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Under Discussion: No Client Under 30 Should Own Bonds

'Bonds are reward-free risk, not risk-free reward' and best avoided altogether for younger clients, some advisors say.

Conventional wisdom has it that investors should have both stocks and bonds in their portfolio, with a baseline weighting of 60% stocks and 40% bonds.

But advisors will tell you there is no such thing as a “conventional” client. Age, risk tolerance and financial goals play the biggest role in determining how much a portfolio should skew toward equities, and how much should be “protected” from price swings in steadier securities like bonds, money market funds and treasuries.

That said, some advisors have a more direct take: No investor under the age of 30 should be invested in bonds, they say.

“The only reason for someone in their 20s to have bonds is for a more comfortable ride, slightly less volatility,” thanks to the diversification, says Tom Fredrickson, a New York City financial advisor. “But if you are in all stocks, very likely in several decades you will come out ahead. If people are OK with volatility, it’s not a bad idea and may pay off significantly.”

As you’re undoubtedly aware, historical returns are much higher for stocks than for bonds. The S&P 500 stock Index returned an annualized 13.9 % in the 10 years ended June 4, compared with 4% for the Bloomberg Barclays US Aggregate Bond Index, according to FactSet.

For the past 20 years, it was 5.8% for stocks, compared with 4.9% for bonds. The 20-year numbers are skewed a bit against equities in that they start near the peak of the stock market before its 2000-2002 crash.

Obviously the long-term advantage for stocks is meaningful for portfolio allocation. “Because stocks inarguably outperform bonds over the long run, the only reason [for young people] not to have an outsized exposure to stocks is the possibility of being a forced seller” when a need for cash arises, says Steve Grey, chief executive officer of Grey Value Management, a money management firm in Singer Island, Fla.

To avoid your being a forced seller, he and others stress the importance of having adequate cash holdings, not an allocation to fixed income securities. “People in general have gotten out of the habit of simply having cash in reserves,” Grey says. It’s probably wise to have at least six months of living expenses in cash, says Mick Heyman, a financial advisor in San Diego, assuming an individual’s financial situation allows them the ability to save that much.  

That way your clients can avoid liquidating any stocks if unexpected expenses arise or they lose their job. And they can put cash to work if stocks decline, buying at bargain prices.

In addition, with bond yields sitting at historically low levels, cash can provide close to the same amount of income as safe bonds. Indeed, bottom-dwelling bond yields represent another argument for young investors to go 100% for stocks, as safe bonds now provide minimal income.

“With quantitative easing having driven rates so low, from a return perspective much of fixed income offers reward-free risk,” rather than risk-free reward, Grey says. “The yield doesn’t even come close to compensating you for the related risks, especially when you take inflation into account.”

Central banks around the world are desperately working to boost inflation rates. “Why would you want to own fixed income instruments that not only provide a paltry return, but are guaranteed to get killed if central bankers succeed?” Grey says.

Fredrickson says in some cases there is an argument to having a small allocation to bonds. Investors who have a big purchase, such as a home, looming in near-future years could benefit from bonds, he says. One strategy might be to go 100% stocks in your client’s retirement accounts and 50% stocks in the client’s nonretirement account.

You also might consider a 90% stock/10% bond portfolio for your young clients, Fredrickson says. That’s because the growth in returns you accrue as you increase your stock weighting diminishes as the weighting rises from 90% to 100%. A portfolio of 91% stocks has a projected annual return of 6.56% versus 6.91% for a 100% stock portfolio, Fredrickson says, citing analysis from MoneyGuidePro.

So how should young investors who want to go all equities structure their portfolio? Experts recommend shying away from individual stocks, unless you the advisor will do the research, because most young investors don’t have the knowledge or time to properly analyze individual companies.

You may have to do some coaxing here with your clients. “One of the biggest misconceptions about investing is casual competence, where people believe that because they’re smart, they can invest successfully without expending enormous amounts of time and effort,” Grey says. “Unless they have the time and experience that enables them to evaluate individual securities, they should diversify via low-cost index-based or thematic vehicles.”

Fredrickson agrees. “A standard S&P 500 or total stock market mutual fund or ETF would be a fine place to start,” he says.

Heyman recommends a portfolio allocation of about 50% to a broad stock market index for young investors. Then he suggests a 10%-20% weighting in small-cap and mid-cap ETFs, a 10%-20% weighting in technology-oriented ETFs and a 10%-20% weighting in dividend-stock funds. The dividend stocks provide income that would compensate for not owning any bonds.

And, of course, fees are important, as these positions may be held for decades. “Fortunately, there are many ways to invest at extremely low cost, including ETFs,” Grey says. The average U.S. stock ETF has an annual expense ratio of 0.39%, according to Morningstar. As you’re undoubtedly aware, hundreds of ETFs trade commission-free on the larger custodial platforms, and many charge only a couple of basis points annually.

All the more reason young investors can do well without bonds.

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