Before the article, here’s what’s happening this week on our podcast, Personal Finance for Long-Term Investors:
I don’t know what a diversified stock portfolio will return this year. Or next year. Or the year after that.
Short-term stock returns are a mysterious black box. Schrodinger’s investment. If short-term portfolio returns are vital to your survival, stocks aren’t the asset for you. This is a simple truism of investing. We need a different asset for the short-term.
But if you need your portfolio to last for decades, stocks come into focus. We can use long-term averages to smooth out any short-term stock uncertainty. It doesn’t lead to 100% certainty; we can’t peer through the foggy future. But it’s better.
And by measuring over decades, we get a convenient side effect: we see the incredible power of compounding.
What do I mean?
The basic investor might say:
- Stocks return 10% per year.
- Bonds return 5% per year.
- Cash returns 3% per year.
This framework is flawed for so many reasons. First, for the reason we already covered: stocks are too volatile to make any reasonable 1-year predictions or averages. Second, such a myopic view overlooks the concept of compounding.
One could look at these averages and think, “Oh – bonds return about half of what stocks return. Not great, but not bad.” But as you’ll see below, that’s a flawed conclusion too.
Instead, I’d implore long-term investors like us to think for decades. And, to think not in nominal terms, but instead to consider the undeniable impacts of inflation and taxes.
When we think in real, inflation-adjusted, after-tax returns over decades, we come to the conclusion that, over a reasonable 30 year period:
- Stocks compound our real wealth by 300 – 400%
- Bonds compound our real wealth by ~0%
- And cash loses 25% – 50% of our real wealth
These numbers might surprise or shock you. That’s a good thing. Yes – they’re actual historical numbers, using actual inflation data, actual tax rates, and actual investment returns.
Bond returns aren’t “half” of stock returns. It’s not a fractional different. They’re orders of magnitude different.
Bonds do nothing over the long run. Cash gets decimated. Whereas stocks show real positive growth.
This isn’t “apples and oranges.” This is night and day.
Why Own *Any* Bonds Then?
And it begs a question: why would anyone use bonds or cash in the first place?!?!
To answer that question, we have to go back to the beginning of this article, Tarantino style.
The simple truth is, I don’t know what stocks will return this year.
It’s that simple.
Stock returns cannot be relied upon in the short- or medium-term. We must use a more dependable, less volatile asset for those outlays. Cash and/or bonds are a suitable choice for this, and we must accept the lower returns from those assets as the price to pay.
This is a continuation of the “asset liability matching” concept we discussed recently.
However, bonds and cash do not provide long-term growth. Instead, the underlying “growth engine” of your portfolio should come from actual risk assets, like stocks. To achieve that growth, however, higher volatility is the price to pay.
Nothing is free, you see? For higher growth, the cost is more volatility. For greater stability, the price is less growth.
This is why we diversify across asset classes, why we own both stocks and bonds (and real estate, alternatives, etc.). They serve simple, important, and drastically different purposes.
And that’s why our measurement period – months, years, or decades – matters.
Thank you for reading! Here are three quick notes for you:
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