When you are buying equities (stocks) you are buying part of ownership in a company. The price of stocks greatly varies and is affected by a lot of factors but in broad terms, the price is determined by the potential future earnings.
If a company is seen by investors to have great earning potential, they will be ready to pay more to get a piece of the action than if a company is showing meager prospects.
Stock prices can jump up as fast as they can drop down and so the risk associated with stocks is perceived to be high. You can always mitigate this risk by diversifying into a lot of different stocks such as buying an index fund or you can lower your exposure by holding other investments such as bonds.
Bonds are boring. They are made to be boring.
On the other side of the spectrum, the bond market represents debt investments where you loan your money to a company or a government for a defined period of time at a fixed or variable interest rate. They are designed to stay relatively steady and generate income for the debtholders.
Bondholders do not get a share of company’s profits but rather collect interest at an agreed upon rate.
If a company finds itself in financial troubles, the stock would tumble and might even go to zero but bondholders get priority claim over stockholders if the company gets dissolved. In other words, if the company has any assets, such as equipment or inventory, the bondholders would get paid back before any money goes towards the stockholders.
For the issuers, it is a simple way to raise capital for new equipment, new schools, or new war efforts without giving away equity.
Source: Vintage Ad Browser
For the holders, bonds hold two main functions; hedging against equity risk and generating steady income. By holding a diverse portfolio of stocks and bonds, you can choose the level of risk and reward you wish to take on. Bonds tend to return less but have been historically steadier than stocks.
The chart below shows the growth of $1 invested in stocks using the S&P 500 Index versus $1 invested in bonds using the Barclays Capital US Aggregate Bond Index.
Source: Russell Investments
As shown, over this time period, an investor would have made $112 out of his dollar in stocks compared to only $24 if he had invested in bonds. The choice seems obvious.
However, just look at the chart now and notice how bumpy the stock roller coaster was compared to the smooth sailing bonds. In rough times, bonds will be there to balance things out and that is their main attraction.
Investing in bond-index funds, such as the Vanguard Total Market Aggregate Fund (BND), involves inflation and credit risk but long-term returns have historically been stable. According to the average rollover of the fund, the risks are minimal if you are holding it for over 7 years.
The average maturity of the Vanguard Aggregate fund is about seven years, which means that over that period, its entire portfolio has been rolled over to new bonds. It also means that it is virtually impossible to lose money by holding this fund for seven years, – Cullen Roche
The fixed income market has been disappointing lately, now that interest rates are so low, but over the long-term, bonds should still provide considerable returns.
However, there is room for fixed income in a portfolio even in a low-rate environment.
Managing risk with the bond market
The main benefit of holding a good part of your portfolio in bonds (let us use a balanced 60% stock / 40% bonds allocation) is that you will be able to sleep well during the next major crash.
During the latest bear market in 2008, we saw stocks plummet drastically but the Barclays U.S. Aggregate bond index had a positive return of more than 5% in 2008 and almost 6% in 2009.
A balanced portfolio would have dropped but not nearly as much as a 100% stock allocation. Depending on your risk profile, you might be tempted to sell when your portfolio falls 40% but that is exactly the worst time to sell!
Holding a good part of your assets in bonds will lower the swings of your portfolio and might save you from selling at the bottom.
| Historical Returns (1926–2016) for a 60% Stocks, 40% Bonds Portfolio | |
|---|---|
| Average annual return | 7.8% |
| Best year (1933) | 27.9% |
| Worst year (1931) | –18.4% |
| Years with a loss | 16 of 91 |
Looking at historical data from 1926 to 2016, Vanguard compiled the variations in different portfolios. For a balanced portfolio, the worst year only drops 18.4%. On the other hand, if you look at a 100% stock portfolio, the worst year dropped your portfolio’s value by a whopping 43.1%.
| Historical Return (1926–2016) for a 100% Stocks Portfolio | |
|---|---|
| Average annual return | 10.2% |
| Best year (1933) | 54.2% |
| Worst year (1931) | –43.1% |
| Years with a loss | 25 of 91 |
If you are risk-averse, the worst thing you can do is sell as soon as you see your portfolio drop 43% but having bonds would have enabled you to keep your calm, hold on, and ride the market back up.
