In case you haven’t figured this out yet, I spend a lot of time thinking about financial things and how money works. I think about the effects that raising the minimum wage would have on low-wage workers (they aren’t good). I think about why our healthcare payment system is so messed up (you don’t have clear prices, plus everyone is trying to get more than they pay for, so you don’t have an efficient, competitive market). I also think about things like when using an annuity would be good (normally when you don’t really have enough to live on in retirement through investing).
One conviction I’ve had for a long time is that you should always be 100% invested in stocks (with maybe a little invested in REITs) unless you cannot afford a 50% loss or bonds are paying really high interest rates. I reasoned that the return on bonds is always a few percentage points less than the return from stocks, so why should you give up a 10% return for a 6 or 8% return? Having a 50-50 stock/bond portfolio when you’re 60-years-old will help protect you should the stock market decide to drop 40% like it did in 2008, but if you were worth $10M and could live perfectly well with $5 M, why would you want to own 50% bonds?
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And then I kept thinking and started to realize an issue with my convictions: While it is very unlikely that you will lose money in stocks if you hold them for more than 5 years, and very, very unlikely that you will lose money if you hold stocks for more than 10 years, that does not mean that stocks will always do better than bonds over a given five or ten-year period. While the average return from a stock portfolio is 10-15% per year, that includes some great periods like the 1940’s-1950’s and the 1980’s-1990’s that really goosed the averages up.
A chart showing the annualized returns (the kind of return you would need to get each year at a fixed rate to end up with the same return) for the stock market (the Dow Jones Industrial Average – DJIA) during different decades is given below. If you held the DJIA stocks from 2000 through 2009, sure you would be up, but your average rate of return would only be 1.07%. If you held the DJIA stocks through the 1930’s, you would have actually seen a negative average return of -0.63% per year.
(Source of data: http://www.stockpickssystem.com/historical-rate-of-return/)
During most 20-year periods, you would have been better off in the DJIA stocks than you would have been in bonds, assume a rate-of-return of 6%. This is only true for seven of the twelve 10-year periods shown. Of course, during periods like the 1930’s, many of your bonds would have defaulted, so being in bonds during that period would not necessarily have saved you either. During the 2000’s, however, bonds returned about 6% annualized. You would have therefore fared better in bonds from 2000 to 2010, but not as well as you would have in DJIA stocks from 1990 through 2010. For the period from 2000 through 2018 so far, you would be about even, but we’re seeing extraordinary returns right now, so the next few years may well cause stocks to outperform bonds again for the 20-year period from 2000 through 2020.
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So what does this mean? If you have at least 20 years until you need the money, I would stay 100% invested in stocks. A twenty-year-old who is just starting a 401k account should therefore be 100% in stocks, assuming she can handle the market fluctuations that such a portfolio would provide. (If you can’t handle the fluctuations, consider adding 20-30% bonds, which will help to stabilize things a bit but not hurt long-term returns too badly.) If you’re sixty-years-old and planning to start living off of your portfolio over the next few years, you might want to consider a 60-40 stock-bond portfolio even if you have a lot more money than you need in your portfolio and therefore could stand a big decline in the stock market without falling short of spending cash. If you make it to eighty, you will probably get a better return from being entirely in stocks, but you might very well do better with a stock-bond portfolio between now and age seventy than you will if you are entirely in stocks.
What would this look like? Let’s say that you were invested 50% in Vanguard S&P 500 Fund and 50% in Vanguard Small Cap Fund with a $4 M portfolio at the start of 2017. If you were to have shifted $800,000 from each fund into the Vanguard Total Bond Market Fund you would then have had $1.2 M in the S&P 500 Fund, $1.2 M in the Small Cap Fund, and $1.6 M in the Total Bond Fund. In 2017 you would have received $24,400 and $18,350 in dividends from the S&P 500 and the Small Cap Funds, respectively, and $41,000 from the bond fund. This means you’d have about $84,000 in income from your funds each year. You would also make substantial capital gains in the stock fund during 2017, making $316,000 from the S&P 500 Fund and $213,000 from the Small Cap Fund. This would mean that your total return for 2017 would have been about $613,000, or about 14% for 2017.
You would have done better during 2017 if you had been entirely invested in stocks, but if stocks had declined a bit during the year, you would still have $84,000 in income to use as needed while you were waiting for your stock portfolio to recover. If 2017-2027 looks like 2000-2010, with the meager stock market returns during that period, you would gain about $400,000 over the period with an all-stock portfolio. If you had the stock-bond portfolio, you would still gain about $1,080,000 through the period due to the dividends and interest payments that you were collecting during the time. You would have substantial gains from your portfolio, rather than having a lost decade.
So, in conclusion, while you will probably do better with all stocks over long periods of time (two decades or more), you might actually do better if you mix in some bonds for shorter periods of time. This is because the high stock returns are due to a few short periods, while bond returns are fairly steady and constant. So don’t fear the bond. Learn to love it for the steady returns it provides.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.