Stocks and Bonds Play Different Roles in Your Portfolio

A Look at How Different Mixes of Stocks and Bonds Performed Over Time

Market maker
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When you begin investing, you need to understand that stocks and bonds play different roles in your portfolio beyond just generating capital gains, dividends, and interest income.  These two asset classes have their own pros and cons, advantages and disadvantages.  It is important to familiarize yourself with them so you can make more informed decisions about what is right for you and your family.

 To provide a general illustration, with few exceptions, such as a young worker at the start of a career with a 30+ year time horizon before retirement or an older retiree who cannot afford to take any meaningful volatility risks with the capital accumulated over a lifetime of work, it is often foolish to have an allocation of 100% stocks or 100% bonds.  Unfortunately, it isn't unusual for me to see new investors, and even those who have been investing for years through a 401(k) plan or Roth IRA, to go from one extreme to another, frequently at the least opportune moments.

Perhaps the temptation is understandable.  Think about an extended secular bull market from the perspective of an inexperienced investor.  After years of seeing stocks rise, account values grow, and dividend payouts increase, it may seem to make sense to continue doing what has worked in the past.  The reality is that times such as this are often when it is most dangerous to buy stocks because valuations are elevated, in particularly dangerous cases to the point that cyclically-adjusted earnings yields fall to half, or lower, of Treasury bond yields.

 Prices inevitably revert to their mean valuation lines - you cannot escape mathematical reality indefinitely - many time going much further in the opposite direction as an overreaction.  Huge losses are incurred.  The now-burned investor swears off stocks until the cycle repeats itself again, later.

 More commonly, the investor doesn't understand that a long-term investment should be measured, at a minimum, in periods of five years.  They look at their stocks, index fundsmutual fundsETFs, or other holdings and after a few weeks, months, or even years, suddenly decide they aren't doing as well as they think they should be doing.  They then dump these positions for whatever has performed well recently.  The problem is so catastrophic to the wealth-building process that mutual fund data giant Morningstar has shown in its research investors earned only 2%, 3%, or 4% during periods when their underlying holdings were growing 9%, 10%, and 11%.  Human behavior, in other words, is responsible for many of the sub-optimal returns experienced by investors, perhaps to the point on a system-wide basis they exceed even aggregate investment advisory fees and taxes.  At least with fees you get personalized financial planning to help organize your fiscal life and taxes pay for infrastructure, defense, and anti-poverty programs.  Losses from behavioral mistakes have few redeeming qualities.  You are simply poorer as are your heirs and beneficiaries.

In this article, I want to look at how stocks and bonds can lead to better outcomes than stocks or bonds can by themselves.

 I'm not going to tell you, precisely, how much you should invest in either of these asset classes, though I will say that I fall into the camp of value investing legend Benjamin Graham, who thought that smaller, non-professional investor should keep no less than 25% and no more than 75% in either asset class, modifying them based only on major life changes when your needs become different than they were or when extreme valuation scenarios arise as they do every couple of generations.  A perfect example of this in the real world would be John Bogle, the founder of Vanguard, deciding at the height of the dot-com era to liquidate all buy 25% or so of his common stock ownership and invest the proceeds, instead, into bonds.

 Instead, I want to arm you with information so you have a better idea of what you want, the questions you want to ask your advisor, and the historical volatility patterns different mixes of stocks and bonds have experienced.

Let's Start at the Beginning: An Overview of How Stocks and Bonds Are Different

It's best to begin with the basics.  What are stocks and bonds?  How are they different?

  • A share of stock represents ownership in a business.  Leaving aside situations where dilution may occur, if you own a sandwich cart and divide it into ten pieces, each of those shares is entitled to a 1/10 cut of the profits or losses.  If you own all 10 shares, you own 100% of the enterprise.  The stock market is a sort of real-time auction where existing and potential owners bid to buy equity (ownership) in everything from chocolate companies to bleach manufacturers, aerospace contractors to coffee roasters, insurance underwriters to software developers, banks to restaurants, alcohol distilleries to spice companies.  To get an idea of the different types of businesses in which you can become an owner by buying shares of stock, check out this explanation of the sectors and industries in the S&P 500.  Over long stretches of time, there is, perhaps, no better asset in the world than ownership of a business with huge returns on capital.
  • A bond represents a loan made by the bond purchaser to the bond issuer.  Sovereign bonds are issued by nations.  Municipal bonds are issued by municipalities.  Corporate bonds are issued by corporations.  Most plain-vanilla bonds, particularly in the United States, involve lending a company an amount equal to the face value of the bond itself then receiving interest from the bond issuer every six months until the bond matures, at which point the principal should be returned unless the bond issuer has become insolvent or somehow unable to honor its obligations, in which case a bankruptcy court will likely get involved.

