(Bloomberg) -- After the beating they took in bonds over the last two years, investors can be forgiven for wondering if it was ever a good idea to rely on fixed income to lay up for old age.
New research validates these suspicions.
It’s a deeply out-of-consensus view certain to rankle the Wall Street establishment. A group of academics set out to test time-honored investing advice that says a diversified portfolio of bonds and stocks is the best way to save for the future. What they found across a sample of three dozen countries over 130 years was that a mix of half domestic, half international equities actually beat blended portfolios in both money made and capital preserved.
The paper, titled Beyond the Status Quo: A Critical Assessment of Lifecycle Investment Advice, adds fuel to an already heated debate after the 60/40 strategy misfired last year. With fixed income suffering subpar returns amid the Federal Reserve’s monetary tightening, some have argued traditional investing advice needs a rethink.
“As long as the equity investors are able to stick it out, they end up being better off with very high probability than somebody who’s trying to smooth out those short-term movements by diversifying into bonds,” says Scott Cederburg at University of Arizona, who co-authored the paper with Aizhan Anarkulova at Emory University and Michael S. O’Doherty at University of Missouri.
Using a computer to run a million simulations for American households, the researchers found that splitting money between domestic and international equities built just over $1 million of wealth on average by retirement, compared with $760,000 for the 60/40 mix. While the maximum loss for the all-stock approach was deeper, it wasn’t bad enough to derail performance over the long haul.
Several factors prevent advisers from grasping the advantages of an all-equity approach, one of them being overconfidence in the stocks-bond blend born of myopic focus on the short term, the authors say. Another issue is a lazy belief in the capacity of the two asset classes to balance one another. The researchers found periods in which they moved in unison are more common than people probably realize and that diversifying share holdings across geographies works better.
Data going back to before the start of the 20th century suggest that the failure to take full advantage of the upside in stocks means lost welfare estimated at $240 billion a year for one type of plan, says Cederburg, whose own retirement account recently held 44% US stocks and the rest overseas equities. (He owns bonds in a non-retirement account.) The study employed a lifetime model that incorporates real-world data on everything from American income to mortality and social security benefits.
Mixing stocks and bonds is the retirement strategy of choice for many Americans, often through so-called target-date funds offered by mutual funds. Such vehicles housed $1.8 trillion of assets in 2021, rising from $340 billion a decade earlier, according to data compiled by the Investment Company Institute.
To be sure, arguing that pension investors should shun bonds completely will strike many as extreme. It challenges a long held and widely followed practice where fixed income constitutes a pivotal part of the retirement pool for many Americans.
The importance of bonds goes beyond just their upside and involves stability, according to Joe Quinlan, head of market strategy with the chief investment office at Merrill and Bank of America Private Bank. Unlike stocks whose performance is random and erratic, fixed income’s steady and predictable returns give people a sense of control over their financial wealth. Many clients, he says, are willing to give up potential profits for the ability to be able to sleep at night.
“It is a trade-off, and that trade-off can be worth it,” Quinlan said. “A lot of investors want to have an idea that X percent of my portfolio is going to give me Y percent return. You can’t do that with equities.”
James Daniel at Advisory Firm LLC cited the dot-com crash as an example of the hazards from going all-in on stocks. “Ask any retiree that fully retired in 2000 after the tech bubble how an all-stock portfolio did while taking distributions for the next 10 years,” he said. “In theory, an all-stock portfolio works great. In reality, not so much.”
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To Cederburg, telling investors to own fixed income because bad things happen in stocks is missing the big picture that equities tend to go up over time and more often than not, when shares do poorly, bonds suffer too. That’s what happened in 2022.
One way in which the new study differed from previous ones supporting the stock-bond mix is that while it let the computer run portfolios among a random sample of months and countries, it strung the months together in 10-year blocks in order to capture market cycles. Big crashes are often followed by big recoveries, for example.
Because the history of US markets is short when considered next to investment lives that may last 50 years or longer, the paper employed data encompassing 38 developed countries that went back to as far as 1890 in order to derive investment outcomes. By including non-US markets, it not only broadened the sample size but also acknowledged the potential that America’s superior performance in recent decades may not repeat in the long run, just as the UK peaked about a century ago and Japan’s heydays ended in the 1980s, according to Cederburg.
The benefit from the all-stocks approach continued after retirement, the study showed.
“Given the sheer magnitude of US retirement savings, we estimate that Americans could realize trillions of dollars in welfare gains by adopting the all-equity strategy,” the researchers wrote. “Bonds add virtually no value for the lifecycle investors we consider.”