Bonds: Sneaky Risky

Bonds are commonly said to be safer than stocks. But how often is that true?

It turns out that this applies to only one situation: avoiding sudden, severe drops in investment value. For instance, if you have a bucket of money that you are depending on in the next few weeks or months, investing it in bonds give you the chance to earn some interest while any loss in bond value is unlikely to be more than a few percentage points. Price stability–very few big drops–is the biggest positive attribute for bonds.

For people who are living off of their investments, it might make sense to have enough investments in bonds to cover a few years of essential daily expenses. After all, if you don’t have money to eat for a month, then it is difficult to focus on creating long-term profits. This is a good case to use bonds to “keep the lights on,” as described in another article about The Best Way to Determine Your Bond Allocation

The bond risk that hits almost everyone

Let’s say that you have enough of your savings in bonds or cash to survive a prolonged recession. What would be your ultimate objective for the rest of your investments? Could it be to end up with a lot more money and to achieve permanent financial freedom?

Imagine if someone said your investments just dropped from $36,000 down to $12,000. Psychologically, a drop of almost 70% would feel pretty devastating. This is exactly what would happen if you had owned a “safe” portfolio of bonds instead of a broad portfolio of US stocks. If you own bonds, you would not feel this massive loss because, you would never ever have had $36,000 to lose. Then again, if you flat-lined like bonds did in the last 10 years, you wouldn’t feel anything.

Comparison of growth of $10,000 investments in the Total US Stock Market ETF (VTI) versus the Total US Bond Market ETF (BND) since May 2012 (last 10 years). Source: Vanguard.com

If you owned stocks, you would have many more chances to feel price drops of 20%, 30%, or even 50%. But, that is only because stocks gave you massive gains. After all, angels are more prone to falling than worms. Okay, maybe this is just a cherry-picked time period. . .

If you pick any 10-year period in US stock and bond market history, the overall bond market has drastically under performed the overall stock market in the vast majority of the time. (Data source: NYU Stern School of Business). One author found that bonds only outperformed stocks 17.1% of any 10 year period, and only 8.7% of any 20 year period. (Ben Carlson, 2020, How Often Do Long-Term Bonds Beat Stocks?) If this had only been true for a few study periods, then that stock out performance could just be due to chance. The fact that US stocks have outperformed bonds so frequently means that stocks have an inherently better overall benefit to risk ratio. The historical data is so consistent that bonds are clearly lucky in those rare instances when they temporarily out perform stocks. Said a different way, bonds have more long-term risk for the amount of profit that they provide–significantly more long-term risk than stocks.

This isn’t a surprise once we understand that bonds are not even designed to increase in value, aside from their interest payments. A bond is like a loan you can get from a bank. When a bank loans you $200,000 to buy a house, they make money on the interest that they get from you each month–let’s say the interest rate is 4%. However, you will never need to pay back more than $200,000, beyond the 4% interest. Therefore, the bank’s profit is forever capped at 4% per year There is also the risk that you might not pay the interest or the loan back to the bank, so on average, the bank makes less than the interest rate they charge on the loans they make. Investing in bonds is like acting like a bank by making a loan to someone. The best return that you can expect is the interest rate of the bond.

Know when to buy bonds

The take-away is that bonds are a reasonable option for surviving short-term events but they are an inferior option for pretty much any long-term investing. That is clear from historical results discussed above. The next time someone regurgitates the dogma that bonds are “safer” than stocks, be sure to think about whether you are considering bonds for short-term price stability or for long-term investment returns.

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