There is a common misconception that bonds are safer than stocks but this isn't true.  Rather, it is more accurate to say that stocks and bonds face different risks which can be a threat to your purchasing power in different ways if you aren't careful.

Stocks are notoriously volatile.  With investors bidding for them, and profit not being assured, greed and fear can sometimes overwhelm the system.  Perfectly fine enterprises will be given away during periods such as 1973-1974, selling for far less than what they would be worth to any rational buyer who acquired the entire company and held for the rest of his or her life.  At the same time, you get periods during which terrible, non-profitable businesses trade at obscenely rich valuations, completely detached from reality.  A good example of the latter is 1999 when the Internet bubble was fully inflated.  Making it more complicated, even a wonderful business that has made generations of people wealthy, like The Hershey Company, can suffer a period such as 2005 through 2009 when the stock slowly lost 55% of its market value despite earnings getting better and dividends increasing; declining for no apparent reason as the underlying core economic engine prospers and expands.  Some people are simply not emotionally, intellectually, or psychologically equipped to handle this.  That's okay - you don't have to invest in stocks to get rich - but it does make the task more difficult.

Bonds are typically less volatile than stocks, though bonds can experience extreme fluctuations in price as evidenced by the 2007-2009 meltdown when investment banks were declaring bankruptcy and having to raise cash however possible, dumping huge quantities of fixed income securities on the market, driving down prices.  (Things were so bad, one famous investor commented that the very same bond inventory sheet sent to him in the midst of the collapse contained two lines of identical bonds, one yielding twice as much as the other.  Shortly thereafter, sovereign bonds issued by the U.S. Treasury skyrocketed to the point they had a negative interest rate, meaning investors were guaranteed to lose money but were buying the bonds, anyway, as a sort of insurance premium against system-wide obliteration.)  As long as the interest coverage ratio is good and the bond issuer can repay the principal when it is due, the major danger with investing in bonds is the fact that they represent a promise of future repayment in fixed, nominal currency.  In other words, when you buy a long-term bond, you are going long the currency.  Unless there is some sort of built-in inflation protection, as there is with TIPS and Series I savings bonds, you could suffer major reductions in purchasing power even if your nominal wealth increases.  A few types of bonds have built-in protection against volatility, such as the Series EE savings bonds, which can be redeemed for their then-calculated value, including any early redemption interest penalty you may trigger, regardless of market conditions.

These might seem like a small details but every since the United States went off the gold standard - a prudent decision that helped avoid a lot of pain and suffering by giving the Central Bank the ability to combat deflationary liquidations through expansion of the money supply - history has shown that Congress cannot help but spend more than it earns.  This inflationary policy results in a backdoor tax through depreciation in the value of the dollar with each dollar buying less and less as the decades pass.  I've joked that, under present conditions, 30-year Treasury bonds should be renamed "financial suicide bonds" due to the their almost guaranteed future loss of wealth for owners who buy and hold them until maturity but folks still flock to them.  In fact, for an affluent individual or family, buying a 30-Year Treasury in a taxable account at its current yield of 2.72% is asinine.  The risk is far greater than buying stocks which may or may not increase or decrease in value by 50% or more over a period of several years when you begin to define "risk" as the long-term probability of a loss of purchasing power.

A Look At How A Mixture of Stocks and Bonds Stabilized Portfolio Values During Times of Market Collapse

Taken together, though, the benefits of stocks can offset the drawbacks of bonds and the benefits of bonds can offset the drawbacks of stocks.  By combining the two in a single portfolio, it is probable you can enjoy substantially lower volatility, a strengthened defense against the unexpected arrival of another Great Depression (stocks lost 90% of their value at one point with different experiences in different industries with food and beverage stocks behaving much differently than oil stocks; even a modest bond component would have made recovery much easier), greater peace of mind, and a higher level of guaranteed income.  When the Federal Reserve isn't conducting unprecedented experiments with monetary policy and interest rates return to ordinary levels, it's also likely you'll be the recipient of higher yields on the portfolio overall, meaning more passive income.

