Why You Shouldn't Substitute Stocks for Bonds

A friend sent me the following article from the USA Today insert of his local paper. The article proclaimed “ The 60/40 stock-and-bond portfolio mix is dead in 2016” and went on to explain that with bond interest rates near historical lows, one should reach for higher returns by taking more risk with stocks. The article quoted one adviser who suggested investors in their 60s invest 70 to 80 percent of their portfolio in stocks.

I couldn’t disagree more, and here are some facts to consider before you abandon or even lighten up on bonds.

The article’s experts make three points in favor of holding more stocks and less bonds. They are:

1. Interest rates are near an all-time low.
2. Companies such as AT&T pay very attractive 5 percent dividends, which the company has been increasing at 5 percent annually.
3. People are living dramatically longer.
   
   

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First, it’s a misconception that interest rates are near an all-time low. What matters is the real return after taxes and inflation, and rates seem low only until you do the math. In 1980, one could earn 12 percent on a Treasury bond, or about 8 percent after taxes. After 13 percent inflation, the consumer lost about 5 percent in spending power. Over the past year, a Treasury bond yielded about 2.34 percent, or roughly 1.56 percent after taxes. Inflation was 0.17 percent, so the consumer gained about 1.39 percent after taxes. Real rates are actually much better today than when we could get 12 percent nominal returns.

Second, it may seem like AT&T is a very safe company, but so did General Motors and Eastman Kodak at one time. Both paid high dividend yields and were among the 10 most valuable companies on the planet. Both filed for bankruptcy and common shareholders got nothing. As it happens, AT&T isn’t even the same company we all grew up with; it was acquired by one of the former Baby Bells, which took the AT&T name. Stocks are much riskier than bonds.

Finally, though I’ll buy the argument that we are all living longer, that doesn’t necessarily translate into owning less in bonds. In fact, so far this century, bonds have far outpaced stocks. I keep hearing that “everyone knows rates have to rise” (which will cause bond prices to decline) and can’t help but wonder who those “everyones” might be. If it’s many of the top economists, keep in mind that they have correctly predicted the direction of interest rates less than half the time, meaning their forecasting abilities are less accurate than a coin flip.

Also, the market is typically unkind to those investing on knowledge everyone knows. If rates do rise, your yields will go up as bond funds buy new bonds at higher rates as bonds mature. Your bonds should be safe and boring. Bank CDs with easy early withdrawal penalties are an even better place to stash your cash.

My view

Always remember that advisers are people, too, and people are predictably irrational when it comes to stocks. We love stocks, and will reduce bond exposure when stocks are near an all-time high. But that love is fair-weather-based. We will just as quickly move out of them to safety after a stock plunge. Further, advisers shun high-quality bonds because they’re currently not yielding enough to justify the fees they charge their clients. A high-quality bond fund like the iShares US Core Aggregate Bond Fund (AGG) is currently yielding about 1.97 percent. An adviser charging clients 1 to 2 percent of assets to manage their money would then be taking half to all of the nominal return — and the consumer wouldn’t like that.

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I’m 58 years old and won’t be taking the advice in this USA Today article to put my portfolio in 75 to 85 percent stocks. I won’t even go with the standard 60-40 portfolio. I’m sticking with my 45 percent stock portfolio in 2016. I’ve seen too many “new paradigms” end poorly for investors.

 

Allan Roth

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