Today's Investing Thought

Recently my friend Cullen Roche posed an interesting question: "Why invest in bonds? Given that equities have historically outperformed bonds, I wonder why anyone in their 20's or 30's would hold any bonds whatsoever? Or am I missing something?"
That is a very interesting question because it invokes a lot of issues of which entire books have been written. However, for the purpose of this article we need to make a few assumptions. The first is that there are very few individuals that actually save and invest money on a regular basis in their 20's and 30's. They may speculate in the markets with a few thousand dollars they scraped together, and assuming they don't lose it all speculating in the markets, they spend it on rent, dating, buying a car, a house, getting married, etc. In their 30's they are supporting kids and generally struggling to pay the bills. In the real world individuals don't start to effectively save for retirement until they begin to approach their peak earning years in their 40's. As an example, I give regular seminars to groups of 200 or more and I always ask how many people in the audience have 30, 20, 15, 10, and 5 years left to save for retirement. Not surprisingly, 90-95% of the audience consistently falls within the 15 year time horizon or less.
Secondly, we are talking about investing in individual bonds - not bond funds or ETF's. Those are entirely different investments. Individual bonds mature at face value and pay a regular interest stream. Bond funds and ETF's are a bet on the direction of interest rates. For the purposes of this analysis we are assuming two things: 1) That investors are buying investment grade corporate bonds rated BAA. The stock market is a volatile, and risky bet, and comparing the returns of AAA government securities (a risk free investment) to the stock market is not an equivalent comparison, and 2) That the bonds are bought at par and are held to maturity. This aligns with buying the stock market and holding for an equivalent time frame.
With these assumptions in place we can do an analysis of the total return of an initial $10,000 investment for the holding period from 1945 to present.
The inherent problems with most analysis of the "stocks versus bonds" arguments are as follows:

It is usually based on percentage returns rather than actual dollars. The impact of losses of actual invested dollars is masked by analyzing only the annual percentage returns of assets. The analysis period is generally too short. Analyzing only the last 30 years for example is two short of a time span due to the capture of an outsized asset bubble created by a very long period of falling interest rates, falling inflation, artificial influences, deregulation and a demographic influence. As stated above the comparison is often between risky stocks and risk-free bonds. In reality investors would be seeking a relative return from bonds as compared to stocks.

The first chart below shows the annual total compounded return of a $10,000 investment made into bonds and, separately, into stocks.

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A $10,000 investment made into the stock market in 1945 morphed into a $1.07 million dollar value as of the end of 2012. However, that same $10,000 invested in bonds accumulated into $1.28 million during the same period. Why the difference? It all comes down to volatility.
As Albert Einstein once stated: "Compounding is the most powerful force in the universe." That is true but only as it pertains to a continual stream of payments over time which is only achieved by bonds and gives it the smooth growth curve. Investing in stocks, however, is quite a different matter as the inevitable losses in the stock market destroy the compounding effect on money for long periods of time. The chart below shows the real, inflation adjusted returns, of the stock market over time.

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The question of whether, or not, you should invest into the stock market is clearly more of a question of "WHEN" rather than "IF". As you can clearly see someone who was within our stated saving time frame of 15 years to retirement making an investment in 1965 actually lost money to inflation by the time he actually needed the funds for retirement. The same has occurred for those that started saving for retirement in 2000. With only a couple of years left to retirement many individuals are ill-prepared for retirement today.
The importance of bonds, to any portfolio for any age investor, is about reducing portfolio volatility and minimizing the damage that losses inflict on invested dollars over time. As Cullen Roche pointed out just recently - you are a "saver" and not an "investor." There is a critical distinction between the two. Individuals "save" money for future needs (i.e. retirement, college, etc.) and these savings are required to be intact at a specific date in the future. An investor puts capital at risk in the hopes of making a future return on that investment. There is a substantial risk of loss to an investor but these dollars are not required for a future need.
The next chart is a $100,000 investment made into the stock market and into bonds. This time I use mutual funds to offset any issues about impact of fees from the example above. As of the end of 2012 an individual who had been solely invested in bonds since the turn of the century has seen their "savings" grow to $116,000. This is drastically opposed to those invested solely in the stock market which has seen a decline of $3000 during the same period.

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By diversifying the portfolio and adding bonds to the mix individuals would have markedly improved their returns over time as compared to being invested in stocks only. Would those portfolios beat the stock market in terms of percentage returns in many years? Absolutely not. However, that really isn't the point. Investing is not a competition. There is no "prize" for winning but there are sharp penalties for losing. Statistically, the sad reality is that virtually all individuals that chase the market lose more than they make over time.
It is allocation, diversification, risk management and discipline that set the great long term investors (Ray Dalio, Seth Klarman, etc.) apart from the rest. While they may take aggressive bets in the markets from time to time they are generally hedged against losses. Cash is a comfort zone when they don't know for sure what to do and fixed income plays an important role in the asset allocation strategy.
The bond bull market is a long way from ending for one simple reason - the Federal Reserve. Rising interest rates will kill the nascent housing market recovery and undo much of the work that the Fed has engineered in recent years. While the bond bull market may not produce substantial capital gains from current levels - it is far from over and the Fed itself will make sure of that.
As I stated - there are many reasons why should own bonds in your portfolio but there are considerations to be given as to what types, duration risk, credit risk, and much more. But those are articles for another day. The purpose of this article is simply to get you thinking about the importance that fixed income can play within your portfolio structure. The advantage of owning bonds are many. Even if interest rates do rise in the future - for those dependent on income streams for retirement can replace maturing bonds with higher yields in the future.

So, if you are thinking you have the knowledge and skill to successfully navigate the markets long term - you don't. The reality is that no one can successfully speculate in the stock market without suffering substantial losses. Everyone loses eventually. You may get lucky for a while by catching a bullish market cycle and you will find yourself to be a genius. The fall from such heights will be disastrous to your financial health as the realization of excess risk takes its toll. Unfortunately, while you can make up the losses, you cannot regain the time lost in doing so. Do yourself a favor - add some bonds to your portfolio.