On this note, it's informative to understand how stocks and bonds fared in diversified portfolios during some of the more challenging investment environments of the past.  For this, I'm going to turn to the gold standard of investing record keeping, the Ibbottson & Associates Classic Yearbook, published by Morningstar.

First, let's examine at annual returns for a single year.  Looking at periods between 1926 and 1910, how did different mixes of  large capitalization stocks and long-term government bonds perform under the best and worst case scenarios?

  • A portfolio of 100% stocks generated its highest return in 1933 when it grew by 53.99%.  It generated its lowest return in 1931 when it lost 43.34% of its value.  Out of the 85 years during the measurement period, returns were positive in 61 of those years and negative the rest of the time.  During those 85 years, the all-stock portfolio was the highest returning out of stock/bond mix portfolios in 52 years.  The arithmetic annualized average compounding rate for all periods was 11.88% per annum.
  • A portfolio of stocks and bonds divided 90% stocks and 10% bonds generated its highest return in 1933 when it grew by 49.03%.  It generated its lowest return in 1931 when it lost 39.73% of its value.  Out of the 85 years during the measurement period, this particular mix of stocks and bonds was positive in 62 years of those years and negative the rest of the time.  During those 85 years, it was never the highest returning portfolio compared to other mixes of stocks and bonds.  The arithmetic annualized average compounding rate for all periods was 11.25% per annum.
  • A portfolio of stocks and bonds divided 70% stocks and 30% bonds generated its highest return in 1933 when it grew by 38.68%.  It generated its lowest return in 1931 when it lost 32.31% of its value.  Out of the 85 years during the measurement period, this particular mix of stocks and bonds was positive in 64 years of those years and negative the rest of the time.  During those 85 years, it was never the highest returning portfolio compared to other mixes of stocks and bonds.  The arithmetic annualized average compounding rate for all periods was 10.01% per annum.
  • A portfolio of stocks and bonds divided 50% stocks and 50% bonds generated its highest return in 1995 when it grew by 34.71%.  It generated its lowest return in 1931 when it lost 24.70% of its value.  Out of the 85 years during the measurement period, this particular mix of stocks and bonds was positive in 66 years of those years and negative the rest of the time.  During those 85 years, it was never the highest returning portfolio compared to other mixes of stocks and bonds.  The arithmetic annualized average compounding rate for all periods was 8.79% per annum.
  • A portfolio of stocks and bonds divided 30% stocks and 70% bonds generated its highest return in 1982 when it grew by 34.72%.  It generated its lowest return in 1931 when it lost 16.95% of its value.  Out of the 85 years during the measurement period, this particular mix of stocks and bonds was positive in 68 years of those years and negative the rest of the time.  During those 85 years, it was never the highest returning portfolio compared to other mixes of stocks and bonds.  The arithmetic annualized average compounding rate for all periods was 7.61% per annum.
  • A portfolio of stocks and bonds divided 10% stocks and 90% bonds generated its highest return in 1982 when it grew by 38.48%.  It generated its lowest return in 2009 when it lost 11.23% of its value.  Out of the 85 years during the measurement period, this particular mix of stocks and bonds was positive in 66 years of those years and negative the rest of the time.  During those 85 years, it was never the highest returning portfolio compared to other mixes of stocks and bonds.  The arithmetic annualized average compounding rate for all periods was 6.45% per annum.
  • A portfolio of 100% bonds generated its highest return in 1982 when it grew by 40.36%.  It generated its lowest return in 2009 when it lost 14.90% of its value.  Out of the 85 years during the measurement period, returns were positive in 63 years of those years and negative the rest of the time.  During those 85 years, the all-bond portfolio was the highest returning out of all portfolio mixes of stocks and bonds 33 times.  The arithmetic annualized average compounding rate for all periods was 5.88% per annum.

