Bonds play an important role in a portfolio, generally providing diversification and safety. Stocks, meanwhile, provide the potential for capital appreciation over time, but generally entail a higher level of risk. The roles of stocks and bonds expressed here aren’t hard and fast, but they do provide an adequate generalization. These relationships are good to keep in mind when building and maintaining a portfolio.
In fact, this is particularly true today. Bond funds have been favored by investors for several months, with recent weeks showing net outflows in stock funds but continued inflows into bond funds. With a stock market that seems to be performing relatively well, the only logical reason for this seems to be fear. And there is a lot to be fearful of in the world’s financial markets today, from the generally weakening economic picture overseas, to our own middling and tentative recovery, to the potential for the destruction of the euro currency itself. The performance of the domestic stock market, though relatively strong, is another reason to be fearful since the advance is coming against a weak backdrop.
So, judging by the safety factor of the fixed income asset class, it would seem that switching into bond funds makes a great deal of financial sense. Bond funds, however, have had an incredible run of performance over the past 10 to 15 years. In fact, if given the choice between Vanguard 500 Index Fund (VFINX) and Vanguard Long-Term Bond Index Fund (VBLTX), investors would have been vastly better off in the bond fund for the past 15 years—the exact opposite of what one would have expected based on the historical relationship between stocks and bonds.
Strikingly, Vanguard Long-Term Bond Index Fund outperformed Vanguard 500 Index Fund over the trailing one, three, five, 10, and 15-year time periods through the end of July. Amazingly, over the 15 year period, the bond index fund outperformed by 4.1 percentage points annually! With all of the concerns around, it would be understandable for investors to look at the historical performance figures and wonder why they are bothering to take on the risk of equity investing. Bond funds would seem the safer and better performing option.
The problem comes in the legal disclaimer that every fund advertisement contains, “Past performance is no guarantee of future results.” The past 10 to 15 year period has been an oddity in the capital markets, if for no other reason than the fact that it contains a financial crisis that some consider second only to the Great Depression. So, instead of chasing safety and return, investors should take a step back and ask themselves about portfolio construction. Indeed, the issue that needs to be monitored is the diversification benefit of owning bonds. The old adage of not putting all of your eggs in one basket could be a risk that investors aren’t thinking enough about.
The big concern is that interest rates are at historic lows. Since bond prices and interest rates move in inverse fashion, recent bond performance makes sense. Interest rates have been declining since the early 1980s when they reached highs in the upper teens and low 20s. Since they now reside in the low single digits, bond prices rallied strongly since then, leading to capital gains. When rates begin to rise (and they will definitely rise eventually), bond prices are going to fall. Although high-teens interest rates aren’t inevitable, and certainly won’t come overnight, the current low level of interest rates doesn’t require that drastic a move to result in material losses of bond value.
This is a material risk and one that suggests that loading up on bonds may not be the best option over the longer term. If that fact isn’t on investors’ minds, then enough thought hasn’t been put into the asset allocation decisions being made. Indeed, what many investors should have learned from the market drop during the 2007 to 2009 recession isn’t that bonds are better, but that they hadn’t properly considered their risk profiles.
Instead, mutual fund inflow data tracked by The Investment Company Institute, the fund industry’s trade group, suggests that investors are either chasing performance or trading based on near-term fear—without fully considering the long-term concerns they should have. While there is no single asset allocation that is right for everyone, Value Line provides a questionnaire to help subscribers fit themselves into one of nine model allocations that can be used as the backbone of a well-diversified portfolio.
It would be well worth the time to “go back to the basics” and review what portfolio Value Line recommends for you, especially with the hard won knowledge generated by the steep market sell offs of recent years. Another idea would be to examine a few target date funds that coincide with your expected retirement date. Both of these options would provide a good reference point to which you can compare your own portfolio to make sure that you aren’t straying too far from the “science” of asset allocation because you are being driven by fear and/or greed.
At the time of this articles writing, the author did not have positions in any of the securities mentioned.