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.