Why does anyone invest in bonds long term?

[mrWinter]

Another AA question that possibly has been answered before but I searched and didn't find exactly what I'm asking.

I'm talking long term static Asset Allocation, not any market timing, I've yet to find any real reason to put any money into bonds. I get the general theory, that it lowers overall risk/volatility, but I can find no long-term scenarios in firecalc where any amount of bonds is helpful. The only scenarios I can come up with that have a higher success rate with any bond allocation are around 10 year timeframe, where you are drawing down a high rate, like 8% or more, basically you know the end date and are trying to burn through it all by then. For example, in firecalc, 1mil, drawing 80k over 10 years, if I use the investigate tool and look at what various allocations do for the success rate, yes I see that a 25/75 has the highest success rate, but that's only a 6% higher success rate than 100/0, hardly a significant decrease in risk. And at what cost? If I take the same scenario over to ******** where I can better compare average portfolio balance at the end, I have twice as big an average ending portfolio in the 100/0 scenario as I do in the 25/75 scenario.

And I had to work hard to find this scenario that actually benefited having any bonds, almost all scenarios show a better success in firecalc when having higher equity allocation, especially anything longer than 10 years.

So my challenge to all interested is to come up with a scenario in firecalc that uses a static AA and shows significantly higher success rate or average ending balance with any bond allocation as compared to 100/0.

It seems apparent that many people on this forum are using an allocation of 70/30 or 60/40 or so, there are plenty much more knowledgeable people on this forum that know more than me, so what am I missing? Keep in mind I'm only talking about static AA holders here, if you think equities are currently overvalued so you've sold some for bonds so you can buy in the next trough, I get that. But if you are holding that ratio long term, why? If you are mitigating volatility, why not do so with an annuity?

The conclusion I'm being drawn to is that I either want to invest my money or I don't. If I do want to invest it, it goes in equities, if not then bonds, cash, whatever. So long term, it's all equity. When I want to cash it out, I cash it out.

 

[2017ish]

Sequence of return risk near to and in a planned-for ~50 year retirement for DW.

(We were 100% equities until age 53. Knew we'd retire at 56/55 or 57/56, so started to shift. Now up to 30-35% short/int. bonds/cash and retire in 2 months. Haven't found an attractive annuity alternative at this age, but that may change in 15 years or so.)

 

[exnavynuke]

It's not just about success rate, it's also about the psychological benefit of having a more calm portfolio (swings that aren't as wild). If year 2 of retirement sees a 45% drop, many FIRE's people would be uncomfortable sticking with the plan to stay retired and would probably try and pick up some more income (especially if using a 4% SWR), even if historically they'd still be okay never working again. A 22.5% drop, however, may just make them a bit uncomfortable, yet stay retired.

That volatility has a psychological effect that can be detrimental to an investor sticking with their plan. Taking that 45% loss may cause an investor to panic and shift to a 50/50 portfolio just in time to miss the rise up in stock prices that made FIRECalc show their plan working. Additionally, the increase in returns from 50/50 to 100/0 historically isn't "massive":
Vanguard's info showing 1926-1999 average returns and worst losses were:
Return-- Worst Annual Loss-- Portfolio type
11.3%-------(43.1%)...100% Stock Portfolio
10.5%-------(34.9%)...80/20 Stocks/bonds
09.5%-------(26.6%)...60/40 Stocks/Bonds
08.9%-------(22.5%)...50/50 Stocks/Bonds
08.3%-------(18.4%)...40/60 Stocks/Bonds
07.0%-------(10.1%)...20/80 Stocks/Bonds
06.1%-------(06.7%)...10% Cash/10% Stocks/80%Bonds

Sacrificing 2.4% returns and still getting almost 9% returns, in exchange for about half the volatility, is very appealing to many people.

