“In spite of promising lower returns than most other investment classes, bonds earn inclusion in portfolios by providing protection against the extraordinary circumstances of a financial crisis or economic deflation.” – David Swensen
If you missed Part 1 of my common sense series on bonds please read Investing in Bonds to learn about the different types of bonds and the basic characteristics of a bond.
Over the long-term, the stock market has earned a better return than investing in bonds. Since the late 1920s stocks (as measured by the S&P 500) have averaged a little over 9% per year while bonds (as measured by 10-year treasuries) have returned just over 5% a year.
Bonds are not for everyone and for some it may be possible to invest 100% in stocks. So why would anyone invest in bonds if stocks have been shown to have much better performance in the long-term?
There are a number of reasons that I will discuss in further detail.
INCOME & STABILITY
My first boss in the investment industry once told me that people invest in equities to grow their wealth and they invest in bonds to keep their wealth. Bonds can lose money over time, especially on inflation-adjusted terms, but with a diversified bond portfolio, you usually do not have to worry about a crash that you will typically see with the stock market.
The biggest reason for the stability of bond investments is the fact that as the owner of a bond you are entitled to periodic interest payments. Investors can enjoy the predictability of knowing the exact amount and timing of their payments by investing.
Also, as the owner of an individual bond, you are entitled to a 100% principal repayment when the bond matures. So the closer you get to that end date, the more stable the bond should be because of the fact that repayment is getting closer.
To reduce the bumps in the road along your investing journey it makes sense to diversify your assets. The main reason to diversify is the fact that investments tend to mean revert over time.
This fancy finance term simply means that investments eventually trend towards their average. So top performers will not perform as well in the future while bottom performers will sooner or later play catch up. It’s the biggest reason rebalancing and diversification pay off in the long run.
But another reason to diversify is to smooth out your returns by having investments that perform differently in different environments. Certain investments do better in different economic and market conditions. Since you cannot predict the future it makes sense to plan for all outcomes. Adding bonds to your portfolio will help you do just that.
From 1928 to 2012 the correlation between stocks and bonds was -0.01. A correlation of 1 implies that two investments move perfectly in sync with one another. A correlation of -1 would imply that as one rises, the other fall and vice versa.
Anything close to 0 implies no correlation at all. That means that the returns of stocks and bonds had no relationship over 85 years. That helps your portfolio by having periods when they both perform well and other times when one will perform better than the other.
This number can and will change depending on the environment but in most cases, stocks and bonds don’t move together or with the same magnitude very often.
As most stock investors can attest to, stocks can be very volatile. They can move up and down by large amounts in a very short period of time. The way that finance professionals measure volatility is through standard deviation. Standard deviation simple tells us how much of a range there is around the average the majority of the time.
Stocks have historically had a standard deviation of around 20%. This means that the majority of the time if stocks average 9% returns, you could expect returns to be 9%, plus or minus 20%. So that would mean the majority of the time we could expect to see returns range from -11% to 29%.
This shows you how wide the outcomes of investing in stocks can be and you also have to remember that there will be outliers from time to time that show up outside of this range.
Bonds have a historical standard deviation closer to 7.5%. That would mean that if the average return has been 5%, you could expect the range to be -2.5% to 12.5%. You can see that through the reduced volatility of returns that you can expect much smaller losses and gains over time than stocks.
It doesn’t always work out this way but this gives you a nice idea about how things have played out historically. Matching higher volatility investments with lower volatility investments will obviously give you a portfolio somewhere in the middle. So bonds work as a volatility reducer to the stock portion of your portfolio.
There actually have been periods where bonds have performed better than stocks, even over decade-long time frames. In times of economic instability and deflation (falling prices), bonds have performed better than stocks in the past.
In the 1930s 10-year treasuries returns 3.96% per year while the S&P 500 lost 0.92% per year. Again in the 2000s treasuries gained 6.26% per year while the S&P lost 0.95% per year. These decades happened to coincide with The Great Depression and The Great Recession so you can see that in periods of very poor economic activity, bonds can act as a stabilizer for your portfolio.
Here is the annual performance comparison of 10-year treasuries and the S&P 500 over the past eight decades for some perspective:
These examples only look at treasury bonds, but there are other types of bonds that are more volatile and can possibly lead to better returns (or at the very least more diversified returns). These include emerging market bonds, high yield debt, corporate bonds and mortgage bonds.
As always, more return leads to more risk but by spreading out your portfolio over a number of different assets you can continue to decrease your risk of holding only one type of investment. Using these different types of bonds with a corresponding disciplined investment process that includes periodic rebalancing to a well thought out asset allocation reduces your risks even further.
Bonds also help keep you honest by forcing you to pay attention to the risk in your portfolio along with your returns. Rick Ferri had this to say about bonds in a recent article on his site:
“Investing in bonds is a hedge against bad investment decisions. They may not earn a high return going forward and may even lose some in the next bear market, but I believe the psychology of holding bonds will stop some people from doing the wrong thing at the wrong time. A portfolio with a fixed bond allocation helps reduce behavioral risk and leads to a higher probability for long-term success.”
Bonds can help balance out your emotions along with your portfolio risks and returns. At the end of the day that could be one of the biggest positives about owning bonds in your portfolio.
Hopefully, this gives you a better sense of the reasons to include bonds in your portfolio. But just because bonds have historically been more stable and less volatile than stocks does not mean that there are no risks when investing in bonds.
In Part 3 of this common sense series, I will look at the various risks that you face when investing in bonds. There are more than you think but I will focus on the ones that matter the most to you as an investor.