NO BONDS!
By Chad on Jun 8, 2008 in 401k, Say No to Conventional Wisdom
No bonds! No bonds! No bonds! Why would you include bonds in your portfolio if you aren’t within a few years of retirement? Yes, I know bonds provide a less volatile portfolio with a minor reduction in return. Why would anyone want that?
Most people have the majority of their retirement in their 401k or IRA. Assuming that who cares about volatility! If you are 20, 30, 40…even 50 you probably won’t be pulling any money out of these vehicles any time soon. These accounts are not being used to save for a house, a new car or a vacation, so what do you care if your account goes down 20% this year. A loss in an account you aren’t going to touch for 20 years…big deal.
Of course, along with larger potential loses come larger potential gains. Maybe you get a 30% return the next two years and easily outpace the 7-9% target on a “properly” allocated portfolio.
So, let’s take a look at the returns produced by different mixes of stocks and bonds. These numbers are from 1980 to 2004, so the overall return is a little higher than normal due to the huge bull market. However, the curve is very consistent no matter what time period you use, so the chart is applicable.
As you can see the more stocks the more risk/volatility, but as we have already discussed who cares. The difference of return between an 80/20 stock/bond portfolio and 100% stock portfolio is roughly .5-1%, based on the above graph. This doesn’t seem like much, but it adds up over time.
Also, how much are the bonds really protecting? Let’s assume you are 2-3 years from retirement and the worst happens. We experience a stock market disaster equivalent to the worst in modern history (after the Great Depression), which would be from January 1973 to December 1974 and results in a 45% drop in your stock portfolio. Now assume two people have been consistently saving and investing $10,000 a year for 30 years. One person did the 80/20 method, so they averaged a 7% return per year. The second person invested in 100% stocks and averaged an 8% return per year. As you can see both returns are easily within historical norms, so no wild assumptions have been made.
After 30 years person one, with the 80/20 portfolio, has $1,005,750, while person two, with the 100% portfolio, has $1,216,005. Unfortunately, one year before retirement, in year 31, a huge bear market occurs causing a 45% drop in the market. Person one is pleased they were “smart” enough to have allocated 20% of their portfolio to bonds, so they get a 4% return from the bonds and are hit with a 45% loss on 80% of the portfolio in the stock market. All of this brings person one’s retirement to $651,726 from $1,005,750, which is only a 35% loss for the entire portfolio.
Person two with a 100% stock portfolio gets hit with the full 45% drop. Well, this should be pretty bad…right? Nope…their $1,216,005 portfolio is now worth $668,903.
Hmmm…person two with the “risky” 100% stock portfolio had $17,076 more for retirement after the largest market drop in 40 years and the second largest drop in 80 years. How is that possible when person two failed to maintain a conservative portfolio? It’s because you can’t make up for years and years of poor returns by investing like the world is going to collapse every year. Being conservative doesn’t improve your odds of retiring; it increases the risk you will not have enough money to retire on by lowering the total return of your portfolio.
I’m not advocating holding 100% stocks a few years before retirement, I’m saying don’t even think about bonds until your within 10 years of retirement…even then, think about waiting a little while longer.
Don’t accept below average returns in a portfolio when volatility doesn’t matter! A 100% stock portfolio is the only way to go.
On MMND blog you said you’re 65% in cash right now, so why argue for a 100% stock portfolio for others?
Trug | Jun 8, 2008 | Reply
Trug, thanks for the response.
Actually, I said I was 85% cash (in a money market), but your question is still valid. I do some market timing, so I go from 100% stocks to where I’m at right now, every now and then…though not often. I was 100% stocks from roughly 2001 to last fall, which was when all signs strongly suggested a bad recession. So, I got out. I’m still waiting for a good entry point for the long term, so that’s why I’m still in cash.
I wrote my post to address how structuring a portfolio against conventional wisdom works better. It also matches my actual portfolio 90-95% of the time. This does not mean for 5-10% of the time I hold bonds. It just means for 5-10% of the time I’m selling and then waiting for a good entry point.
