The current case for bonds in asset allocation

[Gonzo]

For the early retirement investor there's no good reason for a large slug of your investments to be in bonds. That goes doubly so at current yields, as yields are the biggest predictor of what kind of return you'll get in bonds. If you need bond appreciation for your bond investment to be worthwhile, then you're just speculating and you may as well be in stocks.

It's been shown historically that stocks have the best return on investment. Especially over the long haul. Which, as early retirement investors, is us. And that's the end of the story. Anybody telling you that bonds are a good investment after that, are just wrapping themselves up in a warm blanket because they don't like the scary stock market. And if that's you as well, then great. Buy your bonds "so you can sleep at night." But here's the thing, your final investment allocation is going to look a lot like mine minus the bonds. That is, if you decide you need a million dollars to retire with your 30% bonds, you'll still be 70% stocks ($700,000). My all stock retirement is going to basically be the same, but 100% stocks and $700,000. You'll have definitely worked longer to get that nest egg. I'll have worked less, BUT maybe things don't work out for me and down the line I'll have to grab some income from somewhere. What's the difference? The bond investor DEFINITELY works longer. Me? MAYBE work the same as the bond investor.

So, if you want to work longer now to have your warm blanket, go ahead and build up your bond allocation. If, on the other hand you want to retire sooner with the realization that down the line you might have to be flexible about working here and there then forget the bonds and just buy stocks. And that's really what these arguments come down to: for some people, the idea of going back to work after retiring is HORRIBLE. It has absolutely nothing to do with the merits of owning stocks versus bonds. Because as an investment in and of themselves bonds are qualitatively worse than stocks. So, if the idea of working here and there in your retirement sounds horrific to you, you already know: you're a bond investor.

I really like stocks and my risk tolerance is high, IMO.  I've been through the dot com crash and the financial crisis and it just made me put my buying shoes on.  Although it felt pretty awful to buy when no one else seemed to, I never once considered selling.  However, I don't consider my job completely stable, and I don't believe I can quickly get a new one, so I like to keep a lot of cash. 

I may be a 100% stock investor, if you can give allowance to a larger than normal emergency fund. 

[Geekenstein]

I think if you lack risk tolerance, maybe you shouldn't be investing and thinking about early retirement. Even with a large bond percentage in a downturn, you're still going to be carrying 60-70% stocks. And you're still going to be seeing a stomach wrenching loss in your portfolio. And now, we're to believe that Mr Safetypants is going to move their precious bonds into stocks right at the moment when it seems like the whole world is on fire? When, like in the depths of 2008-2009, people were having serious discussions that Bank of America might go bankrupt?

And for bond lovers, that's usually the only case they can point out where bonds are worthwhile. Go look at the investment quilts. For that one year where bonds outperform stocks (and only because stocks did poorly, not because bonds did great or anything) you've got another nine years or so where bonds and cash are in an epic battle for dead last place.

The only time I can think to invest in bonds: when you've already got more money than you'll ever need. Why roll the dice at that point? And that's what people that are accumulating large bond portfolios are essentially doing. Working and paying taxes  to the government longer in order accumulate more money then they will probably need. All done in service to the comforting warm blanket of lending your money back to the very same government. Crap, I almost sound Libertarian (I'm not by a long shot).

For yourself I'm sure everything you mention is excellent advice.  As someone who was in 100% equities for most of my investing life I have no quarrel with the fact that equities, over a long time horizon, outperform non-equity assets.   That said, every forum on investing is chock full of people who thought they were OK with whatever outsized asset allocation they had chosen, but discovered they could no longer sleep at night when their portfolio was suddenly worth half what it was a short time before.  So they sell.  They converted paper losses to real ones.  I can't think of a better way to absolutely decimate long-term portfolio returns than this.  In most cases where people fail to meet their investment goals, this is the reason why. 

It's fine to say "if you lack risk tolerance, don't invest" but you are talking to a very large number of people who really MUST invest.  Early retirement is a GOAL and no more.  However, most everyone will need to replace their working income at some point, early retirement or not.  Being invested in even a 50/50 portfolio, as abhorrent as it may be for you, will get an investor much farther than avoiding the market entirely.  To get the best risk adjusted returns you only have to go to 60/40.  For this "warm blanket" that investor forfeits 1.6 percent in average annual return (8.6 vs 10.2).

Another thing to note.  Choosing when to ramp down from 100% stocks to non-equities isn't as easy as you make it sound.  You can pick the age you think you want to do that, or choose the dollar value of your portfolio that you believe "is enough" but neither of those controls for market conditions.  If you decide you want retire at 45, and you have to accumulate until you are 44, you hope the market is not down significantly or you run into sequence of returns issues.  If your 100% equity portfolio is down 20 percent you probably aren't going to sell to re-allocate to bonds.  Hopefully your dividends will be sufficient to cover your income, but that isn't a given.  Hopefully its just a short downturn.  So what to do then?  Probably work longer. 

