Why Fixed Income Investors Lose In The End

It’s possible that during certain years the income a “T-Bill investor” earned was actually as high or higher than inflation. But consider what happens to the purchasing power of your income along the way, and, worse, the constantly shrinking real value of your principal.

Each year inflation takes its silent bite, and by the end of the period you can only buy a fraction of the goods and services you might have bought with your capital at the beginning of the period. Let’s say you put away $10,000 in 1945 for your child’s college. That might have seemed like a lot of money at the time and, indeed, you could have bought a small house with it. And let’s say during the interim you spent the interest you received from a bond investment on extras like vacations or a second car payment. By the mid-sixties, when your child was ready to enter college, the annual cost for a private university was already $10,000 per year (I went to one that cost slightly more than that during the mid-sixties). The grand sum you saved for college would barely pay for one year after inflation had done its work!

Even at a moderate rate of 4% inflation (less than the post-World War II average) the value of money is cut by nearly 50% in about a decade. For many key items, such as health care, it may be cut by more than half. Clearly, if you plan to live for more than ten years or so, your investment must rise enough to overcome the effects of inflation---and this is true of the income your investment produces if you need current income or will need the income later.

The nature of the economic environment leads to one inevitable conclusion: you cannot hide in fixed-income investments. So-called “safe” investments aren’t safe at all when you realize that stagnant capital will not keep ahead of inflation. On the contrary, since we know that inflation exists, and since we know that bonds do not rise along with inflation, we know that bonds are actually riskier in the long term than investments which can increase in value.

Except for short-term parking of funds and to preserve fixed amounts that you may need in five years or less, all investors, whether they are retirees or corporate pension plans or churches or foundations, must say “goodbye to bonds,” to T-bills, to bank C.D.s, to GIC’s, to N.O.W. accounts and to money market funds. For fixed-income investments are also fixed-principal investments, and the real value of your principal---as well as the real value of your “fixed” income---will diminish over time, like a vigorous man becoming frail and weak in old age.

The image in Chart 2 is something like the bible for professional investment advisors and students of investing. It shows the long-term return of various kinds of assets---T-bills, bonds, large stocks, small stocks---all as compared with inflation. Clearly, history has shown that stocks are far superior to fixed income (T-bills and bonds) when compared to inflation. And reason supports the view that this should be so. After all, investments in stocks are, theoretically at least, investments in something that grows, that gets larger. Investments in fixed income are investments in something that is intended to stay the same, something that’s “fixed.” One would expect stocks to do better, and history shows that they have, by a wide margin.

Chart 2

Bouncing Principal
But there’s another big difference between stocks and fixed income. Stocks fluctuate in price. T-bills don’t. Bonds fluctuate less than stocks (the shorter the time to maturity of a bond, the less it fluctuates in price). If you want the gains that stocks can provide, you’ve got to pay the toll. The toll is fluctuations. “Yeah, yeah, sure, sure, I know that!” say most investors. But you’ve got to do more than know it intellectually. You’ve got to accept it deeply, in your heart. You’ve got to embrace it. You’ve got to give yourself to the truth of it---or your investment process will fall apart, done in by bad decisions and inadequate returns.

It’s often said that everyone wants to get to heaven but no one wants to die. Investors, like everyone else who wants to reach a goal, have to pay a price. It’s really not that difficult, once you realize that fluctuations are just a natural part of the process, a process that leads in laddered stair-steps to the heaven of solid investment returns. There’s nothing wrong with an investment that fluctuates moderately, but their intolerance of fluctuations causes many overly cautious investors to pass up wonderful opportunities available to part-owners of sound and gradually growing businesses.

Note that there is no real competition between stocks and bonds over long term returns; stocks win mightily. Could this be caused by some odd period, some anomaly that appears in the middle of the data and produces a lopsided result when at most times the returns of bonds and stocks would be more similar? No way. Since 1926 (the start of Ibbotson’s data) there have been fifty-nine twenty-year overlapping periods. In only one of those, the 20-year period starting in 1929, did bonds manage to outperform stocks---and it was by less than 1 percentage point. In every other 20-year period stocks outperformed bonds, through recessions and booms, war and peace, famine and pestilence, you name it. And they did so by a mile.

Let me put it bluntly, bonds are a bad investment. And they don’t even do what most people think they do, which is provide a decent return with low volatility, as we shall see in the paragraphs upcoming.

Bonds, Bad

Bonds aren't investments, they're savings.

