August 21st 2023.
It seems that more and more people are arguing against investing in bonds or only having a small percentage of a portfolio go into bonds, especially if you are retired or close to retirement. However, I challenge that idea. Bonds do serve a purpose in a portfolio and I believe that this misunderstanding of bonds comes from two main facts.
The first fact is that the average return on equities, when adjusted for inflation, is roughly 7%, while the average return on bonds, when adjusted for inflation, is about 2%. According to the data I ran through cFireSim and Microsoft Excel on August 21, 2023, the actual average real return of an all-stocks portfolio was 6.64%, while the actual average real return of an all bonds portfolio was 2.14%.
The second fact is that stock prices and returns swing wildly from year to year, but the variability dampens down over time. This is often followed by the idea that if you can just hold on to your stocks long enough, you will win. But this is a bit of a misunderstanding. There is no guarantee that you will get the better average return from stocks if you just hold on long enough. There is a significant chance that you will lose money with an all-stocks portfolio compared to a balanced portfolio that includes stocks and bonds.
To illustrate this point, I put together a graph that shows the annual returns of three portfolios over a period of time. The blue line shows a 100% allocation to US stocks, the red line shows a 70% allocation to US stocks and a 30% allocation to US long treasuries, and the yellow line shows a 100% allocation to US long treasuries. From this graph, it is clear that over two decades, an all-stocks portfolio performed worse than an all bond portfolio. Even after more than 22 years, the balanced portfolio was still ahead of the all-stocks portfolio.
I also used the Portfolio Visualizer's Monte Carlo simulator to assess the effects of adding bonds to a portfolio. This tool can give you an idea of how much upside risk you give away by adding bonds, how the average return is affected, and how the downside risk is reduced. From this information, it is clear that adding bonds to a portfolio can reduce your downside risk over a couple of decades.
Overall, the evidence shows that investing in bonds can be beneficial to a portfolio. While you may give up some of the higher upside from stocks and the likely higher average return, you can avoid some of the worst-case scenarios. Bonds can help to reduce the downside risk in your portfolio and may even lead to higher returns than an all-stocks portfolio in the long run.
Have you ever encountered someone who argues against investing in bonds? I know I have, especially if you or I are retired or nearing retirement. But can I challenge this idea? I certainly think so. It's clear to me that many investors and investment advisors don't understand the math behind investing in bonds, and so I would like to quantify the ways in which bonds can help and hurt.
The biggest misunderstanding when it comes to bonds is the average return. When adjusted for inflation, stocks have an average return of 7%, while bonds have an average return of 2%. Now, it's true that stock prices and returns can swing wildly, but over time, the variability reduces. This is usually followed by the idea that if you can just hold onto stocks long enough, you'll win.
To illustrate this point, I created a chart to show how as time passes, the annual return on stocks "reverts to the mean" or "averages out". This chart fosters a misunderstanding; it doesn't guarantee that you'll earn the better average return on stocks if you just hold on long enough. In fact, there's a significant chance that you'll lose money with an all-stocks portfolio as compared to a balanced portfolio that includes stocks and bonds.
To show the disadvantage of an all-stocks portfolio, I created a line chart that compared the performance of three portfolios over two decades. The blue line showed a 100% allocation to US stocks, the red line showed a 70% allocation to US stocks and a 30% allocation to US long treasuries, and the yellow line showed a 100% allocation to US long treasuries. The chart showed that over two decades, an all-stocks portfolio performed more poorly than an all-bond portfolio. Even after more than 22 years, the balanced portfolio beat the all-stocks portfolio.
The Portfolio Visualizer Backtest Portfolio tool can be used to quantify the effects of adding bonds to a portfolio. Specifically, it can show how much risk is taken away by adding bonds, how the average return shrinks, and how the downside risk lessens. To assess the downside risk avoided by adding bonds, you can use the Monte Carlo simulator on the Portfolio Visualizer website. I used it to create a line chart with the first, fifth, tenth, twentieth and thirtieth percentile outcomes for an all-stocks portfolio based on historical returns. By entering a 70% allocation to US stocks and a 30% allocation to US intermediate treasuries, I could see how much risk was reduced by including bonds in a portfolio.
So while it's true that stocks may outperform bonds in the long-run, they don't always do so. There's a significant chance of losing money with an all-stocks portfolio, and it would be wise to consider including bonds in some cases. With the right tools, you can quantify the downside risk avoided by adding bonds to your portfolio.
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