Most of us have too much in bonds

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a former chair of Yale’s Investment Committee, an ex-board member of Vanguard and the author of 21 books, mainly about finances and investing.

It has long been shown that the returns on bonds are lower than those for equities for long-term investors. And most investors are going to be investing for so long that a bond-laden portfolio is far from optimal for them.

A century ago there was a near monopoly of bonds in investor portfolios until economist Edgar Lawrence Smith proved that higher returns that could be earned by investing in equities. Gradually, over the following decades, a consensus developed that a 60/40 stock-to-bond ratio was “prudent” for both individuals and pensions and endowments.

Then, David Swensen, when he was Yale’s brilliant chief investment officer, changed the question from “what seems prudent?” to “what makes logical sense?” Since Yale had been around for nearly 300 years and planned to be around for at least 300 more, he began to ask whether it made sense to invest in bonds for the long term.

Fortunately, Nobel laureate James Tobin had developed a formula for smoothing the year-to-year distributions from the endowment to the university and the application of this formula liberated the endowment from concern about short-term asset and income fluctuations so that it could focus on long-term results. That liberated Swensen to focus on the very long term, equity investments and their higher returns. The rest is history.

Most individual investors incorrectly define “long term” as a typical “market cycle” of a few years. And for most institutions five years — or the average tenure of investment committee members — seems, too often, to be the working definition of the long term. The reality of investment horizons stand in stark contrast to these conventions. Indeed, most individuals begin investing at about age 30 and continue to invest until their late 80s — suggesting that their real investment horizon spans half a century. Most institutions with endowments expect to stay in operation for at least 100 years. These longer-time horizons should be used to frame their critical investment policy decisions, including their allocation to bonds.

Most individual investors have more money invested in bonds and fixed-income equivalents than they realise. When assessing their investment portfolio’s asset allocation, they look only at their formal bond investments. They do not include in their thinking two important bond-equivalents: future social security benefits (which are effectively inflation-protected annuities from the government) and the equity value of their homes (a relatively stable asset that does not fluctuate with the stock market and rises with inflation).

For most investors, the present value of these fixed-income equivalents are big numbers and may, for some, total more than their 401(k) retirement fund assets. The value of both should be included in assessing the extent of needed bond holdings when structuring each individuals’ total financial portfolio. Institutions similarly have diverse and multiple sources of regular funding. As such, endowments could and should be “all equity” or nearly so. When factoring in the reliable cash-flows over the very long run, what was once a “risky” investment policy should now be appreciated as “prudent”.

Since most individuals succumb to the conventional wisdom of a 60/40 stock and bond portfolio, they will probably have less than they would like to have when they get to retirement. This is becoming a societal problem with rising numbers of individuals without the financial assets needed for lengthening lifespans. The sooner we deal with it, the easier the solving will be.

Yes, there are exceptions where bonds are appropriate investments. When there is a substantial expenditure on the horizon where cash will be needed (for example, for a starter home or a child’s college tuition), bonds for asset stability make great sense. And, historically, many people have relied on the predictability of bond income when they worry about funding their retirement. However, there is a way to create the necessary income stream, but not forsake the higher returns of equities. Instead, a sensible and pragmatic “spending rule” can be employed. 

A pragmatic solution for an individual with enough savings is to use the average of the year-end asset value held in his or her portfolio over five to seven years and to apply a sensible spending rate. A 5 per cent spending rate should allow you to retain the purchasing power of your assets — or a higher percentage of say, 7 per cent or 8 per cent will give you a more generous spending stream if you are comfortable spending down the principal over time. In any case, investors can create a sustainable income stream from adopting their own spending rule. While nothing is ever perfect, this simple scheme avoids the need to bulk up on, or even use, bonds late in life.