are lower but the lows are higher.  Diversification must be working.

[DMFA]

I hate when mom and dad fight in front of us...

Personally I've got a li'l bit of bonds in my TSP via the G and F funds...in fact, I need to make a thread about that.

[PhysicianOnFIRE]

FYI, Bonds: What Are They Good For? Part II, the thrilling conclusion to this nailbiting saga is now live. More good discussion in the comments.

[conniebird]

Really enjoyed both articles. I have about 3-5% in bonds.

 

I was planning to have at least a years worth of living expenses saved up at retirement, but like the argument for 2 years to weather market downs.

Not sure I'd be comfortable with still having nearly 95-100% in equities at retirement though (slated for in 20-ish years now).

[Rando]

What is it good for
Absolutely nothing
Uh-huh huh

Bonds ain't nothing
But a heartbreaker
Friends only to the undertaker

 

Sorry I start singing that every time I see this headline.

[PhysicianOnFIRE]

An alternate viewpoint from none other than WCI in this article @ Physician's Money Digest.

Cheers!

-PoF

[Shamwow]

I love that we have a place that we can discuss the merits of both sides without resorting to name calling (you know, presidential type stuff!).

I see valid points from both points of view... for now, I will stick with 15% bonds and anxiously await my first real bear market massive stock sale!!!   Keep my savings rate as high as I can, and have some bonds for rebalancing when my target asset allocation differs significantly from actual!

[Raster]

Thank you for that perspective.  Even if you have nerves of steel, this is likely a suboptimal strategy.  Likely because who knows what the future holds, but it is hard to believe the future will be as dramatically different from the past as Johanna imagines, when risk adjusted returns of stocks have lagged badly that of more diverse portfolios.  A portfolio that delivers similar return with less volatility is simply a better portfolio.  A long time horizon doesn't fix the volatility problem, because unless the portfolio is held indefinitely or withdrawals are optional (i.e. you never actually NEED the money) you will be making withdrawals at some point.

The article on portfolio charts explains it very well and is well worth a read:

https://portfoliocharts.com/2016/07/25/thinking-beyond-stocks-can-fortify-your-accumulation-plan/

As you can see, stock diversification alone does not provide the same benefit as diversifying across multiple asset classes including bonds.  Most portfolios he cites provide much better drawdown protection for the same minimum growth rate.  You are more likely to hit a home run with an all stock portfolio than a multiple asset class portfolio.  But the whole point is to construct a portfolio with the smallest risk of underperformance over the time frame required.  5 years is much too short for an all stock portfolio.

If you invested 100% in TSM in 1982, your 10 year annual real CAGR was 12%.  The return on the same investment in 2000 was -2.73%.  Per year.  For a decade.

If you are feeling lucky, you have a chance of ending up with a much larger portfolio with 100% stocks.  Historically, many diversified portfolios had a similar (or higher) real CAGR with far less risk.  If you picked your beginning year just right, you did better with all stocks.  I don't get to pick my beginning years.  I get EVERY year for the next X years, so I want a portfolio that has the best chance of providing a reasonable return.