Forget Either; Forget Or

The two biggest building blocks for any investment portfolio tend to be stocks and bonds. Both are vital. And I want to convince you that both should be in your portfolio.

First, let’s start with some basic definitions. I find that some people immediately shut down when they hear the words ‘stocks’ and ‘bonds.’ They think, “I don’t understand those terms, and I’m surely not taking the time to figure them out.”

But it’s simple.

Stocks are direct ownership in companies, and bonds are loans to companies – or government entities. Stocks are riskier than bonds because if a company fails financially, the bondholders are paid before the stockholders. So if you own stocks, you should anticipate receiving higher returns for the risk you are accepting compared to holding bonds.

That’s it. That’s the reason stocks are riskier and why they should theoretically offer higher returns than bonds.

I say “theoretically” because it doesn’t always work out that way. Sometimes the opposite is true. And that is the exact reason why your portfolio should be stuffed with both stocks and bonds. We simply don’t know how the future will unfold.

Fortunately, we can look to history as a helpful guide.

If we analyze the long-term history of stocks and bonds, we discover a perfectly logical outcome. Stocks returned 6.8% per year, after inflation, and bonds returned 3.3% per year, again after inflation. This covers data going back to 1802. And as I said earlier, that outcome is exactly what we would expect.

If you’re an investor, though, you may be asking yourself a reasonable question, such as, “If stocks have returned more than bonds, then why would I ever own bonds?”

The reason is it doesn’t have to be that way. And the historical record clearly shows it hasn’t, at times.

Case in point: From 1969 to early 2009 – that’s 40 years! – long-term bonds provided investors with a slightly higher return than stocks. Of course, those dates are cherry-picked. In early 2009, the stock market hit its low point after the Great Financial Crisis. But the point still stands.

According to research by Ben Carlson, a financial author, bonds beat stocks in 28% of five-year periods, in 17% of 10-year periods, in 9% of 20-year periods, and in 1% of 30-year periods. This is why the long-run figures I presented earlier, going back to 1802, can be misleading. Sure, stocks outperformed in that timeframe. But there are 30-year periods – and at least one 40-year period – where that wasn’t true. That could be an entire career or an entire retirement for some investors.

We have been blessed to live through an environment where stocks have shined brightly. That’s great. It has tremendously boosted the value of investment portfolios. Just remember, however, that’s far from a sure thing over the next five, 10 or 20 years.

In a recent research brief, the CFA Institute made the following observation: “…studying history is the best way for investors to understand the future. When it comes to investments today, the future is the only time period that matters, but we cannot see even a wisp of it. So study history – and, as history would tell us, allocate our assets between stocks and bonds…”

Even Benjamin Graham, who was Warren Buffett’s teacher and mentor, advised investors to “never have less than 25% or more than 75% of funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.”

That’s sound advice. When it comes to stocks and bonds in your investment portfolio, forget ‘either’ and forget ‘or.’

It’s both.