By Brett Arends
In general, bonds add little or no value to the portfolio of ordinary long-term investors
Nearly three years into the worst crash in the modern history of the U.S. bond market, ordinary investors hardly need to be told that bonds are far less “safe” and “secure” than many financial experts have claimed.
But bold new academic research, drawing on financial history going back to the 1890s, goes even further than that.
Bonds in general add little or no value to the portfolio of ordinary long-term investors, such as anyone saving in a 401(k) or IRA for their retirement, argue finance professors Aizhan Anarkulova of Emory University, Scott Cederburg of the University of Arizona and Michael O’Doherty of the University of Missouri.
A simple all-stock, two-fund investment portfolio of 50% U.S. stocks and 50% international stocks is far less risky than traditional advice would have you believe, and is likely to be a much better long-term strategy than more mainstream alternatives, the researchers say.
“An even mix of 50% domestic stocks and 50% international stocks held throughout one’s lifetime vastly outperforms age-based, stock-bond strategies in building wealth, supporting retirement consumption, preserving capital, and generating bequests,” they argue. It also outperforms the so-called 60/40 portfolio of 60% stocks and 40% bonds.
Intriguingly, they argue that this strategy also generates a lower risk of running out of money in retirement than the supposedly safer alternatives.
The research is based on a million simulations using lifetime earnings data, actuarial tables for an opposite-sex couple, and data for U.S. and international stock markets going back to the 1890s.
This is pretty radical. Most mainstream financial advice urges us all to build a portfolio that balances stocks with bonds. The theory is that more stable, if low-earning, bonds will offset or “balance” out the volatile performance of higher-earning stocks.
The researchers offer three contrary arguments. The first is that when adjusted for inflation, bonds’ returns are dismal and offer far less “safety” than the headline numbers would suggest. People who hold 40% or even more of their portfolio in bonds, expecting that this will protect them from volatility, are taking on much more risk than they realize when measured in real, inflation-adjusted terms.
The second is that stocks’ returns are typically so much higher than those of Treasury bonds that the extra money you make on the stocks over the longer term more than makes up for the extra volatility you’re likely to face over a bad few years. Since 1928, the performance gap between the S&P 500 SPX stock-market index and 10-year U.S. Treasury bonds has averaged 5 full percentage points per year.
The third argument is that international stocks offer better diversification for U.S. investors than U.S. bonds. The authors make a similar argument for investors in other countries — namely, that your best diversifier is going to be foreign stocks, which most investors typically underown.
Is this advice correct? Nobody can know for certain. You’d be a bold individual who took it.
It’s worth remembering that economics, including financial economics, isn’t an actual science, even though practitioners often think it is. It’s a branch of social studies, not physics. Or, as one wit likes to say, economics is a branch of astrology that thinks it’s a branch of astronomy.
This research and its advice rests on several assumptions and calculations. They may be right or wrong, but they are, at least, open to serious scrutiny.
For instance, the researchers have attempted to forecast likely future outcomes using simulations based on “29,919” past months of stock-market data.
But we only have about 130 years of reliable investment data, going back to the late 1800s. The researchers have gotten around this by looking at the monthly stock-market data since 1890 for 38 different countries.
If only this were the same as looking at many, many centuries of independent data. It isn’t.
There again, the research looks at bond-market data using nominal, pre-inflation bonds. Those are the only bonds that existed until very recently.
Today, investors have ready access to bonds that are protected against inflation. They are issued by the U.S. government, they are known as Treasury inflation-protected securities, and at the moment they are the only bonds I own. I am not worried about my bond returns being ravaged by a period of inflation. On the contrary, I know exactly what return I will get in real, inflation-adjusted dollars from my bonds if I hold them till maturity, because it says it right on the label.
For all these caveats, Anarkulova, Cederburg and O’Doherty deserve credit for knifing some industry sacred cows. Among them: the cults of U.S. equities and nominal Treasury bonds.
Too many investors draw the conclusion that U.S. stocks will continue to outperform international stocks because they have been doing so for years. But this is to engage in double-counting. A key reason U.S. stocks have outperformed international stocks is that they have become much more expensive in relation to earnings. According to SG Securities, the U.S. stock market now sells for about 19 times next year’s expected per-share earnings.
Europe? Just 12 times.
And Japan is only 14 times, even though its earnings per share this year are rising faster than those in the United States.
In any event, sticking to U.S. stocks alone is to skip out on a massive free lunch: the diversification benefits of including foreign stocks. International stock funds are available with fees as low as those that invest in the United States. It’s a gimme.
As for regular, “nominal” U.S. Treasury bonds? I still have no idea why anyone considers their interest rate to be the “risk-free rate,” as it is quoted only in pre-inflation numbers. Human beings do not live on pre-inflation numbers. And their long-term returns, when adjusted for inflation, have been pretty dismal. Since 1928, they have earned an average return of about 1.5% a year in real terms. You were much better off in stocks (6.4% in real terms) but also, interestingly, in blue-chip corporate bonds.
According to data from New York University, BAA-rated corporates, meaning the investment-grade bonds with the highest yields, have earned an average of 3.5% a year after inflation over that time. They also held up better than Treasurys during the inflationary 1970s, and much better than stocks during the infamous crash of 1929 to 1932.
It’s controversial to suggest people should go all in on stocks. But diversifying internationally, and thinking of bond returns in “real,” post-inflationary numbers, are slam dunks.
-Brett Arends
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11-25-23 1412ET
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