Welcome back to Personal Finance for Professionals Part II, our multi-lesson series teaching you everything you ever wanted to know about investing in stocks and bonds. We were introduced to bonds in Lesson Eight. In this lesson, we will discuss the relationship between stocks and bonds and learn how they work together in your portfolio.
Stocks & Bonds
Bonds are fixed-income investments that provide steady, simple interest payments and return of capital. While bonds carry risks, investing in index bond funds can mitigate many of them, providing a safe, reliable return.
Stocks, on the other hand, offer higher returns with greater risk. Index stock funds reduce some risk, but the stock market remains volatile. However, over the long term, stocks have consistently produced a higher return than bonds.
Since the stock market has consistently produced higher returns, why don’t we just invest all our money in stocks? Why do we need bonds at all? The graph below shows the returns of Vanguard’s highly diversified stock (VTSAX) and bond (VBTLX) funds.
You can see that the blue line (stocks) has been consistently higher, but its lows are lower, and it has much more volatility (ups and downs), while the orange line (bonds) has been much more stable. As the graph clearly demonstrates, stocks produce higher returns with greater risk (volatility), while bonds produce lower returns with less risk.
The Purpose of Stocks & Bonds in Our Portfolio
The goal of investing for retirement is to earn enough money to provide for us when we stop working, whenever that may occur, whether chosen or forced upon us. Our portfolio must therefore be risky enough to provide the necessary returns, while not being so risky that we lose it all. Stocks and bonds each serve a purpose towards that goal.
Diversification
Diversity in stock investing reduces risk. If you put all your money in one company’s stock, it could go to the moon, or to zero. By investing in many companies, you dramatically reduce the chance of them all going bankrupt at the same time. This is the principle behind index funds, since no one knows which stocks will go up or down. Instead of trying to find the needle in a haystack, just buy the haystack.
The same principle applies to bond investing. Purchasing one bond leaves you vulnerable to default risk, which is reduced by buying many bonds. You can further reduce risk by buying bonds with varying maturity dates, different terms, and issuers in unrelated industries. The easiest and best way to ensure this diversification is through index bond funds.
Diversification also works on a more macro level. If all your investments are in stock funds, a 35% drop in the stock market means a 35% loss to your portfolio. Downturns in the market are expected during your investing timeline, and drops of this magnitude are not out of the question. As shown in the graph above, this has happened to me twice: the S&P 500 fell 56% in 2007-2008 and 34% in 2020.
While the US stock market has historically recovered from every previous downturn, it’s unclear how long the market can stay depressed. While the COVID crash in 2020 corrected very quickly, the S&P 500 took 25 years to recover from the Great Depression. If you were to retire just before a prolonged stock market downturn, the ride could get rather bumpy. Bonds help cushion the ups and downs of expected stock market volatility.
Hedge Against Inflation/Deflation
Of the many risks to our money in retirement, both inflation and deflation loom large. With inflation, our money becomes less and less valuable each year, until the money you have each year suddenly isn’t enough to comfortably pay your bills.
When we invest in stocks, the underlying businesses provide an inflation hedge. A company can raise prices to keep pace with inflation, which can increase its value. Governments typically combat inflation by raising interest rates, which causes bond values to fall.
Deflation causes the price of goods and services to fall. Deflation harms businesses as consumers don’t want to buy anything, feeling they can wait and get a better deal later. This can cause companies to lose money and their stock prices to fall. Governments fight deflation by lowering interest rates, which raises bond prices.
The net result is that stocks hedge inflation in our portfolio, while bonds hedge deflation.
The Relationship Between Stocks & Bonds
Historically, stocks and bonds have been negatively correlated, meaning that, in general, when one goes up, the other goes down. What follows is a very simplified version of the complex relationship between stocks, bonds, and the economy, but it is sufficient for our purposes.
Stocks, Bonds, & the Economy
Warren Buffett famously said that in the short term, the stock market is a voting machine, but in the long term it is a weighing machine. This means that while the long-term value of stocks is based on company earnings, short-term value can be affected by many factors, including interest rates, investor sentiment, and the broader economy.
When times are good, people are optimistic about future returns. Stock prices tend to rise as investors believe the good times will keep rolling. Why invest in fixed income when there is (potentially) an unlimited upside in the soaring stock market? In these economic conditions, investors favor stocks, increasing demand and raising prices. Conversely, the demand for bonds is low, driving their prices down.
When the economy is bad, people get scared and tend to flock toward “safe” investments. This can mean a shift from growth stocks to value stocks, but it can also mean a flight from stocks to bonds. This shifting economic sentiment increases demand (and prices) for bonds and lowers demand (and prices) for stocks.
