Stocks or bonds? Most people grasp the value of an equity position in a company. In addition to the periodic payments of dividends, the value of the equity can also rise if the company or its prospects grow. Just look at companies like Apple, Amazon, and Nvidia that have led equity markets with large returns over long time horizons! Historically, broad indices of stocks (IVV) have produced annual total returns of about +10% over long time horizons.
But, bonds seem a bit foreign to most people. Though bonds start out looking like bank certificates of deposit (CDs) paying periodic interest payments with their principal value paid at the end of the term, they also can go up or down in value like stocks. As we have seen, while interest rates were rising in 2022, core bonds (AGG) generated total returns of -13% while core stocks (IVV) were down -18%. Over the longer term, core bonds have generated a total return of only about +3%.
If all we care about is “terminal value”, i.e., the value at the end of a chosen time horizon, and stocks generally outperform bonds, why buy bonds at all? The answer lies with the definition of risk and the needs of the investor.
Interest rates from bonds today seem fairly attractive given the recent history of “ZIRP”, i.e. zero interest rate policy. Short term Treasury bills currently pay a bit over 5% interest per year and longer term 10-year Treasury bonds pay a bit over 4%. For a very risk averse investor, a 100% allocation to bonds today could help to generate about 4% annual total returns over 10 years. Depending upon the specific needs of the investor, this could be a viable strategy.
However, for a young investor with a long time horizon and a good deal of human capital to earn income from their labor, they can generally accept more risk and can tolerate a larger equity content with more market volatility to potentially capture higher returns.
The chart below highlights the 16-year performance of core equities (IVV), core bonds (AGG), and three asset allocation funds with equity/bond allocations of 40/60 (AOM), 60/40 (AOR), and 80/20 (AOA). As you can see, over this time horizon 100% core equities (IVV) led the pack with an annual total return of +10.5%, handily beating core bonds (AGG) with a total return of +2.6%. As expected, as the equity content increased, total returns of the asset allocation funds increased with +5.7% for AOM, +7.5% for AOR, and +8.9% for AOA.
But, those higher returns came with higher risk from the equity component. If you trace the green line (IVV, core equities), from its initial drawdown in 2008/2009 you can see that it took almost 5 years for its cumulative return to catch up to the returns from the 40/60 fund (AOM, gold line). Also, the quantitative measures of volatility show much higher levels of risk for core equities (+20.2%) compared to core bonds (+5.5%) and the asset allocation funds.
D&A works with their clients to help determine an appropriate asset allocation and risk profile to help them meet their goals. Some investors can accept more risk while others cannot wait five years for the markets to recover (like the green line above from 2008 through 2013).