Technical note: In the two charts below, each portfolio's performance is indexed to the pre-crisis bond market peak. All returns are geometric total returns, inflation-adjusted, with dividends reinvested. The two charts are drawn to different scales, with black circles showing the point at which each portfolio permanently regained its pre-crisis real value (assuming no portfolio withdrawals).
1. The World War I Inflation Shock
U.S. inflation rose from 1% in 1915 to 20% by 1918, and stayed above 17% until 1920. Why this massive inflation spike? After the war began, U.S. banks monetized the large quantities of gold that European nations were moving into the U.S., as protection from the conflict and to pay for U.S. exports, since the U.S. was on the gold standard. All portfolios suffered (chart below), with bond-heavy portfolios losing 40% of their value and not fully recovering for 10-12 years.
2. The Progressive Inflation Disaster of 1940-1989
After World War II, the 1940s saw high inflation, with spikes of 10%-15% during the decade. By the early 1950s, bonds had lost 35% of their real value (in blue below) — and did not fully recover for another 40 years! The Oil & Inflation Shocks of the 1970s drove bond values down even further, finally rescued by the dramatic monetary policies of Fed chairman Paul Volker in 1979. Interestingly, even a 20% allocation to stocks would have preserved the capital value of a bond-heavy portfolio over this period (in green below), assuming no portfolio withdrawals.
Personally, I've never thought much about bond-heavy portfolios, since we've never held less than 50% stocks (currently 50/50 in retirement). But based on the past history of bond disasters above, a few observations:
- 1) 100% nominal bonds is not a safe portfolio allocation for any long-term investor. Allocating 25%-40% to stocks would likely help preserve real capital values over long holding periods, especially with periodic withdrawals.
2) Allocations to TIPS, short-term bonds and cash would add further portfolio protection against high inflation.