Conversations between financial advisors and their clients are going to get more difficult in the coming months. With bond yields collapsing around the world, it is harder and harder to justify their role in long-term portfolios focused on total return. I can imagine the conversation going something like this:
Financial Advisor: Thank you for coming to see me today. I want to talk to you about the importance of a balanced investment portfolio?
Client: Yeah, no problem. I’m not a trader, I know that. I need a portfolio that gives me decent gains over the next 30 years so I can retire comfortably.
Financial Advisor: Well, you’ve come to the right place! Do you know what I mean by a balanced portfolio?
Client: Stocks and bonds, right?
Financial Advisor: Yes. Historically, a balanced portfolio of 50% stocks and 50% government bonds has returned slightly less than a portfolio consisting of all stocks. The return is even better when it is risk-adjusted.
Client: Huh?
Financial Advisor: Sorry, I sometimes get carried away with industry jargon. When portfolio returns are risk-adjusted, it means you compare the return of the portfolio to its annual volatility. Including bonds in a portfolio lowers its volatility because bonds and stocks often move in opposite directions, so when your stocks fall, some of those losses may be offset by gains from your bonds.
Client: Sure. Sounds good. That makes sense. So what kind of return can I expect over the next 30 years? I want to know if I will ever have enough money to retire at some point.
Financial Advisor: Over the last 30 years, the average return of the S&P 500, assuming you reinvested all dividends, was just under 10%, and 10-year government bond yields are currently 1%, so if we assume stocks will deliver similar returns over the next 30 years, a 50/50 mix would return 5.5% over the long haul. There are a lot of assumptions in there, but that will at least give you an idea of what you might expect.
Client: Hold on. What was the bond yield?
Financial Advisor: 1%.
Client: 1%!
Financial Advisor: Yes. Oh, I should mention the 1% yield is before inflation. The real yield is -1.50%.
Client: Huh?
Financial Advisor: Sorry. There I go again with the jargon. When evaluating bonds, it makes sense to look at the yield AFTER you take into account inflation. So if the bond yields 1% and the inflation rate stays at 2.5% like it is today, you would have a negative return because the interest you earn on your bond won’t keep pace with the rise in the cost of living.
Client: So let me get this straight. I come to you because I need my money to grow, and you want to put half of it into something that will make it shrink? What am I missing?
Financial Advisor: That is correct, sir. Remember, a balanced portfolio that includes a sizeable allocation to government bonds can mitigate drawdowns when risk assets fall?
Client: You are starting to annoy me. Speak to me in plain English, and answer this question: if I invest in these bonds that you say are so great, will I have more or less money in 10 years than I do today?
Financial Advisor: Less…If inflation stays at 2.5%. You will break even if inflation averages 1% over 10-years.
Client: Is that realistic?
Financial Advisor: Over the last 30 years, the average inflation was 2.4%.
Client: This bond allocation sounds like a horrible deal. Just saying. Is there something else we can do?
Financial Advisor: Well, you are relatively young, and you do have a long term time horizon. We could put you 100% in stocks. I want to emphasize, though, that your portfolio will probably be quite volatile, and there may be periods when you could see your account value drop 30% or more.
Client: Yeah, I get it. When I walked in here, you made me sign that piece of paper that says I understand investing is risky and that I needed to be patient and let time work its magic. Like I said before, I care about having more money in 30 years than I do today. Your bond strategy is not going to help me get there. I would rather learn to live with the ups and downs and at least give myself half a chance of achieving my goals rather than dump 50% of my cash into your bond strategy that almost guarantees that I lose money. Am I missing something? It seems pretty obvious to me?
Financial Advisor: You make a strong argument. Again, are you sure you can handle the volatility?
Client: I have no choice.
This article originally appeared on Forbes.