 

[Al in Ohio]

Asset allocation is part target average long term overall rate of return and part risk tolerance that matches your investment style. You are only gaining understanding of half of the key to investing. Read the Boggkeheads guide to Investing. If you are 100% equity and the market crashes and you lose 50% of your entire portgolio, will you panic or not

 

[mathjak107]

there is a difference between losing 50% of your porfolio vs it fluctuating by 50%.

in fact odds are pretty good someone 100% in equities for a long time who falls 50% would still be a head of much more conservative portfolio's .

it really is a mental thing instead of a financial thing .

 

[ESRwannabe]

I guess it comes down to your withdrawal strategy. I have never liked the total return withdrawal strategy, where you are counting on spending down capital gains (or capital loss). I like to invest to build up income.

Bonds are very handy for building up income. If you buy high credit quality bonds then the likelihood of defaults can be very low. As a result you have a very predictable stream of income coming in on a monthly basis.

If you are investing for income then bonds are an obvious choice for at least some of your portfolio. The main issue with bonds is how to offset inflation, or even grow the portfolio. The easiest way to do that is to simply have more bond income coming in than you need, and plan on re-investing that amount. So, if you have say $1,500 a month coming in, plan on only spending $1,000 of that and always re-invest the other $500.

Another nice feature of bonds is that because the income is predictable, you can use leverage to juice your returns depending on your borrowing costs. One easy way to do this is to buy Closed End Funds. If you buy a CEF you now have a professional managing the leverage for you, and also having borrowing costs lower than you could ever hope for.

I own a lot of high credit quality municipal bond CEFs. The 10 and 15 year total returns are around 7% after tax on most of them. That's pretty descent.

EDIT:

Hmm, I just went on morningstar to check and actually 15 year after tax total returns are around 7.5% for many of them... which is roughly the same as the S&P 500.

Here are the muni bond CEFs I own right now: MQY, BFK, NAD, MYD, NZF, VKQ.

All of these were purchased at a discount. A few even at -10% discounts. When I bought them I looked for things like historical NAV performance, UNII, Z-stat, etc. and also decided to mainly stick with BlackRock and Nuveen (owned by TIAA-CREF) as they are companies I trust.

 

[Nightcap]

there is a difference between losing 50% of your porfolio vs it fluctuating by 50%.

in fact odds are pretty good someone 100% in equities for a long time who falls 50% would still be a head of much more conservative portfolio's .

it really is a mental thing instead of a financial thing .

You're right, it's a mental thing. We are not rational animals, we are rationizing animals. But it's something that every advisor had dinned into our heads for forty years.

 

[OldShooter]

This is quite a good slide deck:

https://am.jpmorgan.com/blob-gim/1383280028969/83456/jp-littlebook.pdf

If you look at the graph on page 64 you can see how a diversified portfolio has cushioned the ride over the last ten years. The twenty year comparison bar chart is interesting too, especially the little orange block at the lower right. IMO this result comes primarily from trying to time the market.

 

[stepford]

It kind of depends on your "merit function" i.e. just what it is you're optimizing. This is just a fancy way of saying that not falling below a certain value may be much more important to some folks than maximizing their returns. I'm one of those with a 50/40/10 AA for this reason, despite knowing that it is (very) likely that my returns will ultimately be significantly less than those with a higher equity allocation.

 

[Whisper66]

While I was working, I never invested in bonds (long term or at all). I was fine with the large ups and downs of a pure equity portfolio and felt it would provide better returns. In preparation for retirement, I moved some money into bonds to avoid having to sell equities at a large loss during a market downturn. So yes, I now have bonds longer term.

 

[phil1ben]

Some on here will remain in the highest tax bracket after retirement and for the foreseeable future. As a result it is prudent to me to keep 30% of my portfolio in individual tax free muni-bonds spread across different states, maturities and credit ratings. I buy and sell the bonds myself using the Schwab platform. As bonds mature or are called they are replaced with new bonds. I retired in January at 57. High on my list of goals is asset retention and tax savings thus I am willing to sacrifice a degree of upside potential for the benefit of tax savings and security. My allocation after the muni-bonds is about 25% individual stocks, 25% real estate and 20% cash (i.e. money market and CDs). Very conservative I know but it works for me.

