Q: If you have a very long time horizon, and won't need the money for 40 years, is there any point in diversifying into bonds or any other asset class that traditionally earns far less than equities? Is diversifying among different types of equities enough?
A: If you don't need the money for several decades, you are correct that you don't need to have a large allocation to fixed income. Because stocks, despite their volatility, are likely to outperform bonds over extended periods, the longer one's time horizon, the greater one's allocation to stocks should be.
But even if you have four decades until you retire, it never feels good to lose money. As Morningstar's director of personal finance Christine Benz explains in this article, your risk capacity--how much risk you can tolerate given your time horizon--is often very different from your risk tolerance--essentially, your comfort level with short-term volatility. That's why a sliver of fixed income can be helpful, as just a tiny allocation to bonds can help tamp equity volatility in a portfolio without giving up too much upside.
Time is on your side
To assess the margin by which stocks have outperformed bonds, and the volatility of both asset classes, over long periods, we looked at the annualized return of the S&P/TSX Composite Index versus the Bank of America Merrill Lynch Canada Broad Market Index, which tracks investment-grade debt denominated in Canadian dollars, over the past 20 years (as of June 30, 2016). The former was the clear winner with a return of 8.5%, compared to 6.5% for the latter.
But because stocks are more volatile, and thus riskier, they should be expected to underperform over shorter time periods. However, periods shorter than 40 years can still be pretty long. What if equities don't compensate investors for their risks over a period that's as long as a decade? While the S&P/TSX Composite Index (or its predecessor the TSE 300) has never lost money over a 10-year period since its launch in 1977, it produced an annualized total return of just 3.6% for the decade ended January 2016. By comparison, the bond index gained a shade over 5% for that period, at a fraction of the volatility.
Are stocks still worth the risk?
Over the past 10 years, many investors haven't been as well-rewarded as they would have liked for taking equity risk. That has left some investors wondering if stocks are worth the risk at all. After all, the stock index returns have trailed those earned by bonds, but with much, much greater volatility.
Without making explicit expected return prognostications for asset classes, I will say that I wouldn't expect the same pattern to continue over the very long term. The events that occurred in the market over past 10 years have been unique. The index lost more than 43% during the financial crisis of 2008-2009, and while the subsequent bounce-back was impressive, stocks went into a freefall again in 2011-2012.
As for bonds, the past 10 years was a period when yields were on the decline (and hence bond prices rose). In July 2006 the yield on a 10-year Government of Canada bond was 4.2%; it now hovers around 1%. Going forward, we're unlikely to see an extended period of declining yields given that rates are so low.
Finding the right allocation
As mentioned, a small fixed-income stake can make sense even for a very young investor, as it can smooth volatility a bit and reduce your portfolio's downside. (This can be especially helpful if you think you might find it hard to resist the urge to sell into the teeth of a downturn.) Just be sure that your bond allocation is small, or you risk giving up too much potential upside. In other words, even if you have an appropriate savings rate, you may still fall short of your retirement goal if you don't take on enough equity risk in your portfolio.
"A small splash of bonds can help tamp volatility in a big way," said Brian Huckstep, co-head of target risk strategies for Morningstar Investment Management. "When moving up from 0% of any asset class with attractive low correlation characteristics (which not all investments have), the first few percent often give you the biggest bang for your buck in volatility reduction. There is typically a decreasing marginal benefit for each incremental percentage of allocation until you hit an optimal allocation," he added.
