Tag: diversification

Should you invest in bonds? What about gold?

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I thought I would run through a little portfolio theory for today’s post. I want to answer whether it still makes sense to invest in bonds (and perhaps even Gold).

I know, this may be a shocker to some people given (i) the fed was raising rates, (ii) I am a follower of Buffett and Munger who shun no-income earning gold and low interest rate bonds and (iii) I typically run a very concentrated equity portfolio in order to capture the upside of my ideas.

That said, the broader goal of this post is similar to the one on Ray Dalio’s All Weather Portfolio post – that is to say that diversification pays off.

To counter the points above, let me first re-iterate something I said before in my post, Is it time to rotate into consumer staple stocks? (And a digression on interest rates). One quick bragger is that the consumer staples ETF is up 6.7% since that was published compared to 3.96% for the S&P.

But coming back to the topic at hand – no one can predict interest rates, especially long-term rates. The former Fed Chief, Ben Bernanke recently said in late 2015 that he admittedly didn’t expect rates to remain this low for this long and followed that perhaps lower rates are here to stay:

“Certainly there has been a long-term downward trend in longer-term interest rates and every indication is that the equilibrium interest rate —the rate that ultimately will be consistent with stable growth — is lower than it has been in the past. So that’s clear. I expect the Fed will be very cautious and gradual, that’s what they’ve told us many times, and they’ll be looking for evidence that the economy has been able to accommodate the higher rate increases and still continue to grow.”

It is important to remember that demographics change.

People in the US are living longer and population growth is slowing. This puts a downward pressure on interest rates. The former causes pressure since people live longer = people need to save more and this may have a ripple effect (e.g. pensions need to adjust for longer life times than the past).

In addition, as people still retire in the 60-65 age range, but need their capital to be stable for retirement, they buy more bonds. Demand is greater than supply.

Low population growth also means slower GDP growth which pushes interest rates down.

Are we anchoring to high interest rates?

Look back at the interest rate in the 1960s. This followed WWII’s boost to America, creating a powerhouse economy, and encompasses most of the baby boomers being born (this ranges from early-to-mid 1940s and ends in early 1960s). From 1960-1965, the US GDP growth rate was anywhere from 5.5% to 10.7%, much higher than the 2% growth we target today. and yet, where was the rate on the 10 year treasury??

It was between 4.0%-4.5%.

1960s ratesx

Sure, that’d be nice to have if you want to put cash away in a safe place and earn 100-150bps more than what you get today, but the times were different then.

Ok, now that I can get off my soapbox and hopefully help you think somewhat differently about interest rates, I want to turn to the argument of why someone who chooses to invest in bonds is really adding a ballast to the portfolio.

While it’s tough to swallow a security that is guaranteed to only return ~3% p.a. if you  hold it to maturity, I think it’s helpful to realize that you want something in your portfolio that will zig while everything else zags.

That is to say, when you invest in bonds, don’t look at just the coupon on bonds and think that is the only return you can get. If we hit a recession or there is fear in the market, these safer bonds will likely move up, while the equity market goes down. Indeed, since the Fed’s main tool here is to tighten rates in order to stimulate an economy going through a recession that is what we saw in 2008.

However, the counter argument that “interest rates may not help you in the next down turn because they are already low” is equally weak. At the end of 2013, the 10 yr treasury sat at 3.0%. It then went to 1.38% in the beginning of 2016. If one had chosen to invest in bonds at that time, it would have paid off.

For context on that, lets run through a case where you invest in bonds at the end of 2013: you buy the 10 year and sold it 2.5 years later when rates actually tightened. After 2.5 years, you have a 7.5 yr bond now with 3% coupon. The rate for 7 yr bonds at that time after some tightening was then 1.2% in 2016, which means your bond would’ve traded up to ~113 to match current on-the run rates.

Even though you bought a 3% 10 yr bond, it went up as people flocked to securities that are safe havens and that investment would’ve provided a ~8% IRR if you then sold it. Not too bad!

T-bond in 2013

Comparison of Different Portfolios
I’d like to show you a few scenarios. First, the results of a portfolio invested 100% in US stocks late in a cycle where a bubble bursts (tech bubble) compared to one that is 80 / 20 stocks to bonds as well as one with some allocation to gold to show the impact of non-correlated assets. I will also show this for 2008. This comes to an interesting tool I’ve been utilizing at www.portfoliovisualizer.com. I know I’ll get this comment, but obviously past results are not a predictor of the future, but do think it helps at what may happen in the future.

The first results show what the value would be if you invested $10,000 in 1998 and rebalanced semi-annually.

  • Portfolio 1 = 80% US stocks, 20% 10-year treasury
  • Portfolio 2 = 60% US stocks, 20% 10-year treasury, and 20% Gold
  • Portfolio 3 = 100% US stocks

As you can see, portfolio 1 & 2 performed better over this time frame. Interestingly, portfolio 2 performed the best with its allocation to gold. It worst year was only a 5.7% drop as well, compared to 21% drop for Portfolio 3. Portfolio 1 & 2 underperform in bull markets, which might be obvious, but helped outperform during the bear.



Let’s again look at the 3 portfolios with a starting point of 2004 and ending in 2012. Again, portfolio 2 outperforms the all US stock portfolio as does portfolio 1. Portfolio 2 this time outperforms by a much wider margin since gold is seen as a hedge against extreme scenarios, like the one we saw in 2008. Remember from 2004-2006, the Fed was also raising rates.

PortfolioPic3PortfolioPic4PortfolioPic5 I am a total Buffett follower and understand the difficulty buying gold since it is an asset that produces no cash flows. But from a portfolio perspective, I understand the rationale for buying. If your gold assets go up in a time like 2008, that gives you flexibility to sell it and buy stocks at very attractive valuations, which is flexibility I find valuable (though admittedly, I currently have no allocation to gold in my personal accounts). Also, you should watch this video I find humorous on Bernanke’s view on gold vs. Ron Paul.

At the same time, I also realize that a 30 year bond today that will fall 17% if rates go up by 1% may not be attractive despite the upside if rates tighten. The point of this analysis is to say that having a moratorium on bonds may not be the best idea either.

Bottom line: Do I think one should invest in bonds and even gold? Yes. Do I think they will return less than stocks over the next 10-20 years? Also yes. But the flexibility these asset classes may provide this late in the cycle may be attractive (much like insurance). You also have the option to buy corporate bonds which offer slightly higher yield than treasuries, but are still safe havens in times of distress.