I will be writing a future post on why conventional wisdom is the same for all financial planners and many mutual fund managers.
I’m hesitant to write a market timing post. If I do it won’t be a how to post, but a why I do it post.
If I didn’t answer your question or you have more questions, please reply.
Chad | Jun 9, 2008 | Reply
When I was 20 years old and looking at getting into investing, someone told me that my portfolio should be 70% stocks and 30% bonds. And I thought he knew what he was talking about at the time, but I’m sure glad I did my homework and went with 100% stocks. I don’t see the point of bonds. You get a low rate of return, and they can still have a double digit loss any year.
Hunter Nuttall | Jun 9, 2008 | Reply
@Hunter - That was the main reason I wrote this post. I read so many articles/blogs advocating 20 and 30 somethings to be 20% or more in bonds, when the big risk isn’t losing the money, but not having enough to retire on.
Nhaving a high enough return to generate a proper retirement fund is a huge risk for stock/bond protfolio investors. Planners never mention that.
Chad | Jun 9, 2008 | Reply
I don’t own bonds even though I am retired (unless they score well with Upgrading– or the funds that score well are holding bonds in their portfolio). Since I’ve retired early and have a long life ahead of me, I want to push as much return out of my portfolio as possible.
But you have to have the stomach for the volatility. The “average” person (the ones not reading PF blogs) aren’t likely to stick with investing after experiencing a major down trend. I have quite a few friends - and a brother - who refuse to invest in equities again (after 2000-2002).
Millionaire Mommy Next Door | Jun 10, 2008 | Reply
You’re completely correct on needing a strong stomach for volatility. It takes a little fortitude and a lot of knowledge to see your porfolio lose 20-30% over a few months time and stay the course.
In order to have the knowledge, to stay the course, you really need to be familiar with your investments. This knowledge then gives you a better chance to rationally think through the reasons behind the drop. Just knowing why and how is enough, most of the time, to eliminate a lot of the fear involved.
Chad | Jun 11, 2008 | Reply
Greets Chad - At this point I’d concur with your market timing. CEO of Gazprom is predicting $250 oil in 18 months - stock valuations should be more attractive then.
Trug | Jun 13, 2008 | Reply
Hello there,
the only advantage of holding any bonds is when the market is going south… as it is doing from time to time…
when you have say, minus 25% form the former high, then go back to the stock market with full leverage…
you will then have “the butter and the money to pay for the butter”
you reduce volatility, and you raise your averall return…
Yohann | Jun 19, 2008 | Reply
Chad, your decision to go all cash is intriguing, so I’ve been looking for the relevant post, and I haven’t found it. Did you already write about your market timing decision, or are you saying that you will one day?
Em | Jun 30, 2008 | Reply
@ Em - I don’t have a post on market timing. The big reason is I pulled most of my money out last fall and I didn’t start this blog until 2 months ago. I’m currently looking for a good entry point. I have put some back in, but I’m not sure if it was a good idea or not. I’m thinking, it wasn’t.
Chad | Jun 30, 2008 | Reply
IMO the only sectors worth holding are Energy and Materials. That way if the stock market recovers, you’ll capture that gain, however if oil succeeds in beating stocks into submission, you’ll hold up well, maybe even make money since Energy sector is at 11 P/E. On timing your way back in - ask yourself what will happen if oil keeps making new highs. I think new lows will be made.
Trug | Jun 30, 2008 | Reply
@Trug - The only problem is that oil may be overvalued. I have seen some very good rationale from people outside of government/special interest groups that suggests a significant portion of this is speculation. I’m not saying I’m completely in the speculation camp, but the argument is compeling enough for me to avoid oil on either side.
Chad | Jul 1, 2008 | Reply
I used to think it was speculation also, until I looked at the EIA (www.eia.doe.gov) stats on world oil production. Reconciling that with, say, 8% growth in EM - there’s an increasing use of energy to achieve that growth.
Trug | Jul 1, 2008 | Reply