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BEFORE THE FIRST World War, serious investors invested serious money in bonds, real estate and railroad shares. Other stocks were deemed “speculative” and “not investment quality.” Then came Edgar Lawrence Smith and his extensive 1924 study, Common Stocks as Long Term Investments, in which he documented the higher returns to be had by investing in stocks.
Soon, the focus of institutional and individual investors was centered on stocks, but bonds were still considered important for every investor’s portfolio. Life insurance companies and public pension funds typically continued to hold more than 90% in bonds. But private pension funds and personal trusts became more evenly balanced, often with a 60-40 or 40-60 mix of stocks and bonds. Even so, for long-term investors, the opportunity cost of holding significant investments in bonds has been large—and it’s likely to continue to be so.
With record-low interest rates, investors would be wise to recall the words from Lincoln’s 1862 message to Congress: “As our case is new, so must we think anew, and act anew.”
Nominal yields on 10-year Treasury notes are near record lows. The Federal Reserve has been striving to fulfill its responsibility for guiding the economy toward full employment by buying bonds in bulk and driving down interest rates. While admiring the Fed for doing its duty so skillfully, investors would be wise to take a fresh look at the conventional thinking about bonds as important long-term investments.
When the Fed decides at a future date to let interest rates move to their natural level, we all know that those rates will be higher. Getting to those higher rates will mean a reduction in bond prices from current levels. Not only are bond holders already losing money because—net of inflation—yields are negative, but also holding bonds today means knowingly accepting future capital losses when rates are allowed to rise, which will drive down the price of existing bonds.
Why do bond investors, then, continue to own bonds? Habit is one “reason” but hardly sufficient to justify a major commitment of real money. Another reason investors do so: to reduce exposure to stock prices that are also mighty high and that fluctuate more than many investors can comfortably tolerate.
But we must also face that being irrational, including focusing excessively on short-term results, is endemic to us all. That’s why it’s important to study behavioral economics, and why Daniel Kahneman’s book Thinking, Fast and Slow is so richly entertaining and educational.
But back to Lincoln and thinking anew.
Does owning bonds make sense? Yes, it does for funds we know we’ll spend in the near term, say the next five years or less. This can be for buying a new home, or paying college tuition, or covering a gap between current earned income and current expenses. Calculating our near-term need for bonds in this mathematical fashion helps offset our probably irrational feelings about today’s unusual market environment.
One way to uncover our true feelings about the market is to challenge ourselves with a series of questions. How would we feel if the stock market dropped next week by 10%, 20% or 30%? What would we then do? What would we most wish we’d done differently? Then ask: If we could do something differently, what would we do and when would we have done it?
Pretty soon, we’re back to the hard reality that market timing is so very difficult. Most of the time, most of us aren’t successful at both getting out and getting back into the stock market. We might want to be realistic about the limits of our forecasting abilities, and about the costs that come with being long-term owners of bonds.
Just as our fingerprints and the irises of our eyes make us unique and identifiable, so each investor is also unique. When we sort people by age and life expectancy, by income, wealth, ability to save, attitudes toward risk, experience with investing and so on, we find that no two of us are alike.
Since each of us is unique, our best-for-me investing program will also be unique. This applies directly to our best-for-me decisions about bonds. To illustrate, take the conventional canard: Invest your age in bonds.
First, a confession: I am 84 and own no bonds today—and certainly not 84% in bonds. I have never owned bonds and never expect to. Why not?
All my adult life, I’ve earned enough to cover all of our family’s expenses. Still do. Over the long term, my investments—largely in low-cost stock index funds and Berkshire Hathaway—have been wonderfully rewarding. Even now, in my mid-80s, most of my investments will be converted into spending not by me, but by family members, particularly my grandchildren, whose average age is 12. My investments will be spent many long years from now.
One of the great joys of my very lucky life has been the benefits of learning about investing. If you’re considering incurring the heavy opportunity costs of investing a lot in bonds instead of stocks, you might decide to commit a few weeks to reading the best books ever written on investing, including Warren Buffett’s Essays, Burton Malkiel’s A Random Walk Down Wall Street and David Swensen’s Unconventional Success. To immerse yourself in a once-in-a-lifetime study would be one of the most rewarding—and interesting ways—to help yourself.
