Stocks Stink. Buy Bonds!

By Joe Ponzio on February 6, 2008  |  19 comments

How much is today's gut-wrenching, hair-raising volatility worth? Let me ask a different way: After 40 years of investing in markets like these, how much more money would you expect to have versus investing in bonds and ignoring the markets altogether? $500,000? $1 million? $10 million? What if I told you the difference was just $40,000?

Is all this crazy volatility, nail-biting terror, and self-doubt for forty years worth just $40 grand or less?

One thing that time has proven is that non-conventional, business-minded investors can beat the markets. Ask Warren Buffett, Walter Schloss, or any of the "Super-Investors From Graham and Doddsville." The secret to "beating the markets" is simple: Realize that stocks are pieces of businesses, that businesses have an actual value, and that, from time to time, it is possible to buy businesses on sale. Then, use market prices as tools, not guides.

It's not easy, but it is possible.

So, What Is The Easy Way?

There is a way to virtually match, or even beat, the markets without experiencing the volatility or gut-wrenching swings. You can invest comfortably and confidently without spending hours a day pouring over annual reports and stock screeners. And the answer has been overlooked and ignored for far too long: buy bonds.

Before you ignore this little piece of crazy, boring advice, let me explain:

The Case Study: 1967-2007

There is no denying that the forty years from 1967 to 2007 were good for stock investors. Sure, we had the crash of 1987 and the crash of 2000. Corporate scandals wiped out trillions of dollars in wealth. Still, over that period, stocks were the investment of choice, right? Dollar-cost-averaging into a mutual fund that tracked the S&P 500 would have netted you a handsome amount, right?

Wrong.

Wall Street loves to show you the difference between investing in their mutual funds and stocks versus the 10-year U.S. Treasury. Over long periods of time, stock returns crush T-Bonds, even through the rough, or downright ugly, markets. The key: Time in the market, not timing the market.

And so I thought, why not test the theory?

The Assumptions

You have to be scared of your own shadow to invest in nothing but U.S. Treasuries. As such, their charts are garbage. But what if you invested in investment grade corporate bonds — bonds with ten year maturities, backed by healthy companies? Surely you could do better than treasuries, right?

In addition, what if you didn't have $10,000 to invest in 1967? What if you could put away just $50 a month? To save on transaction costs, what if you decided to invest just once a year — the first business day of each year — in either an investment grade bond or a no-commission mutual fund that tracked the S&P 500 (minus 1% in expenses).

Finally, what if you increased your contributions just 6% a year and reinvested all dividends, interest, and capital gains?

The Process

The bond investor purchases 10-year bonds. As his bonds pay interest, he invests that interest and his new savings into more 10-year bonds. Starting in 1977, as the first batch of bonds mature, he buys more 10-year bonds.

The stock investor purchases shares of the S&P 500 mutual fund and let dividends and capital gains reinvest.

The Experience

The bond investor's experience is quite boring. Bonds mature; he buys more. Interest is paid; he leaves it in his account until the next January purchase. His account fluctuates a bit; still, he is holding bonds to a definite maturity so he doesn't worry much. His portfolio never earns less than 6% a year.

The stock investor experiences some real thrills. At times, she sees her investment soar 35% in a single year; other years are dismal as 20% or more of her investment is wiped out. She manages to stay the course (though most investors don't, and tend to fare much worse than the markets).

The Results

On February 5, 2008, the two investors come together to compare portfolios. The stock investor is generally happy with her results. Over forty years, she has invested $98,000 of her own money and is sitting on $745,000. Her S&P 500 portfolio is generating more than $1,000 a month in regular income from dividends. She stayed the course, and she was rewarded handsomely.

The bond investor didn't do as well. Also investing $98,000, he has just $609,000. As he faces retirement, his portfolio looks quite small compared to the "enterprising" stock market investor. Fortunately, the bond investor will find solace in his $3,000 a month income.

Let's Be Fair — She Can Rebalance!

Of course, our stock investor can shift money into bonds as she retires. Also needing $3,000 a month, she liquidates her S&P 500 portfolio, pays her capital gains taxes (15% on $745,000 minus $98,000, or $97,117). Now, our enterprising investor can invest the balance of her account — about $648,000 — in bonds and earn her $3,000 a month.

Was It Worth It?

Wall Street overlooks bonds because they aren't fun, exciting, or nearly as profitable as constant rebalancing and mutual fund investing. And yet over 40 years, the difference between a well constructed bond portfolio and a buy-and-hold investment in the S&P 500 was just $39,000 when retirement hit.

And so I ask you this: Was the current 4-month, 15% drop in the S&P 500 worth the ride? Do you still believe in Wall Street's "advice"? How much is your sanity and peace-of-mind worth?

Why Are You Telling Me This? I Thought We Were Business Investors!

F Wall Street is a resource for non-conventional, business-oriented investors seeking to invest the time and energy into beating the markets. This post is not for F Wall Street regulars, but for the millions of investors and advisers that have lost their faith. It is for the millions of investors looking for that perfect spreadsheet, the ideal formula, or the armchair investors guide to beating the markets.

Why I am telling you this? Because you need to be aware of the various strategies and alternatives out there; and, because I feel like ranting about Wall Street's garbage advice that is losing trillions of dollars for regular, hard-working people who would benefit from having a bond portfolio and a little serenity in their portfolios and lives.

Some seventy years ago, Benjamin Graham defined investing as follows:

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.

That definition still holds true. If you are not willing to conduct a thorough analysis, you will never have safety of principal and you shouldn't expect a satisfactory return.

When should you consider bonds? If you:

• are nervous about today's markets;
• can't stomach the volatility;
• are considering selling your stocks today; or,
• want to invest comfortably and with confidence, without putting in too much time or effort.

The Final Results

(Added on Feb. 8, 2008): How do the two portfolios compare on a percentage basis? Our bond investor earned an average annual return of 9.8% versus (a) 10.6% for the stock investor before she rebalanced and (b) 10.1% after she rebalanced. Note: If I factored in the effect of money market interest during the years, the effect would have had a greater positive impact on the bond investor's portfolio and it would likely be even closer to, or perhaps beat, the stock investor's after-rebalancing returns.

Call your adviser and get your portfolio straightened out. Better yet, call my office and one of my guys will do it for you.

And now, back to our regularly scheduled programming.

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