When I was in elementary school, I hung out with a guy whom I’ll call Jake. He wasn’t a great student, nor was he athletic. His left eye drifted and his mouth was a little crooked. But I liked the guy. At noon, we sometimes walked to his house and his mom made us sandwiches and fries.
Jake didn’t badmouth other kids. He was loyal. He also kept me out of trouble. Plenty of people have Jakes in their lives. But far too often, we push our Jakes away. They might not be exciting. They might be a little quirky. In some cases, either socially or professionally, we might think they hold us back. Today, that’s what many people think about bond market funds.
Over the ten-year period ending May 17, 2019, Vanguard’s Total Bond Market Index (VBMFX) averaged a paltry 3.49 percent per year. Ten-year Treasury bonds currently yield a miserly 2.4 percent per year. In contrast, Vanguard’s Total Stock Market Index (VTSMX) averaged a compound annual return of 14.79 percent over the same ten years. Compared to stocks, bonds are the misfits we want to turn away at the door.
But here’s why we shouldn’t. Bonds are a lot like my old friend Jake. They can help to keep us out of trouble. Consider what happens when stocks fall hard. Bond allocations can help to cushion market falls.
When Stocks Fall Hard, Bonds Are Parachutes
|Duration||100% U.S. Stocks||$10,000 In U.S. Stocks Fell To…||60% U.S. Stocks / 40% U.S. Bonds||$10,000 In A Balanced Portfolio Fell To…|
|January 1973-September 30, 1974||-55.86%||$5,414||-27.28%||$7,272|
|January 2000-September 30, 2002||-40.59%||$5,941||-12.67%||$8,733|
|January 2008-February 28, 2009||-43.18%||$5,682||-26.78%||$7,322|
In his book, Thinking Fast and Slow, Daniel Kahnemann, a Noble Prize winner in Behavioral Economics, says we dislike losses twice as much as we like gains. When our portfolios fall far, it increases the risk that we’ll do something silly. If we see a 40 percent or 50 percent decline in our portfolio’s value, it might tempt us to sell. Meanwhile, there’s no shortage of scary headlines adding fuel to our fear:
Stocks Will Fall Further!
You Can’t Make Money With Stocks Anymore!
This Crash Will Be Worse Than 1929!
Buy Gold Now To Protect Your Money!
We know we shouldn’t sell when the stock market drops. Retirees should keep calm. Young investors should keep adding money. However, that’s easier said than done. That’s why bonds might help to calm ragged nerves when stocks hit the skids. It’s true that stocks beat bonds. But when stocks and bonds are rebalanced once a year, the results aren’t as bad as many people think.
Consider the period from January 1, 2000 to April 30, 2019. That’s almost 20 years. A portfolio invested 100 percent in U.S. stocks would have earned a compound annual return of 5.99 percent. A portfolio comprising 70 percent U.S. stocks and 30 percent bonds would have earned a compound annual return of 6.03 percent. And a portfolio with 60 percent U.S. stocks and 40 percent bonds would have earned a compound annual return of 5.95 percent.
These balanced portfolios didn’t shame themselves. They would have also been a lot easier on the nerves.
How 100 Percent Stocks Can Test Investors’ Patience
January 2000 to April 30, 2019
|Allocation||Annual Average Return||$10,000 Would Have Grown To…|
|100% U.S. Stocks||5.99%||$30,769|
|70% U.S. Stocks, 30% Bonds||6.03%||$31,004|
|60% U.S. Stocks, 40% Bonds||5.95%||$30,583|
If you have a strong stomach and a long-term horizon, you might not need bonds. But most mortals do–just like most people could use a good old friend like Jake.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas