AUGUST WORDS ON WEALTH

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Here is a question with a seemingly obvious answer: Between a short-term bond fund and a diversified stock mix, which is safer?  The bond fund has never lost even -1% over any month in the last 25 years.  The stock mix, on the other hand, would have seen seven different episodes of -20% or more losses; from 2007 to 2009 it dropped almost -60%.

Most investors would elect the short-term bond fund due to its principal stability. But June’s newsletter suggested that you examine investments through a different lens than short-term returns.  Instead, consider them within the context of your long-term financial goals and a plan designed to achieve those goals.  

First, goals.  Then a plan.  Only then do you consider the portfolio.  This month I will discuss the portfolio as well as the crucial difference between investment safety and financial safety.  

Redefining Safety

The short-term bond fund is indeed safe if the goal is a return of your principal in a few months or a year.  But it’s incredibly risky if the goal is a premium return on your savings over 15+ years that will allow you to achieve financial independence.  It’s similarly risky if the goal is to produce 20 to 30 years of a rising income stream from your nest egg to support you in retirement.  

In 1995, if you took $1M and invested it in the short-term DFA One-Year Bond Fund, and tasked it with producing $50k per year in withdrawals (increased annually by the rate of inflation), the portfolio would have been fully depleted by mid 2019.  The fault lies not with the fund—it achieved the unprecedented: higher returns than its index, the BofA 1-YR T-Note Index, with less risk.  Instead, it was the low long-term returns—characteristic of all investments and portfolios with minimal short-term price swings—that meant an ever-increasing amount of the annual withdrawals came from spending principal until there was nothing left.  

That same $1M, invested instead in a diversified stock asset class portfolio*? It fluctuated wildly in the short run, but grew to over $5.3M, net of more than $1.5M in cumulative withdrawals, in the long run.  Juxtaposed with the relative stability and paltry returns of the bond fund, the high short-term volatility of the diversified stock portfolio translated into long-term returns that far exceeded the spending rate.

Rethinking Financial Goals

This example reveals why “avoiding losses” is not a financial goal, it’s an investment goal.  A financial goal, on the other hand, is to not have to work for the rest of your life (in the absence of sufficient savings), to not run out of money in your later years, and to leave your beneficiaries with a larger portfolio than your initial investment.  In this regard, financial safety is found in an unlikely place: diversified stock portfolios.  Let’s explore this further.

Every financial goal you have must be evaluated in terms of the future dollars you will need.  This means you have to take into account inflation.  When considering investments for the portfolio to execute on your plan, we need to look at their long-term, after inflation (i.e. “real”) returns.  We don’t know what the future will hold but looking back at historical results provides us a starting point for building expectations.

Reframing History

Stock and bond index data begins in 1928.  The return on a diversified stock asset class portfolio has been 8.5% per year in excess of inflation (6.7% for the US stock market).  Bonds have earned just 2.2%.  Simply stated, stocks have produced 4x the amount of real wealth as bonds. 

The biggest take away from the chart above is that in terms of long-term financial goals that require significantly more wealth than you have today, bonds are risky and stocks are safe.  The likelihood that you’ll earn sufficient returns in excess of inflation in bonds or bond-heavy portfolios is extremely low.  In stocks or stock-heavy portfolios, the odds are very high.  If you need a much larger portfolio in 10 or 20 years to retire, or multiple decades of cash flow, only stocks will get you there. 

What makes stocks so much safer in terms of helping you achieve your long-term financial goals?  They carry greater investment risks.  Stocks go down more often than bonds, and their losses are far greater.  Over all 12-month periods since 1928, bonds have only lost value net of inflation 20% of the time; their worst loss was just -15%.  The diversified stock asset class mix, on the other hand, lost value 35% of the time, and its worst decline was -70%.  

It is these investment risks that cause investors like those introduced in June’s newsletter, Dr. Sklar and Mr. Eberline, to lose sleep.  They mistakenly believe that the short-term investment setbacks will result in long-term financial risks.  That’s the wrong way to look at it.  Instead, it is the chance for, and eventual certainty of, short-term investment losses that gives you the greatest chance to earn long-term returns sufficient to achieve your financial goals.  Without the volatility and short-term loss potential of stocks, you wouldn’t expect to earn (at least historically) over 4x greater real returns.  No volatility, no success.

Refocusing On the Future

Winston Churchill reminds us that “The farther back you look, the further ahead you can see.”  The past helps us measure what the relative spread between stocks and bonds, as well as different types of stocks, has been.  But it doesn’t tell us exactly what they’ll be going forward.  In terms of bonds, the future looks even worse than the past.  Today, a five-year Treasury Note yields just 0.3% per year, a ten-year maturity Treasury Bond pays just 0.7%, going out 20 years gets you just 1.2%.  A more practical strategy—a short-term global bond mutual fund like the DFA Five-Year Global Portfolio, which includes high-quality corporate bonds, still yields less than 2%.  

The likelihood that bonds earn positive returns, net of inflation, over the next two to three decades is exceedingly remote. The more money you allocate to bonds, the less chance you have to achieve your financial goals.  Sure, your portfolio will fluctuate less in the short-term, but that only matters if you don’t understand that investment risk (volatility) is not financial risk.  Most investors still don’t appreciate this, and some who have been exposed to the truth still cannot accept it, which is why you have a chance to achieve far greater future financial success than everyone else.

Realizing When It’s Working

How do I know when clients or prospective clients finally “get it?”  When you no longer fear short-term stock market swings and temporary losses; instead you understand that the losses are a necessary condition of achieving your long-term financial goals.  You recognize that when your portfolio goes down, that it’s “working” and it’s doing what it has to do.  When, even in a bear market, you’re asking if you have enough invested in stocks.  Because, as I said before, without the volatility, without the setbacks, you would have no chance of earning the long-term returns required by your plan.  The most enlightened and informed clients aren’t just able to repeat these insights back to me, but they are actively explaining and teaching them to others.  Many newer Servo clients this year have come from these very conversations.

Can you learn to love volatility?  Until you do, you won’t be as financially successful as you deserve.