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.

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