As you can see from this extensive data set, the mix of stocks and bonds in a portfolio creates a sort of continuum.  On the pure stock side, you have substantially higher returns but achieving these require an iron will, nerves of steel, and a soundly constructed collection of equities.  In 33 out of 85 years, you ended the year poorer than you were at the start of that year.  In the most extreme example, you saw 43.34% of your precious capital go up in smoke.  To put that into perspective, that's like watching a $500,000 portfolio drop by $216,700 to $283,300 in a period of twelve months.  A lot of people cannot handle this sort of scenario despite equity ownership demonstrably proving to be one of the most effective and, on a broadly diversified, long-term basis, safest, ways to build wealth.  On the other hand, you saw the relative price stability of bonds produce materially lower returns compared to stocks.  All things in life have a trade-off cost and compounding your money is no exception.

The sweet spot appears to exist somewhere in the middle.  A portfolio of half bonds and half stocks not only produced a good return, it was positive in 66 out of 85 years.  That means you only had 19 years after which you were poorer at the end of the year than when you started, at least as measured in nominal terms.  That's a much different experience than the all-equity portfolio which had 33 down years over the same span of time.  If the peace of mind from the greater stability of the portfolio split equally between stocks and bonds allowed you to stay the course, it could have caused your family to end up with more money than you otherwise would have had trying to stick with the more-frightening pure stock asset allocation.  This is the difference between traditional finance, which looks at theoretical optimality, and behavioral finance, which looks at the best outcomes given human conditions and other variables.

Let's Look at the Same Portfolios of Stocks and Bonds Over 20-Year Rolling Periods

Annual returns are interesting but so, too, are long-term rolling periods.  Let's go one step further than the annual data we've been examining and look at how these same portfolios performed on the basis of rolling twenty-year measurement spans.  That is, an investment in 1926 would be measured at its completion in 1946, an investment in 1927 would be measured at its completion in 1947, and so forth.  Please note that these portfolios do not include any of the techniques investors are often encouraged to utilize, such as dollar cost averaging, which can help smooth the good and bad times, evening out returns.  A good example, which you will see in a moment, is 1929-1948, during which period an all-stock portfolio grew by only 3.11%.  However, had you been investing during this period, and not simply a lump sum at the beginning, your returns would have been remarkably higher as you captured ownership in some tremendous businesses at prices typically seen only once every few generations.  In fact, it did not take that long to recover from the Great Depression but this misunderstanding about the nuance of how the numbers are calculated often confuses inexperienced investors.

  • A portfolio of 100% stocks generated its highest twenty-year rolling return between 1980 and 1999 when it compounded by 17.88% per annum.  It experienced its lowest return between 1929 and 1948 when it compounded by 3.11% per annum.  The arithmetic annualized average rate of compounding for all periods was 11.30%.
  • A portfolio of stocks and bonds divided 90% stocks and 10% bonds generated its highest twenty-year rolling return between 1980 and 1999 when it compounded by 17.28% per annum.  It experienced its lowest return between 1929 and 1948 when it compounded by 3.58% per annum.  The arithmetic annualized average rate of compounding for all periods was 10.84%.
  • A portfolio of stocks and bonds divided 70% stocks and 30% bonds generated its highest twenty-year rolling return between 1979 and 1998 when it compounded by 16.04% per annum.  It experienced its lowest return between 1929 and 1948 when it compounded by 4.27% per annum.  The arithmetic annualized average rate of compounding for all periods was 9.83%.
  • A portfolio of stocks and bonds divided 50% stocks and 50% bonds generated its highest twenty-year rolling return between 1979 and 1998 when it compounded by 14.75% per annum.  It experienced its lowest return between 1929 and 1948 when it compounded by 4.60% per annum.  The arithmetic annualized average rate of compounding for all periods was 8.71%.
  • A portfolio of stocks and bonds divided 30% stocks and 70% bonds generated its highest twenty-year rolling return between 1979 and 1998 when it compounded by 13.38% per annum.  It experienced its lowest return between 1955 and 1974 when it compounded by 3.62% per annum.  The arithmetic annualized average rate of compounding for all periods was 7.47%.
  • A portfolio of stocks and bonds divided 10% stocks and 90% bonds generated its highest twenty-year rolling return between 1982 and 2001 when it compounded by 12.53% per annum. It experienced its lowest return between 1950 and 1969 when it compounded by 1.98% per annum.  The arithmetic annualized average rate of compounding for all periods was 6.12%.
  • A portfolio of 100% bonds generated its highest twenty-year rolling return between 1982 and 2001 when it compounded by 12.09% per annum.  It experienced its lowest return between 1950 and 1969 when it compounded by 0.69% per annum.  The arithmetic annualized average rate of compounding for all periods was 5.41%.

