Common Misconceptions About Bonds

Hi. I’m Jamison Smith, a wealth advisor at EWA. In this video, I’m going to break down a common misconception that bonds are safer to own than stocks. So let’s first look at why do we own bonds in our investment portfolio?

The main reason is for liquidity or any short term needs and any short time horizon, which we’re going to look at this chart in a second that’ll break this down in more detail. But any short term time horizon, generally under five years, bonds are going to be less volatile than equities will be.

Other needs for bonds would be if you’re getting ready to retire. Our rule of thumb with EWA is that you should always have seven years backup of spending as you enter retirement. And bonds are a safe asset.

So if you have a pension and Social Security paying you, let’s say, on top of that you have to pull up $10,000 a month from your portfolio to meet your monthly needs. It’s $120,000 a year. And that by the time seven years, $840,000 that we would want you positioned in bonds or a safe asset as you’re in retirement.

Whereas if you’re 35 years old and you have a 30 year window till you get to retirement, we would say invest in all equities. So the main reason we want to hold bonds in the first place is any financial planning needs or any short term time horizon, anything that would be on the radar that you would want to be spending in the next five years.

So if we look at this chart, this first one is going to look at any five year rolling time period in the stock market, looking at historic returns. The green is going to be returns, and the purple is going to be standard deviation.

So first chart, in any five year rolling period, if you were invested 100% in equities, you on average return 10%, and the volatility or standard deviation was about 8.6%. Whereas in this five year period, if you were invested 100% in bonds, the rate of return was almost half.

About 5.2%, but the volatility or standard deviation was also cut in half to 4%. So point of this first chart, any short term time horizon, we know that bonds are safer. Where the misconception comes into play is if we look at a longer time horizon.

So this 30 year rolling period of stock market returns, if you invested 100% equities over this rolling 30 year period period, you had 11.1% rate of return and the standard deviation was only 1.3%. Whereas if you were invested in 100% bonds in this 30 year rolling period, rate of return was about half at 5.6%, but the standard deviation was actually double at 2.7%.

So why would this be interest rates change so much over that long time horizon? There’s a lot of other variables within the bond market so that would make bonds a lot more volatile. So any long term time horizon, we would want to see you invested in equities and bonds in the event that there is any short term liquidity needs.

The downside to that though, in any down market you’re going to feel the volatility of the bonds, but as long as there’s no need to sell, you don’t need that money for anything, then it’s going to be in your best interest to ride that out and look for the higher return later on with invested in equity.

So your total asset allocation of bonds to equity should really vary depending on your situation, your goals and your financial planning needs. So if you have any specific questions, feel free to reach out.