Investing is about making money long term.  Being successful has more to do with temperament and understanding your own limitations than strategy.  Buying high and selling low is the exact opposite behavior we want to have as investors, but that behavior is found most often in those who misread their tolerance for risk, and who misunderstand their time horizon.

[Tyler]

I think if you lack risk tolerance, maybe you shouldn't be investing and thinking about early retirement.

I disagree.  Having a risk tolerance less than 100% does not make you weak -- it just makes you human.  Investing is about a lot more than risk taking, and there are more conservative methods for investing and early retirement than putting all of your money in stocks that also work just fine. 

Fundamentally, there's a big difference between risk tolerance and risk capacity (There's a good book called "Risk Less and Prosper" that goes over these ideas).  Risk tolerance is a purely emotional measure -- how you feel (right now) about risk.  Risk capacity is based on your real-life needs and whether you can truly afford the downside risk.  Can you really afford for your all-stock college fund to lose 50% of its value the year your child goes to college?  Do you actually have a choice to work another 10 years when markets do not cooperate on your retirement timeframe, or will your age and skills force your hand? 

Those who have a high risk capacity but a low risk tolerance may be considered overly conservative.  Those with a high risk tolerance but a low risk capacity may be considered foolish or naive (many young investors believe they have a very high risk tolerance right up until the moment they learn otherwise the hard way).  Those whose risk tolerance matches their risk capacity simply know themselves well, and I think that's a good place for any investor to be in order to make wise decisions.

BTW, big +1 to everything Indexer and Geekenstein have contributed to this thread.  Lots of wisdom there. 

[LAGuy]

I think if you lack risk tolerance, maybe you shouldn't be investing and thinking about early retirement. Even with a large bond percentage in a downturn, you're still going to be carrying 60-70% stocks. And you're still going to be seeing a stomach wrenching loss in your portfolio. And now, we're to believe that Mr Safetypants is going to move their precious bonds into stocks right at the moment when it seems like the whole world is on fire? When, like in the depths of 2008-2009, people were having serious discussions that Bank of America might go bankrupt?

And for bond lovers, that's usually the only case they can point out where bonds are worthwhile. Go look at the investment quilts. For that one year where bonds outperform stocks (and only because stocks did poorly, not because bonds did great or anything) you've got another nine years or so where bonds and cash are in an epic battle for dead last place.

The only time I can think to invest in bonds: when you've already got more money than you'll ever need. Why roll the dice at that point? And that's what people that are accumulating large bond portfolios are essentially doing. Working and paying taxes  to the government longer in order accumulate more money then they will probably need. All done in service to the comforting warm blanket of lending your money back to the very same government. Crap, I almost sound Libertarian (I'm not by a long shot).

For yourself I'm sure everything you mention is excellent advice.  As someone who was in 100% equities for most of my investing life I have no quarrel with the fact that equities, over a long time horizon, outperform non-equity assets.   That said, every forum on investing is chock full of people who thought they were OK with whatever outsized asset allocation they had chosen, but discovered they could no longer sleep at night when their portfolio was suddenly worth half what it was a short time before.  So they sell.  They converted paper losses to real ones.  I can't think of a better way to absolutely decimate long-term portfolio returns than this.  In most cases where people fail to meet their investment goals, this is the reason why. 

It's fine to say "if you lack risk tolerance, don't invest" but you are talking to a very large number of people who really MUST invest.  Early retirement is a GOAL and no more.  However, most everyone will need to replace their working income at some point, early retirement or not.  Being invested in even a 50/50 portfolio, as abhorrent as it may be for you, will get an investor much farther than avoiding the market entirely.  To get the best risk adjusted returns you only have to go to 60/40.  For this "warm blanket" that investor forfeits 1.6 percent in average annual return (8.6 vs 10.2).

Another thing to note.  Choosing when to ramp down from 100% stocks to non-equities isn't as easy as you make it sound.  You can pick the age you think you want to do that, or choose the dollar value of your portfolio that you believe "is enough" but neither of those controls for market conditions.  If you decide you want retire at 45, and you have to accumulate until you are 44, you hope the market is not down significantly or you run into sequence of returns issues.  If your 100% equity portfolio is down 20 percent you probably aren't going to sell to re-allocate to bonds.  Hopefully your dividends will be sufficient to cover your income, but that isn't a given.  Hopefully its just a short downturn.  So what to do then?  Probably work longer. 

Investing is about making money long term.  Being successful has more to do with temperament and understanding your own limitations than strategy.  Buying high and selling low is the exact opposite behavior we want to have as investors, but that behavior is found most often in those who misread their tolerance for risk, and who misunderstand their time horizon.