Again, even on a twenty-year rolling basis, the decision regarding the right mix of stocks and bonds in your portfolio involved a trade-off between stability (as measured by volatility) and future return.  Where you want to position yourself along that probable distribution line, assuming future experience largely resembles past experience, depends upon a variety of factors ranging from your overall time horizon to your emotional stability.

How the Asset Allocation Between Stocks and Bonds Would Have Changed Over Time Had the Investor Not Rebalanced His or Her Portfolio

One of the most interesting data sets when examining how portfolios performed over time based on their particular asset allocation ratio between stocks and bonds is to look at the ending proportions.  For this data set, again, I am concluding at December of 2010 because it is the most convenient, top-shelf academic data available to me at the moment and the bull market between 2011 and 2016 would only serve to make the returns higher and stock proportion larger.  That is, the stock components would have grown to be an even larger percentage of the portfolios than I'm about to show you so the basic outcome would hardly change.

For a portfolio built in 1926 to be held without any rebalancing whatsoever, what percentage of the ending assets would have ended up in equities due to the nature of stocks; that they represent ownership in productive enterprises which, as a class, tend to expand over time?  I'm glad you asked!

  • A portfolio that began with a mix of stocks and bonds weighted 90% to the former and 10% to the latter would have ended up with 99.6% stocks and 0.4% bonds.
  • A portfolio that began with a mix of stocks and bonds weighted 70% to the former and 30% to the latter would have ended up with 98.5% stocks and 1.5% bonds.
  • A portfolio that began with a mix of stocks and bonds weighted 50% to the former and 50% to the latter would have ended up with 96.7% stocks and 3.3% bonds.
  • A portfolio that began with a mix of stocks and bonds weighted 30% to the former and 70% to the latter would have ended up with 92.5% stocks and 7.5% bonds.
  • A portfolio that began with a mix of stocks and bonds weighted 10% to the former and 90% to the latter would have ended up with 76.3% stocks and 23.7% bonds.

What's even more incredible is that the stock component in these portfolios of stocks and bonds are going to be heavily concentrated in a handful of "superwinners", for lack of a better term.  Inexperienced investors frequently fail to grasp how extremely important the mathematical relationships of this phenomenon are to overall wealth accumulation.  Essentially, along the way, a certain percentage of holdings will go bankrupt.  In many cases, these will still generate positive returns, just like Eastman Kodak did for its long-term owners even after the stock price went to zero, a fact that many new investors don't inherently understand due to the concept of total return.  On the other hand, a few firms - often firms that you cannot fully predict ahead of time - will so far exceed expectations, they will blow everything else out of the water, dragging up the return of the overall portfolio.

One famous example of this is the ghost ship of Wall Street, the Voya Corporate Leaders Trust, formerly known as the ING Corporate Leaders Trust.  It began back in 1935.  The portfolio manager responsible for putting it together chose a collection of 30 blue chip stocks, all of which paid dividends.  Between over the 81 years between its formation in 1935 and the present, it has been passively managed to the point it makes index funds look absurdly hyperactive (this is because index funds, even S&P 500 index funds, are not actually passive investments despite the marketing literature to the contrary.  They are actively managed by committee).  It has crushed both the Dow Jones Industrial Average and the S&P 500 over that timeframe.  Through mergers, acquisitions, spin-offs, split-ups, and more, the fund has ended up with a concentrated portfolio of 22 stocks. 14.90% of the assets are invested in Union Pacific, the railroad giant, 11.35% are invested in Berkshire Hathaway, the holding company of billionaire Warren Buffett, 10.94% is invested in Exxon Mobil, part of John D. Rockefeller's old Standard Oil empire, 7.30% is invested in Praxair, an industrial gas, supply, and equipment company, 5.92% is invested in Chevron, another part of John D. Rockefeller's old Standard Oil empire, 5.68% is invested in Procter & Gamble, the world's largest consumer staples giant, and 5.52% is invested in Honeywell, the industrial titan.  Other positions include AT&T, Dow Chemical, DuPont, Comcast, General Electric, and even shoe retailer Foot Locker.  The deferred taxes are enormous, acting as a sort of leverage for the original buy and hold investors.

