Why bonds? — Passive Investing Australia

Why bonds? Their returns are just so underwhelming compared to equities!

Bonds serve a few different purposes.

Some stable money available when the shit hits the fan, and you need to avoid selling equities when they’re half price and depleting your equities at double the speed and taking much longer to recover.
Because it’s hard to stomach your life savings falling to the value it was many years earlier and not knowing if it will take a decade or more for the market to recover (yes, this has happened).
To protect the money that you’ve earned. More on this below because I know you’re sceptical of it because so am I.
Diversification from equities. Equities do great when the economy is booming, but during other parts of the economic cycle, their risk shows up, and bonds can be a great way to diversify into something uncorrelated. High-quality bonds usually (not always, but usually) tends to do well when equities are doing badly.

1. Stability of assets to draw on

When the market falls, it can fall a lot, and it can stay down for a very long time. The amount of safe assets you need will vary depending on your situation. You’ll need more if you have a less stable job, single income, more dependents, more liabilities (house loan, car loan), and especially so in retirement when you have no job and will be drawing down indefinitely. Conversely, if you have a double income, no dependents, both in secure fields, paid off house, you can afford fewer safe assets to draw on.

A common mistake people make is assuming they can be fully employed continuously for 20 to 30 years. People have different levels of ability to take risk depending on whether they can remain continuously employed versus the possibility of becoming temporarily or permanently unemployed or under-employed, especially after hitting their 40’s and 50’s. If you lose your job and become permanently unemployed in your profession, can you survive for five years without selling any stock? Major drawdowns are one thing, but it’s not uncommon for the recovery to take a lot longer than it did during the GFC.

2. Ability to stomach stock market volatility

It’s easy to sit here today and say you’ll be fine if your $800,000 next egg falls to the value it was a decade earlier, but I doubt most people wouldn’t lose a lot of sleep over this and potentially panic-sell. We can look back at bear markets of the past and say it recovered, but while it was happening, people weren’t so sure. During the GFC, people were talking of an Armageddon type situation. There was a lot of panic, and the fact that the value of the stock market halved is indicative that people were selling in droves. They weren’t selling because they’re stupid — many had valid reasons to freak out.

3. Asset protection

From a video that put it succinctly –

Stocks remain volatile every day of every year, including the day before you sell them, even if it’s in 40 years from now. We often hear that stocks held for decades rarely lose money. That’s true. But not losing the amount you originally invested becomes much less important than not losing the value it grows to become and that you’ve come to rely on.

For a longer and visual explanation of this, please take a look at this paper Stock market charts you never saw
(note, at time of writing, you need to create a free SSRN log in to access)

For those who say that crashes always end, I wonder if those investors in Japan 1992, Germany 1945, Argentina 2002, Iran 1979 felt the same way. I see a common sentiment these days that even if equities crash, they’ll recover in a short period of time. This isn’t necessarily true.

4. Diversification

Often in severe economic crises, the government is pulling out all the stops to stimulate the economy, which includes lowering interest rates, which in turn drives up bond prices. This lack of correlation to equities when it is really needed during the time equities are falling provides an excellent form of diversification. This is especially true where higher stock allocations are thin at the extreme end.

You can see it visually here where 10% bonds reduced return by only 3.5%, and 20% bonds has reduce returns by only 7%.

But in this low interest rate environment, bonds have an expected return of almost nothing!

Yes, they do, but the purpose of bonds is not to maximise your returns. This is like saying eating vegetables is a waste of time because they give you no calories to power your body. Yes, that’s true, but does that piece of information lead to the conclusion that you shouldn’t eat vegetables?

The purpose of vegetables was never to get energy. It’s to get vitamins, minerals, and fibre.

The purpose of bonds is not to get a high return. There are four purposes listed above. If none of them are useful to you, then sure, go ahead and leave bonds out of your portfolio. That’s a reasonable argument. But if you think the fact that bonds have a low return is a valid reason to go with 100% equities, maybe it’s time to stop eating vegetables too.

But (someone with a $10M portfolio) said bonds are rubbish!

If you have so much money that you can comfortably live off 2% of your portfolio each year, then you can financially tolerate being 100% equities because if your portfolio halves and stays down for even a decade, you would be drawing down so little that it wouldn’t be much different to not really drawing down at all because you’re still leaving most of it alone to recover and even continuing to reinvest dividends buying equities when they’re cheap just like during accumulation.

However, for most people, it would require working a lot more years to get enough money for a withdrawal rate that low. A withdrawal rate of say 2% would mean saving up 50 times your annual spending needs before retiring compared to a 4% withdrawal rate requiring 25 times your annual spending needs – a massive difference.

People who don’t want to work until they have so much money as to have an extremely low withdrawal rate aren’t able to financially tolerate these very high equities allocations due to an extended bear market potentially depleting their portfolio to the point where it may never recover.

Besides your financial tolerance, how many people have the ability to sleep well at night, seeing their life savings halve in value? Someone who has lived and breathed investing for decades might be ok with it because they’ve been through the wringer several times and they’re used to it, but let’s face it, it isn’t normal for the rest of the population to be comfortable seeing that happen to their nest egg.

And the most important question of all – why even tolerate that level of market volatility and stress when you don’t need to? At that point, you can meet your needs with far lower volatility and anxiety, so why even go for such a high-risk portfolio? The goal of a portfolio for most people is not to die with the most money. The goal is to meet your needs.

If you have a sub 3% withdrawal rate and an appetite for risk, then sure, bonds aren’t necessary, and you can go for a 100% equities allocation. I doubt that applies to all that many people, though.