Charles D. Ellis is the author of 18 books, including Winning the Loser’s Game, which is now in its 8th edition, with 600,000 copies sold. Charley has taught investing courses at both Yale and Harvard business schools, and he served for 17 years on Yale’s investment committee. Check out his earlier articles.
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Thank you Mr. Ellis for writing this article on bonds for Humble Dollar. The recent articles concerning i-bonds by Dr. Lim, Mr. Zaccardi and Mr. Sayler motivated me to start a bond ladder of i-bonds. I am aware of the annual purchase limitations and the required initial holding period of one year before sale, but otherwise i-bonds seem exempt from the usual inverse rate relationship for bonds when rates change. For me, i-bonds seem to be a good place to park my emergency and short term cash. Not a perfect solution but a good one for me with greater flexibility than CDs. I am interested in the thoughts of others who may care to comment.
William, I was with you until you said “with greater flexibility than CDs.” I assume you mean they have greater flexibility because you don’t pay a penalty for early withdrawal (after a point). If you’re already buying I-bonds, you’ve navigated the Treasury Direct website, so you’ll understand when I say that I don’t want me or my wife to be dealing with that when we need to get cash in a hurry. So, we’ll continue to hold CDs at our much more user friendly online bank. We’ll also continue buying $10,000 each in I-bonds every year for reasons discussed already, but it won’t be for flexibility.
Edit – also, when I do need to go somewhere for cash, I-bonds wouldn’t be the first place I’d turn. I’d prefer to leave these in place for the reasons we both appreciate and detailed in the articles you mention.
I appreciate the replies to my to my post. I am currently buying a new position in I-bonds every month which process I now find simple, but have not sold any yet so I that may be a different experience. When I get a sufficient cash reserve built up in I-bonds being over one year from purchase I will likely reduce some of my other cash reserves. As for what I am thinking regarding flexibility a little context – I am a CPA over age 70 and waited until age 70 to claim my social security benefit. I am still working at about 80% of the time I worked when I was younger. With my previous financial decisions I am trying to take the minimum from my retirement accounts until a time after my human capital earnings cease. My thoughts about flexibility centers around which I-bonds I might choose to sell and have to realize the interest income before I stop having the W-2 earned income. I agree with your thought that the I-bonds would not be the first place I would turn to. I have some large unused credit card borrowing availability for any quick needs that I would pay in full with the next statement and can tap a low rate HELOC if I need more quick cash in the short term. The flexibility I value is that I now expect to have time from another financial tool to make good economic and tax decisions and I value the ability to choose when to recognize the interest income that is generally not available in a bank CD. It is rare that I have ever used my emergency cash and one time I did was after a car accident and because of that experience I keep a sufficient amount of dead president hard cash on hand. Doing the above helps me sleep better.
My apologies, I had misunderstood what you meant by flexibility. Appreciate the interesting and helpful context. Your approach makes sense to me.
I Bonds are a gift at this time. Max out your annual purchases for you/spouse/kids. We’ll see someone pop up complaining that they only keep you at zero real return, but you’re not going to find anything better with no risk. You are way, way ahead with I Bonds over CDs. On Monday, coming 6 months rate will be announced and it is highly likely to be 7.12% – from a government-backed security, and interest free from state taxes. Again, nothing is going to beat that for no risk.
I stopped investing in bonds after I understood that holding bonds reduces your total real return, always, and this effect was exaggerated when bond yields fell below the rate of inflation, because of the Feds QE. I believe that the popularity of holding US bonds (excluding those in foreign countries with negative yields) is because most people have been told all their lives that bonds are safe, and safe is what they want most for their life savings, and also there are those who admit they have no stomach for stock market volatility. I also would wager that the vast majority of the public does not understand that bond principal decreases when rates rise. They are about to learn this relationship very soon, as their 401k quarterly report shows a decrease in value when Fed tightening begins. I am 77, own zero bonds, sit out market downturns, and have maximum return as my objective. I use ETFs exclusively, to reduce risk and volatility.
How do you sit out market downturns?
My husband and I invest our money separately – he’s great at getting out before a downturn but terrible at getting back in before a recovery. I’ve done much better over our 32 year marriage by letting it ride. I earned less, spent more and now match his net worth.
