Don't Buy Bonds Without Understanding the Risks

by Benjamin Beck, CFP® Benjamin Beck, CFP® | August 31, 2022

When people meet us for the first time, one of the things that they are most surprised to learn is that we don’t buy bonds. Not ever. I love it when they ask, “Why not?” 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 have probably talked to you about allocating a portion of your portfolio to bonds. What portion of your portfolio is invested in fixed income vehicles such as bonds is traditionally determined by your age and how much time you have before your retirement. Here, we’ll discuss some of the considerations when looking at investing in bonds vs. stocks.

 

Volatility vs. Risk: What’s the Difference?

Before we explain why traditional advisors include bonds as part of their investment strategy, 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 destination. 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.

 

Inflation Means Expect a Decrease in Your Purchasing Power As Time Goes By

The painful reality is that bonds simply soothe investors’ anxiety versus doing something productive with their money. People don’t buy bonds because they want to reach their financial goals, they buy them because they want a security blanket. After all, 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, followed up by the record inflation we have right now? 

In terms of reducing risk, equities outpace bonds over time…rather substantially. By fully investing in stocks for longer periods, you actually lower your overall risk, versus being invested in bonds (or sitting out the market altogether), which makes it impossible to achieve long-term investment goals.

 

How to Properly Diversify Your Portfolio

So if bonds don’t help you diversify, what does? 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. You could experience a liquidity event or have your business shut down due to uncontrollable events. The world is constantly changing. To account for change, 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 (TDF): One Size Does Not Fit All

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. As Investopedia explains, 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 portfolio. 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.” 

 

Investing in Bonds vs. Stocks

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 10% in 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 50 or 55 years 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. This means you need a long-term investment strategy that can support a fruitful retirement — which bonds can’t do.

 

Protect Your Purchasing Power: Don’t Buy Bonds

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: 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. Don’t buy bonds. Instead, speak with a financial advisor who understands that equities are most likely the way you will achieve your most cherished long-term financial goals.

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.

 

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