Stocks might be driving you crazy with their manic ups and downs. But there is no doubt; they’re still the life and soul of the party. No matter what the economy tosses at the markets, stocks continue to deliver. Despite the COVID-led market bath in March, the S&P 500 gained about 7.3 percent from January 1st to October 7, 2020.
That’s on top of 31.2 percent last year. All told, U.S. stocks have gained about 370 percent since January 2009. That’s a compound annual return of 14.13 percent.
Bonds, in contrast, are like uninvited guests. Twenty years ago, they eked out decent interest. But now they slump at their stools and seem to barely breathe.
This has many people asking, “Should I own bonds at all?” I think you should. Maintain a globally diversified portfolio of low-cost stock and bond market index funds. Yes, I know bonds pay paltry interest. Vanguard’s Total Bond Market Index (VBMFX) recorded a 12-month interest yield of just 2.26 percent.
But there’s much more to bonds than their interest rate. When stocks fall hard, bonds act like parachutes. They might not always rise when the equity markets drop. But broad bond market indexes don’t crash like stocks.
Below, the shaded dark blue line represents the U.S. stock market (VTSMX) for the 2020 calendar year, ending October 7, 2020. Notice that stocks dropped about 28 percent from January 2020 to March 19, 2020.
The red line represents a total bond market index (VBMFX). Over the same time period, it dropped just 1.14 percent.
The light blue line is a balanced stock index: 60 percent U.S. stocks and 40 percent U.S bonds. The bonds tempered the portfolio’s drop, as the balanced portfolio fell just 15 percent.
Stocks win when markets rise. But balanced portfolios, with bonds, defend against the falls. And today, perhaps more than ever, investors should think about defense.
After all, stocks are expensive. They might be running on fumes because their share prices (for at least a decade) have risen faster than business earnings.
The DOW Jones Industrials, for example, sported an average PE ratio of 27.7 times earnings on October 7, 2020. That’s nosebleed high.
According to the Value Line Investment Survey, the Dow Jones Industrials had a similar PE ratio in 2001. Much like today, over the previous ten years (1991-2001) stock prices rose far faster than corporate business earnings. And when that party ended, stocks fell hard, cratering almost 43 percent between January 2000 and September 30, 2002.
That also marked the lost decade for U.S. stocks. Including reinvested dividends, equities barely made a profit after ten long years. Could that happen again? It’s entirely possible.
But while stocks struggled from January 2000 to December 31, 2011 (averaging just 0.46 percent per year) portfolios balanced with stocks and bonds averaged 3.37 percent per year. Balanced portfolios didn’t drop as far when the markets dove. Psychologically, that might have helped many investors stay the course.
Critical readers, I can hear what you might be thinking: Bond interest rates were higher then. Today’s rates are pathetic. That’s entirely true. But that shouldn’t stop investors from owning a bond market index fund.
Let’s go back to that period between January 2000 to December 31, 2011. Let’s assume bond interest rates were as low then as they are right now. We can simulate that scenario using portfoliovisualizer.com. Instead of using bonds in the back-test, I’ll use cash. After all, the interest rate on cash, during that period, mirrored the low interest rates of bonds today.
Over the 12 calendar years, cash averaged just 2.3 percent (that’s about the same as the 12 month yield on Vanguard’s Total Bond Market Index today). From 2009-2012, the annual interest rates on cash shrank to 0.16 percent, 0.14 percent, 0.07 percent and 0.08 percent respectively.
However, despite these paltry rates, anyone with a portfolio 60 percent in U.S. stocks and 40 percent in cash would have beaten a portfolio invested 100 percent in U.S. stocks over the 12 calendar years ending December 31, 2011.
This is why we shouldn’t dismiss bonds today, despite their low interest. Diversification matters.
Now let’s focus again on the high price of stocks. Equities can’t outpace corporate business earnings forever. That’s like a Cinderella party with a broken clock. And when that clock strikes midnight (and it always does) the carriage turns back into a pumpkin and the footmen back to mice.
That’s why portfolios built 100 percent with stocks would take nerves of steel. Plenty of people say they can handle market plunges. But many of those same people capitulate under pressure. They sell at a low. Their tolerance for losses isn’t what they think.
That’s why most investors should ignore the chants against bonds. Stocks can fall hard. And they will, once again. If you can handle a decade-long slump when you don’t see a profit, then you might not need bonds. But too many people fool themselves when push comes to shove.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas