I am going to make a case for ignoring a bedrock of conventional investing wisdom. I don’t do this lightly and this is not a recommendation. I have been dancing around the subject in recent articles including a case for investors to only invest in shares and my plan for retirement. These articles have elicited questions and rather than answer them individually via email I wanted to put my view on proverbial paper.

Here is why I don’t invest in bonds.

Why are we told to invest in bonds?

We are told that adding bonds to a portfolio lowers risk. The rule of thumb used to be that investors should strive for a 60 / 40 portfolio. Allocating 40% of your portfolio to bonds is not an insignificant amount.

Many people consider a 60 / 40 portfolio an anachronism. Yet millions of Australians are still allocating a significant amount of their portfolio to bonds. AustralianSuper’s balanced option allocated 19% of the portfolio to bonds at the end of December 2023. 35.9% of the balanced portfolio is in defensive assets. What those defensive assets are is hidden within the maze of undisclosed private investments. Even the high growth option allocates 11.6% to bonds and 24.5% to defensive assets.

The conventional wisdom is that adding bonds to a portfolio lowers risk. There are some misconceptions about what this means which I will cover later but we need to start with what is meant by risk.

The definition of risk according to the Cambridge Dictionary is “the possibility of something bad happening”. In the investing world the “something bad happening” is volatility. Volatility is prices – or the value of a portfolio – bouncing around.

When I think about “something bad happening” to my own portfolio it is not volatility that I’m worried about. My portfolio does not exist in a theoretical world. My portfolio is made up of assets that I want to sell in the future to pay for things I want and need. That means my risk is not having enough money in the future to pay for what I want and need.

When I need the money to buy things is based on my personal circumstances. I might want to buy lunch tomorrow. I might need to pay for living expenses in 20 years when I retire. What matters to me is how much the assets I hold are worth when I want to sell them. If I want to sell some assets in 20 years it doesn’t matter what they are worth tomorrow and it doesn’t matter what they are worth in 5 years.

Over the long-term the real risk I face is that my portfolio doesn’t grow enough to meet my goal. In order to reach my goal I need to save a certain amount and I need a certain return. I have an estimate of what I need to save and the return I need because I’ve gone through the goal definition process. The growth of my portfolio needs to be at a certain level in excess of inflation to reach my goal. That is because my paper wealth doesn’t matter. What matters is how much stuff I can buy with it in the future.

I don’t fault professional investment managers for equating volatility with risk. They don’t know anything about any of their investors. AustralianSuper has 3.3 million members. 90% of those members are in the balanced option. Some of those members are 25. Some are 75. Some have millions in super and modest goals. Some have $10,000 and want to retire on a yacht.

Professional investment managers need to create portfolios and measure success for a disparate group of members with completely different circumstances. And they are in the dark about those circumstances. They are doing the best they can. That doesn’t mean I need to make the same choices they do.

Are bonds riskier over the long-term?

Volatility may be a risk for investors at very specific times in their lives. That is because volatility is a short-term risk. And bonds can help solve that problem by lowering volatility. Yet solving the short-term problem introduces a long-term risk to portfolios that many investors are taking on by not interrogating conventional wisdom. That is the risk that you won’t earn a return high enough to meet your goals.

Each of us is investing for a reason. We need to earn a certain return for our portfolio to grow and pay for the life we need and want. I recommend that investors set goals and calculate the return needed to achieve them which I’ve outlined in this article. Yet even if you don’t go through this process it is likely that the return needed is higher than what bonds have historically delivered.

According to Vanguard, over the past 30 years Australian bonds have delivered 5.5% annual returns. Australian shares provided 9.2% annual returns and US shares 10%. That is a big difference. If you invest $1000 a month for 30 years and earn a 9.2% return annually you end up with $1.768m. A 5.2% return results in $844k.

Obviously investors are not choosing between a portfolio 100% invested in shares or 100% invested in bonds. But this is illustrative of the trade-off investors are making as the percentage of bonds in a portfolio increases. Over the short-term bonds lower volatility which for most investors is not a real risk to achieving their long-term goals. Over the long-term they are putting their goals in peril with more bonds.

The real risk embedded within bonds

The returns that I referenced earlier are nominal returns which means that they do not take inflation into account. Those are the returns often quoted by the media and most professional investors. But those are not the returns that matter to investors. As investors we need to care about real returns or inflation adjusted returns.

If the whole point of investing is to grow our money to buy goods and services in the future it matters how many of those goods and services we can buy with each dollar. Over the same 30-year period the real returns from Australian bonds were 2.8% per year. Australian shares delivered 6.5% annual real returns and US shares 7.3%.

