As we begin our lifelong investing “career” we must recognize the risks inherent in investing. A primary risk for investors accumulating the funds for their retirement years is that they fail to accumulate a nest egg that can outpace the cost of living.
In attempting to garner positive real, after-inflation returns, investors tend to rely on the long-term historical return of asset classes, and harbor a hopeful expectation that the future will offer similar long-term returns. The 1900 – 2013 performance of globally diversified investment markets shows that the global markets have provided positive real returns.
- Historically, the markets have offered investors compensation for bearing risk, as equities have realized premium returns over bonds; and bonds have offered premium returns over bills.
The world risk premium for stocks over bonds was 3.40%
The world risk premium for bonds over bills was 0.90%
The world risk premium for stocks over bills was 4.30%
- Although some nations have realized better historical performance than others, and we can expect differences in future returns, we can have no assurance of exactly which national markets will be relative winners or losers going forward.
- Investing globally can diversify the risk that one’s home market will offer poor future returns.
Owning stocks is necessary to get the expected return needed to accumulate funds for retirement. Stocks give us a share of the profits generated by publicly owned companies in the economy. But in exchange for the hope of high return, stocks are extremely volatile and risky. Stock prices can stagnate or decline for decade-long periods
The chart below shows US stock market performance (1929 – 2011) as measured by the S&P 500 index. As seen, the long-term upward trend is punctuated with periods of extreme losses. These periods can result in:
- Investors abandoning the stock market during the depths of the downturn, thus locking in the loss. The emotional scars can lead to an investor deciding to never again invest in stocks.
- Note that many bear markets accompany economic recessions. In recessions you might lose your job or suffer reduced income. You might need to tap your investments for living expenses, thus forcing a sale at market lows.
- A severe bear market occurring as you approach retirement or are entering your retirement years can either delay your retirement, or greatly reduce your portfolio’s ability to provide a sustainable life-time income.
It is easy to underestimate stock market risk and to overestimate your tolerance for risk. Many people found out the hard way after the crash of 2008. Those people learned too late they should have held more bonds, so you should think carefully before choosing an asset allocation with high stock market allocations. If you have not been through a major market downturn before, it is hard to explain how your logical considerations of risk can quickly become emotional ones.
This is why having a bond allocation is a necessary element of asset allocation.
Bonds are a promise to pay back a loan of money on a pre-set schedule. Bonds do not produce the same expected high returns that stocks do, but they are much less volatile. (see table to the right).
Inflation is a large risk affecting nominal bonds. For US bonds, two periods of extreme duress occurred from August 1915 to June 1920, when treasury bonds provided a -51.0% real return. Bonds recovered the loss in August 1927.
Treasury bonds lost -67.0% in real value from December 1940 to September 1981. Treasuries recovered the loss in September 1991.
Investors holding balanced portfolios of stocks and bonds experienced lower draw downs and experienced shorter recovery periods in real value.
For example, Vanguard research shows that a 50% US equity/ 50% US bond portfolio has produced annualized real returns of .5.26% during economic recessions and annualized 5.59% annualized returns during economic expansions. Note however that the historical averages mask recessionary periods when returns for this allocation were negative. These periods include the Great Depression; 1937; 1973; and the 2008 financial crisis. During these periods real return annual losses ranged between -5% and -15%.
The way to get reasonable growth without stomach-churning drops is to hold a mix of stocks and bonds.
Bogleheads like to own bond funds instead of individual bonds for convenience and diversification. Using individual corporate or municipal bonds require a very large holding to achieve the broad diversification and increased safety of a bond fund. The high number of bonds in bond funds let you ignore the risk of any one bond defaulting.
Interest rate risk can be managed if you select funds with short and intermediate-term duration, while default risk can be managed by selecting funds with high credit ratings. The central idea here is that your bond holdings are for safety, to reduce violent up and down swings in overall portfolio value. Bogleheads tend to take risks on the equity side, not the bond side.
The goal is to select an asset allocation that lets you sleep at night, and avoid the destructive urge to sell out in a panic the next time the market plummets; then having to agonize over when its a “good time’ to get back in. This leads to selling low and buying high, the exact opposite of prudent investing.
How much bonds? That’s the basic question of asset allocation. Before you decide, you first need to balance your ability, willingness, and need to take risk. The more risk you can handle, the less bonds you need. When you are young, your prime earning years lie ahead, and it will be decades before you need to access the money. So, higher stock allocations may be suitable since big drops in stock prices will not hurt as long as you do not flee the market.
Although your exact asset allocation should depend on your goals for the money, some rules of thumb exist to guide your decision. Any rule of thumb is only a starting point for decision making, not the end.
Consider Benjamin Graham’s timeless advice:
“We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequence inverse range of 75% to 25% in bonds. There is an implication here that the standard division should be an equal one, or 50-50, between the two major investment mediums.”
John Bogle recommends “roughly your age in bonds”; for instance, if you are 45, 45% of your portfolio should be in high-quality bonds. Mr. Bogle describes the idea as just:
“a crude starting point” which “[c]learly . . .must be adjusted to reflect an investor’s objectives, risk tolerance, and overall financial position”.
“Age in bonds” and its variants, (age – 10) or (age – 20), are only crude starting points to be adjusted for the investor’s circumstances; a key circumstance being the presence or absence of a pension, which would change ones willingness or need to take risk.
Bogleheads typically divide bond allocations between just two categories: nominal bonds such as the Vanguard Total Bond Market fund, and U.S. Treasury Inflation Protected Securities (TIPS) such as the Vanguard Inflation Protected Securities fund. The use of a TIPS fund provides additional diversification as well as inflation protection.
I-Bonds are also an attractive alternative to TIPS. They are sold directly to investors by the U.S. Treasury; can be bought using your IRS tax refund; don’t need to be held in a tax-protected account; and accrue interest tax-deferred for up to 30 years. There are annual limits on how much you can buy in I-bonds.
- Graham quote: The Intelligent Investor, p. 93 of the 2003 edition annotated by Jason Zweig
- Bogle quote: Common Sense on Mutuals Funds, (2010) pp.87-88.