Much of the investing world looks at bonds as the “safe” portion of an investment portfolio, a bulwark against the volatility in the stock market. Hence, you have popular asset allocation strategies like the 60/40 balanced portfolio and target date funds that increase bond exposure as investors get older.
However, recent research calls into question the traditional view of bonds and it’s attracting a lot of attention. The research by three U.S. finance professors led by University of Arizona professor Scott Cederberg comes to the surprising conclusion that a portfolio holding 100% stocks and no bonds is best, even for people already in retirement.
That’s certainly an eye-catching conclusion, but one that comes with many important nuances.
The researchers studied data from 39 developed countries over 130 years of returns from stocks, bonds and treasury bills as well as inflation.
In the first of three papers based on this database, the authors show that while stocks are risky—the probability of losing money in real terms (net of inflation) is 12% after 30 years—bonds and treasury bills are even riskier. Across the 39 countries, the probability of losing money on treasury bills was 37%, and on intermediate-term government bonds 27%.
In the second paper, the researchers found that while stocks were the least risky investment over the long term, adding international stocks to the mixreduced the riskiness significantly. In fact, for a portfolio composed only of domestic stocks, the probability of losing money net of inflation over 30 years was 13%, but if you add 50% international stocks, the probability of losing money drops to 4%.
The third and most recent paper was the most interesting for us. In it, the professors simulated the financial lives of 1 million couples – from 39 countries – who start saving 10% of their salary from the age of 25 until their retirement at 65.
Upon retirement, they withdraw 4% of their savings, indexed to inflation, until the death of the last spouse. The simulations take into account, in addition to market fluctuations, mortality risk and the risk of job loss. They also take account of old age pensions such as Social Security, the U.S. equivalent of our Old Age Security in Canada.
The researchers—Scott Cederburg, Aizhan Anarkulova and Michael O’Doherty—compared five investment strategies over the lifetime of the couples:
- 100% treasury bills
- 60/40 balanced portfolio
- 100% stock allocation at age 25 and gradually reducing stocks in favour of bonds over the years
- 100% domestic stocks
- 50% domestic stocks / 50% international stocks
The success of each of these strategies was evaluated on a number of criteria, including, most importantly, the couples’ risk of outliving their money.
An internationally diversified portfolio of stocks turned out to be the least risky strategy, both before and after retirement, even though a 100% stock portfolio did expose couples to the greatest risk of a drop in wealth that may be temporary or last several years.
What explains the superior performance of the 100% international equity portfolio?
- Stocks have a much higher expected return than treasury bills and bonds. The authors estimate real expected stock returns to be four times those of bonds.
- After a period of decline, stocks tend to rebound. By contrast, bonds tend to continue to fall because inflation persists.
- International stocks provide protection against domestic inflation.
- In the long run, stock and bond returns have a fairly high correlation of 0.5. Thus, over the long term, bonds offer little protection against poor stock market returns.
So, what to make of the findings? First, they are a clear confirmation that an internationally diversified stock portfolio beats one that is concentrated in domestic stocks.
Second, it’s crucial to remember that these financial simulations assumed the couples were perfectly rational even in the midst of major market declines. In the real world, emotions all too often derail the best intentions of investors.
Many investors—especially those in retirement or close to it—will have a hard time watching their all-stock portfolio sink in a bear market by 40% or more, even if they understand intellectually that stock markets bounce back over time. The danger of panicking and selling at just the wrong moment is real.
The authors are not claiming that equities are “safe” investments. Instead, they are saying you need the higher returns they provide to continue accumulating wealth even in retirement to avoid outliving your money in an era when many people are living to over 90 years old.
The research provides good food for thought about the optimal asset allocation. And, above all, it reinforces the importance of having an experienced investment advisor to guide you in making decisions and sticking with your financial plan through good times and bad.
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In the next episode of our Capital Topics podcast, we take a closer look at this fascinating research with PWL Capital Senior Researcher Raymond Kerzérho, who also gives us an update on our latest estimates of future asset class returns. Be sure to download the podcast and subscribe to never miss an episode.