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.