 

[mrWinter]

Very interesting replies, thanks all. I guess I'm being introduced to a new type of risk that decreasing volatility helps protect against: irrationality risk. I imagine I would be wise to acknowledge that I am not and will not forever be a perfectly rational entity.

exnavynuke:

Additionally, the increase in returns from 50/50 to 100/0 historically isn't "massive"

I'm not sure I agree with this assessment based on the numbers you provide. An additional 2.4% may not sound like much, but compounded over multiple decades is pretty huge in my book. A quick run in ******** (I think I'm running it right, though I don't usually run constant growth simulations) shows an average ending balance of 6.52mil vs 2.16 mil on 1 mil pot withdrawing 40k a year over 30 years. A difference of 4.3 million, around 300%, yes that's definitely huge in my book.

OldShooter: wow that pdf looks like a real trove thanks for sharing. Not actually sure if you were presenting that chart on page 64 as evidence for against my argument but I think it only goes to show my point. Yes the track for the mixed allocation portfolios dips less, but at the end of 10 years the S&P has caught up with and surpassed the mixed asset portfolios. Also one must note that this 10 year period starts right before the great recession. So we are looking at a sample here starting at the worst possible time for equities in recent memory, and the 100/0 portfolio still wins after 10 years. So long term, this confirms what I was thinking. Assuming JP Morgan puts out this analysis every year, then the 2019 version of this chart will have the 100/0 portfolio absolutely beating the pants off the mixed allocation portfolios.

Yikes that bar chart is scary though, boy I hope I don't turn out to be an average investor.

 

[Fedup]

I looked at page 64, it shows virtually no difference in the long run, whether it's 40/60, 60/40, or sp500. So why take the risk with higher stock allocation? Interesting I set my husband's AA at 40/60, mine at 60/40. Maybe there is no difference.

 

[ejman]

I would guess exhibit A for having bonds in a portfolio would be Japan. 27 years after hitting a peak in 1990 the Japanese stock market has only recovered about 50 % or so of that high. The US is not Japan, but this doesn't mean it couldn't happen here.

 

[gcgang]

Bonds are for getting out of jail. Stick with equities while you're building assets.

 

[Chuckanut]

I have been seriously thinking of going to a stock/cash allocation of 80/20 for my situation (modest pension + SS at age 70). I need to run that through FireCalc for starters.

 

[OldShooter]

... OldShooter: wow that pdf looks like a real trove thanks for sharing. Not actually sure if you were presenting that chart on page 64 as evidence for against my argument but I think it only goes to show my point. Yes the track for the mixed allocation portfolios dips less, but at the end of 10 years the S&P has caught up with and surpassed the mixed asset portfolios. Also one must note that this 10 year period starts right before the great recession. So we are looking at a sample here starting at the worst possible time for equities in recent memory, and the 100/0 portfolio still wins after 10 years. So long term, this confirms what I was thinking. Assuming JP Morgan puts out this analysis every year, then the 2019 version of this chart will have the 100/0 portfolio absolutely beating the pants off the mixed allocation portfolios. ...

Yes. The other interesting thing to me is that there is really no difference between a 60/40 and a 40/60. (But I wouldn't be so confident in predicting the market this year. BTDT and often regretted it.)

... Yikes that bar chart is scary though, boy I hope I don't turn out to be an average investor.

Easy. Every time you are tempted to sell into a down market, look at the bar chart and sit firmly on your hands.

Bonds are for getting out of jail. Stick with equities while you're building assets.

A tad too simplistic I think. The problem with equities is that you suffer greatly if you have to draw on them when the market is in the tank. When you do that, the equities are not there to participate in the subsequent recovery.

So, I agree and that's what we did --- near 100% equities up until we got near the point of having to draw on our savings. At that time, fortunately, the market was in good shape and we were able to sell some equities at good prices and buy TIPS.

