I’m not sure if the prevalence of “Why bonds?” and “Should I use a 100% stock portfolio?” threads on internet forums is inversely correlated with future stock market returns, but it wouldn’t surprise me. I do know that I didn’t see very many of them in late 2008. I’m seeing a ton of them now, so it is probably time to readdress the topic.
I fully understand the desire to use a 100% stock portfolio. Once somebody looks at past behavior of the stock market and understands the general rule between risk and return, it seems obvious to question why they might want to put 10%, 25%, 40% or more of their portfolio into those pesky low-returning bonds. I mean, look at the data:
The intermediate investor looks at that data and thinks “If I can get 10.1% returns instead of 9.5% returns, over 30 years that means I end up with 12% more money. Or I can retire over a year earlier with the same amount of money. All I have to do is tolerate losing a little more of my money in a bear market. I’m sure I can do that since stocks have ALWAYS come back….eventually.” People also have an understandably hard time getting excited about investing in bonds given current yields of 0.1-3%, especially when they understand that the best predictor of future nominal bond returns is current yield.
However, today we’re going to poke some holes into the argument for 100% stocks. Now if at the end of this article you still want a 100% stock portfolio, knock yourself out. But I think any 100% stock investor owes herself two things:
- Fully understand the arguments against a 100% stock portfolio
- Pass through her first bear market and STILL feel comfortable with a 100% stock portfolio
Obviously, obeying those two requirements rules out the opportunity for any investing virgins (anyone who hasn’t invested in a bear market) to have a 100% stock portfolio. That’s probably a good thing. A 100% stock proponent might then argue “But that means that anyone who has started investing in the last decade can’t have a 100% stock portfolio when their risk tolerance should be highest at the beginning of their career.” To which I would reply, “The fact that we haven’t had a real bear market in a decade is not an argument for increasing your stock allocation.” Besides, there were (admittedly short) bear markets in the summer of 2011, December 2018, and March 2020, so that excuse really doesn’t fly.
All right, let’s get into it.
# 1 Why Not 130% Stocks?
I never see threads arguing for 95% stock portfolios. Nor 105% portfolios. It’s always 100%. I’m not sure what the fascination with that round number is other than it is round. If 100% stocks is good, 110% stocks must be better, right? How do you get 110% stocks? Well, debt is basically a negative bond. So if you borrow 10% of the size of your portfolio and invest the entire portfolio plus that 10% in stocks, you have a 110% stock portfolio. In truth, it doesn’t matter what the source of that debt is. If you have student loans and a mortgage and a relatively small portfolio, in reality, you may already have a portfolio that is already > 100% stocks. If the possibility of a margin call scares you (and it should) then don’t borrow against the portfolio, borrow against your house to get there. Actually, don’t. At least not until you’ve read this fascinating thread started in 2007 and progressing through the Global Financial Crisis.
# 2 Why Not 100% Small Value Stocks?
The primary reason people cite for 100% stock portfolios is because in the long-run, at least in the United States, a 100% stock portfolio has had higher returns than a portfolio that contained any percentage of bonds, although at the extremes the “cost” of a few bonds or a few stocks isn’t very high, as you can see in this chart:
We can carry that higher return argument out further. Long-term data suggests that small value stocks outperform the overall market. So if you’re just going for the highest possible return, you should use a portfolio that is 100% small value stocks.
A factor investing fan would argue you’re even MORE diversified doing that, since you are now taking not only market risk, but also size and value risk. Does a 100% small value portfolio make you feel uncomfortable? You don’t want to put all your money into what accounts for just 2% of the stock market?
# 3 Bonds Might Outperform Stocks
There have been long time periods in the past when bonds outperformed stocks, even in the US, and even longer time periods in other national markets. It might not be “normal” but it does happen. The problem is we all get seduced by stocks when we look at tables like this one:
(By the way, that’s a really fun chart to pull out when the gold bugs start doing their thing too.) But if you carefully examine shorter time periods, you’ll see that there are many periods of time where bonds outperform stocks for quite a while. Take a look at this chart of rolling 10 year periods:
As you can see, stocks outperform bonds most of the time over 10 years, but nowhere near all the time. It becomes especially noteworthy if you also include all those 10 year periods when stocks barely outperformed bonds while taking far less risk. Even at 15 years, a bet on stocks hasn’t always worked out well. In this chart, S&P 500 stocks are compared to 5-year treasuries.
15 years can be a long time. Consider where you were financially 15 years ago. 15 years ago I had a four-figure net worth as a brand new intern. Now, imagine you’ve been investing ever since then in a 100% stock portfolio and you’re STILL underperforming a 100% bond portfolio. It happens. It has happened even more frequently outside of the United States. Check out the real (after-inflation) equity returns from various countries:
As you can see, US bonds outperformed some of those countries over more than a century! That might be twice as long as your investing career. Maybe the future looks more like Japan or heaven forbid, Austria rather than the US or South Africa. This idea that stocks always outperform bonds over 20+ year periods really only applies to the US and the comparative advantages the US has enjoyed in the past were significantly higher. (To be fair, some of the bond returns of these countries were even worse than their stock returns!)
More recently, I saw a post that looked into stock versus bond returns in the US, but not over the typical time period that we look at. If you start in 1793, there is a 150 year period where bonds outperformed stocks!
I look at all this data and to me, as a long-term investor, the message is clear. Bet on stocks, but don’t bet the farm. A 100% stock portfolio is betting the farm. The future may not resemble the past at all or we may have one of those periods like the 1930s, 1970s, or 2000s.
