Last Updated Jan 9, 2011 10:18 PM EST
I can't tell you how many articles I've read suggesting that investors load up on stocks and dump bonds this year. They approach the stock vs. bond question as if it's only an issue of which will provide the better return in 2011. That's not the way to analyze these two options.
First, there's no proof that any market strategist can consistently predict market returns each year. Yes, ask 1,000 analysts, and someone is bound to be close for the year on stock and bond market returns. But you can't find one who gets it correct each year. So why would you load up on stocks or bonds based on what one of these strategists thinks? They're just guessing, and if they're wrong, which they usually are, then you have to live with the consequences.
Second, on average, stocks should do better than bonds in any given year. Why, because stocks are riskier and investors should be rewarded over the long term for taking on that risk. So predicting stocks should do better than bonds is nothing more than predicting what should happen.
But here's the problem. Stock returns are not guaranteed. That's why they're risky. If stock market returns of 10% were guaranteed, then of course there would be no reason to have bonds; nobody would buy them. The reason prudent investors use high-quality bonds is to hedge against the possibility that stocks might go down in value for periods longer than anticipated.
For bonds, let's just look at the safest type of bond you can buy, which is a US Treasury bond. If you buy a 10 Year US Treasury bond today, you're guaranteed to receive about 3.35% interest each year for 10 years and then you get all of your money back. Don't expect anything more.
Compare that to stocks. If you invest in stocks today, you're guaranteed return for the next 10 years is what? There isn't one, and that's the point. If you load the boat on stocks, you don't have any idea what your retirement plan will be worth in the future. For individuals, there's a value in having some portion of your retirement money in guaranteed investments (bonds).
This is especially true as you get closer to retirement. While the odds are in your favor with stocks (as they always are), you don't get to invest in 1,000 historical cycles and then pick the average cycle for your returns. You get one cycle, and that's why you should consider always holding some high-quality bonds.
For a sober reminder about stock market returns, consider for the last 10 years the US stock market has gone down in value. Bummer, the odds are that's not supposed to happen. Then consider that the Japanese stock market has been going down for 20 years. It has gone from about 39,000 to 11,000 over those two decades. Ooops, the odds are that's really not supposed to happen.
- The reason to look at Japan is to understand that major, sophisticated stock markets can decline in price for decades. That's all you really need to know about the risk.
- Now, the bond market is very big and complex. But for individual investors, there are simple ways to invest in safe fixed income securities. You can use either individual US Treasury bonds or FDIC insured CDs. If you start to venture into other areas, like high-yield (meaning junk bonds) or emerging market debt, then you're introducing bigger risks that you won't be paid back and thus are defeating the purpose of owning the bonds. If you're not sure how to invest in safe bonds, then look to get some help.
Bottom line. Stocks and high-quality bonds aren't substitute investments. You should consider having some of your money in each asset class every year.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.
Above material does not constitute investment advice. Consult your individual financial advisor before making any financial decisions.