In the last 20 years, there were two periods where the 10-year Treasury rate increased, with the average yield as follows:
2012: 1.80%
2013: 2.35%
2014: 2.54%
2016: 1.84%
2017: 2.33%
2018: 2.91%
Using the Vanguard Balanced Index and Vanguard Total Stock Market Index as proxy’s of an all-stock, and balanced (60%S,40%B) portfolio, the returns were as follows:
2012: Balanced 11.49% Total Stock 16.38%
2013: Balanced 18.10% Total Stock 33.52%
2014: Balanced 9.99% Total Stock 12.56%
2016: Balanced 8.77% Total Stock 12.66%
2017: Balanced 13.89% Total Stock 21.17%
2018: Balanced – 2.86% Total Stock -5.17%
Past is not prologue, but there is some recent history to suggest that the risk-reward relationship between an all-stock and balanced portfolio remains largely intact, even during periods of rising interest rates.
If bonds in a portfolio helps an investor achieve a comfortable risk level, that allows them to hold on through bear markets, I don’t see a huge risk in them being held.
Everyone has an opinion about bonds. But in the end, nobody knows nothin’. The market continues to have the last laugh as most “experts” are routinely proven wrong.
I’m certainly not smart enough to know which way’s the winner and my crystal ball is on the fritz, so I diversify. Some equity, some bonds, some cash.
Every day, I’m part right and part wrong. I can live with that.
If part of a portfolio isn’t underperforming somewhere, you’re not diversified.
Interest rates are so low that the only direction for resale value of bonds is lower. They look riskier than stocks and riskier than cash (factoring in inflation). I don’t see any reason for bonds unless government issued and planning to hold to maturity as though they were CDs.
I never understood the allure of bonds funds. The math of bonds held to maturity makes sense, but with traders in fact buying and selling, stocks and stock funds always made more sense. It seems to me that marketing bonds as stable investments is about marketing, not reality.
I disagree that the bonds can be riskier than cash. What would be a bad year for bonds? Losing 2 or 3%? Stocks can lose more than that in a single day.
“My investments will be spent many long years from now.”
Whoa! Slow down. As sages such as AOC, Chuck Schumer, and Nancy Pelosi have instructed us, we now have only about a decade before the world ends. Therefore, spend it all now, while you can!
We all are indeed unique. There are so many different respected experts, all smarter and more knowledgeable than I, who offer different or even opposing ideas. So how does an average guy like me sort through all these ideas and advice, and adapt them to my own unique situation? I particularly like your recommendation of Kahneman and Buffett. You discuss the risk of buying or owning bonds now when their yields are at historic lows, and more broadly, dispute the conventional advice of owning bonds at all for the long term. Those who read Buffett know he personally prefers stocks for long term investment, and short term Treasuries (bills, not bonds) for liquidity. I don’t think he owns any bonds either. And he disclosed his advice for how his wife might invest her assets, should she survive him (90% S&P 500 index fund, 10% short term treasury bills). But I have not read any specific advice he may have for ordinary folks, like me, on asset allocation and withdrawal strategy in retirement. The closest I found was what he wrote in two different annual letters. In one, he discussed the growth in value of his portfolio despite having already donated a specific percentage of shares each year, which he has lately adjusted upward. In another, he addressed the request from many that Berkshire Hathaway distribute an annual dividend. He explained that simply selling a portion of your shares each year, say 3.2% or so, would accomplish the same thing for those who desire a dividend, while those who do not desire a dividend would not be forced to receive one and then be taxed on the distribution (if owned in a taxable account). I could take my annual distributions in retirement by selling a similar fraction of shares from a similar, albeit much, much, smaller portfolio. I should anticipate volatility of the value of the annual income stream, and greater volatility of the annual portfolio valuation, but over the longer term, growth in the value of distributions, along with relative preservation or growth in the value of the portfolio. To moderate that volatility, a portion of the portfolio could be allocated to short term treasuries to dip into, only in years when stocks are down, yielding a smaller but less volatile annual cash distribution (3.2% of shares from a 100% stock portfolio versus 3.2% of shares from a now smaller 90% stock portfolio). (One obvious point here is that for a portfolio worth billions, a 10% or even 1% cash allocation is gigantic, whereas for a more typical sized portfolio, a cash cushion of 10% might only meet living needs for perhaps 3-5 years before becoming depleted). Most distribution strategies I’ve read about, such as the “4%” guideline and its myriad modifications, and many others, are designed to adjust the annual income stream for inflation and to eliminate or temper its volatility. Withdrawal amounts may be reduced somewhat for those who desire some degree of portfolio preservation for heirs and/or charity after death. Not to mention the fact that most advice includes holding a substantial proportion of bonds in the portfolio to moderate its volatility. Whether Buffett is right or wrong is not the question I should ask. It’s more useful for me to ask whether adapting a strategy form what Buffett follows would be suitable for a retired average investor like myself, or would following a strategy based on more familiar “conventional” guidelines make more sense. (Just a few obvious caveats regarding an average guy trying to emulate Mr. Buffett include: Given his enormous wealth, if he put just 1% into short term treasuries and kept the other 99% in stock, and his stock then plummeted for decades, he or anyone could live indefinitely on that pot of cash; he is famously frugal; he has not retired yet at age 91 and so still draws a salary (minuscule as it may be for someone of his abilities); and, despite having already donated a large portion of his wealth, he has not, so far as I know, had to sell any stock to cover any personal expenses yet). I sort of compromised between what Jonathan and others have recommended, and what Buffett has done. I’ll leave it to other smarter folks to figure out the optimal approach. I am flexible, and always willing to modify my strategy if things change or as I learn.
