Why Stocks And Bonds Are The Core Of Any Portfolio

To be clear, I am not at all averse to owning all that other stuff. Real estate, physical assets, commodities, gold bars, Bitcoin, collectibles, Beanie Babies, etc. If you want to own that stuff I think that’s great. But we need to separate cash flow generating assets from non-cash flow generating assets because the latter doesn’t provide us with the predictable cash flow streams that allow us to prudently prepare for the future.

But Stocks Are Overvalued!

It’s true. Stocks are overvalued by most metrics. They’re very likely to generate lower risk adjusted returns going forward than they have in the past. So what? You could have said that at many points in the last 20 years. The key to understanding stocks is in putting them in the proper temporal bucket. For instance, I always say that I like to think of the stock market like it’s a 30 year high yield bond with a 7% coupon. If you have a long time horizon the likelihood of you losing money in that instrument is extremely low because the cash flows from Corporate America over very long periods are highly predictable.

(Likelihood of losing money in stocks over specific time horizons)

Now, this doesn’t mean it’s imprudent to manage the risk in your stocks. Set it and forget it doesn’t work for everyone. In my opinion, for certain people, it makes a lot of sense to rebalance your stock portfolio dynamically to take advantage of tax efficiencies and cyclical events that change the future expected returns of this asset class. 60/40 isn’t the right choice for everyone. But that doesn’t mean we should abandon stocks entirely.

But Interest Rates can Only Go up!

I started in this business over 20 years ago and I can still remember my first boss telling me this exact narrative. A portfolio of long-term bonds has generated 6.5% per year since then. Of course, that’s not gonna keep happening. It literally can’t keep happening because rates are low and current rates are the best predictor of future returns. And yes, you’re right that bonds will generate lower risk adjusted returns going forward. I’ve stated that repeatedly. But it absolutely does not mean that bonds will generate negative returns. As I’ve written about exhaustively, it’s absolutely wrong to say that bonds will necessarily lose money if interest rates rise. In fact, we know from the history of the rising rate period of 1940-1980, that bonds did just fine. A 10 year T-Bond generated 3% annualized returns over this period.² How is that possible? It’s possible because that  10 year T-Bond kept maturing at par regardless of what interest rates were doing. So, even if you bought bonds at the worst possible time in the early 1940s you still clipped that 2% coupon every year until the bond matured.

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Disclaimer: The content in this article is provided as general information only and should not be taken as investment advice. Article content shall not be construed as a recommendation ...

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