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Basic, But Necessary
Bonds are not sexy, they are not glamorous, and they do not have the appeal of stocks, real estate, and other hot asset classes – both speculative and legitimate. However, bonds do not need to be appealing for them to be necessary.
As covered in my first article, Not Your Grandma’s Guide to Stocks & Bonds, bonds are safer investments that represent I-Owe-You-Notes between yourself and a borrow. In return for lending out your money, the borrower pays you interest. Eventually, you get your principal amount back, too.
Now, the more likely a borrower is to go belly-up, the higher the interest rate paid, and vice-versa. Consequently, this is why US government bonds generally pay some of the lowest interest rates, as the chances of our government going belly up are slim, especially when we have the world’s most potent military backing it. Hence, the designation risk-free is currently afforded to US bonds.
Besides the US, many other governments’ bonds are considered minimal risk, and examples include Australia, New Zealand, & several Scandinavian governments.
The nature of bonds makes these low-risk investments the basic building blocks of portfolio construction since they are not as perilous as stocks. However, risk-free bonds have endured seven centuries of declining yields. As a result, many have begun to ask whether the 60/40 stock/bond portfolio is teetering or dead.
Is Change Warranted?
Looking at the diagram above, we can see that risk-free government bond yields hovered around 7% in the latter parts of the 13th century – today, they hover below 2%.
As a result, one would assume portfolio construction must adapt because, while necessary, bonds no longer can provide a meaningful return, right? Well, let’s see what the research says.
According to Vanguard, the 60/40 portfolio is still alive and well. In their view, bonds are the steady hand that keeps the reins under control when the markets start bucking around like a wild horse. As a result, Vanguard believes that bonds are still worthy of 40% of retirees’ money despite historically low yields. Notably, Vanguard contends that lower than average returns are to be expected from a 60/40 portfolio for the next decade due to more moderate economic growth.
If we look beyond Vanguard, T. Rowe Price (TRP) recently released a report that indicates that a stock allocation of 73% – with a bond allocation of 27% – would be required going forward to maintain the historical performance of the 60/40 portfolio. Importantly, TRP stresses that this change is not due to the slowing growth of the global economy, but instead due to persistently low yields bonds will provide into the future.
A Hedge Against Declining Yields
There are several ways to interpret the data above, but regardless of how you decipher it, change is required going forward for a sustainable retirement.
There are several ways to change your retirement plans and portfolio, of which I cannot highlight all. However, one solution is for investors to increase their savings rate while lowering their withdrawal rate. Financial Samurai advocates for this, and it has its merits.
However, I am more fond of another solution: to increase allocations towards riskier assets – like stocks. By doing this, investors can ensure a higher likelihood of retirement success, which is defined as not running out of money before death.
I prefer increased stock exposure because while some people can save more, not everyone has this ability, plus a minimum withdrawal rate is needed to survive.
If you are skeptical of a change to the 60/40 portfolio, which many educated people are, I am okay with this! The future is unknowable, after all. However, lower yields are likely, as Vanguard highlights.
Everyone Will Be Different
While there are no guarantees of what the future holds – that is the nature of investing, after all – hedging into a higher stock allocation may provide benefits if you can stomach the volatility. However, everyone’s situation will be different, and some people will choose to work longer rather than subjecting themselves to the increased risk such portfolios hold. Others may have the ability to save more now or to cut their expenses down once retirement comes.
Regardless, navigating the centuries-long decline of bond yields is a reality most investors will no face, so how will you construct your portfolio going forward? Let me know in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time