Should I Buy Stocks or Bonds?

Two Chinese Companies Join New York Stock ExchangeRon asks you to think about the following perspective: as of today the interest rate paid on U.S. Treasury bonds is 1.88%. If you buy these bonds and hold them for a full ten years, you could make just under 2%, and you are guaranteed by the government to receive all your money back at the end of ten years.

In contrast, if you would buy the U.S. stock market as measured by the Standard and Poor’s 500 Index, the dividend yield is 2.12%. If you are looking for income, you would make more by investing in stocks. Remember that it’s impossible to buy the index without some cost, but a simple index mutual fund would have an internal cost as low as 0.1%. With this approach there is no guarantee what the value would be at the end of ten years.

Let’s consider how this might actually impact *Jim and Peggy (not their real names) who are both in their early 60s and are working out their retirement plans after four decades of hard work and sacrifice for their family. They say, “Wait, I might need the money before ten years comes around!”

Well, let’s look at this for a moment. I agree that they might need a portion of their portfolio before the end of ten years – to do some travel, to make a significant contribution to their church or favorite charity, or to help their adult children to buy a business – so that portion of the portfolio should be in investments that are less risky than the stock market. A simple financial plan can figure out how much this should be.

Now let’s focus on the permanent part of their portfolio – the principle portion of their nest egg that they plan to never touch – and let’s look at different possible outcomes.

If Jim and Peggy can hold their portfolio with bonds and not touch the money for ten years, they will only get their original investment back. With stocks the outcome is uncertain. However, there has never been a ten-year period where stocks have experienced a loss.

I agree that there have been some scary times, but even in the worst of these times there has never been a loss if you hold for a full ten years. Statistically one shouldn’t experience a loss, and one might actually make a lot more. The key is to not get scared out, which many people do during the worst of times.

If Jim and Peggy ask, “What happens if we don’t hold our portfolio for the full ten years?” Then bonds are not as safe as they might think. It might seem illogical to some, but as interest rates rise bond prices fall.

If one would need to sell the bonds before maturity, sellers would have to go into the open market and find a buyer. One’s low-yielding bonds would not be as attractive so they would be depressed in price. On the other hand, if interest rates fall, bond prices rise.

Many bond investors have experienced a bull market over the past decade as rates have been lowered, and to them bonds feel safe and profitable.

So, let’s pose this question to Jim and Peggy: “In today’s environment, which way would you guess interest rates are headed?” In my opinion, rates can only go up from where they are today. So buying bonds today is like “heads I lose, tails you win.” If Jim and Peggy hold for ten years, stocks will more than likely perform better. If they need the money before then, bonds carry a risk of their losing money, and this risk could be as much as the risk of stocks in today’s environment for investing.

So why would we put bonds into a portfolio for Jim and Peggy in the first place? Because bonds reduce the overall perceived risk in the portfolio. When times get tough, the average investor tends to make poor decisions and ends up locking in a loss. Having a portion of Jim and Peggy’s portfolio in bonds may give them the ability to stay invested during turbulent times, rather than abandoning their investments entirely.

Conclusion: Many investors in retirement believe they should be more conservative and I agree with that. However, in reality if couples like Jim and Peggy will stay invested for the long run, stocks may actually be a more logical choice than bonds.

This might sound a bit adventuresome for the average retiree, but there are some alternative investments to bonds that can also provide income. We are recommending for retirees to consider reducing their exposure to bonds by investing in real estate, master limited partnerships, and preferred securities. These can be rather complex investments, so we would prefer to sit down with you in person and explain the pros and cons of each and how they may fit best into your plans.

 

Committed to your successful retirement,

Ron Dickinson

 

[*Jim and Peggy are fictional names, but they represent the kind of clients we serve.]

[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor.  Statistics and market information provided by Litman Gregory Advisor Intelligence.]

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