Riding the Bond Bull—With a Helmet

Bonds have long outperformed stocks, but is this about to change?

Feb. 29, 2012— -- Most investors think of bonds as being less lucrative investments than stocks. They should think again.

When you buy bonds, you're lending money to corporations or governments in return for interest. When you buy stocks, you buy a piece of a company with the hope that it will grow in value. Because bonds issued by companies and governments that have good credit (yes, the U.S. government still has good credit) carry far less risk than stocks, investors are willing to accept lower returns than they would likely get from stocks.

Yet many individual investors aren't aware that bonds are providing better returns than stocks. We've been in a bull bond market for the past 30 years — not exactly your father's bond market. The stock market languished over the last decade, returning less than 2 percent annually. So we have a bull bond market coinciding with a bear stock market.

Over the last 10 years, bond returns have been so high and stock returns have dipped so low that Treasury bonds (those issued by the U.S. government) outperformed stocks by 5 percentage points. That doesn't sound like much of a difference. But remember: Stocks are supposed to way outperform bonds because they carry far more risk. Without stocks' historical performance edge, no one would want to leave the relative security of bonds to invest in them.

Yet, given the last decade, why do we think of bonds as likely to return less than stocks? Because of historical performance data. This data is important because the future of any type of investment is far more likely to resemble its long-term past average than its recent performance. (That's why fixating on current "winners" is foolish for long-term investors.)

This long look back shows that for taking the additional risk of investing in stocks over bonds, investors should generally expect substantially higher returns. Some respected analysts say stock returns should be more than 4 percentage points higher.

But this is assuming that there is enough time. As the past decade shows, expecting stocks to return more than bonds during shorter periods can be dangerous. At the same time, however, people investing for retirement 20 years from now shouldn't expect the bond bull market to continue indefinitely.

Odds are, historically low interest rates will rise over the next several years, depressing bond returns. Meanwhile, although the three- or four-year outlook for stocks is for low-single-digit annual returns, greater growth over the next seven or eight years is entirely possible.

This dual scenario would cause the pendulum to swing back, meaning that bonds would once again return substantially less than stocks. So cashing in a lot of your stock holdings now to buy bonds could be risky, depending on your age and when you plan to retire.

If you're planning to retire in 20 years, investing too heavily in bonds now could prove hazardous to your wealth, especially if you plan to draw heavily from your portfolio to pay living expenses early in retirement. One solution is to take advantage of the bull bond market without being trapped by it.

Investors can do this by buying bonds gradually. That way, you won't be too heavily invested when they start to decline.The idea is to maintain the right mix of bonds and stocks, adjusting this mix over time to fulfill your asset allocation — the percentage of different types of assets in your portfolio. A key factor in your mix of investment types is your age. Your allocation should become more conservative as you approach retirement, given your individual risk tolerance . This is why it's generally considered a good idea to decrease the weight of stocks and increase the weight of bonds in your portfolio as you get closer to retirement.

Traditionally, many financial advisors have recommended a set series of asset allocations for investors in given age brackets with given risk tolerances. This includes an allocation to bonds of 55 percent or more for people with a moderate (more or less average) risk tolerance at the age of about 60, despite the fact that people are living and working longer and that the risks of different types of investments change over time as the trends of bond-versus-stock returns show.

A better approach would be to think of your bond allocation as a range, with the precise percentage at any given time governed not just by your age and risk tolerance, but also by changes in bond-versus-stock performance. These changes show the evolving risk/return relationship between bonds and stocks — that despite their lower risk, bonds can outperform stocks for relatively long periods.

Yet, despite bonds' lower risk and current returns, you should moderate your investments in them, taking care not to pass up potentially superior returns from stock investments made in the right measure.

Hockey legend Wayne Gretzky famously said he always skated not to where the puck was, but to where it was going to be. By adjusting your bond-to-stock ratio as you go along — with an eye toward potentially rising interest rates — you'll be more likely to reach the asset-allocation puck and your retirement accumulation goals.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group http://capstoneinvest.net. He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com.