Using an All Bond Portfolio Approach for Tough Times

One Couple Suggests That Investing in Bonds is the Right Thing to Do in This Market

This was the title of an article I came cross in one of the recent editions of Investment News. It was written by Stan and Hildy Richelson, who are very credentialed, have written four books on bonds, and even the president of Scarsdale Investment Group. After taking notice of the provocative title, I just had to dig into it and see how this concept played out.

The basic premise is that individual investors would should be advised to move entirely into the safest government bonds. This flies in the face of the traditional methodology of creating a diversified portfolio and holding on. Surely, this goes against everything I’ve been taught, so there has to be something behind this theory.

According to the authors:

Investors are told to put their faith in the holy name of diversification, and they will be saved. But why diversify into multiple asset classes to reduce risk when investors would be much safer if they bought only safe bonds?

Why diversify? Well, I just wrote about the benefits of diversification on Monday. If you recall from that post, the benefits of diversification, at least over the past 20 years, is very clear. Is there still a risk of negative returns at times? Of course, but with that little bit of risk comes greater long-term rewards.

Fees and Expenses

The authors go on to make another case for bonds because you can save on fees. While I will agree that buying individual bonds, just like individual stocks can save you from annual expenses, it is their information of how high these fees are that really gets to me. According to the article, they say that the average actively managed large-cap fund has annual expenses of 2%, small-cap and foreign funds have an average of 4% annual expenses, and emerging-markets have annual fees of nearly 10%. Are you kidding me?

According to Morningstar:

The average individual investor paid 0.93% for U.S. stock funds in 2006 compared with 0.96% in 2005…The biggest price break came in international funds where big returns have spurred big inflows. The average individual investor paid 1.07% for international funds in 2006 compared with 1.13% in 2005. Balanced funds’ expenses fell from 0.82% to 0.79%, while taxable bond expenses dipped from 0.84% to 0.81%.

Bottom line is if you’re paying 2, 4, or 10% annual expenses, not even investing in bonds will help you. The fact that they throw around these high numbers to make a case for bonds is troubling.

History is no Predictor of the Future

The authors continue on to discuss returns. People expect stocks to average around 10% over the long-term, and while they may not have performed that well in the past few years, going back 20 or more years shows that this is the case.

If the typical investor actually earned a historical return of substantially less than 10% after the three categories of reductions [bad timing, taxes, and fees], why would anyone believe that a 10% or more return would be earned in the future? … No one knows what stocks will earn in the future. If there are losses followed by gains, individual investors may not have enough time to recoup their investment losses before retirement.

Again, the claims being made are on some pretty dramatic assumptions. First, bad timing. Now, I’ll admit that most investors have terrible timing, but this is assuming people are regularly making changes to their portfolio. But if you’re regularly investing money each month and stick it in a diversified portfolio, target date fund, or a few index funds, you aren’t fooling with timing, so that point is moot. Then the issue of fees. If the fees were even remotely close to what they mentioned, that would be a concern. But considering most investors, even in actively managed funds and not index funds are paying less than 1% a year, this impact is minimal. And finally, the comparison is being made to tax-free bonds. Well, if you’re investing in a Roth IRA or 401k, you’re already going to receive tax-free earnings. Even if you’re in a pre-tax account, you’re getting the added benefit of tax-deferred growth. All of these so far are weak arguments for bonds.

Who Should Buy Bonds?

After reading this, I was hoping there would be a caveat saying this advice is for people very near, or already in retirement and relying on cash flow that bonds can provide, but I was disappointed to find nothing to that extent. This is general advice trying to convince people that ultra-conservative bonds are where you should put your money right now. All this is doing is advocating market timing. Sure, we’ve had a a rough 8 or 9 months, but we don’t know what the future holds.

I know this is fairly strong criticism coming from me since I’m a strong proponent of bonds, even for younger people, but this advice and rationale is a bit over the top. I believe bonds can do a great job in assisting in creating a diversified portfolio that minimizes risk while maximizing returns. It isn’t an all or nothing choice like the authors suggest.

In fact, look at a portfolio over the past 20 years that was nearly a 50/50 mix of stocks and bonds. In 20 years, it had only 3 years with losses. Two of those were under 1% and the greatest annual loss was only 3.35%. With these minimal losses, the average annual return was nearly 10%.

balanced portfolio

Had you been invested in government bonds over that same time, you would have earned about 6.2% annually. I don’t know about you, but I’ll gladly take another 3% on average while taking on only slightly more risk. 3% over 25-30 years is a lot of money to throw away for a little bit of safety. But you’re free to invest your money however you want, but don’t be too quick to jump on the fixed income wagon just because we’ve had a bad few months in the market.

Author: Jeremy Vohwinkle

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

7 comments
Sean
Sean

Another aspect your forgetting to mention is that they strongly argue against the use of bond funds. A bond fund works exactly like stock fund. There is no maturity date for the fund so you are never going to absolutey get your principal back like a true bond. Given the last year, you would have actually lost a lot of money if you were to get out of that bond fund now.

I like the basic idea of this book and can absolutely understand where they are coming from. Some people just absolutely DON'T want to be in the market, and to say there aren't options out there to get similar returns is crazy!

Ace
Ace

Interesting article. In the last paragraph you mention that there is an annual extra 3% over bonds. For a 10% return on stocks, you are looking at capital gains of 10 ~ 15% long term, or if short term, maybe 28 ~ 35%. And then, it might put you into AMT, reducing a lot of your deductions like property tax. Now for bonds, chances are you'll get some type of tax exemption, either from federal or state and local. The great thing about municipals, for example, is that you don't pay ANY tax on the interest, AND it's not subject to AMT. Additionally, if you even hold the bond till maturity, you get the full principal back, so you can play the waiting game if your bond tanks.

As for myself, I've been making a minimum of 7% per annum, and some bonds, after tax and fees, I get an equivalent ROI of between 10 ~ 14% per annum. The added benefit is I don't sweat bricks looking at the DJ index

Jeremy
Jeremy

That's right Matt. MPT and the efficient frontier is something I planned on exploring here, but I haven't gotten around to it yet. Plus I don't want to make anyone's head explode :D

Matt Hubbard
Matt Hubbard

Great Post. Just to add a twist: a 100% bond portfolio offer less returns and more risk than a 50% stock 50% bond portfolio. Ya, it baked my noodle the first time I read it too. But that's the magic of Modern Portfolio theory. Wikipedia or investopedia has a pretty good description of it. It's around 60/40 stock/bond where you have the least risk, according the MPT, higher than that you can start to take on more risk, commiserate with the returns you are looking for. As long as you stay on the Efficient Frontier. (again, see the investopedia)

Jeff
Jeff

From your review it almost sounds as if they don't spend much time contemplating returns. Is this the case? Are these guy bond industry spokesman? Did they mention that it probably isn't a good time to buy bonds when yields are so low? Or that buying a bond fund when yields are so low could put a serious damper on returns when yields start rising again (say the gov't actually wants to encourage dollar appreciation or inflation becomes a problem)

Jeremy
Jeremy

Well, ETFs, mutual funds, index funds, all can be applied the same way when constructing the portfolio. I just mentioned mutual funds since that was what the article used for a comparison.