June 18, 2018

Why an Allocation to Bonds Always Makes Sense

A decline in stock prices during a bout of market volatility often elicits the comment that “this is a buying opportunity because markets always bounce back”.  From a historical perspective, that’s generally been true but is it possible for a stock drop to be something closer to permanent?  Is this a realistic possibility, and if so, is there a strategy that we can use to manage that outcome?

We can gain an understanding as to whether a stock drop can be more than temporary volatility by examining the Japanese experience.  Suppose it’s January 1990, you live in Japan, and you are an investor saving for retirement.  You’ve been told that stocks have a higher expected return than bonds and, even when stocks drop, they always come back.  Given that information you’ve selected a 100% allocation to a fund that tracks the MSCI Japan Index (a diversified exposure to the Japanese stock market).

So how has that worked out?  The chart below compares the Growth of Wealth of ¥ 1 invested in either Japanese stocks or Japanese government bonds beginning in January 1990 through May 2018.

Over the twenty-eight year-plus period, Japanese stocks returned a total of -7.8% compared to a 173.0% return for government bonds.

The Japanese stock market experience shows us that stocks don’t always bounce back after falling.  Said more precisely, historically, stocks usually bounce back after falling.

The key insight is that investing entails accepting uncertainty of outcomes because we can’t successfully predict the future.  Given that, what are smart ways to manage this uncertainty of outcomes?  The most important step is including high-quality bonds in the portfolio.  As an example, had the hypothetical Japanese investor selected a balanced 60% equity/ 40% government bond portfolio, the portfolio would have returned 73.4% or about 2% per year.  Nothing great but a higher floor than what the all equity portfolio delivered and maybe enough to avoid a personal financial disaster or to successfully fund a retirement goal.