One of our most asked questions is if we prefer stocks or bonds for most portfolios—and the short answer is stocks.
When building a portfolio, the first thing you need to do is to decide how much of your money to put in equities (that is, stocks and ETFs that invest in stocks), and how much to put in fixed-return investments such as bonds and money-market instruments.
Some investors try to base their choice of stocks or bonds on how they expect these two to perform in their portfolios. But, this requires the kind of foresight that no investor has. Far better to base the split between stocks or bonds on your own needs and on the characteristics of these investments.
Our relative view of stocks or bonds is based on today’s realities
Our stance on choosing between stocks or bonds shouldn’t be categorized as “philosophy.” It’s more a matter of history. Specifically, it’s a reaction to today’s economic and investment situation. Up till the mid-1990s, in fact, we routinely advised that fixed-return investments, such as bonds, should make up anywhere from one-third to two-thirds of a conservative investor’s portfolio.
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Back then, fixed-return investments paid 8% to 10% a year. That was close to the long-term returns available from the stock market. Of course, fixed-return investments leave you fully vulnerable to inflation, unlike stocks.
But back in the 1990s, we saw little risk of inflation. In addition, we felt interest rates were likely to move sideways to downwards for an extended period, and that’s a favourable environment for bonds.
Now, we believe zero is a good proportion for bonds with a term of any more than two to three years. The best you can get from bonds now is the 3% or 4% interest they offer. The worst that can happen is that you will lose money, or at least lose purchasing power.
Choosing between stocks or bonds results in different odds
In our opinion, bonds now offer you a “heads-you-break-even, tails-you-lose” situation. That’s the exact opposite of our ideal investment, which offers odds that are more like “heads you break even, tails you win.”
As you probably know, a bond pays a fixed rate of interest during its life. Eventually, a bond matures, and holders get the bond’s face value, and nothing more. Note that receiving the fixed interest and face value at maturity is the best that can happen. Corporate bonds can go into default. Inflation can devastate the purchasing power of bonds and all fixed-return investments.
Bond prices and interest rates are inversely linked. When bond prices go up, interest rates go down, and vice-versa.
Bonds started a long period of rising prices (a bull market) since 1981. That year, long-term interest rates reached an historic turning point when long-term U.S. Treasury bond yields peaked near 15%. For many years, interest rates went through wide fluctuations, but they essentially headed downward.
Today, interest rates just don’t have that much further to fall. But under certain conditions, interest rates could go substantially higher. Remember, when interest rates go up, bond prices drop.
Even so, brokers continue to sell bonds to their clients. That’s partly because most of today’s brokers had not yet entered the investment business when the bull market in bonds began in 1980. All they know is that bonds do tend to reduce the volatility of your portfolio, since they tend to rise when stock prices fall. Of course, bonds also generate more commission fees and income for the broker, compared to stocks, especially if you buy them via bond funds and other investment products.
Our investment advice: When it comes to choosing between stock or bonds and you’re reluctant to hold a 100%-stocks portfolio—and many people are—then one alternative to consider is to keep a portion of your investment funds in relatively short-term fixed-return investments, with maturity dates of a few months to no more than two to three years in the future.
These fixed-return investments will lose value when interest rates rise, but not enough to make a serious dent in their value, because of their short terms. You can hold them till maturity, then get your money back and reinvest. Our advice is to stay out of long-term bonds.
Canadian Wealth Advisor covers safe money investments for turbulent times, primarily ETFs, REITs and well-established dividend-paying stocks.
Do you prefer stocks or bonds, or both? Share your experiences with us in the comments below.
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