But once you are drawing, you need (IMO) enough cash and fixed income assets to ride out a bad market time without having to sell. See page 4 of the JP Morgan slide deck that I linked. A retiree having to sell equities in '03-04 or '09-10 would have suffered greatly compared to one who had cash and bonds to live off of for a few years. This despite the fact that he/she might have seen themselves as having the goal of "building assets" with the the equities.

Personally, I think the "bucket" approach is much more sensible than talking ratios. As retirees, we need a bucket of cash sufficient to ride out a few years of bad times. Everything else can be in equities if that is our taste. The bucket might be 10% of the total portfolio or it might be 80%. That doesn't matter. It's having the bucket that matters.

 

[exnavynuke]

Very interesting replies, thanks all. I guess I'm being introduced to a new type of risk that decreasing volatility helps protect against: irrationality risk. I imagine I would be wise to acknowledge that I am not and will not forever be a perfectly rational entity.

exnavynuke:

I'm not sure I agree with this assessment based on the numbers you provide. An additional 2.4% may not sound like much, but compounded over multiple decades is pretty huge in my book. A quick run in ******** (I think I'm running it right, though I don't usually run constant growth simulations) shows an average ending balance of 6.52mil vs 2.16 mil on 1 mil pot withdrawing 40k a year over 30 years. A difference of 4.3 million, around 300%, yes that's definitely huge in my book.

OldShooter: wow that pdf looks like a real trove thanks for sharing. Not actually sure if you were presenting that chart on page 64 as evidence for against my argument but I think it only goes to show my point. Yes the track for the mixed allocation portfolios dips less, but at the end of 10 years the S&P has caught up with and surpassed the mixed asset portfolios. Also one must note that this 10 year period starts right before the great recession. So we are looking at a sample here starting at the worst possible time for equities in recent memory, and the 100/0 portfolio still wins after 10 years. So long term, this confirms what I was thinking. Assuming JP Morgan puts out this analysis every year, then the 2019 version of this chart will have the 100/0 portfolio absolutely beating the pants off the mixed allocation portfolios.

Yikes that bar chart is scary though, boy I hope I don't turn out to be an average investor.

The final number, I agree, is significantly different. What I mean by "massive" in this case is that the "change in lifestyle" an investor is likely to have isn't massive. The guy retiring at 60 with $1M at 50/50 asset allocation with a baseline 4% SWR is probably going to have similar spending as the guy retiring at 60 with a $1M at 100/0 AA with a baseline 4% SWR. Both people are spending $40k/year. Now, the latter person could potentially start spending more if both are using % of portfolio withdrawal methods moving forward etc, but for the years they're likely to spend more (before their spending would traditionally decrease) their returns aren't likely to generate a "massive" difference in their affordable lifestyle.

Also keep in mind that we're only looking at one particular "index" as the only data point when tons of others exist. If you choose other data, the results change. If a person was invested 100% equity in the DJIA in 1928, 10 years later their portfolio had a -1.3% annual return (bonds greatly outperformed over that time). Even worse, if your portfolio was 100% equities diversified in the Nikkei 225 in 1990, you still haven't gotten back to even 27 years later, needless to say that bonds have done much better.

 

[MrFlish]

Yes. The other interesting thing to me is that there is really no difference between a 60/40 and a 40/60. (But I wouldn't be so confident in predicting the market this year. BTDT and often regretted it.)

Easy. Every time you are tempted to sell into a down market, look at the bar chart and sit firmly on your hands.

A tad too simplistic I think. The problem with equities is that you suffer greatly if you have to draw on them when the market is in the tank. When you do that, the equities are not there to participate in the subsequent recovery.

So, I agree and that's what we did --- near 100% equities up until we got near the point of having to draw on our savings. At that time, fortunately, the market was in good shape and we were able to sell some equities at good prices and buy TIPS.

