Challenge Your Perspective on Bonds and Stocks
An investor who is insistent on being 100 percent invested in stocks for the long run likely does not understand the inherent risks they are subjecting their financial future to.
No investor is guaranteed a return from the stock market – including stock funds and stock indexes. Stocks prices rely on corporations growing and consumer sentiment remaining high in order to continuously push upward. Even a business, or a group of businesses, that are continuously profitable can experience a prolonged period of stagnant or declining stock prices due to changes in valuation, economic outlook or speculation Extenuating circumstances can include, but are not limited to: A recession, prolonged inflation or deflation, changes in consumer trends or sentiment, and population or demographic changes.
A classic example of a broad, prolonged stock decline is the Japanese stock market, as represented by the Nikkei 225, from 1989 to 2023. From 1989 to 1998 the Nikkei 225 shed 80% of its value and subsequently averaged stagnant returns until 2012. The Nikkei 225 did not surpass its 1989 levels until 2023. The entirety of corporate Japan did not go bankrupt; an array of factors, including high valuations in the 1980s and a banking crisis that led to a prolonged period of deflation, led to this stock market behavior.
Even through the many arguments that the Japanese economy can not be compared to that of the United States, the sentiment stands that markets are not immune from long term losses. At the time of this article being written, the United States stock market, as represented by the S&P 500, is sitting at its highest valuation in over thirty years. Like a healthy person is not immune from developing an illness, the United States is not immune from developing its own set of economic symptoms that result in a prolonged period of stock declines.
A rude awakening for many is that portfolio losses compound just as effectively as portfolio gains. For every percent that you lose, you need to earn two percent to get your lost money back. Many people talk to the effect of being able to “ride out” prolonged stock market losses, but the simple reality is that there is much more nuance and psychology that goes into a stock market decline. A lot happens in an investors mind during a market decline and a lot more happens in an investor’s life during the indefinite amount of time that the stock market is down. A study conducted by JP Morgan revealed that, between 1996 and 2017, the average retail investor saw just an average return on investment of just 2.6% despite the S&P 500 index offering an average return of 7.2%1. Perhaps relevant to this retail investor underperformance is the fact that the S&P 500 saw negative returns from 2000 to 2010. The need to pull from a portfolio in a decade is likely due to the psychological impacts of a market decline or simple life nuances, and selling at a loss can be devastating to a portfolio and its long term growth.
So, what is the strategy of hope here? Consider a portfolio of high quality bonds. As stated, the S&P 500 is sitting at very high valuations, according to its historical averages. Resultingly, there is a probability that present day interest rates on high quality bonds may outperform the average returns on stocks in the next decade or two.
At the time of writing this article, a high quality, federal income tax-exempt, municipal bond coming due in 15 years can yield upwards of 4 percent. A similar bond coming due in 25 to 30 years can yield upwards of 5 percent. Taxable high quality municipal and corporate bonds yield upwards of 5.5% to 6% in some durations.
Compound interest works best uninterrupted. A portfolio compounding annually at 5% would increase the face value of your portfolio:
- 27.63% in 5 years
- 62.89% in 10 years
- 107.89% in 15 years
- 165.33% in 20 years
- 238.64% in 25 years
- 332.19% in 30 years
We buy into stocks “for the long run”, in hopes of receiving some form of return during whatever duration that turns out to be. Seemingly, it would only make sense to prioritize an asset that releases you from that speculation and provides a known return that allows you to plan your life and sleep at night. A portfolio of stocks may see higher year over year returns during some time frames, but there is no predicting what the long term average return will be following years of volatility and potential declines. If you have any questions on how a portfolio of high quality bonds may work for you, feel free to reach out.
The Conservative Investor
- https://stablebread.com/why-investors-underperform-market ↩︎
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