Home > Uncategorized > Bonds For The Long Run? Another Study Says Yes

Bonds For The Long Run? Another Study Says Yes

One of the ongoing debates I have with myself is whether it’s worth including a bond component in a long-term portfolio. Andrew Hallam’s book Millionaire Teacher points to an interesting study showing that a 60% stock / 40% bond portfolio in the US, from 1973 to 2004, would lag an all-stock portfolio by only 0.7% per year. To compensate for that, the worst drop in 1 year is -9% rather than -20% for the all-stock portfolio.

Studies like this show that even a moderately large bond component may not be all that bad. The Canadian Couch Potato Portfolio from MoneySense shows that with 67% in stocks and 33% in bonds from 1975 to 2010, a balanced portfolio would beat the stock market on its own.

This seems to conflict with evidence from others such as Jeremy Siegel who finds stocks beating bonds every time over periods of 30 years or longer. If you’re going to put $1 in the market and not touch it for 30 years, does it make sense to put it in stocks alone and get a slightly higher return over time? Or can you do even better with a good balanced portfolio?

Despite all the evidence from studies, this is a trick question unless you can precisely plan the next 30 years of your life. You could have financial emergencies and unexpected expenses. I could need a couple of years of investment income while starting a new business. Someone might find out they can afford to retire 10 years earlier than expected or can’t work as long as they thought.

Money in the stock market only grows as long as you leave it in the stock market long enough to grow. It doesn’t matter if the stock market goes up 300% if this happens to be in the late 90s and you don’t sell before it comes back down. With the many uncertainties in markets and life there’s something to be said for paying a small price and gaining the ability to access your portfolio when you have a true need rather than having it locked away. And if this safety allows you to invest twice as much because you can take out a little when needed, you can do better than someone else who gets a slightly higher market return.

However even a balanced portfolio requires discipline and courage to manage well. To take advantage of the growth potential you need to re-balance when needed, which could still be hard for some people. Andrew Hallam shows the potential as he stuck to a disciplined plan with his balanced portfolio and became the Millionaire Teacher. If you follow that path consistently there is no reason for envy over other peoples’ investment returns.

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  1. March 11, 2012 at 7:10 pm

    Stocks beat bonds over the last century in almost all developed countries, and during most rolling 10-year periods. But the last 30 years saw a remarkable trend of declining interest rates: in 1982, 10-year Canadas were paying 16%. Interest rates can remain low for a long time, but they can’t fall too much further: 10-year bonds are now paying 2.5% in Canada and less than 2% in the US. So it would be dangerous to assume that the next 30 years are going to be anything like the previous 30. I don’t think that’s forecasting: it’s just math.

    I still believe that bonds belong in almost every portfolio. I just think that their chances of outperforming stocks over the long term going forward are pretty low.

  2. March 11, 2012 at 8:23 pm

    Thanks for the comment! You’re absolutely right; if I had to pick which one will perform best, especially after the last 30 years, it would be stocks. Any time I’m not 100% confident that stocks are selling at a fair value or below it’s good to have some protection though. If a stock index fund has a great 10 years and you don’t touch it while it loses 40% of the value, did you really get that great 10-year return?

    Regardless of the long-term prospects of bonds they seem to be pretty effective for diversifying stocks because everyone still flees to them when in doubt. If they’re used in a way that doesn’t weaken returns much (maybe not possible) then it’s hard to argue against that. If the future is anything like the studies mentioned it might be safe to have a higher bond allocation than I thought.

    If we get a nice crash there’s no question I’ll dump the bonds and leverage into stocks 🙂

  3. Lagoonboy
    March 13, 2012 at 8:42 pm

    Yes, bonds are often thought of as vehicles of poor return, but as you show, they are useful drivers.

    1) When the news said that interest rates in the UK would definitely go down from 5% to 1% I suggested everybody buy Gilts (UK government bonds) because the simple arithmetic of how they work requires that their capital value must increase if you want their effective interest rate to decline (and stay in line with the prophesysed new Bank rate).

    People looked at me blankly (not understanding the intrinsic arithmetic connection between effective interest rate offered by the bond and bond’s current price), but the drop in the UK interest rate was so well signposted and mentioned well in advance that I couldn’t believe everybody wasn’t intent on profiting personally from the rise in the price of bonds, by rushing to the Post Office to buy gilts with the form available there.

    Here’s the maths:
    Current interest rate is 5%, so a 5% bond will have a price of £100 & pays £5 per year.
    If the Bank rate takes interest rates to 2% then the bond’s price must be £250, so the £5 a year the bond pays is now 2% of the bond’s price.

