Week 16 Day 4: Why Bother With Bonds at All?

Stocks beat bonds over 20+ years. But if a 50% stock decline causes you to panic-sell, you lose the entire benefit. Bonds dampen the ride. A portfolio with 20% bonds might drop 40% in a crash instead of 50%. That 10% cushion might be the difference between staying the course and panic-selling at the bottom.

The real purpose of bonds is behavioral. Vanguard studied investor behavior during the 2008-2009 crash. Investors in 100% stock portfolios were significantly more likely to sell at the bottom than investors in 60/40 (stock/bond) portfolios. The 60/40 investors experienced a smaller decline (-34% vs -51%) and were more likely to stay invested. The ones who stayed invested recovered fully by 2012. Those who sold in March 2009 locked in permanent losses. The 'sleep at night' test: if a 50% decline would cause you to sell, you have too much in stocks. Rules of thumb for allocation: (1) Age in bonds (age 30 = 30% bonds). Simple but overly conservative for most people. (2) Time-based: more than 15 years to goal = 80-100% stocks. 5-15 years = 60-80% stocks. Less than 5 years = 40% or less stocks. (3) Risk tolerance questionnaire: most brokerages offer these. The best allocation is the one you can actually maintain through a severe market decline.

The optimal stock/bond allocation is a function of the investor's human capital, risk aversion coefficient, and investment horizon. Merton (1969) and Samuelson (1969) showed that for investors with constant relative risk aversion (CRRA) and returns that are independent over time, the optimal stock allocation is constant regardless of horizon. However, Campbell and Viceira (2002) demonstrated that when stock returns are mean-reverting (which empirical evidence supports weakly), the optimal allocation increases with horizon -- justifying the common advice to hold more stocks when young. Canner, Mankiw, and Weil (1997) identified the 'asset allocation puzzle': conventional advice suggests increasing the bond/stock ratio as risk aversion increases, but the standard model suggests the ratio of risky assets should remain constant (the separation theorem). The resolution involves considering human capital (a bond-like asset for most workers), background risks, and transaction costs. For practical purposes, the evidence supports: (1) high stock allocations for young workers with stable employment, (2) gradual increase in bond allocation as retirement approaches, (3) sufficient bond allocation to prevent behavioral mistakes during bear markets.