When people meet us for the first time, one of the things that are most surprised to learn is that we don’t invest in bonds. Not ever. I love it when they ask why not because it gives me a chance to explain how having bonds in your portfolio can cost you in a really big way.
If you’ve worked with a traditional advisor, they will have spoken with you about allocating a portion of your portfolio to fixed-income vehicles, more commonly known as bonds. What portion of your portfolio is invested in the fixed income category is traditionally determined by your age and how much time you have until you retire.
First, let’s get one thing clear: volatility is not equivalent to risk.
Before we explain why traditional advisors take this approach, let’s clarify some very confusing terminology. There are two words that are used quite frequently in the financial services industry. Unfortunately, they are used interchangeably, even though they actually differ in meaning. Those two words are “risk” and “volatility.” They are indeed not the same thing, particularly for the long-term investor. Volatility is the variability of a portfolio over a period of time. Risk, on the other hand, has to do with the probability of you reaching your goals.
Investing in the stock market is certainly more volatile than investing in bonds, generally speaking. However, over time, investing in the stock market is less risky than investing in bonds. Because for almost all long-term investors out there, whether they are younger or already retired, bonds cannot get them to their objectives. If a strategy cannot get you to your stated goal, by definition that makes it a risky path for you.
Traditional financial advisors recommend bonds because their job, at least how they see it, is to lower the overall volatility of your portfolio and produce a smoother ride for you. So they add bonds to the mix.
Your traditional advisor is simply pandering to your emotions.
The painful reality is that bonds simply satisfy investors’ emotional state (meaning they soothe their anxiety) versus doing something productive with their money. Who wants to go through the stress of the financial crisis we experienced in 2008 and 2009? Or the experience we just had with the pandemic, and shutdowns and quarantines and their impact on the markets? At the time of this writing (July 28, 2020), if you stayed invested in the equity markets for the first two quarters of 2020, your portfolio would actually be valued higher today than it was just at the beginning of the year. Would it have been a highly emotional and volatile ride? Absolutely. But in terms of risk, equities outpace bonds over time…rather substantially. By fully investing in stocks for longer periods, you actually lower your overall risk over time, versus being invested in bonds (or sitting out the market altogether), which makes it impossible to achieve a long-term investment goal.
What about ‘diversification?’ Isn’t a ‘properly designed portfolio’ supposed to be diversified?
Diversification to us is not about avoiding volatility. That’s the key distinction between the traditional approach and ours. We regard the inclusion of fixed income instruments as avoidance of volatility and in the long-term, we most certainly see it as a huge increase in risk in the portfolio.
If there’s one guarantee that we have about the future is that it will be different from today. The world is constantly changing. We diversify within the equity markets by investing across a portfolio of companies in order to mitigate the effect of a small number of those companies not doing well over time.
Target date funds play with your future by idling a good portion of your portfolio’s buying power.
I don’t mean to be disrespectful, but I’ve observed many investors blindly investing their money in so-called “target-date funds” and hoping for the best. Target date funds are set up to have certain allocations of equities and fixed income. The “logic” in their design is that the younger the investor, the higher the proportion of equities in the investment basket. The older the investor, the higher the proportion of fixed income instruments in the mix. On the surface, it seems reasonable. But we all know that one size does not fit all. Too many investors take this at face value and simply think, “well, I’ve heard that bonds need to be a part of your portfolio, so this target date fund looks like an easy way to achieve the right mix for me.”
If you’re young and have bonds in your portfolio, you are leaving a whole bunch of money on the table. If you’re in or near retirement and have bonds in your portfolio, you, too, are set up to miss out on future income.
Even a thirty-year-old, who theoretically has over thirty years until retirement will still have roughly ten percent of their overall target-date portfolio invested in fixed income vehicles. If you’re 50, a good majority of your target-date funds will be invested in fixed income, simply because you’re that much closer to retirement. The problem for both of these hypothetical investors is this: the younger investor is essentially giving away money over a thirty-year period by not subjecting a good chunk of his or her portfolio to healthy volatility while there is time to do so.
Historically, equity markets have averaged about 8% returns per year over the long term. Fixed income instruments have averaged roughly half of that over the same period. You just have to ask why a thirty-year-old would have any bonds in their portfolio in the first place. And it’s not just for young people to question. Say you are a 50- or 55-year old, whose target-date fund has close to half or more of it allocated towards fixed income. Just because you’re nearing retirement doesn’t mean that you have to become ultra-conservative. You’re going to live! And if you’re lucky, you’re probably going to live another 20 or 25 years. Your longevity continues to increase every day as our lifespans extend.
Consider this: not only have the equity markets historically produced much higher returns than bonds over time, but they also do one crucial thing for investors that bonds simply cannot by their design, namely protect an investor’s purchasing power.
In other words, inflation is ever-present. The cost of goods and services goes up over time. Bonds pay a fixed rate of interest over time, and so cannot keep up with inflation. A constant is incapable of keeping pace with an increasing variable. At a minimum, you need your money to appreciate more than the rate of inflation, and a fixed income portfolio simply cannot do that for you.
Ben Beck is Managing Partner & Chief Investment Officer at Beck Bode, a deliberately different wealth management firm with a unique view on investing, business and life.
 Based on the YTD total return of the S&P500 as of 7/28/2020