Bonds and Psychology

I’ve written about guaranteed investments before and warned our clients and other readers about the perils of investing in an investment where the income or principal is guaranteed. Despite what many people think, the fact an investment is guaranteed does not mean you cannot lose money on it, and it definitely does not mean it is guaranteed to be a suitable investment for everyone. The lower interest rates afforded by GICs may not be higher than inflation and as a result you could very easily lose money after inflation. Guaranteed investments are often oversold in our industry because of these misconceptions and clients need to be careful not to overuse them.

Similar to this, government and corporate bonds are also often treated by clients and by some advisors as if they are “safer” than stocks. Often this impression of safety convinces amateur (and even some professional) investors to allocate more of their portfolios to bonds to ensure they do not lose money. Unfortunately for those investors, bonds may not be as safe as they think they are.

I recently read the book Contrarian Investment Strategies, which was written by a fellow Winnipegger, David Dreman. Dreman is the Chairman and Managing Director of Dreman Value Management which manages over $5 billion in the US. He is one of the most respected experts on behavioural finance and this book in particular is one of the best I’ve read on the subject. In the book Dreman provides a number of examples of how our psychology can hurt our investment returns. One of the specific examples relates directly to our attitudes towards bonds, and in particular government bonds.

The prevailing wisdom in investing circles has always been that bonds are less risky than stocks because of their lower volatility. This belief also comes from the fact that bondholders get preferential treatment in a liquidation scenario, so it’s more likely that a bond holder would get all of their money back if the company were to close down. There is also the added protection that the bond interest payments are a legal requirement whereas the dividends paid by the company to stockholders are not legally required and can be terminated at any time.

Of course this seems reasonable. Loss of your principal is a definite concern for an investor and it does seem as though bonds have a clear advantage over stocks when it comes to protecting your principal. We’ll call this risk “financial risk”. Unfortunately for bond investors though, financial risk is not the only risk that an investor needs to worry about.

When a person invests money, their goal is to increase their purchasing power over time. This means that after all taxes AND inflation, the investor will have more money in the future then they do now. Potential risks are anything that increases the chance that they will have less money in the future, after all taxes and inflation have been deducted. “Financial risk” does not even consider taxes and inflation in determining the amount of risk. So while bonds have a clear advantage when it comes to financial risk, a bond’s Achilles heel as an investment are taxes and inflation.

If you had invested $100,000 in US treasury bills in 1946 and held the until 2010, you would have $133,000 in 2010 AFTER inflation. That means your gains would only add up to about 0.4% annually. If you held longer term treasury bonds you did slightly better as your $100,000 would have grown to $280,000 after inflation for a return of about 1.6% annually over 65 years. To demonstrate just how bad these investments were, we can look at what $100,000 invested in stocks would have grown to. If you had invested $100,000 in 1946 in the S&P 500 and held it until 2010 your $100,000 would have grown to $6,025,000. You would have 45 times as much money than if you had invested in treasury bills and 21 times more than bonds.

When we account for taxes, the difference gets even wider. Bonds are more heavily taxed than stocks. If an investor in a 60% tax bracket (which believe it or not is slightly less than the average top tax bracket in the US from 1946-2010. The actual average was 62%.) invested $100,000 they would have only $27,000 of purchasing power left by 2010. Inflation and taxes have eaten up 73% of the original principal. T-bills were even worse. However if you had invested that money in stocks, you would have $1,600,000 after inflation and taxes over 65 years. The capital invested in stocks would be worth 57 times as much as the money invested in treasury bonds. More importantly for bond investors… you will have lost almost three quarters of your money after taxes and inflation!

Of course over such a long period we should expect stocks to outperform bonds, so these numbers shouldn’t be that much of a surprise, though the magnitude of how badly bonds did was a surprise to me. But not many people invest with the intention of holding an investment for 65 years. So how did the bonds fare against the stocks over shorter periods? Well here is a chart which I’ve partially reproduced from Dreman’s book which illustrates the way stocks would perform vs treasury bonds:

Source: David Dreaman, Contrarian Investment Strategies. Data Source: Morningstar Ibbotson SBBI 2011 Yearbook.

What this chart basically tells us is that if you intend to invest money for longer than 10 years, it does not make much sense to invest that money in bonds. It is virtually certain that you would do much better by investing in stocks. And while a 65 year time horizon is very uncommon, a ten year time horizon is very common. What is also clear from the chart is that the longer you hold bonds, the more purchasing power you lose. Investors might be rethinking how safe these bond investments are.

Despite these very clear numbers showing the weakness of bonds, billions of dollars continues to flow out of stocks and into bonds every year. There is a variety of reasons for this. Because bonds are less volatile, conservative investors invest more of their money in bonds. For investors who are less able to cope with temporary drops in the value of their portfolio, bonds help to smooth out the ride a bit. This has been reflected in regulatory requirements as courts have sanctioned advisors and firms who have over-invested in stocks without fully explaining the volatility risks to their clients. As a result many advisors and firms tend to err on the side of holding more bonds because they believe that less volatility will be less risky for their clients. Many pension and endowment funds require a large portion of their investments to be held in bonds because of their perception that bonds are safer. For a pension fund with a very long term time horizon, this makes even less sense than it does for an individual. But perhaps the most important factor driving money into bonds nowadays, is the psychology of market participants, many of whom are now at or near retirement and have the scars of 2008 still in their mind. These investors are just looking for something which won’t cause them to lose sleep over the investment.

Bonds have their uses. If you are investing for the short term (for terms under 5 years) you should probably hold bonds with shorter maturity periods as you don’t want to be stuck in a market downturn when you need the cash. In addition, because bonds are less volatile, they can help clients psychologically when there is a pullback in stock markets, as their portfolios will not go down as much. However, if you are investing and you don’t intend to spend the bulk of the money for 5 years or longer, you really need to consider how many bonds you want to own. As we’ve seen above, the longer you hold bonds, the more purchasing power you will lose. That will certainly make most investors re-think how safe these bond investments actually are!

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at the award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.

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