Bonds: What Are They Good For? Part II
[Note: The following is Part II of a guest post that I requested from one of my Gold Sponsors, Johanna Fox, CPA of Fox & Company Wealth Management. In case you missed it, please visit Part I of Bonds: What Are They Good For, then come back for the rest of the story.]
Let’s open this second part of our bond series with a couple of statistics:
- On average, the stock market experiences an intra-year drop of 14.1%.
- On average, we have experienced a bear market (defined as a sustained drop of 20% or more) every 5.5 years since the end of WWII. Excluding the mini-bear in August 2011, we’re going on 8 years since the last bear. That doesn’t mean one is right around the corner, it just means we’re 7 years closer than we were in 2009.
- For more, see Small Stock Market Pullbacks, illustrating the historical frequency by size of drop (“drawdown threshold”) and average length before recovery.
Nobody likes nasty surprises, so preparedness is essential for successful equity investing. If you don’t regard a market drop as the end of the world, but as a normal part of the investing cycle (even an opportunity!), you’re far more likely to act appropriately rather than to react emotionally.
We recite these statistics to our clients at least once a year. We tell them that they should prepare to watch 20% and more of their portfolio vanish, albeit temporarily, in the next bear market. We tell them we will be happy to hold their hands and listen to their terror.
But we also tell them we will not entertain a request to “go to cash” or anything silly like that unless they have decided it’s time for a new financial advisor, at which point we will move mountains to accommodate their request. They may roll their eyes, and say, “I know, I know…” but we field very few panic-driven calls when the market drops 10% or more.
Of course, being a successful equity investor is not easy. In the panic of a falling market, Chicken Little is headlining every media outlet. It’s ok to be afraid, it’s just not ok to give in to your fear.
Remember: the prices of stocks tend to be more volatile than the values of the companies represented by ownership of that stock. And, in the end, that is all we are paying for when we buy shares in a mutual fund or ETF: ownership in a diversified portfolio of living, breathing, operational, valuable businesses, not lottery tickets or poker chips.
What about the “smoothing”?
Which brings us to the desire to “smooth out” the volatility in our portfolios. Because volatility is what allows equity investors to reap great rewards, a true long-term equity investor embraces volatility and hungers for bear markets and panic-driven drops, such as Brexit (when you could bet I was converting to a Roth IRA).
Smoothing out is just another way of saying, “I don’t trust myself to not go off the cliff with the lemmings, even though I know it’s a mistake, so I am happy to settle for less income in retirement and a reduced legacy for my loved ones.”
If history is our guide (and it’s the only guide we have), we know that market drops don’t mean loss of principle – unless we make the conscious effort to replace a temporary, uncomfortable feeling with a permanent loss – they are opportunities. People often take drugs to “smooth out” the rough edges rather than facing life and solving their problems. Is that what you prefer?
But how about as I “approach retirement”, you say? Retirement is another opportunity for you to be dragged back into the mind-numbing Zombieland of “conventional wisdom”.
It goes something like this: the closer you get to retirement, the higher percentage you should allocate to bonds…or…Subtract your age from 100 and that’s the amount you should allocate to equities and put the rest in bonds, sis boom bah, easy-peasy! We like simple rules of thumb, don’t we? But…I don’t have any clients whose plans run according to rules of thumb (or conventional wisdom, for that matter).
The problem with easing into bonds at retirement is that it assumes:
1) You are going to retire without a plan in place, so you must “protect” yourself by owning bonds (an easy albeit costly substitute);
2) You have a plan in place but it stipulates that you will withdraw huge chunks of your portfolio on the day you retire.
3) You know you’re going to die in 5 years and will spend all of your savings in that period.
Wouldn’t it make more sense to dispense savings per the dictates of your financial plan, your estate plan, charitable plan, etc. while allowing your principle to grow for the next 3+ decades?
Make a retirement plan.
As you approach and enter retirement, if you have a real plan in place, I see it going like this:
“When I retire at 62, we will keep 2 years of withdrawal needs (amounts we will need beyond Social Security and other resources for monthly living expenses) in a money market account. Because our joint life expectancy is 30 years and inflation won’t take a break just because I’ve retired, we will keep all but our short-term withdrawal needs invested in the same portfolio that has served me well for the last 30 years. In the event of a bear market, I will not be tempted to risk our long-term financial security by trying to time the market, because I can either cut back on spending and/or turn on the money market spigot while leaving our portfolio undisturbed.”
And so forth. If you have a plan like that in place and you trust that your financial planner is doing her job, why would you need to disrupt your beautifully-designed and efficiently-operating portfolio?
There is no such thing as no risk. There is only the choice of what to risk and when. For early retirees, the risk is even greater and the prospects are grimmer. To retire in your forties or fifties, your plan must incorporate a portfolio that will sustain you for 50 – 60 years.
You choose what is preferable: a plan that exploits the long-term growth of the equity portfolio you have planted, diversified and tended to provide an ever-increasing source of shade and nourishment for decades to come (and beyond as your legacy)?
Or, for want of a better plan (or lacking any plan at all), will you unnecessarily yoke your and your family’s futures to bonds, loans that are guaranteed to return only principle upon maturity, and that at a reduction of purchasing power after years of inflation? What if by understanding and managing risk (defined as the possibility of permanent loss of purchasing power), you can increase your returns exponentially and manage them predictably?
It all gets back to the plan. If you have planned ahead, knowing that you will experience intra-year drops and bear markets and that “this, too, shall pass”, the emotion of the moment (or the weeks or months) does not have to turn you into a bond zombie or force you to jump off the roller coaster at just the moment your portfolio will splat all over the pavement.
Instead, you can focus on the long-term plan. And if you aren’t sure you can do that all on your own, this is a perfect example of how a trustworthy fee-only financial planner who crafts and collaborates on your plan can be worth her weight in long-term results.
[Thank you, Johanna, for this excellent 2-part guest post. Readers, what are your thoughts? Still good with 100 – age in bonds?]