Thank you, Charles Ellis. I did not understand this history. It helps me understand why bonds are viewed so positively in spite of the changes in our world–leveraged buyouts, such as happened to Sears, company splits between the “good assets” and the “bad,” as well as fed money policies et al. I feel affirmed in believing that minimizing my own debt, owning some asset classes that pay out regularly, etc., are ways of paying attention to the reasons why owning debt might be a hedge for ownership stakes in going concerns, even if bonds themselves are not as attractive a way of doing so as they once were. I also recognize that early investors were much more likely to be people running large businesses of their own, while I am not.
Years ago, my (now 83 year old) father said Social Security was his bond fund. I’ve followed his lead on this. It’s a series of guaranteed future payments that holds the same role in my portfolio as a bond fund would. The returns on bonds don’t justify the risk of rates going down and I’m not comfortable holding individual bonds due to the lack of diversification.
So I’m retired at 56 and don’t own bonds. I do hold about six years of my spending in smallish certificates of deposit. When the market drops 10% or more from it’s all time highs, I’ll fund my spending with one of those CD’s, pay the small early withdrawal penalty, and give my stock index funds time to recover. When the market is within 10% of its highs, I sell some index funds to cover my spending needs and replenish my CD safety net.
Curious if anyone is looking at TIPS funds like VAIPX and SCHP, or VCMDX, the Vanguard Commodity Strategy, instead of bond funds?
I love Charles Ellis but have a different perspective.
Markets aren’t stupid. We know the Fed has to end QE and will eventually increase the overnight Fed Funds rate. But if we all knew rates were going to go up then at the weekly Fed auction, we would bid less for the bonds to get higher yields and rates would have already gone up.
The bottom line is we don’t know if rates will stay low and we will be fighting deflation as has happened in Japan for the last three decades or if we will have higher rates and inflation.
Hmm. I’m on the threshold of a 20-ish year retirement, not 30 years.
That’s not long enough to assume time will cure the ravages a big bad stock bear may inflict.
So my portfolio is 50/50 stock index funds and two-year treasuries. Mr. Clements pointed out recently that while bonds no longer provide income they still let you keep spending when the big bad stock bear inevitably arrives. And two-year notes can’t hurt you that much.
The big question is whether the current interest rate suppression can and will persist, and whether persistent high inflation aggravates that into a truly nightmare scenario. Managing one of those is plausible, but both?
For all the stock market ebullience right now this a very challenging time for people in situations as mine.
Not to worry. Biden will take care of everything. After all, he’s done a truly amazing job thus far. Is there any reason to think that his accomplishments in the future won’t be yet more spectacular than they are now?
Mr. Alphonsus, HD readers come here to learn from authors and HD community members who hold a wide range of perspectives and experiences related to personal finance. Political or partisan comments or trolling are best kept to other sites which cater to that.
Completely agreed, David. As a true genius, President Biden will do wonders for personal finance. Just wait and see.
To be fair, recent presidents have done very little to move the stock market. This includes both the presidents I approve of and the ones I don’t.