What Is the Point of All of This Data on the Role of Stocks and Bonds a Portfolio?

Aside from being interesting to those of you who love investing, there are some important take-away lessons from this discussion about the historical performance of different mixes of stocks and bonds in a portfolio.  To help you, here are just a few:

  • Stocks and bonds behave differently under different conditions, making them useful when held in a portfolio together.  It can be tempting to go to one extreme or the other but this is rarely advisable.
  • If past history repeats itself, it is safe to say that the higher the bond component in the overall investment allocation, the more stable, as measured in nominal terms, your portfolio will be.  However, this will most likely come at the cost of a lower compounding rate.  On the other hand, behavioral economics demonstrates people tend to stick with their long-term plan better when volatility is lower, meaning that it may result in higher real-world returns due to its calming effect on human nature; the frequently incorrect desire to "do something" when a lot of money has seemingly disappeared during a market collapse.
  • Under ordinary interest rate environments, bonds add a much higher current income component to a portfolio than stocks, producing more cash flow that can be spent, reinvested, gifted, or saved.  We are currently in a phase that is not at all ordinary and, to a large degree, uncharted.  It is unlikely the zero-interest rate environment continues over the coming decade.
  • Stocks, as a whole, are so much more productive than bonds that the longer the time period, the better the likelihood stocks held in a portfolio will become an ordinarily large percentage of the asset allocation unless the portfolio owner chooses to rebalance (that is, sell off some holdings to increase the size of others to get back to the targeted, desired range).
  • Bad years can be quite bad.  It's one thing to look at them on paper but as someone who has lived through multiple textbook-famous crashes, going through them is an entirely different experience, comparable to the difference between reading about a tornado in a book and actually living through one bearing down on you.  One period that doesn't really show up as its own highlighted point in the data we've been discussing thus far, solely because of how comparably and absolutely horrible the once-in-600-year disaster that was the Great Depression overwhelmed it in the figures, is 1973-1974.  It was catastrophic for equity investors on paper, yet long-term investors got very rich by buying up stocks at bargain prices.  Do not underestimate what it feels like, and how it can cause you to do stupid things, to see 50% of your wealth vanish in the blink of an eye.  The 1987 crash is another illustration.  I once gave an example of how breathtaking the losses were on paper from that event when I compared the long-term results of PepsiCo and The Coca-Cola Company on my personal blog.  If you cannot handle the reality that things like this will happen to you as a shareholder, you're going to be in for an extraordinarily unpleasant time.  There is no way to avoid it and anyone who tells you it is possible to do so is either delusional, lying to you, or attempting to cheat you somehow.
  • Bonds are often highly opportunistic in their appeal - sometimes they are horribly overvalued, especially now that the United States has gone off the gold standard and investors have demonstrated time and time against that they do not demand a sufficient enough interest rate to compensate for taxes and inflation - but the fact that they serve as a sort of Great Depression insurance has a certain utility all its own.  By living off the bond interest during times when stocks are trading at a fraction of their true, intrinsic value, you can avoid liquidating your ownership stakes at the worst possible time.  In fact, as counterintuitive as it sounds, the wealthier you are, the more likely you are to have disproportionately large cash and bond reserves as a percentage of your overall portfolio.  To learn more about this topic, read How Much Cash Should I Keep In My Portfolio?, where I discuss some of the details.

On a final note, it's of the utmost importance when selecting your mix of stocks and bonds you pay attention to a tax management concept known as asset placement.  The exact same stocks and bonds, in the exact same proportions, in the exact same tax brackets, can lead to wildly different net worth outcomes based on the structures within which those securities are held.  For example, for a household that enjoys high taxable income, bond interest is taxed at almost double the rate as cash dividends.  It would make sense to put bonds and high-yield dividend stocks in tax shelters such as a SIMPLE IRA while holding stocks that don't pay a dividend in taxable brokerage accounts, at least to the extent possible and advisable under the unique circumstances you face in your life.  Likewise, you would never put something like tax-free municipal bonds in a Roth IRA.