Bonds, Be Gone

Taking the Long View
Bill Bernstein has released his third "paperback" in his Investing for Adults series. As with the first two installments of the series, this one is terrific. (At $5 for the Kindle version and $10 for print, the price is also very much right.)

The book's title is Deep Risk: How History Informs Portfolio Design. That boggled my mind, too, but the concept is straightforward. Bernstein dispenses with volatility-based asset allocation, advocating instead a different, longer-term approach to building portfolios. Investment adults, he argues, are those who outgrow the stage of fussing over market movements. For assets that they intend to own for several decades, adults pay little attention to the "shallow risk" of investment volatility. They focus instead on avoiding the "deep risk" of permanent damages.

(That's an ironic argument for a man who runs Efficient Frontier Advisors, and whose website looks like this--

--On the other hand, it's consistent with the notion of growing into investment adulthood, as Bernstein snapped up the naming rights for Efficient Frontier many years back, in his early years as an investment thinker.)

There aren't many investment adults. The industry's science, after all, was built to address shallow risk. Research papers are written, and Nobel Prizes awarded, for demonstrating how to achieve the greatest amount of return for the least amount of standard deviation. Banks measure their portfolios via the shallow-risk calculation of Value at Risk. Financial advisors use tools (including those from Morningstar) that attempt to minimize monthly volatility and maximize returns. It's a shallow-risk world.

Also, adulthood isn't easy. Instinct and the media urge action, not staying the course. Plus, not everybody can afford to be patient. It's all very well to adopt a measured, long-term attitude, but philosophy is scant consolation if circumstances force the investor to sell into a weak market. Warren Buffett can (and does) shrug off shallow risk; the principals at Long-Term Capital Management could not.

For those who do become investment adults, the key lesson is more stocks, less bonds. Per Bernstein's analysis, there are four deep risks that may strike: 1) hyperinflation, 2) severe deflation, 3) government confiscation, and 4) devastation/war. In recent history, the first, that of hyperinflation, has been easily the most common of the dangers, and in such cases bonds (aside from the new, inflation-protected variety) have been a complete disaster. 

Even moderate rather than hyperinflation can cause big problems for bonds. For U.S. investors in the mid 20th century, Treasury bonds were truly terrible. From January 1941 through September 1981, per Bernstein's figures, U.S. Treasuries shed 67.3% of their real value. That is, an investor who stashed $10,000 in early 1941 into U.S. Treasury bonds, with instructions that all coupons be reinvested in additional bonds, found upon her return 40 years later that she owned $3,270 in inflation-adjusted terms.

That performance is no better than the most spectacular stock market failure over the past 50 years, Japan post-1990. Bernstein cites a real loss of 58.2% for Japan since January 1990, but that calculation runs through June of this year. Japan's peak-to-trough numbers were worse and about on line with the U.S. Treasury’s 40-year showing. To repeat: U.S. Treasuries spent much of last century performing as badly as the worst developed-country stock market in recent memory. 

Bonds in countries that suffered hyperinflation, of course, did even worse, falling to zero. (It's hard to lose more than everything.) In contrast, stocks in those countries did remarkably well. Yes, an unexpected spike in inflation damages stocks along with bonds. However, as inflation settles in, stocks adjust. Companies pay their costs in devaluing currency, raise their prices, and so on. As a general rule, businesses carry along through hyperinflation just as they were carrying on before. Bernstein reveals that even in the legendary Weimar Republic, stock investors profited. From 1920 through 1923, German stocks doubled in real terms, even as bondholders were wiped out.

In two of the three remaining deep risks, government confiscation and devastation/war, bonds offer no advantages of over stocks. They are not worse, to be sure, but they are also not superior. In Russia 1917 or Cuba 1958 or Italy 1944 or Germany 1945, it was not good to be in either asset.

Finally, high-quality bonds do offer a significant advantage over stocks during the fourth of Bernstein's deep risks (or "Four Horsemen of Financial Disaster," as he likes to put it), severe deflation. This situation was suggested in 2008, when U.S. Treasury bonds appreciated in price even as U.S. stocks plunged, as the market forecast a possible depression. That depression didn't arrive and stocks quickly rebounded--but when a Depression did occur, 80 years ago, the stock recovery was far slower to arrive. High-quality bonds very much came in handy.

Even there, though, bonds were only a temporary help. Stocks were not permanently impaired. Adopting a 30-year perspective, it's questionable whether the U.S. Great Depression was a deep risk at all or merely the largest and longest of shallow risks. It's also unclear how much investors need to protect against deflation. As Bernstein points out, there have been few examples of deflation post World War II. Moreover, in the most infamous case of Japan, the true driver of the stock market decline was not lower corporate profits due to deflation's effects but rather the shrinkage of historically high stock-price multiples.

In short, the investor concerned about deep risk rather than shallow risk has little need for bonds, aside from the inflation-adjusted variety. Such an investor will own mostly stocks, with a large amount of overseas exposure as deep risks are often country-specific. (Bernstein recommends a value tilt to the stock portfolio, which he argues is helpful during inflationary regimes.) The portfolio will also contain commodities, in particular gold bullion stored overseas, in combating the government confiscation and devastation/war scenarios. Foreign real estate could also be used for that purpose.

You won't hear any quarrels here. In my personal portfolio, I follow the basics of Bernstein's recommendations, and for the same reasons. My long-term holdings are 90% stocks. I don't require liquidity with those assets, I'm not worried about short-term market volatility, and I'm as close to sure as sure can be that stocks will outgain bonds over the next two or three decades. So, why not go heavy on stocks?

One thing that I could use--along with perhaps many readers of this column--is greater international exposure. As with most people, I began my investment career buying U.S. securities, and I haven't much changed that habit. While I'm optimistic about U.S. prospects and think that the chance of U.S. assets being permanently damaged by government confiscation or devastation/war is very low, my portfolio nevertheless would benefit from spreading its geographic wings. Almost certainly, my next trade will be away from the United States. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.