Even Very Young Investors Should Own Bonds

In the personal finance realm, there are many topics that will probably never settled completely.  Whether young investors in their 20’s should own bonds at all or if they are better off owning a 100% equity portfolio is one of those topics.  Like the PC vs Mac argument, proponents of both sides have good points.  Also like PC and Mac fans, they are often so emotionally-involved in the debate that they can’t see the forest for the trees.

This Just In:  Even Young Investors Should Own Bonds (Says Me)

This is actually a topic I’ve touched upon before.  A post by Mike at Oblivious Investor advocating a 100% equity portfolio prompted me to write an appropriately-vague post of my own:  Should Young Investors Be 100% In Stocks?  Opting to dance around the issue rather than taking a side, I pointed out that a small 10% bond allocation has in the past decreased risk significantly while decreasing return only a very small 0.22% per year over a sample 30 year period.  I then went on to say

“…If you are a risk-taker, there is nothing wrong with a 100% stock portfolio.  Over the very very long term (30 years at a minimum) you will likely out-perform a slightly less-aggressive portfolio…”

In light of the fact that what I said before is a cop-out and because of some persuasive reasoning by a few Bogleheads, I’ve decided to change my mine:  every investor, regardless of age, should own bonds.  What a reasonable minimum in bonds would be I can’t say, but 10% seems about right.

Why You Need Bonds Even If You’re 20

Much Lower Risk, Slightly Lower Returns

This is a rehash of what I’ve already said, but it bears repeating:  even a small bond allocation can dramatically decrease the risk of a 100% equity portfolio with only a very small decrease in returns over the long run.  The risk/reward profile for a 90/10 or 80/20 portfolio is far superior to that of a 100/0 portfolio.  Remember that both risk and return matter in investing.  Taking on 20% more risk for a 0.5% gain in return strikes me as unwise after a certain point.

The Chances Of Stocks Tanking Is 1000 Times Greater Than You Think

I’ve often heard it said “over a 40 or 50 year period, it’s hard to imagine stocks not out-performing bonds.  And it’s even harder to imagine stocks losing money.”  I agree, it’s extraordinarily unlikely that bonds will out-perform stocks over a 40 year period.  Problem is, most people assume the probability of that happening is so low, it might as well be zero.  Nothing could be further from the truth.

While the probability of such disaster is almost certainly below 1%, there’s a huge difference, probability-wise, between 1% and 0.001%.  As Nassim Taleb says in his book Fooled By Randomness, people become increasingly bad at estimating the probability of an event the rarer it is.  If you estimate the probability of bonds out-performing stocks to be 0.001% and adjust your portfolio accordingly when the actual probability is more like 1%, you’ve just underestimated the probability of portfolio disaster by 1000 times!  In fact, this is precisely what happened to Long Term Capital Management (LTCM) and the big banks in 2008.  They estimated the probability of disaster to be very low, and it was, but it still turned out to be many times higher than they had anticipated.  It went from being “might-as-well-be-zero” to “about 1%” in a heartbeat.

I don’t know the probability of stocks out-performing bonds over long periods or losing money for 40 years straight.  They are undoubtedly low.  But they are most certainly not as close to 0% as most people seem to assume.  If that’s not reason enough to own a few bonds, I don’t know what is.

Keep A Little In Reserve

The final and perhaps most compelling reason I can think of to keep at least a small portion of your portfolio in bonds is simply common sense.  In the event of a market crash like what we experienced recently, it makes a lot of sense to buy more stocks when they are cheap.  A stock bought in the depths of a recession is likely to have a much higher future expected return than a stock bought in almost any other circumstance.

If your portfolio is 100% stocks during a market crash, where are you going to get the money to buy more stocks while they’re cheap?  I suppose you could sell your car or boost your savings, but most people aren’t likely to do that.  If, on the other hand, you’d kept a small portion of you portfolio in bonds, say 15%, you would automatically buy more stocks at their lowest point as you rebalanced from bonds (which lost much less or even gained throughout all this) into stocks (which tanked).  Thus, it makes sense to hold bonds if only for rebalancing purposes.