Bonds: What Are They Good For? Part I
[Note: The following is a guest post that I requested from one of my Gold Sponsors, Johanna Fox, CPA, CFP® of Fox & Company Wealth Management. She was one of the first people to see my Sponsorship proposal. I sent it to her not because I expected she might be interested in sponsoring the site, but because I know she is not afraid to speak her mind. If I was asking too much, she would tell it to me straight. On the WCI forum, she has expressed her opinion on bonds, and I thought it would be great to allow her to more fully explain her stance and rationale here on my site. Thank you, Johanna, for sharing your time and expertise.]
When PoF asked me to write a guest post on bonds, I agreed with gusto. You see, I hold the unconventional belief that bonds have no place in a long-term investment portfolio. Not only that, but I can’t understand why it is not obvious to the smart doctors on White Coat Investor. Not to say that we do not hold bonds for clients, just not for the purpose you might assume. Allow me to lay out my case for the FIRE readers and we’ll see where you stand. Let’s begin with a few contextual definitions for the purpose of this post.
- The short term is the next 5 years. The long term is anything beyond. Given the short-term volatility of investments, the only appropriate holding period is the long term. In fact, we don’t invest in the short term – we speculate, which is very risky.
- Investors are owners – of real estate, common stocks, partnership interests, etc. We invest with the intention of growing an income we cannot outlive and that will provide an ever-more valuable pool of capital to be left as a legacy for our heirs.
- Bondholders are loaners, not owners. We use bonds to provide for planned short-term liquidity needs at a higher returns than a money market account would yield.
- Stocks refer to the universe of stocks, not a personal market basket of favorite equities or your company’s ESOP (Employee Stock Ownership Plan).
- A dollar bill is currency, not money. Money represents purchasing power. Currency represents units of that purchasing power.
- Now, hold onto your hats: Volatility, of the nature we experience as equity investors, is not risk, although the financial pornography media industry would have us believe otherwise.
Volatility is scary, just like riding the famous roller coaster El Toro is scary. But riding El Toro is risky only if you do something stupid, like jumping off during the ride. Volatility is what produces the marvelous growth that equity markets give us.
Unlike a real roller coaster, where you always get off where you got on, the growth is permanent while the declines are temporary. It’s easy to lose your grip on that concept when your portfolio is clattering down the rails of El Toro by 15% or more, but you must hold on in order to reap the reward that true ownership has to offer the long-term investor.
Risk and Returns
So, if volatility isn’t the same as risk, what is risk? And here we have our final contextual definition:
- Risk is the possibility of permanent loss of purchasing power.
I believe the great financial risk we ignore when planning for retirement is not loss of principal, which is almost always the primary focus, but loss of purchasing power. It’s not how many units of currency we own that matters – it is how much that currency can purchase.
Following are some statistics (rounded to the nearest whole numbers) for the period beginning in 1926 (considered the earliest date from which we can retrieve meaningful, measurable market history) through 2014:
- Average inflation has run about 3%
- The average return for high-quality corporate bonds has been 6%
- Large-cap stocks have averaged a 10% return (dividends reinvested)
- Small-cap stocks have averaged a 12% return (dividends reinvested)
What really matters, though, is real returns (returns net of inflation), so let’s calculate them:
- Bonds: 6 – 3 = 3% real returns
- LC stocks 10 – 3 = 7% real returns
- SC stocks 12 – 3 = 9% real returns
When we look at real returns, we see that Large-Caps deliver double that of bonds while Small-Caps yield thrice the returns of bonds. Adjust for income taxes and you’ll realize that bonds have returned little better than nothing after inflation and taxes. So why do we so quickly harness our portfolio to the group-think that bonds are essential to our long-term financial security? I believe it is due to our fundamental misunderstanding of volatility.
Because we define volatility as risk, we also equate volatility to loss. But consider this: permanent loss in a diversified equity portfolio is always a human achievement – of which the markets are incapable. I firmly believe that behavior accounts for 90%+ of our investment results while diversification and rebalancing (management) account for the remainder. So how do we, as investors, avoid these very human behaviors in order to experience the upside of the equity market without the permanent loss we fear? Follow these steps and you can stop worrying about protecting principal and focus on building wealth and an income stream that you will never outlive:
- Do not ever invest without first creating a financial plan. If you don’t know when you will need funds, you are at the mercy of your emotions during periods of volatility. Your plan need not be elaborate, but you do need to reasonably articulate your 5-year needs and your long-term goals. Ignore this step and this article is worthless to you.
- Never invest any funds you will need in the short term. Again: we do not invest in the short term, we speculate. Liquidity and safety, not growing wealth, are priorities in the short term. Even though, odds are that your portfolio will grow in the short term, that’s just not good enough – you need certainty. Long-term goals will change over the next 10, 20, 30 years, and you’ll have more time to adapt. Short-term goals, by their very definition, are less flexible. Allocate short-term savings as follows:
- Funds for unpredictable spending belong in a basic interest-bearing account. This includes your monthly living costs, your emergency account, and so forth.
- Money for “planned needs” should be loaned using debt (CDs and bonds) timed to mature when you will need it. For example, if your plan dictates a car replacement for $40k in 4 years, buy a bond of equal value maturing in 4 years. You’ll earn a little interest along the way and your money will be there for you when you need it.
- The interest you earn in the short term is secondary in the context of your overall plan. Don’t waste time fretting over .9% versus 1%.
- Invest in a properly diversified and managed equity fund portfolio for the long term.
- Our goal of diversification is to capture the overall returns of the world market. As such, our portfolios are split fairly equally among: LC Value, LC Growth, SC Value, SC Growth and International with REITs for a possible 6th sector. Always funds, not shares of stock.
- Proper management mean rebalancing annually, adjusting as goals change, investing according to your long-term plan and, otherwise, leaving your account to grow.
- All things being equal, look for managers who follow the requirements laid out in the fund’s prospectus and also for funds with relatively low turnover. (Index funds work fine and we typically use them for doctor portfolios.)
Assuming we follow the above guidelines, what could possibly cause us to settle for less when we don’t have to?
I bet I know what you’re thinking: What about retirement? What about smoothing out volatility when the market crashes? We’ll address those and other questions in the second half of this series.
[PoF: Do you hold bonds in your portfolio? Why? Do you use a formula to determine your bond allocation? Let us know below, and read on in Part II.]