But once you are drawing, you need (IMO) enough cash and fixed income assets to ride out a bad market time without having to sell. See page 4 of the JP Morgan slide deck that I linked. A retiree having to sell equities in '03-04 or '09-10 would have suffered greatly compared to one who had cash and bonds to live off of for a few years. This despite the fact that he/she might have seen themselves as having the goal of "building assets" with the the equities.

Personally, I think the "bucket" approach is much more sensible than talking ratios. As retirees, we need a bucket of cash sufficient to ride out a few years of bad times. Everything else can be in equities if that is our taste. The bucket might be 10% of the total portfolio or it might be 80%. That doesn't matter. It's having the bucket that matters.

+1 I like this approach as well. There's a big difference in strategies (IMO) that seems to get blurred or lost. (1.)Accumulation while earning income vs (2.) drawing from your portfolio without earning income. Both need to be planned for as separate events.

 

[mrWinter]

But once you are drawing, you need (IMO) enough cash and fixed income assets to ride out a bad market time without having to sell.

I agree this method seems to make good sense, but this is market timing, which I was trying to exclude from this discussion. Whether I'll try my hand at any market timing or not I don't know. I'm talking here about set-it-and-forget-it AA.

 

[OldShooter]

I agree this method seems to make good sense, but this is market timing, which I was trying to exclude from this discussion. Whether I'll try my hand at any market timing or not I don't know. I'm talking here about set-it-and-forget-it AA.

True. Strictly speaking, it is market timing.

But it is a very loose sort and not getting it quite right (the likely result) is probably still better than not doing it at all. If the market drops two or three thousand points, I think history's lesson is that this is not a good time to be selling equities. Eat out of the bucket instead. If the market is hitting new highs, it is probably a reasonable time to replenish a bucket that has been drawn down.

 

[RunningBum]

True. Strictly speaking, it is market timing.

But it is a very loose sort and not getting it quite right (the likely result) is probably still better than not doing it at all. If the market drops two or three thousand points, I think history's lesson is that this is not a good time to be selling equities. Eat out of the bucket instead. If the market is hitting new highs, it is probably a reasonable time to replenish a bucket that has been drawn down.

Yeah, and if you had a 60/40 AA, and your 60% equities took a major hit, you'd be needed to either shift some of the bonds/cash over to equities, or spend the bonds/cash to bring you back into balance. So, bringing your AA back in line means you aren't selling equities in this scenario. But, if you are 100% equities, you have no choice but to do so.

That said, I ask the same question as the OP does at times, or at least why I'm not heavier into equities. I use 115-age myself.

 

[CRLLS]

I looked at page 64, it shows virtually no difference in the long run, whether it's 40/60, 60/40, or sp500. So why take the risk with higher stock allocation? Interesting I set my husband's AA at 40/60, mine at 60/40. Maybe there is no difference.

That bar chart is a 20 year average return, The difference between 40/60and 60/40 after investing 100k for 20 yrs is almost 37k at the end. Investing in the SP500 would add another 82K.

The graph only covers about the last 9 years.

But timing is everything and you can't successfully time the market.

 

[mathjak107]

100% equities has a very very high success rate . just a tad behind 50/50 over 30 years and ahead of it over longer retirements .

without the weight of cash and bonds in up markets 100% equity has a nice juicy cushion for spending down in down years .

it is more a mental obstacle than a financial one .

 

[Lsbcal]

Another AA question that possibly has been answered before but I searched and didn't find exactly what I'm asking.

I'm talking long term static Asset Allocation, not any market timing, I've yet to find any real reason to put any money into bonds. I get the general theory, that it lowers overall risk/volatility, but I can find no long-term scenarios in firecalc where any amount of bonds is helpful.
...

Below are 2 simulations using VPW. Both are for a 60 year old retiring in 1929 with a starting withdrawal rate of 3.5% and a $1M portfolio.

The 100% equity case:

The 60% equity case:

The 60/40 portfolio held up better through the early 1940's. In a deflationary period bonds may be a safer harbor.