When I constructed my portfolio, I made a few assumptions:
- Stocks would outperform bonds.
- Small value stocks would outperform the overall stock market.
- US stocks and international stocks would have similar returns with a correlation of less than 1.
- Stocks and real estate would have similar returns with a correlation of less than 1.
As you might expect, my portfolio reflects those assumptions. But I also wanted a portfolio that was highly likely to reach my financial goals even if one or more of my assumptions turned out to be wrong. I tried to avoid making any big bets that would sink me if they were wrong. As such, I hold lots of stocks, but didn’t go “all-in” with a 100% stock portfolio. I have a significant small value tilt, but I also own the entire market. I own both US and international stocks. I own both stocks and real estate. The goal of investing isn’t to win, it’s to not lose. Consider both the likelihood that your assumptions are wrong AND the consequences when designing your portfolio.
# 4 Easier to Stay the Course
I think it is a big mistake for a new investor who has read a book or two on investing to assume they will be able to tolerate a stock-heavy portfolio in a bear market. When setting up a portfolio in “normal times” lots of stocks make logical sense. But staying the course in a bear market is not a logical experience. It is a profoundly emotional one. Watching money that used to be yours disappear is psychologically painful. That money represents the kitchen upgrade you didn’t do, the Tesla you didn’t buy, the vacation you didn’t take, and the piano lessons you didn’t give to your child. Investing more as the market drops day by day and the talking heads on TV are screaming “This is the end” feels like shoving hundred dollar bills down a rat hole. Ignore the critical behavioral aspect of investing at your peril.
Having SOMETHING invested in bonds at those times not only reduces the volatility of your portfolio but also gives you the psychological reassurance that “At least I didn’t put it all in the market.” In fact, your bonds (at least the high-quality ones) are likely RISING in value at that time, providing you reassurance that something you own is actually increasing in value and moderating the volatility of the entire portfolio. You get to say to yourself, “Now I’ve got some dry powder I can put to work so I can buy stocks while there is blood in the streets,” even if deep down you know that is just a psychological crux and you really don’t want to hold “dry powder.”
All of that helps you to stay the course, which is the most critical aspect of investing. You are far better off holding a 60/40 portfolio for decades than a 100% stock portfolio that you sell low just once during your investing career. Avoiding the investment catastrophe of selling low is the most important aspect of portfolio construction. Far better to underestimate your risk tolerance than overestimate it. It’s kind of like The Price is Right, where you try to get as close as you can to your risk tolerance without going over.
You really don’t want to pull a Happy Gilmore and find out “The Price is Wrong, Bob!”
# 5 Experienced Investors Say Don’t Use a 100% Stock Portfolio
I find it interesting that the majority of those who advocate for a 100% stock portfolio are on the young side. When I talk to older investors, they are very much fans of bonds. Their willingness to take risk has dropped over the decades, of course, but part of it is that they have lived through economic scenarios that you and I have never seen. These older folks say “Pay off your mortgage” even though the numbers suggest you could come out ahead by not doing so. They say, “Own both stocks and bonds” even though they would have come out ahead with a 100% stock portfolio over their lifetime. Ignore the wisdom of your elders at your own peril.
Benjamin Graham, who Warren Buffett considers his mentor, said that you should never hold more than 75% of your portfolio in stocks and no more than 75% of your portfolio in bonds. Graham was born in 1894 and died in 1976, so his investment career really started during World War I, extended through the Great Depression and World War II, endured through the cold war, and ended during the stagflation of the 1970s. Stock yields were over 5% for most of his career (actually higher than bond yields) and that was felt to be normal since stocks were so much riskier than bonds. Taylor Larimore is a big fan of holding bonds and recommends you hold up to your age in bonds. He’s 94 years old. You might consider what he knows that you don’t.
# 6 Don’t Take Risks You Don’t Have To
Some people may need a 100% stock portfolio to meet their goals. Some people may also need to highly leverage their lives by borrowing against the house in order to invest more. Others may need a highly leveraged real estate portfolio to get what they want. But the chances of you needing to do that to reach your goal are probably pretty low. A typical young attending physician reading this site simply doesn’t need to take those kinds of risks to retire early as a multi-millionaire. At a certain point, you’ve got to ask yourself why you’re taking risks you don’t need to take. =Is 24% more volatility worth it to retire in 29 years instead of 30? Would you be better off cutting back your lifestyle a tiny bit and working an occasional extra shift so you could save a little more money and use a 75/25 portfolio rather than a 100/0 portfolio? Probably. These aren’t risks that folks like us need to take. Don’t take risks you don’t have to.
# 7 We Overestimate How Much the Future Will Resemble the Past
A common behavioral error is to expect that the future will resemble the past, particularly the recent past. We project what we have seen will continue indefinitely. A careful study of the past will reveal that time and time again investors are surprised when that isn’t the case. How sure are you that stocks will outperform bonds over the next 30 years? How about the next 20? 10? Be careful that this very natural human tendency doesn’t lead you to take on more risk than you should. In early 2000, people were really sure stocks would outperform bonds in the 2000s, but they were wrong.
There you go. If I haven’t convinced you to add some bonds to your portfolio AND you’ve invested through your first bear market, feel free to use 100% stocks or more. But the Venn Diagram overlap of those who can tolerate a 100% stock portfolio and those who need to take that kind of risk is so small that the odds you’re in that area of overlap are unlikely.
What do you think? Do you hold bonds? Why or why not? What percentage of investors do you think can tolerate a 100% stock portfolio in a down market? Comment below!
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