I don't think it's easy at all to change your allocation, and that's the point I'm trying to make. I think we're giving people that are nervous about investing in stocks a false sense of security by saying they can put some percent of their investments in bonds and be able to sleep at night. If you're 50-70% stocks and there's a big 2008 like event, you are still going to see a major drop in your portfolio value. The fact that you're seeing less of a drop than the 100% stock folks is not going to make you feel any better nor aid in your night time sleep cycle. Now, however, we are to believe that this safe/conservative investor is going to move their bonds into stocks because their reallocation scheme demands it? We've already determined that this is the type of person that SELLS into a downturn, but now I'm to believe that this person is going to BUY the downturn? I'm sorry, but I really doubt they're going to do it. And now they've blown one of the requirements of the 4% rule - keeping your allocation steady in good times and bad. In short, what this investor is going to do is sell their winners in good times and fail to buy stocks when they go on sale with their bond allocation.

You've said it yourself. People must invest. Better to help them get their head around the idea that they're going to see major drops in their portfolio value and they have to hold on. So what if they can reduce their volatility in half with a slug of bonds? What's the difference between a fukton of volatility and 2 X a fukton of volatility? There isn't any. So, just pick the allocation that's going to make the most money and learn to hold on. An investor HAS to learn this no matter their allocation or they're going to fail. At least with the 100% stock portfolio you don't have to BUY when everything is burning like the bond investor does...lol, you just close your eyes and pray.

[dungoofed]

A few of the others have (fortunately) mentioned in the last 24 hours the points I wanted to raise but was struggling to come up with a non-snarky way to say it.

Apart from having your life decisions (retirement, kids' college, etc) beholden to the ups and downs of the stock market, the other thing  people always forget is that some people inevitably lose their job in a downturn. Considering that part of the outperformance of stocks as an asset class is due to purchasing while the market is down I'd say this is pretty important. Imagine being unemployed or underemployed during 2009. Yes, your emergency money should tide you through the tough times and help you avoid selling stocks but who keeps aside enough emergency money to cover a 12 month unemployment stint PLUS the money to pump into stocks that their previous job would have allowed?

Holding bonds or other defensive assets doesn't solve this entirely but it gives you options that you don't have with 100% stocks.

[Geekenstein]

Apart from having your life decisions (retirement, kids' college, etc) beholden to the ups and downs of the stock market, the other thing  people always forget is that some people inevitably lose their job in a downturn. Considering that part of the outperformance of stocks as an asset class is due to purchasing while the market is down I'd say this is pretty important. Imagine being unemployed or underemployed during 2009. Yes, your emergency money should tide you through the tough times and help you avoid selling stocks but who keeps aside enough emergency money to cover a 12 month unemployment stint PLUS the money to pump into stocks that their previous job would have allowed?

Holding bonds or other defensive assets doesn't solve this entirely but it gives you options that you don't have with 100% stocks.

Yeps.  Having a hedge, be it bonds or whatever, gives you options AND it will generally let you stay invested in your chosen equity allocation. 

I agree with everything LAGuy is saying - theoretically.  In practice what matters is that you find what is going to work for you, with the greatest percent of equities you can tolerate, and stick with it.

[thriftyc]

For the early retirement investor there's no good reason for a large slug of your investments to be in bonds. That goes doubly so at current yields, as yields are the biggest predictor of what kind of return you'll get in bonds. If you need bond appreciation for your bond investment to be worthwhile, then you're just speculating and you may as well be in stocks.

It's been shown historically that stocks have the best return on investment. Especially over the long haul. Which, as early retirement investors, is us. And that's the end of the story. Anybody telling you that bonds are a good investment after that, are just wrapping themselves up in a warm blanket because they don't like the scary stock market. And if that's you as well, then great. Buy your bonds "so you can sleep at night." But here's the thing, your final investment allocation is going to look a lot like mine minus the bonds. That is, if you decide you need a million dollars to retire with your 30% bonds, you'll still be 70% stocks ($700,000). My all stock retirement is going to basically be the same, but 100% stocks and $700,000. You'll have definitely worked longer to get that nest egg. I'll have worked less, BUT maybe things don't work out for me and down the line I'll have to grab some income from somewhere. What's the difference? The bond investor DEFINITELY works longer. Me? MAYBE work the same as the bond investor.

So, if you want to work longer now to have your warm blanket, go ahead and build up your bond allocation. If, on the other hand you want to retire sooner with the realization that down the line you might have to be flexible about working here and there then forget the bonds and just buy stocks. And that's really what these arguments come down to: for some people, the idea of going back to work after retiring is HORRIBLE. It has absolutely nothing to do with the merits of owning stocks versus bonds. Because as an investment in and of themselves bonds are qualitatively worse than stocks. So, if the idea of working here and there in your retirement sounds horrific to you, you already know: you're a bond investor.

