16 May 2007

You're young. Do you need bonds?

Conventional wisdom says everyone needs some bonds. If you don't need them for income, you need them for a diversifier, to balance out those bad years in the stock market. Right?

Wrong.

At least when your investment horizon is at least 10 years it is wrong. I recently came across a spreadsheet with total annual returns for most of the major segments of the financial marketplace, dating back to 1972 . . . it also has a handy tool that calculates what your return would be with a certain asset allocation. I added functionality to see what return would be by 10 year periods, since I am not interested in short-term behavior as a long-term investor.

When looking at the total US stock market and the total US bond market, care take a guess in how many 10-year periods bonds beat stocks? Once. Out of 26 10-year periods, bonds beat stocks once, from 1973-1982, by a score of 8.32% to 7.44%.

In only one period out of 26 did holding bonds enhance your returns over the returns of the total stock market. Not what I would have expected, but then I had never held all the numbers before.

Is there a better option to limit the chance of a "bad" decade in the market? Yes, there is. Let's start with Large Cap Value stocks. In the short term they are clearly more volatile than bonds. But when smoothed out over 10 years, they are never beaten by bonds. Ever. Not once in 26 periods. The worst period for large cap value stocks was from 1993-2002, where it saw 9.27% gains. That was the worst period. Read that again . . . let it sink in. The average return for bonds since 1972 is 8.06%. The worst 10-year period for large cap value stocks is 9.27%.

Hello.

And Large Cap Value isn't alone. Mid Cap Blend (10.64%) and Small Cap Value (10.92%) also outperformed the average bond return in their worst 10 year period. I didn't have info on mid cap value, but I would be willing to bet that it did too.

So it's clear here that there are better investments when it comes to minimizing long-term risk-- and they return much, much better. But what of the possible return enhancements of diversifying with bonds? Is it possible that in some years, their higher returns over stocks will actually improve the overall return? Assuming you aren't psychic and can't time the market, you'll have to keep some bonds all the time if you hope to accomplish this.

So I took this question and some handy common portfolios to try it out. Here are the portfolios:

  • Swenson: 30% US market, 20% REIT, 20% international, 30% bond. The total return of this portfolio over 35 years is 11.56%. The worst period was 8.35% and the best was 16.78%. What happens when we replace the bonds with
    • Large Cap Value stocks? Total return of 13.00%, worst period of 8.83%, best of 18.55%.
    • Mid Cap blend? 13.89%, 9.48%, 19.05%
    • Small Cap Value? 13.55%, 9.44%, 21.18%
  • CoffeeHouse: 10% large cap value, 10% large cap balanced, 10% small cap balanced, 10% small cap value, 10% reit, 10% international, 40% bonds. Returns of 11.68%, 8.63%, 17.04%. Replace bonds with:
    • LCV? 13.61%, 9.29%, 21.02%
    • MCB? 13.71%, 10.13%, 21.73%
    • SCV? 14.26%, 10.01%, 24.56%
  • My portfolio: 35% large cap blend, 15% mid cap blend, 10% small cap blend, 30% international, 10% bonds. Returns of 12.26%, 8.14%, 18.89%. Replace bonds with:
    • LCV? 12.70%, 8.24%, 19.46%
    • MCB? 12.73%, 8.48%, 19.40%
    • SCV? 12.91%, 8.50%, 19.46%
Hm. So in all 3 of those portfolios, replacing bonds with one of the other 3 asset classes raised returns EVERY time. Overall, in the best times, and in the worst times. So much for the diversification benefits of bonds.

I'm almost convinced that I need to get rid of my bonds and get into something better. I'll do some more reading first. If my investment window were less than 10 years, I would reevaluate bonds over that short timeframe. As it is, my investment horizon is at the very least 20 years away. From the looks of it, I'm only going to lose money by keeping anything in bonds.

15 comments:

Jeremy said...

Good timing on this post. To answer the question in the title of this post, I would have to say "It depends on what types of bonds you own". For someone looking downside protection by adding bonds that return an almost insulting 4-5% I would agree with you and say no.

But, someone who takes a little time to dabble into more speculative bond holdings could actually use bonds to help outperform the overall market during certain economic conditions.

Actually just this morning I was asked by another blogger to discuss my current portfolio holdings and I provided a fairly detailed breakdown of my asset allocation. The bottom line was a mix of about a 70/30 mix of stocks and bonds, yet an overall return of about 20% for 2006 and a 2005 return right in line with the overall market. You can see my breakdown here:

http://www.thedigeratilife.com/blog (sorry, can't post the complete link to the post, it cuts off part of the URL)

The main reason for this is that while 30-40% of my portfolio may be in bonds, they are essentially in junk bonds that are providing yields of 8-12%. So unlike a typical conservative bond holding these are essentially just as risky as the equity holdings.

What helps boost returns even more is that these high-yielding bonds are constantly churning out healthy dividends in the form of cash that can continue to be added to the portfolio. While the equities are seeing good returns as well they are in the form of capital gains with very little in terms of income. This steady stream of income allows you to put that money back to work just enhancing your returns.

Of course this strategy doesn't work all of the time and it isn't something you can set and forget. So I certainly wouldn't recommend someone building a similar allocation with just a bond index fund or etf because in all likelihood that would just bring down the total return while providing only modest downside protection.

So that being said, I just wanted to comment on this good post you had to point out that not all bonds are created equal, just as not all stocks are created equal.

Brad said...

Thanks for the great comments! I admittedly know very little about junk bonds . . . your review of your portfolio was very enlightening.

I should probably have been clearer that I was referring to a total bond index, and that the mileage of specific bonds may vary (just, as you said, like stocks).

Jeremy said...

No problem. You are correct though, since most investors are generally creating a portfolio with funds inside an employer plan, index funds or pre-allocated funds this is generally not an option so having a significant holding of those types of bonds would have little positive impact.

dong said...

Jeremy, great comments. I'm curious if you invest in Junk Bond funds or junk bonds by outright? I've been thinking about diversifying a bit more into Junk bond offerings, but have been apprehensive given the relative small risk premium as of late... Any thoughts?

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