I come from a large family, and through my older siblings I have a growing number of nieces and nephews who are entering their 20s. What often strikes me when talking with them is their tendency to believe that when it comes to investing, they should take as much risk as they can. After all, if they are saving to buy a house, or for the more long-sighted ones thinking about retirement, they figure that more risk means more return, so why not reach as far as possible? They are young; sure there may be bumps along the investment road, but they have the time and patience to ride it out. In a world of only stocks and bonds, they would put all of their money into stocks which have returned 9.05% per year over the past 21 years, and nothing into bonds which have only returned 5.64% per year over the same period*. Seems simple.
This is where I get to step in and play the role of wise uncle. Investors generally understand that investing in stocks implies more risk, but risk is a tricky topic because it is often hard to conceptualize. People know that risk is bad, but it can be hard to get your head around just how to think about it in practical terms. In the case of stocks and bonds we generally think about risk in terms of the volatility of returns. Stocks tend to have higher risk, so the best years for stocks are better than the best years for bonds, but the worst years are also worse. To illustrate this point further take a look at the two below charts. They show the frequency with which stocks and bonds have achieved different monthly returns over the past 21 years. For example, bonds have returned between 3% and 4% in a month only three times, and they have never returned more than 4%. Stocks by contrast have returned more than 3% 79 different times, including more than 10% in a single month. The flipside is that bonds have never returned less than -3% in a month, while stocks have returned less than 3% on 41 different occasions, including four different months where they lost more than 10%.
Source: Barclays, monthly returns from 1/31/1994-7/31/2014
So why would a Millennial add bonds to their portfolio? Diversification. Yes, you give up some of that big upside when stocks are really doing well, but you can also create some cushion to help reduce the impact when stocks are struggling.
For example, let’s say that my 21 year old niece (Note to nieces and nephews who may be reading this piece: No, I don’t mean you. This is meant only as an illustration.) is considering two options: either putting 100% of her savings into stocks or creating a balanced portfolio with 79% in stocks and 21% in bonds. Over the past 21 years the best return for the 100% stock portfolio has been 37.58% (in 1995), but the worst year has been -37.00% (2008). For the balanced portfolio the best year has only been 33.38%, but the worst year has been only -29.46%. So she would have given up just over 4% of the good year upside, but taken away more than 7% of the bad year downside. The average annual return of the balanced portfolio was 8.54%, just half a percent below the 9.05% for stocks. This is diversification in action. The balanced portfolio provided a more stable experience in most markets and less volatility in the value of the portfolio. This can create more comfort about how much money an investor has today and in the future, and makes it easier to budget and plan for future savings.
So why did I pick a 21% allocation to bonds in the balanced portfolio? There’s an old investing rule of thumb that says you should allocate the equivalent of your age, in percentage terms, to bonds. If you’re 21, this would mean that you allocate 21% of your portfolio to bonds; if you’re 50, 50%; and so on. Like all rules of thumb it is far from perfect, but it’s a good starting point for thinking about how much risk an investor should have in their portfolio at different ages.
If you look at where yields are right now, the idea of buying a 30-year bond with a coupon of four percent may not seem that attractive. If you’re a Millennial, and you’re looking to earn more on your investments in the near term than that four percent yield, you may forgo bonds altogether. However, if that’s the path you take, you may be setting yourself up for disappointment. Think not just about what you could earn, but also about what you could lose.
In my next post I will discuss how bonds aren’t just for retired people or Millennials, showing how they can also be put to work for multiple life stages.
* Data for S&P500 and Barclays Agg from 1/31/1994-7/31/2014. Throughout this post, stocks are represented by the S&P 500 index and bonds are represented by the Barclays U.S. Aggregate Bond Index.
Matthew Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.