So, say the market crashes at retirement, like it did in 2008.  Your 700k all stock portfolio will be cut in half. Additionally, you will be withdrawing on that now 350k to live on.  If you can handle that mentally and financially - more power to you.   However, if you were holding some bond indexes during 2008 your portfolio would not have gone down as much, allowing you to withdraw from the bonds while stocks were down, plus allowing you to rebalance when stocks are on sale (selling bonds, buying stock at low prices).  The accumulative effects of rebalancing a properly allocated portfolio of 75/25% stocks bonds are very close to the results that you would get in an all stock portfolio - but with less downside risk of running out of money during retirement.

[steveo]

A 75% stock/25% bond portfolio has historically had better returns and lower risk than a 75% stock/25% cash portfolio. It is a far more efficient portfolio. It is because stocks and bonds hedge each other to a degree that cash does not. By adding bonds to an existing stock portfolio you can decrease risk a lot without having a huge impact on returns. Historically a 100% stock portfolio has averaged around 10%, but can drop 50% in a crash. On the other hand a 60/40 has historically averaged almost 9% and tends to drop about 25-26% in a major(2008/1929) crash. Historically you would be giving up about 1% return per year to cut your volatility almost in half. Yes, that is pretty $&%^ing powerful!

Yep. There is a really good reason to hold some bonds as part of your asset allocation. I think you also just buy a Vanguard Bond fund. Simple.

[steveo]

I think if you lack risk tolerance, maybe you shouldn't be investing and thinking about early retirement. Even with a large bond percentage in a downturn, you're still going to be carrying 60-70% stocks. And you're still going to be seeing a stomach wrenching loss in your portfolio. And now, we're to believe that Mr Safetypants is going to move their precious bonds into stocks right at the moment when it seems like the whole world is on fire? When, like in the depths of 2008-2009, people were having serious discussions that Bank of America might go bankrupt?

Why won't you rebalance ? Diversifying your assets works. Even if you only do it a little bit it might help. I also would rather sell bonds to live off than sell stocks especially at a low.

Risk capacity is based on your real-life needs and whether you can truly afford the downside risk. 

Yep.

[steveo]

Holding bonds or other defensive assets doesn't solve this entirely but it gives you options that you don't have with 100% stocks.

I reckon this is important.

I suppose it's each to his own but when I FIRE I want to be able to use my bonds to live off if the market crashes.

[Scandium]

So, say the market crashes at retirement, like it did in 2008.  Your 700k all stock portfolio will be cut in half. Additionally, you will be withdrawing on that now 350k to live on.  If you can handle that mentally and financially - more power to you.   However, if you were holding some bond indexes during 2008 your portfolio would not have gone down as much, allowing you to withdraw from the bonds while stocks were down, plus allowing you to rebalance when stocks are on sale (selling bonds, buying stock at low prices).  The accumulative effects of rebalance a properly allocated portfolio of 75/25% stocks bonds are very close to the results that you would get in an all stock portfolio - but with less downside risk of running out of money during retirement.

This is already accounted for in the CFIREsim simulations of 4% WR with 100% stocks. It's still better than having bonds. The gains during good times make up for the scenario you describe.

[thriftyc]

So, say the market crashes at retirement, like it did in 2008.  Your 700k all stock portfolio will be cut in half. Additionally, you will be withdrawing on that now 350k to live on.  If you can handle that mentally and financially - more power to you.   However, if you were holding some bond indexes during 2008 your portfolio would not have gone down as much, allowing you to withdraw from the bonds while stocks were down, plus allowing you to rebalance when stocks are on sale (selling bonds, buying stock at low prices).  The accumulative effects of rebalance a properly allocated portfolio of 75/25% stocks bonds are very close to the results that you would get in an all stock portfolio - but with less downside risk of running out of money during retirement.

This is already accounted for in the CFIREsim simulations of 4% WR with 100% stocks. It's still better than having bonds. The gains during good times make up for the scenario you describe.

Oh, I get the math, think we all do here. 
ER and financial planning is just as much about emotion than it is pure math. If it was just math - we would just keep working forever.   Again, if one can stomach their portfolio being sliced in half during a downtown - my hats off to them!!

[Tyson]

Oh, I get the math, think we all do here. 
ER and financial planning is just as much about emotion than it is pure math. If it was just math - we would just keep working forever.   Again, if one can stomach their portfolio being sliced in half during a downtown - my hats off to them!!

I don't see why people don't look at it the same way you look at equity (or non-equity) in a home - it's not real until you sell it.  So whether it goes up or goes down doesn't matter, especially if you are in accumulation phase.  Now if you are FIRE, it is true that your portfolio is most vulnerable during the first 10 years.  So I can see running up some bond accumulations as you approach FIRE as a hedge for those first few years.  But certainly during accumulation doing 100% stocks is pretty much optimal.