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Heard on the Street Blog

Want To Build Wealth? Stay Away From Bonds.

The traditional financial advisor will tell you that as you get older you should decrease equity exposure and replace it with bonds or other fixed income securities until you get to to retirement where you have a traditional "balanced" portfolio wherein your portfolio is comprised of 60% stocks and 40% bonds. The typical rule of thumb advisors have suggested for decades is to subtract your age from 100 and that should be your equity exposure.

But I am here to tell you that the balanced portfolio needs to die. Why? Because in the end, you're losing out on gains by having 40% of your portfolio essentially stagnant. Bonds typically rise when stock fall and have traditionally been seen as a safe haven and can provide stable income in retirement. But bonds face a number of unique risks that, in my opinion, can make them riskier than stocks while also not affording you the capital appreciation aspect that stocks give you for the risk taken. Below are just a few of the risks associated with bonds:

  1. Reinvestment Risk

  2. Interest Rate Risk

  3. Call Risk

  4. Financial Risk

  5. Default Risk

  6. Credit Risk

  7. Purchasing Power (Inflation) Risk

  8. Liquidity Risk

  9. Event Risk

Out of your Control

Unlike stocks which are incredibly liquid, meaning they can quickly be sold and turned into cash, there are very few bonds sold in the secondary market, so you're usually stuck with the bonds unless you're willing to sell at a steep discount. Additionally, while stocks are usually bought with either capital appreciation or dividends in mind, bonds are usually bought with the interest payments in mind. However, bonds the price and value of bonds, with all of their associated risks are essentially out of your control. For instance, individual investors have no influence on interest rates. Interest rate risk is a very real concern with bonds and interest rates are determined by a very small group of people on the Federal Open Market Committee (FOMC). With the currently low yield environment for bonds does it really make sense to take on all the risks of bonds for such low returns? In my opinion, NO! In fact, there are plenty of dividend equity portfolios that pay a higher dividend yield than current bond yields with the additional component of the stock being able to appreciate in value as well (whereas bonds just receive the face value at maturity).

Follow the Money

Over the past decade, stocks have soared over 360% averaging compounded returns of 16% annually.[1] Meanwhile, bond yields, which were already low to begin with, have only fallen.: 10-year Treasuries yield slightly over 1%, municipal bonds less than 1%. But do bonds offer protection during a market crash or an equity sell-off? Not anymore. With yields so low, bonds can no longer rally when stocks sell-off. Essentially bonds give you downside exposure with little to no upside exposure which is not an ideal risk vs. reward tradeoff. But as Keith Singer of Singer Wealth Management outs it: "When bonds used to pay 6-8% annually and interest rates were falling, the 60/40 model worked great." But as they say, past performance is no guarantee of future results, and that is especially true with the 60/40 portfolio. Singer would continue to say, “The 40% which is supposed to reduce risk is now fraught with interest-rate risk, and if interest rates rise, the bonds will go down in value. Why take that risk for such a small potential return?” and this quote sums up the exact same investment thesis smart investment managers have been preaching for years. Low yields and low expected returns mean bonds will not contribute to overall performance, nor play their traditional role mitigating the risk of stocks. BlackRock warned that the 60/40 portfolio is likely to generate a lower return than it has over the past decade.

The Honest Truth

You can find plenty of articles online from many firms like PIMCO, John Hancock, and Fidelity on why the 60/40 portfolio is alive and well and they will cite past research dating back to the early 1900's (but as we know, past performance is not indicative of future performance), so even when framed in the best possible light and during the best time periods, the 60/40 portfolio always underperforms the 100% equity portfolio in the long-run. These firms are also biased in their opinions because they have a vested interest in pushing bonds (because they offer 60/40 funds, target-date funds, and bond mutual funds). While there are low-cost index funds, these firms make a lot of money from the fees associated with bond mutual funds, so why would they want to deviate the status quo. Additionally, having bonds in one's portfolio often times shields a financial advisor when they consistently underperform benchmarks because they can place blame on the bonds rather than face the blame for their poor asset allocation or stock picking. It has always been my opinion that financial advisors should outperform the appropriate benchmarks of an individuals risk tolerance. At a minimum, the advisor should outperform benchmarks by at least the percentage of their fees charged in addition to any fees incurred through the purchase of stocks, index funds, or mutual funds. At most, a financial advisor should create alpha or excess return above the benchmarks.