Friday, July 28, 2017 EST

This post looks at investing in Bond Funds vs. the Stock Market. 

This is an approach you can accomplish with No Fees, No Financial Adviser, and have access to your money at anytime.

For investors that invest in bonds (not bond funds) they will argue that you should put your money in bonds because bonds mature and bond funds do not. This means if you buy a bond and it sinks in value (as long as it is good quality) the bond will mature and you will get all of your principal back plus the interest earned.   This is very true, but when it comes to 401K Investing you are limited to of course the funds in your 401K.

Setup: Looking at 3 portfolios using Vanguard Bond Funds and SPY.  (one bond fund, two bond funds, and the S&P 500) we will examine returns.

What we see over the long haul is what are are familiar with, that is, the Stock Market has the highest return.  But when you look under the covers what you see are gut-wrenching downturns, and measures that look at investment risk / reward the stock market has a worst risk / return ratio than simple buy and hold bond funds. 

Some items to look closely at: 

  • Sharpe Ratio: The Sharpe Ratio is a measure for calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. Greater than 1 is considered acceptable to good. A ratio higher than 2 is rated as very good, and a ratio of 3 or higher is considered excellent.  - You will not see the S&P 500 reach a level of "good" over the long haul. Which means the risk / return is not all that great. 
  • CAGR: The compound annual growth rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer than one year.

Here are the 3 portfolios we back-tested using Portfolio Visualizer.  

Date: January 1995 - June 2017 - starting with $10,000

I. One Bond Fund:  VBMFX - Vanguard Total Bond Market Index Fund

  • Return: $33,600
  • Sharpe: 0.89
  • CAGR: 5.4%
  • Best Year: 18.19%
  • Worst Year: -2.25%
  • Max Drawndown: -4%
  • US Market Correlation: -0.03

II. Two Bond Funds: VBMFX - Vanguard Total Bond Market Index Fund &  VBLTX - Vanguard Long-Term Bond Index Fund

  • Return: $43,660
  • Sharpe: 0.72
  • CAGR: 6.7%
  • Best Year: 23.9%
  • Worst Year: -5.69%
  • Max Drawndown: -7.9%
  • US Market Correlation: -0.03

III. Stock Market: SPY (S&P 500)

  • Return: $79,853
  • Sharpe: 0.55
  • CAGR: 9.67%
  • Best Year: 38%
  • Worst Year: -36.81%
  • Max Drawndown: -50.80%
  • US Market Correlation: 0.99

When looking at pure returns anyone would take $79,000 vs. $40,000 on a $10,000 investment over 22 years. The point here is knowing the risk you can handle.

Meaning if you saw the stock market drop 30% or a drawn down of 50% of your investment money, what would you do?  

It is all about knowing the risk you can handle and still sleep well at night. If you look at the bond fund investments the max drawn down is -8% vs. -51% for the stock market. If you go with just a Total Bond Market Fund the max drawn down is -4% vs. -51% for the stock market.

You could of course setup a 60/40 or 40/60 allocation to stocks and bonds (or bond funds) but would still have to handle some gyration. Market timing is an option but even as we see with our SMS Model it is never 100%.

Summary of Portfolios: