Free-quent Flyer
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I've been reading Jack Bogle's "Common Sense on Mutual Funds," and had high hopes that it would answer a question that has been bugging me for a while: why should funds invested for the long term have any allocation to bonds?
Let me be clear, I'm not asking why people should hold bonds. Bonds are great! Lower volatility than stocks, better returns than cash. For funds needed in the next 5-10 years it makes perfect sense to allocate some portion to bonds in case stocks tank right before the funds are needed.
But in a retirement account that I'm not going to touch for at least 29.5 years (I'm 30), why should I care about volatility if it is my reasoned belief that equities will out-perform bonds over the next 29.5 years (conveniently close to Jeremy Siegel's 30-year timeframe over which equities outperformed bonds in every period between 1861 and 2011)? Obviously, as above, it makes sense to gradually allocate funds to bonds over the 5-10 years leading up to the beginning of withdrawals, so there's a portion of less-volatile funds that can be relied on in the first years of retirement.
Jack Bogle basically provides three answers to this question:
1) Psychological. Here the claim is that while I shouldn't care about short-term volatility in a long-term portfolio, in fact I do. This is a very unpersuasive claim which could be reframed as: "Because you're weak, you should earn lower long-term returns in your retirement accounts." But if you're asking someone to make sacrifices because they're weak, why not ask them to sacrifice their weakness? Doesn't it make more sense to say, "because you're weak, you're going to need to need to exert a lot of energy not looking at your portfolio day-to-day, month-to-month, or quarter-to-quarter." You're still asking the weak person to make a sacrifice (hard mental work), but not to sacrifice long-term returns as well!
2) Strategic. A fixed bond allocation allows you to buy low and sell high. Now this is a more interesting claim. The argument goes that since bond and stock prices are somewhat inversely correlated, and that therefore bond and stock yields are somewhat inversely correlated, allocating a fixed percentage of your portfolio to bonds is a way to shield some of your assets from the stock market when it's over-priced by moving the "unbalanced" amount to suddenly-cheap bonds, and to then buy back into the stock market when it's underpriced by moving the over-allocation in bonds to stocks.
The problem with this argument is that it proves too much. The exact same logic could be used to prove that the only correct asset allocation is 100% bonds (when the stock market is overpriced) or 100% stocks (when the stock market is underpriced)! Of course, when framed that way the problem is obvious: this is market timing, plain and simple. All you're doing is locking in the stock market price/earnings ratio that obtained when you first entered the market! If you enter the market at a 25 P/E ratio, any P/E ratio below that will be "cheap" and require you to buy stocks in order to maintain your asset allocation. If you enter at a 7 P/E ratio, any ratio above that will be "expensive" and require you to move to bonds. This is true even though a 24 P/E ratio is historically high and an 8 P/E ratio is historically low! Why would you want to automate that assessment? If you're going to time the market, time the market — and good luck to you!
3) Equity premium risk. Note that I don't say the equity risk premium, but rather equity premium risk. There are a lot of theories for why equities earned more than bonds in the 19th and 20th centuries, and risk premia are only one. Since we don't know for sure why equities have historically returned more than bonds, we can't say with any certainty they'll continue to earn higher returns than bonds. That being the case, we can't treat as fact that an allocation to bonds will generate a drag on portfolio returns — it may be that in 30 years we'll find that equities were the drag, and bonds provided consistently greater returns!
I'll be honest: I like this argument a lot. It speaks to my general antagonism towards predicting future returns based on past performance. So rather than argue that it's false (an argument I would lose), I will just throw out some general points that are convincing enough to me to keep me from keeping a fixed allocation in bonds.
If the long-term return on a bond is established by its starting yield and the rate at which coupons are reinvested, we know one of those numbers up front: the starting yield. If the starting yield is high enough to meet your investment goals, you should simply buy long-term, safe, inflation-adjusted zero-coupon bonds with that starting yield.
What you don't know is what the path of interest rates will be over the course of an investment lifetime, so you don't know what interest rate target-maturity bond funds will be reinvested at. For example, the Vanguard Intermediate-Term Bond Index Fund that Jack Bogle likes holds bonds with a target maturity of 5-10 years. Owning that fund is making a series of rolling bets on interest rates in the intermediate-term. While its price will certainly be less volatile than the S&P 500, it feels to me like a MORE speculative bet that its returns over 30 years will outpace the returns of the S&P 500, simply because the price of the S&P 500 today, and in 30 years, is an inflation-adjusted reflection of the state of the largest companies in the US economy (plus the effect of speculative capital flows).
Still, I like this argument enough that I wouldn't try to convince someone NOT to allocate 5-10% of their long-term portfolio to a bond fund as a hedge against long-term underperformance of equities. But I'm not going to do it, and I wouldn't try to convince anyone else to do it, either!
