May 6, 2019
You say you detest bonds? Hey, I sympathize. With yields so dismally low, and conventional wisdom running so strongly in favour of holding stocks, anyone who purchases a bond today has to feel as if they’re auditioning for a masochists’ club.
But allow me to suggest something. Rather than dismissing bonds out of hand, let’s take a minute to look at what history has to say.
An easy way to do so is by opening the Credit Suisse Global Investment Returns Yearbook, compiled by the all-star research team of Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School. This annual compendium provides data not just on the United States, but on many other countries.
Take a gander at Canada. The yearbook tells us that over the half-century between 1969 and 2018, Canadian stocks generated an average annual return of 4.4 per cent. (The returns include dividends but are after inflation.)
How did bonds do? Hmmm, this is interesting. It appears they also produced average annual real returns of 4.4 per cent. Rather than lagging their equity siblings, the way conventional wisdom says they should, bonds finished in a dead heat with stocks.
Since the turn of the century, bonds have ruled. Between 2000 and 2018, Canadian bonds beat Canadian stocks, 4.9 per cent a year to 3.5 per cent, according to Credit Suisse.
This is not what financial theory would predict. Stocks are supposed to generate higher returns than bonds, because they’re riskier than bonds, and in a rational world, investors should be rewarded for the higher risk that goes along with being a shareholder.
But the historical results demonstrate that theory doesn’t always hold true, especially if you take a global view. Yes, over the past half-century, U.S. stocks have easily beaten bonds. But in the rest of the world, bonds have edged out stocks.
Most pension funds know all about this variability. They hold both stocks and bonds, as well as other assets, because they know economic climates can shift from one decade to another, and vary from one country to another. They want to ensure they can deliver decent results even if the next few years produce some nasty surprises.
Bonds can help buffer such shocks because they are generally less volatile than stocks. They cushion your results during bear markets. Especially if you are relying on your portfolio to generate income, you don’t want to be forced to sell stocks after they have plunged in value and before they have a chance to recover. Bonds are enormously useful as a way to get through such hard times.
But won’t bond prices be hurt if interest rates rise? Yes, but that doesn’t mean stocks will thrive. The market plunge in the final months of this past year demonstrated that any attempt to raise rates will threaten stocks, too.
Both bonds and stocks face the same fundamental challenge. All over the developed world, economic growth is slowing. The slowing trend has depressed bond yields. It is also likely to drag on stock returns.
Admittedly, nobody knows how the future will turn out – and that is precisely the point. In the two decades before 2000, global stocks produced an average real return of 10.6 per cent a year. Over the following decade, they lost an average of 1.3 per cent a year. “The volatility of markets means that even over periods as long as 20 years, we can still experience ‘unusual’ returns,” the Credit Suisse researchers say.
Smart investors are aware of this volatility and hedge their bets. Combining both stocks and bonds in your portfolio guarantees you benefit from whichever asset does better in the coming years.
Consider the classic 60/40 portfolio, which combines 60 per cent stocks with 40 per cent bonds. It offers a balance between the potentially higher returns from stocks and the lower volatility of bonds.
Even in the United States, where a heavy allocation to stocks should have paid off best, the 60/40 concept has proved its mettle. In the nine decades between 1926 and 2017, a U.S.-based 60/40 portfolio would have generated an average annual return of 8.8 per cent, according to fund giant Vanguard. Over the same period, an all-stock portfolio would have done only slightly better, with a 10.3-per-cent average return.
In exchange for that marginally lower return, the 60/40 portfolio would have slashed your risk. While the all-stock portfolio would have vaporized 43 per cent of your money in its worst year, the 60/40 portfolio would have lost only 27 per cent. Yes, both experiences would have been painful, but the 60/40 investor would be nowhere near as devastated as the all-stock investor.
If you’re within a decade of retirement, or in retirement, you don’t want to run the risk of seeing your portfolio eviscerated by a stock market slide. One of the most reassuring features of a U.S.-based 60/40 portfolio is that it has never lost money over a 10-year period, according to calculations by Ben Carlson at Ritholtz Wealth Management.
You can’t say the same about stocks: The S&P 500 has lost money over about 5 per cent of 10-year periods since 1926. Keep that in mind before you kiss your bonds goodbye.
This Globe and Mail article was legally licensed by AdvisorStream.