    You don’t hear of people who have claimed to have profited from this simple strategy, do you?

    2) I’ve been researching options as an alternative to buying stock. What is truly amazing is you only have to pay a fifth of the stock price to get 80% of the stock’s price move.
    Stock costs $100 – price moves up $8 – 8% gain
    Option costs $20 – price moves up $6.40 – 32% gain.

    In fact, 3 month out option is twentieth the price of the stock:
    Apple Inc at 568 – while June expiry option 570 strike at 32.70

    Again it’s just arithmetically better – no tricks.

    An even better reason to use options as a stock replacement is that you can take your money out as the stock goes up.

    But when you buy the stock, and its gone up, say, $200 you get real nervous as there’s nothing you can do except either continue to hold; or sell.

    With options you cash-out at each level and bank some money, but still stay in the game.

    Stock at $100 – option 100 strike has price $5
    Stock at $120 – $21
    Sell 100 strike at $21 and buy 120 strike option for $5
    Stock at $130 – repeat as walk up option price ladder, even to
    …..
    Stock at $570 – option 550 strike has price $21
    Sell 550 strike at $44.50 and buy 570 strike for $28.50

    So you only have a little money at risk at any one time, and all the profits along the way are banked.

    I think using options as direct stock replacements could be an incredibly powerful method if you were determined to buy that particular stock anyway, but now with less capital outlay, just by using an options platform to place the trade. Brilliant!

    @KNKC on twitter

    • March 14, 2012 at 1:15 am

      Thanks for the comment! I don’t generally look at very long bonds similar to gilts because of the risks when interest rates rise, but if they fit into your portfolio they can have interesting results. If interest rates get to 15-20% I’d be interested in quality securities that pay that in perpetuity 🙂

      On the other side, options would require too much management for me. They work for some but if they require frequent changes to the portfolio you need enough time to stay on top of that.

  4. March 15, 2012 at 7:52 pm

    A guy came up to me the other day and said that I could keep 80% of my portfolio safe and out of the market, and still make nearly as much money as I would have made from being fully invested in stocks alone.

    I said: “No thanks – I’m too busy”.

    “But your returns will be three times greater than the return on capital that you could have obtained from stocks”, he said.

    “Sorry”, I said, “I’m too busy. Besides, I’m a stocks guy – don’t talk to me about options. Thanks anyway”.

    =====

    Does putting on your stock trades on an options platform sound just too good to be true?

    I’m really interested in the resistance I get to this approach, particularly as it seems such an unabashedly great idea.

    Plus you can bank your profits as the stock rises.

    If you like, I’d be happy to demonstrate it – if you give me 5 to 10 stocks that you would buy today for your portfolio, I’ll place the trades on an options platform and we’ll see how things go.

    Or I’ll choose them, if you prefer.

    Would you be interested in that? Especially if I show the time it takes?

    An interesting experiment, don’t you think? Maybe of some interest to your followers too?

    I’ve never demonstrated such a thing before, so it would be interesting for me also.

    Kind regards,
    @KNKC on twitter

  5. March 15, 2012 at 9:44 pm

    Sounds like something you could start a blog about 🙂 I research new strategies from time to time but it takes a while to fully understand something and see if it’s worth changing and if the risk is suitable. Typically it usually just results in a small adjustment to my strategy.

    I’m convinced that options can make nearly as much money as pure equity ownership but I prefer the simplicity of making exactly as much by owning equities. And there might even be a way to keep 80% of your capital safe and make up for the lost returns using the rest. In that case I would expect some large hedge fund to figure it out and do it until it’s unprofitable. If you write it up well enough that could even be you!

    All I’m doing is following another classic hedge fund strategy: buy something when people don’t want to hold it another day and sell when they can’t go another day without it, at a price that makes it a good deal as a patient long-term investor. That way it’s a good price for both sides.

  6. March 19, 2012 at 9:26 am

    Thanks, VI.

    I’ve made a start at

    http://lagoonboy.tumblr.com/

    and I’ve registered the domain

    http://www.optionsarebetter.com

    That’s not an assertion – in my mind I put a question-mark on the end, until the results are in!

    I’m having fun at the moment running screens and things to determine which 10 stock symbols to start with.

    I’m also considering running a virtual account that displays the results on

    http://optionscentral.collective2.com/cgi-perl/system68780464#

    Again, many thanks.

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