Withdrawal strategy in retirement
Even if historically, a 100% stock portfolio has returned more than a balanced portfolio, Monte Carlo simulations actually show a higher chance of success when you add some bonds.
Running Monte Carlo simulation using available historical returns data from January 1972 to December 2016, the historical return for a 100% stock portfolio for this period was 11.71% mean return (10.18% CAGR) with 15.53% standard deviation of annual returns.
Using the 4% rule and historical inflation with 4.02% mean and 1.32% standard deviation based on the Consumer Price Index (CPI-U) data from January 1972 to December 2016, the simulation calculated an 86.23% chance of success over a 30-year period.
Now, when using a balanced portfolio with a 60/40 asset allocation, the historical return for the same period was 9.30% mean return (8.76% CAGR) with 9.35% standard deviation of annual returns.
Lower returns indeed but the chances of success over a 30-year period now jumps to 97.64%.
As shown, having a nice cushion to smooth the ride is crucial when in the withdrawal phase. Having bonds will minimize the need for you to sell stocks during the worst bear markets.
As discussed earlier, selling stocks at their lows is not preferable so if you are depending on a withdrawal rate to live, having bonds would allow you to hold on and ride the market back up.
Another option would be to hold a year or two’s worth of living expense in cash but then you would miss out on potential bonds returns. They have been low lately but, historically, has returned more than cash-equivalent holdings.
Buying the dip
If you are not withdrawing and are still in your accumulation phase, bonds could also be used as a lever when stocks do very poorly. You could sell bonds while they are high (assuming they keep their value in during that crash) and buy stocks when they are low.
This can be achieved with cash too, we currently hold our money in a 1.90% savings account on top of the 5% to 10% of our portfolio in Vanguard’s Total Bond Market index fund.
In a situation where the market would dip considerably, you could sell some bond index fund and buy some Total Market Stock index fund for cheap. This might sound like market-timing. Well, that is exactly what it is.
However, this strategy offers all the benefits of bonds mentioned above and our bond allocation is so low that we might consider it a reasonable gamble to take.
If we see our portfolio cut by 40% in the next crisis, our 5% to 10% bond allocation will not really smooth the ride as much as a balanced portfolio would. We are talking about a few percentage points difference compared to a 100% stock portfolio.
However, switching these into equities would greatly increase our total returns if the market then goes back up.
Using the fictional representation above, doing a switch from a 90% stock to a 100% stock portfolio anywhere in the blue zone would increase our total returns.
From the absolute bottom of a 40% drop (it is impossible to time it but let’s use a round number for the math), our new purchase would have grown 66.66% once it recovered to its original high.
Our total portfolio value would then have grown 16.67% more than if we had kept the same allocation. Of course, this assumes that the bond market would be steady, or increase, at the time when the stock market is crashing.
Another big assumption here is that you are able to buy within the blue section. If you do not buy near the bottom, you are missing the dip.
So in the end, a 10% switch from bonds to stocks increased returns 16.67% in our fictional recession. The lower your portfolio dips, the more profitable this switch would be. In this example, we used the absolute bottom of 40% but this is nearly impossible to do in real life.
We highly discourage market timing since it is a gamble. When will it be profitable to buy the dip? Will you miss opportunities waiting for the right time? No one knows.
The chart above shows a real market this time. If you had been waiting for the right time to buy the dip, would you go at the first or second drop or those were too slim?
What if you finally went on the fourth dip? Then, you would have probably been better off with a 100% stock portfolio from the beginning.
Holding on for too long, in the hopes to buy the dip, might not increase your returns. The yield on a U.S. 10 Year Treasury Note, pretty much the safest bond you could get, has fallen from 14% in 1984 to 8% in 1994 then to 4% in 2004 and to under 2% today.
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The verdict
In the end, we choose to hold bonds to smooth out our returns, while holding a certain security in case of emergency or opportunity.
The reason we hold some bonds, although a very little percentage of our total portfolio, is to have flexibility.
The flexibility to buy the dip if we feel like it. The flexibility to use it as an emergency fund if we go through our current savings. It will not save us from the next crash but again, what would?
Xyz.