The past 30 years was a low inflationary environment. The difference between the nominal and real returns was the annual inflation rate of 2.7%. High inflation is a risk that all of us face as investors since we are focused on real or inflation adjusted returns. If returns stay the same and inflation increases our real returns are lower. Yet inflation isn’t a risk that impacts all types of investments equally. It is far more impactful to bonds. This increases their risk far beyond anything that is measured by volatility.

Anytime you buy an investment there are future expectations baked into the price. For shares the price refers to the valuation. The valuation is reflective of the expectations about how the company will do in the future. Bonds also have future expectations baked into the price. In this case the price is the yield to maturity of the bond.

The yield of the bond is based on several expectations about the future. The first expectation is the chances of the bond issuer defaulting. But for the sake of this argument we can assume there is a minimal chance of default and you are buying a high-quality fixed rate government bond. If I buy a 10-year fixed rate Australian Government bond at a 5% yield that I plan to hold until maturity the bet that I am really making is on future inflation.

If inflation over the next 10 years is more than 5% per year my purchase of this bond is a huge mistake. That means by purchasing this bond I am able to buy less stuff in the future. Higher inflation isn’t great for shares. Yet historically during inflationary environments they have outperformed bonds on both a nominal and a real return basis. And they have done so at a meaningful level. You can read more about it in Ashley Owen’s excellent article.

It makes sense that shares do decently in high inflation environments. A company can raise prices to offset inflation. A fixed rate bond has no such recourse to compensate investors.

Are bonds less risky than shares? They are less volatile. Yet bonds can be a risk to achieving your goals if you can’t earn a high enough return. The risk of inflation is also much higher with a bond. Do bonds belong in your portfolio? That is up for you to decide but it is worth considering the trade-off.

What is the trade-off between volatility and returns?

Bonds are less volatile than shares. Therefore, if more bonds are added to a portfolio it will lower overall volatility of the portfolio. One commonly used measure of volatility is standard deviation.

Standard deviation measures volatility as a dispersion of returns around the average return. Higher standard deviations indicate more volatility than lower standard deviations. Over the past 10 years the ASX 300 as represented by the Vanguard Australian Shares ETF (ASX: VAS) has a standard deviation of 14.04. Australian Bonds as represented by the Vanguard Australian Fixed Interest ETF (ASX: VAF) has a standard deviation over the previous decade of 4.40.

A 60 / 40 portfolio of the two ETFs would have a standard deviation of 10.18 which is lower than an all-equity portfolio. Over the past 10 years that same portfolio would have delivered returns of 6.24% a year. Over the decade Aussie shares delivered returns of 8.80% a year. Bonds had returns of 2.40%.

That means that based on historical figures and a normal distribution there is a 95% chance that on a yearly basis the return on a 60 / 40 portfolio will fall between 26.60% and -14.12%. For an all-share portfolio with the same conditions there will be a 95% chance of returns falling between 36.88% and -19.28%.

The standard deviation allows us to estimate – using historical figures – the dispersion around average returns. Does this matter in the non-theoretical view of investing? Maybe. Does it tell you anything other than bonds are less volatile over the short-term than shares and have lower long-term returns? I don’t think a whole lot.

In relation to individual goals an investor needs to think about what is most important over the long-term. Is it the dispersion around the average return or is it the average return? I’ve decided it is the later.

Does lowering volatility matter?

It may matter based on your specific goal. For instance, during the transition to retirement lowering volatility can be an important way to combat sequencing risk. It also matters because volatility causes investors to make poor decisions.

In Morningstar’s Mind the Gap Survey we look at the differences between returns on investments (an ETF for example) and the returns that investors achieve. Turns out that investors do worse than the investments they are buying and selling. You can read more about Mind the Gap in my article on how to save yourself 1.7% a year. The reason that investors underperform investments is because we make poor decisions on when to buy and sell investments.

In periods of rising volatility, we make more poor decisions and the gap between investment and investor returns widens. It would be easy for me to say just act rationally and don’t panic when the market drops. And yes, it is possible to reason your way out of an emotion like fear. But it is hard. There are things you can do to help like establishing a goal and investment strategy that includes criteria for changes to your portfolio. But to simply say don’t let your emotions impact you would be disingenuous.

I remember what it was like as an investor during the global financial crisis (“GFC”). The market drops and the constant headlines that the financial system was going off a cliff took a toll. I worried about my job. I thought about and checked my portfolio constantly. I beat myself up for choices I made. I wondered if this time was different and that shares would never bounce back. I read about the great depression. My emotions were on overdrive.