The net result is that historically, stocks and bonds don’t rise and fall in unison. Negatively correlated assets work together in a portfolio to reduce risk. If you had 100% of your money in stocks and the market falls, your entire portfolio falls. But if you have an 80/20 mix of stocks/bonds and the stock market falls while the bond market rises, your portfolio has lost significantly less.
Asset Allocation
Your asset allocation is the percentage of your total portfolio you have in each asset type. In this series, we are focusing on securities, or stocks and bonds. A 90% stock, 10% bond portfolio can be shortened to 90/10 and represented as follows:
Your ideal asset allocation changes with your age and financial situation. Investing 100% of your money in stocks is fine for a brand-new investor with 30-40 years of working ahead of them, because they can ride out even the longest market downturns through dollar-cost averaging. This describes most newly graduated medical residents.
However, this situation changes quickly as the investor grows their portfolio, takes on more responsibilities, and eventually approaches retirement. A physician about to retire would be foolish to put 100% of their money in stocks, as a market downturn could decimate their portfolio and jeopardize their retirement.
Conversely, investing 100% of your money in bonds at the beginning of your career will not provide enough growth, leaving you with insufficient funds for a comfortable retirement. While having 100% bonds at the end of your career is completely safe, you may not have enough growth potential to keep up with inflation during retirement.
Stages of Investing
Stocks are needed to provide the investment returns you need to outpace inflation during your working career. Remember that risk and return are connected. Without the volatility (risk) of stocks, you wouldn’t get a sufficient return to fund your retirement. Bonds are needed to reduce volatility as your career winds down, and you face living off your investments for 30-40 years.
Your asset allocation can be thought of as a balance between growth and security, between the risk of losing all your money from a terrible stock market crash and running out of money in retirement. You need both stocks and bonds in your portfolio.
While you may need both, you need different amounts of each depending on which stage of investing you are in. When you start your career, you are in the accumulation stage. If you are young, single, and broke, you don’t have much to lose and can be aggressive. You should hold a higher percentage of stocks because you have a long investing timeline and need the additional returns stocks can provide.
At some point, when you have substantially more assets, are nearer to retirement, and have more responsibilities, you will enter the wealth preservation stage. You now have something to lose, and less time to make it up. You should therefore be more conservative, with a lower percentage of stocks in your portfolio. You no longer need outsized returns; you need modest returns and to not lose what you have.
A good guide is to start your career with a 90-100% stock allocation and end your career with 40-60% stocks. For example:
Age 25 (90:10)
Age 40 (80:20)
Age 50 (70:30)
Age 60 (60/30)
Age 65 (50/50)
Another rule of thumb is to use your age to calculate the percentage of stocks you should own.
110 – Your Current Age = % Stocks
For example, when you are 50 years old, you should own 60% stocks. When you are 60 years old, you should own 50% stocks.
The 4% Rule
These rules of thumb can often underestimate the percentage of stocks you need in your portfolio. Extensive research into how much money you need to retire safely has yielded what is commonly known as the 4% Rule. I have written extensively about it before, which you can read here.
The original 4% Rule states that in retirement you can withdraw 4% of your portfolio each year, indexed to inflation, and not run out of money over 30 years. This is the part that everyone seems to remember. However, the details show that for the rule to work, you need both stocks and bonds, with stocks driving performance.
The above chart, taken from the 4% Rule research, shows the success rate over 30 years of different asset allocations at different withdrawal rates. The data clearly demonstrates the need for stocks in your retirement portfolio. To balance returns with peace of mind, the study’s author concluded that the ideal retirement portfolio is 60/40, which yields a 96% chance of success. But the author also cautioned against going below 50% stocks.
Conclusion
Stocks and bonds work together in a complex way, influenced by the broader economy, but each plays an important role in our portfolio. Stocks get all the glory by driving the returns needed to fund our retirement. It’s easy to say you can handle the volatility of a 100% stock portfolio, since the returns will be so much higher over time. However, if the stock market drops 58% just before your retirement, you’ll be happy to have bonds in your portfolio to cushion the fall.
Some of you may also hate risk and consider going all into bonds in retirement. After all, you are guaranteed a return. Unfortunately, bond returns are typically too low to support a 30-year retirement and are subject to the whims of inflation. An investor that is too conservative might never reach a balance sufficient for retirement or may run out of money before it ends.
We need both stock and bonds. As we progress through the two investing stages, we should reduce our risk by shifting from a stock-dominated portfolio to a more balanced one. In our next lesson, we will discuss how to do this.
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