“Common sense” is a misnomer in an investing world where good sense is rare. Take the conventional advice about bonds. Supposedly, the closer you are to retirement, the higher your allocation to bonds should be. But I don’t believe it is safe to reduce the value of your nest egg by stuffing it with bonds when you are most dependent on it. Bonds have a place in a portfolio – just not the place they often hold.
Consider what happens when you retire:
- You no longer have a predictable stream of income from your job and
- You and your spouse are facing a joint 30-year life expectancy (up to 40 years if you retire in your 50s).
- Therefore, an investment portfolio designed to carry you through three to four decades of zero earned income, should, at a minimum, outpace inflation and taxes. Otherwise, you may be looking for a job to support your lifestyle in retirement.
If your retirement comfort depends heavily upon a nest egg that is shrinking, concerns about running out of money will sabotage your peace of mind. The alternative, an ever-growing pool of capital from which to spend reliably and without worry, will allow you to enjoy retirement without constantly counting pennies. Bonds are not the answer.
A basic knowledge of market history is where we begin to find our solution. Since 1926:
- Large cap stocks have returned, on average of 10% annually, small cap stocks 12%, both with dividends reinvested.
- High quality corporate bonds have returned 6%
- Inflation has averaged 3%
When you adjust for inflation and income taxes, the long-term return of bonds is close to zero. Deduct inflation and the return on large cap stocks is double that of bonds and triple for small caps. So what draws us, like zombies, to bonds? It’s because investors (and many advisors) equate volatility with risk.
Guess what? Volatility is not what makes stock investing risky. Volatility is what gives us the opportunity for superior returns. Risk, on the other hand, is the self-emasculating behavior that causes investors to buy high and sell low during temporary periods of volatility.
Allowing emotions to drive your actions is risky behavior – in love, in war, and in investing. And that is why investors use bonds – to take the edge off of their emotions. When we understand volatility and embrace its potential, then we can benefit from a portfolio that does more than “just keep up” during the most financially vulnerable period of our lives.
But how can we overcome emotion in order to realize optimal long-term returns? Here’s my solution:
- Set aside the funds you will need in the next five years (the “short term”). This represents the liquidity your budget calls for and should be protected (i.e. not invested). And this is where bonds can fulfill an important need: to earn more interest than you would in a bank account and timed for repayment of principle when your budget calls for it.
- Invest money you will not need in the next five years in a diversified portfolio of 100% equity mutual funds, no bonds needed. Investing only for long-term growth provides optimal returns, safe from the desire to “do something” during periods of temporary volatility.
If this sounds like the beginnings of a financial plan, it is. It’s rather simplified for the purposes of this article, but it is highly logical. When you know your liquidity needs are safely tucked away, why should you care if the S&P 500 drops 57%, as it did at its bear market trough in 2009 (to 1099.2) and subsequently skyrockets 225% (to 2202) as of the date of this article?
Speaking of bear markets, since the end of WWII, we have experienced one on an average of every 5.5 years. The longest bear market in that period lasted three years (1968) and the shortest was 1.5 months (1998). If you’re wondering what will happen if a bear market is long enough to wipe out your full five years of liquidity, let’s just say that your bonds wouldn’t be worth much, either. Increasing your allocation to bonds as you approach retirement is a very poor substitute for a real financial plan.