A few weeks ago I posted some comments on a thread by Early Retirement Now about bond diversification that inspired these thoughts. The concept of his post was that a 30% bond 70% stock portfolio does not lower your risk significantly compared to a 100% stock portfolio because of stock and bond random correlation. I agreed with much of this post but not necessarily the conclusion.
Bonds not for Normal Variation
I’ve written a number of posts on investing over the last 11 weeks, but what I’ve yet to give you are my thoughts on why you would want to invest in bonds. ERN hit the nail on the head that due to weighting a bond to stock 30-70 mix does little to smooth normal levels of volatility. Simply put the lower variance of the 30% portion is not low enough for it only accounting for 30% of the portfolio. However, my conclusion from this evidence is a bit different.
Risk Tolerance and Bonds
I talked about risk tolerance previously. This is probably the number one reason to not go 100% stocks. Unless you’ve lived through a 50 percent stock drop without losing your cool and selling out, you are not in a position to judge whether you are ready for 100% stock. If your entire portfolio drops by half will you be able to avoid selling all your stocks and moving to cash? If you don’t know the answer, or you’ve never tested your resolve in such a scenario you probably have no business being 100 percent stocks. I saw more then one friend and family member pull out of the market in the depths of 2008, their accounts have still not recovered. Don’t be like them.
Extreme Situations and Bonds
The secondary reason to avoid 100% stocks is because of what happens at 3 sigma, or in major drops in the market. The reality is the outlier performance of the market is all too common. There is nothing to guarantee that the stock market won’t go down by 50%, and stay there almost indefinitely. In fact, Japan has had much the same scenario over the last 25+ years. By parking 30% of your funds in a lower risk option like bonds you give yourself some cash to invest in the market at it’s down point or to keep you going through a depression/recession if you lose your job. Vanguard has posted a great article on their site about allocations and the impact of the best and worst years on returns: It shows nearly a 13% reduction in worst year loss from 100% stocks to 70-30 while the average return only declined by 1%. Their data represented 1926-2015. That 13% reduction could mean the difference in being able to pay your bills, and not if you experience job loss during this period.
Your perception to the market tends to be driven by it’s recent performance. This is called Recency Bias. After a long Bull as we have recently experienced you can see the impacts of this bias in media articles and in people’s behavior. Individuals that do not usually take an interest in the market are suddenly talking about buying stocks on the dip of the day to day fluctuations of the market. Worse you may run into some people who are doing things like day trading and considering quitting their jobs to do so.
I’ve recently started to have both of these experiences in my regular life whereas the last time I did was with real estate investors in 2006. I believe we also are seeing this in some forms in the personal finance blogs. There are some clear cut decent plans for early retirement and financial independence, but the more I read on the fringes the more I see retirement fund targets that are getting ever lower. I also see more and more people investing at 100 percent stocks. Some are even using dividends as a safety option. Especially if you’ve already hit early retirement I would suggest you reconsider unless you truly know yourself. I personally keep about 25% -30% bonds/CDs/I-Bonds. I do this not to handle the day to day risk of the market, but because I can see that if I experienced a 50% crash situation that the remaining ~65% of my portfolio would still mean I’m on track to retire in 30 years.
Past Performance doe not Indicate Future Success
Consider investing in bonds and equivalents to ensure you can handle what you may lose in the exceptional situation. Maximizing return is great, but reaching for yield could put you back at 0. Never forget that. “Past performance does not indicate future success”.
Disclaimer: Full Time Finance is for entertainment purposes only. Any investment choices you make are yours and yours alone.