Stocks versus Bonds, Part 3

Arthur Stein Financial, LLC |
The July 2, 2012 “Ahead of the Tape” article in the Wall Street Journal discusses investor preferences for bonds over stocks.
You can read it here
 
According to the article:
  • “Since the start of 2007, a cumulative $350 billion has flowed out of stock funds and a little over $1 trillion has moved into bond funds.”
  • “…the mix of consumers' holdings in funds has shifted markedly. In 2011, 45% was in stock funds and 25% in bonds; in 2005, the mix was 55% for stocks and 15% in bonds.”
The article continues that the most likely reason is “bonds' unusually good performance versus stocks since 2000—a pattern not seen since the Great Depression. That has been compounded by investors' more recent flight to safety” and these flows show that “stocks are going out of fashion.”
 
Unfortunately, bond investors may be ignoring important issues. For instance:
  • Can bond investments increase purchasing power?
  • What do people mean when they say bonds are “safe?”
  • Can the “unusually good performance” of bonds continue?
Purchasing power: Historically, US interest rates have fluctuated up and down but showed no tendency to increase. Interest rates are actually lower than they were at any time since at least 1962.
 
Because prices did increase over time (inflation) and interest rates did not, it caused the purchasing power of interest income (and the principal – or value – of the bond) to decline. In short, money invested in bonds, savings accounts, money market funds, etc. loses purchasing power over time if there is a positive inflation rate.
 
Safety: People who say bonds are “safe” probably mean that bonds are less volatile then stocks and -- short of bankruptcy -- bond interest will be paid and principal returned at maturity. However, bonds can be volatile and do decline in value when interest rates rise. Since interest rates on many types of bonds are at or near historic lows, that risk is significant.
 
Recent performance: A primary cause of “bonds' unusually good performance versus stocks since 2000” was declining interest rates increasing the value of existing bonds and the poor performance of stocks. It is not possible to predict future stocks performance, good or bad. However, interest rates cannot continue to decline much more, unless there is a prolonged period of negative interest rates.
 
My take on this: Bonds have a place in most portfolios but don’t let “fashions,” emotions or unusual events fool you into overinvesting or changing your allocation.