April 28 2020 Newsletter

APRIL 2020 NEWSLETTEr: Stocks vs. Bonds – A Discussion of Volatility, Risk, and Safety

The financial media say stocks are “volatile” and “risky” and bonds offer “stability” and “safety”. They say that limiting volatility and risk is an important goal for all investors, and especially retirees. They say “protection of principal” is of the utmost importance, especially as one moves from working years into retirement.  We take a very different view.

Protecting your principal simply means protecting the number of dollars you have at a given point in time. This feels especially good during market downturns, until the long-term consequences are considered. The real goal of an investor should not be preservation of principal, but instead, preservation of purchasing power. 

We know the goods and services we enjoy cost more as years pass. Inflation erodes the purchasing power of a dollar; its effect is difficult to discern over a few years, but very evident over several decades. For about the past 90 years, inflation has averaged three percent per year (Ibbotson/Morningstar). That means over a three-decade retirement, the cost of living will go up by about 2.5 times. Said a different way, the purchasing power of your “protected” principal will decline by about 60 percent (e.g. $100k feels like $40k over that time)!

Preservation of principal is accomplished by holding cash and/or bonds. Preservation of purchasing power is accomplished by holding equities. But holding equities is “risky” and can be “volatile”, right?  Let’s explore this in more detail. Historically, small company common stocks in the U.S. have compounded at about 12% per year, large company common stocks at about 10% per year, and long-term, high-quality corporate bonds at about 6% per year. At first glance, this suggests the returns of owning common stocks have exceeded those of good corporate bonds by a factor of slightly less than two. However, this ignores what really matters – the “real” rate of return, which accounts for the eroding effects of inflation on purchasing power. When factoring in the long-term inflation rate of 3%, the real returns of small stocks, large stocks, and corporate bonds become approximately 9%, 7% and 3%, respectively. Real stock returns are about 2.5 to 3 times higher than those of corporate bonds (if Treasury bonds were included, the results would be even more disparate). Stocks are far less risky than bonds in the long run.

But what about volatility, which is also portrayed as being synonymous with risk?  First, let’s recognize how the term is used in the media versus its true definition. The media’s definition is something like, “large and very scary market declines that happen without warning.” But the true definition of volatility includes both negative and positive fluctuations. Stocks are certainly more volatile than bonds, but this is the reason for their premium returns, noted above. And, most importantly, the downward portion of market volatility historically has been temporary, whereas the upward portion has been permanent. For example, since 1980 the average annual intra-year decline of the S&P 500 index is about 14%, and every five or so years it goes down about 30%. But at its recent close above 2,800, the index has risen about 26 times from where it was at the start of 1980.  So, to suppress volatility is to also suppress return. For a long-term investor (no matter whether you are in the accumulation or distribution phase) with a diversified portfolio, why not embrace volatility instead of fearing it?

The foregoing is not a recommendation to exclude bonds as a part of one’s portfolio. Using bonds for diversification can be an important part of one’s overall financial planning, and we customize the percentage of bonds in your portfolio to your specific needs. We simply hope the foregoing portrays the “risk”, “volatility” and “safety” of stocks vs. bonds in a different light.

In closing, we include a quote from Warren Buffett, found in Berkshire Hathaway’s 2017 annual report: “It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment “risk” by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk.”

Sincerely,

Karl Kuelthau, Principal, Author
Louise Googins, Principal
Michael Googins, Administrator
Kim Rankin, Accountant
Carson Bieber, Associate

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