Our Quibbles With a Recent Asset Allocation Study on Bonds

Are investors better off owning all stocks versus a mix of equities and bonds to reach their retirement goals? A new academic paper has grabbed some eyeballs by definitively saying “yes.” While the research is interesting, its real-world implications are more nuanced, in our view. The “right” asset allocation depends on the individual.

The paper making headlines challenges the conventional wisdom that bonds have an unquestioned role in a diversified retirement portfolio. Using a bootstrap simulation, the professors crunched one million scenarios of a US couple who save and invest for 40 years and retire at age 65 (and then withdraw 4% of their starting value annually, adjusted for inflation, to fund living expenses). They tested four general asset allocations: 100% fixed income, 100% US stocks, 50% US stocks/50% international stocks, and different blended allocations (mix of US stocks and bonds). According to their findings, the all-equity portfolios (whether 100% US stocks or 50% US/50% international) fared best—and they conclude investors are better off owning all stocks instead of a mix, as the long-term returns outweigh efforts to smooth out market bumpiness (by having bonds).^[i]

The findings provide an opportunity to review some timeless investing lessons. For example, the conclusions are consistent with our own research showing that over longer timeframes (think 20 – 30 years or more), stocks historically outperform bonds by a wide margin despite sharper drops in the short term—so the higher stock allocation, the higher a portfolio’s long-term growth potential. We also agree stocks’ superior long-term returns make them an effective inflation hedge and important to combat longevity risk (the risk of outliving your money). Moreover, this isn’t just a US phenomenon. Despite differences in retirement systems, the professors found owning a mix of US and international stocks benefits non-US investors, too—a reminder markets are global.^[ii] By diversifying, investors can decrease their exposure to individual country risk.

Overall, the paper provides some compelling, rational arguments for owning an all-equity portfolio over a blended one, and for some, those arguments will prove water-tight. But real-life investing is much more nuanced and complicated, and the tradeoffs between long-term returns and short-term volatility apply to different people in different ways. We believe bonds’ primary role is to dampen portfolio swings—particularly important for those with higher cash flow needs. In theory, and often in practice, having a blended portfolio reduces the risk of having to sell and withdraw during sharply down markets, which would increase the likelihood of premature portfolio depletion. We aren’t arguing bonds necessarily zig when stocks zag, as 2022 showed. But overall and on average, fixed income’s milder zigs and zags can work with stocks to benefit investors taking regular cash flow. In this case, the goal is often more to minimize the likelihood of running out of money too soon than to maximize the long-term value.

Comfort with the potential for short-term declines is another important factor that may validate a blended strategy despite its lower long-term return potential. As the paper acknowledges, the all-equity strategy has a “tendency for larger intermediate drawdowns,” which “inflict psychological pain, and some investors may abandon their investments rather than stay the course.”^[iii] The authors argue advisers and regulators should focus their energy on keeping people disciplined, whether in the form of increased financial education, more reporting focused on long-term performance, or other rules.

In general, we agree! We are proponents of helping investors look past the short-term noise and focus on the long term. But investing can be emotional, especially on a daily basis. It is one thing to see a chart and table illustrating a -10% pullback. It is another to see your portfolio in the red for several weeks as scary headlines warn more trouble looms (see this autumn for more). This is why owning bonds may make sense for some investors even if their cash flow needs are minimal. Yes, some may be able to handle stocks’ temporary declines and face little temptation to react. But others can’t—even with all the counseling in the world. If an investor can’t stay disciplined in an all-equity portfolio and routinely exits the market when it is down and misses the recovery, they aren’t able to reap the long-term returns the paper’s tables and charts illustrate. But if a blended portfolio—which isn’t as bouncy by design—decreases the likelihood of bailing out of the market, that may be a worthwhile tradeoff.

In our view, the reports of bonds’ death in diversified portfolios are greatly exaggerated. That financial headlines are featuring this report perhaps reflects that bonds just endured a lengthy bear market that partly coincided with stocks’ 2022 bear market. Last year led many to question the value of blended portfolios, and that skepticism remains. To us, that view is emblematic of where sentiment is today: Pessimism and doubts remain prevalent, suggesting the wall of worry remains high.