I suspect that Mr. Ellis is addressing primarily younger investors who may sell stocks during a bear market, locking-in losses. A fear of loss can cause some investors lose their long-term perspective and forget that bear markets eventually end because stock markets run in cycles. If some over-invest in bonds to limit their losses in a bear market, they also diminish their long-term returns. I think this is the point Mr. Ellis was trying to make.
However, retirees could choose to invest in bonds for the income stream they provide. They don’t care about capital gains from bond investments. A rising interest rate environment would be welcomed by such investors because their bond yields would rise. A declining share price would not concern them since they have no plans to sell.
However, retirees also need to be cognizant of inflation and try to earn positive real returns to maintain their purchasing power over time. Therefore, it is still necessary to avoid over-allocating to bonds at the expense of stocks, even in retirement.
I wouldn’t be putting money I need in the near term for buying a new home, or paying college tuition in bonds. As the author pointed out earlier, rising interest rates means a reduction in bond prices from current levels.
I do have a 50% of my retirement savings in bond funds and currently earn about $1,200/month. I welcome higher interest rates because that means higher monthly income. A decline in the NAV doesn’t worry me because I don’t spend the principal and plan to hold them forever.
My 50/50 stock/bond portfolio has earned 8.3% over the last 10 years. That’s good enough for me.
I believe your statements and justifications for not owning bonds, or when to own bonds is no different than any Wall Street shill talking his book. Your way is the best way, right? Wrong.
Own bonds for short term needs, say within 5 years? No, that is the time frame for which you keep your money as cash!
I believe you also have a fundamental misunderstanding of how bonds work…as do many folks who poo-poo them. Being someone who doesn’t own bonds and never will, this is not surprising. When I buy a bond (not a bond fund), I have absolutely no concern for what the price of that bond will be in the future – regardless of what interest rates do. Why? For the basic reason that my intent is to hold until maturity – on the maturity date I will collect 100.0. No matter what price I buy at, no matter what the market price is tomorrow or the next day, at maturity (or the call date if applicable) my bond will be redeemed for 100.0.
When I buy, I know absolutely everything – I know when I will get my money back, I know when I will be paid interest, and I know what my return on investment is…the moment I hit that buy button. And that is why you own bonds – for certainty. Why would I care if the price of the bond in the market goes down? I’m not selling, and don’t have to. What’s the issue, maybe I see the bottom line on my portfolio go down for the time being? Who cares? The future value is guaranteed. If the price of bonds go down, well, that may be telling me it’s time to buy more…for even higher yields.
On the flip side, if the price of my bonds go higher (as we have happening these days), well, then that changes things, because now my return on investment (for my holding period) has gone higher if I choose to sell.
When people become very wealthy and are looking for safe places for their money, when they have enough that their investment objective turns to capital preservation, do you think they are 100% in equities? LOL – of course not. They gravitate to municipal bonds (not municipal bond funds). Take a step outside your comfort zone and go learn why.
Except that isn’t actually true. You do not actually know everything about your bonds and that is probably the reason some have ‘downvoted’ you. Also the insinuation that Mr. Ellis doesn’t understand about buying bonds. I assure you that he does, probably far better than either you or I ever will. Just because someone disagrees with you does not mean they are ignorant. Naturally, his situation and yours or mine are all different, so we may reach different conclusions about what is best for each of us.
It is true that when you cash in your bond, you are handed a stack of say $100 bills. You know exactly how many you will receive and you get exactly that number. But when you look them over carefully, you will notice that the 100 has been (figuratively) crossed off and replaced with another number. It could be 98 or it could be 95. What you don’t know is what that number is going to be. What you can be pretty sure of, with the current low yields, is that number will be less than 100. You will get back less than what you paid for them.
This doesn’t mean you shouldn’t buy any bonds. Of course loosing a little money from bonds may be far better than loosing a lot of money from stocks, which can certainly happen in the short or even medium term. But in the short term, as you said, what you really need is cash, not bonds. In that case it is the medium term you really need to worry about, which is where the low yields combined with inflation really start to cause serious harm.
As I tell colleagues all the time, everything has pros and cons. It comes down to a cost/benefit analysis. What is the benefit if I’m right and what is the cost if I am wrong. Not just the odds, but in real dollars and standard of living.
Makes sense to me. I have no idea why you are getting downvoted.