I didn’t end up taking any money out of the market. Yet this wasn’t because I was able to go into a Spock like rational disassociation from what was happening around me. I’m not sure how I managed to not let the panic I felt translate into panicked actions. I’m glad I did.

Is there a better way?

I’ve tried to make a couple points so far in this article:

  1. Volatility is not how most investors should think about risk over the long-term. The real risk is not earning high enough real – or after inflation – returns to meet your goal.
  2. The trade-off for getting lower volatility is meaningfully lowering long-term returns. This significantly impacts the risk of not achieving your goal.
  3. Bonds lower volatility but have significantly higher inflation risk when compared to shares. The risk of inflation destroying the purchasing power of your portfolio is one of the biggest risks that you face as an investor.
  4. While volatility is not a risk most long-term investors face it does cause most people to make more bad decisions. That impacts long-term returns and also puts your goals at risk.

This is the conundrum that we face as investors. Is there a way to lower our chances of making bad decisions while minimising the trade-off of lower returns and putting our goal at risk?

In my own portfolio I think I found a way to do that.

Bonds lower volatility but they do not eliminate it. Bonds still exhibit volatility. Just less than shares. Sometimes bonds are negatively correlated to shares meaning their prices move in the opposite direction as share prices. Sometimes they are positively correlated which means they move in the same direction. It all depends on the economic environment.

But bonds still go down in price. The recent environment of increasing interest rates is illustrative of this risk.

There is one asset that has no volatility. Cash. If you put $100 in the bank it will be there when you want to get it out. And it will grow. The growth will be less than bonds. Over the past 30 years cash has delivered returns of 4.2% a year according to Vanguard. That is less than the 5.5% from Australian bonds.

Like bonds inflation is a large risk to holding cash. It may not have volatility but the money you put in the bank will also lose purchasing power over time. Over the last 30 years cash has delivered real returns of 1.5% a year vs 2.8% for bonds.

While inflation is a risk to achieving my goals and inflation is an outsized risk to both bonds and cash I think cash is preferrable in a period of high inflation. Higher inflation and higher interest rates cause bond prices to go down. Cash held in a savings account or shorter-term term deposit does not go down in value and adjusts to the higher interest rates quicker.

I could buy shorter-term bonds either individually or in an ETF. However, in an upward slopping yield curve where longer-term bonds earn higher returns I wouldn’t get Vanguard’s long-term bond returns without them. I just don’t think the trade-off is worth it.

And the beauty of cash is that to reduce the volatility of your portfolio by the same amount as holding bonds you need less of it. That means you can hold more higher returning shares. And if you’ve decided like I have that volatility is not a risk I face as a long-term investor cash may help to reduce the poor decisions you make by providing safety.

As I have gotten older I’ve grown the amount of cash I hold. It is nothing outrageous in relation to my overall assets but it is meaningful when compared to my income. It helps me sleep at night. Call it an emergency fund. Call it a strategic allocation to cash. Whatever it is it gives me comfort which I think makes it less likely fear will influence my decision making. It sure worked during the COVID market drop.

How much cash to keep? That is up to each person that pursues this approach. One important thing to remember is that market drops don’t happen in isolation. They typically occur when other things are going on. In the GFC the market drop occurred with significant job losses in the financial services industry where I worked. I was worried about my job. In COVID we were all worried about the impact on jobs initially as well as health outcomes. If I was in a different profession with more job security maybe I would hold less cash. Your circumstances matter far more than any theoretical examination of risk can ever capture.

The other advantage of cash is that because there is no volatility it can insulate you from volatility in other parts of your portfolio when that is a risk. That is the approach I’ve outlined for my transition to retirement plan where a cash bucket means I don’t have to sell shares if the market drops.

Final thoughts

This is my approach. It is not a call for anyone else to follow my approach. It is a call to spend some time thinking about if the investment industry’s definition of risk is the one you face. And it is a call to think about how to limit the impact of poor decisions on your portfolio.

I think that every investor can benefit from having clearly defined goals and an investment strategy that governs when changes are made to your portfolio. In my case I think cash further insulates me from fear leading to poor decision making.

I don’t think most of the investors in the balanced option of super funds have thought about the trade-offs they are making. I think they picked balanced because they equated it with a personality trait that sounds positive. Who doesn’t want to be known as balanced? Whatever the reason I am positive that a balanced portfolio is not reflective of the needs of many of the Australians who are currently invested in it.

More than anything this is a call to think about the approach you are taking with your finances. Interrogate the foundation upon which conventional wisdom and the actions of professional investment managers rest. It doesn’t mean it is wrong. But it might not be right for your personal circumstances.

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