Let me be clear, I'm not asking why people should hold bonds. Bonds are great! Lower volatility than stocks, better returns than cash. For funds needed in the next 5-10 years it makes perfect sense to allocate some portion to bonds in case stocks tank right before the funds are needed.
But in a retirement account that I'm not going to touch for at least 29.5 years (I'm 30), why should I care about volatility if it is my reasoned belief that equities will out-perform bonds over the next 29.5 years (conveniently close to Jeremy Siegel's 30-year timeframe over which equities outperformed bonds in every period between 1861 and 2011)? Obviously, as above, it makes sense to gradually allocate funds to bonds over the 5-10 years leading up to the beginning of withdrawals, so there's a portion of less-volatile funds that can be relied on in the first years of retirement.
Jack Bogle basically provides three answers to this question:
1) Psychological. Here the claim is that while I shouldn't care about short-term volatility in a long-term portfolio, in fact I do. This is a very unpersuasive claim which could be reframed as: "Because you're weak, you should earn lower long-term returns in your retirement accounts." But if you're asking someone to make sacrifices because they're weak, why not ask them to sacrifice their weakness? Doesn't it make more sense to say, "because you're weak, you're going to need to need to exert a lot of energy not looking at your portfolio day-to-day, month-to-month, or quarter-to-quarter." You're still asking the weak person to make a sacrifice (hard mental work), but not to sacrifice long-term returns as well!
2) Strategic. A fixed bond allocation allows you to buy low and sell high. Now this is a more interesting claim. The argument goes that since bond and stock prices are somewhat inversely correlated, and that therefore bond and stock yields are somewhat inversely correlated, allocating a fixed percentage of your portfolio to bonds is a way to shield some of your assets from the stock market when it's over-priced by moving the "unbalanced" amount to suddenly-cheap bonds, and to then buy back into the stock market when it's underpriced by moving the over-allocation in bonds to stocks.
The problem with this argument is that it proves too much. The exact same logic could be used to prove that the only correct asset allocation is 100% bonds (when the stock market is overpriced) or 100% stocks (when the stock market is underpriced)! Of course, when framed that way the problem is obvious: this is market timing, plain and simple. All you're doing is locking in the stock market price/earnings ratio that obtained when you first entered the market! If you enter the market at a 25 P/E ratio, any P/E ratio below that will be "cheap" and require you to buy stocks in order to maintain your asset allocation. If you enter at a 7 P/E ratio, any ratio above that will be "expensive" and require you to move to bonds. This is true even though a 24 P/E ratio is historically high and an 8 P/E ratio is historically low! Why would you want to automate that assessment? If you're going to time the market, time the market — and good luck to you!
3) Equity premium risk. Note that I don't say the equity risk premium, but rather equity premium risk. There are a lot of theories for why equities earned more than bonds in the 19th and 20th centuries, and risk premia are only one. Since we don't know for sure why equities have historically returned more than bonds, we can't say with any certainty they'll continue to earn higher returns than bonds. That being the case, we can't treat as fact that an allocation to bonds will generate a drag on portfolio returns — it may be that in 30 years we'll find that equities were the drag, and bonds provided consistently greater returns!
I'll be honest: I like this argument a lot. It speaks to my general antagonism towards predicting future returns based on past performance. So rather than argue that it's false (an argument I would lose), I will just throw out some general points that are convincing enough to me to keep me from keeping a fixed allocation in bonds.
If the long-term return on a bond is established by its starting yield and the rate at which coupons are reinvested, we know one of those numbers up front: the starting yield. If the starting yield is high enough to meet your investment goals, you should simply buy long-term, safe, inflation-adjusted zero-coupon bonds with that starting yield.
What you don't know is what the path of interest rates will be over the course of an investment lifetime, so you don't know what interest rate target-maturity bond funds will be reinvested at. For example, the Vanguard Intermediate-Term Bond Index Fund that Jack Bogle likes holds bonds with a target maturity of 5-10 years. Owning that fund is making a series of rolling bets on interest rates in the intermediate-term. While its price will certainly be less volatile than the S&P 500, it feels to me like a MORE speculative bet that its returns over 30 years will outpace the returns of the S&P 500, simply because the price of the S&P 500 today, and in 30 years, is an inflation-adjusted reflection of the state of the largest companies in the US economy (plus the effect of speculative capital flows).
Still, I like this argument enough that I wouldn't try to convince someone NOT to allocate 5-10% of their long-term portfolio to a bond fund as a hedge against long-term underperformance of equities. But I'm not going to do it, and I wouldn't try to convince anyone else to do it, either!