The important point here is that investors all too frequently buy bonds because they are “afraid” of the “market.” This would be fine if bonds gave back a return that at least exceeded inflation, but not only do bonds underperform stocks, the chances are high that in any given period bonds will not beat inflation. In that case investor fears of the market are actually causing them to incur an inflation-adjusted loss. No one wants to invest for a loss, and if you’re reading this book you’re obviously seeking a better way. The path to a better way starts with the acceptance of the “bouncing principal” principle. You need to accept some risk---but that doesn’t mean that you need to assume that risk is equal to loss. It’s not.

Further, most people are still living in a sentimental historic past when it comes to understanding bonds and their market characteristics. You must bear in mind that ever since the inception of the Federal Reserve Bank as a response to conditions which led to the Great Depression, the Fed tightly controlled interest rates nationwide. In 1978 however, the Fed decided to let interest rates float freely. Most observers see this as a distinct benefit to the economy, but look at this chart to see what the action did for the volatility of bond prices. As you can see, commencing from the date of “freedom,” bonds became just about as volatile as stocks. Yet most people still think of bonds as in the old days, with low volatility. Yes, they’re still less volatile, but just a pinch less so. Hardly enough to make up for the radical haircut you take when it comes to returns.

Learning To Love Fluctuations
With the correct perspective, one can learn to appreciate---and eventually seek out---investments that fluctuate (at least a little!). To be fair, a more volatile investment does harbor the possibility that it might be on a down-jump just when you need to sell because you need the money. In that case you would, in fact, lose money in an absolute sense, but it would have nothing to do with the intrinsic opportunities for that particular investment over the long term. What you should note about the volatility chart (chart 3), though, is that there’s almost no substantive difference between bonds and stocks, yet we’ve already seen that stocks provide exponentially more reward.

There are, certainly, a few kinds of investment such as troubled companies, options and futures, or outright scams, where you can lose your money with no hope of ever getting it back. But in most cases, in most reasonable investments, we might say, the notion of risk is really more precisely a notion of volatility. That is, the value of the investment will fluctuate up and down---this is a given, based on the premise of an investment and the fact that an investment with no fluctuations can’t be expected to generate an equal return to one that fluctuates. In theory, if “risk” is actually fluctuation, the greater return you get for investing in something with higher fluctuation is actually a kind of payment for tolerating the fact that the value of your principal may bounce up and down.

The return you earn is a “payment” for accepting the “bouncing principal,” and it is also a payment for accepting the fact that you might need the money at a time of downward fluctuations.

In a real investment---as opposed to a speculation---your analytic process has already reduced the chances of permanent loss of some or all of your money to statistical unlikeliness. In other words, if you choose generic “growth stocks” or “index funds” as your investment, if you choose “real” investments with “investment quality” (as determined by the credit ratings agencies such as Standard and Poor’s, for example), the issue of losing your money forever isn’t really the right understanding of risk.

The right understanding of risk is an assessment of how often and how deeply the value of your investments will fluctuate, and whether you will be paid enough to accept that bouncing, compared to how much you get paid to accept the bouncing or lack of bouncing in other investments. Most important, what are the qualities of the fluctuations and the qualities of the investments that are fluctuating, which affect how you feel about the fluctuations, which affect how well you are able to tolerate the fluctuations?

The Risk/Confidence Equation
Obviously, the right investment is going to have a moderate magnitude of fluctuations relative to the return you can expect to get. It is also going to have a moderate quantity of fluctuations relative to the return you can expect---it’s not going to be jumping around all the time. But most important, the best long-term investment is going to be one where you have the fullest faith and confidence that it will fluctuate back up after it fluctuates down. That it will become more valuable over time.

Otherwise you’ll be tempted to sell at the bottom out of fear, and your investment results will suffer. Indeed, the best long-term investment is the one that is easiest---from a psychological standpoint---to buy when the fluctuations have been down. In other words, one test of how good an investment is in terms of the ease of holding it, is to consider how attractive it may be to purchase or add more when its value has been decreasing.

When that is the test, and when that test has been passed, then you know you are talking about real investing---as opposed to swaying with whatever breeze happens to be passing at the moment. When your understanding of your investment is sufficiently great to overcome the natural fear that declining prices will persist forever, then you’re no longer just a pawn of the great industry dedicated to selling investment products, then you are actually an investor.

This is not to say that good investments must decline before they become interesting to buy: far from it. Many of the best stocks never really experience big or noteworthy declines. This, as they say late at night on TV, is merely a test. It’s like a kind of litmus paper. If you feel so insecure about an investment that you’d be tempted to sell on a 10% or 20% percent decline, you need a better and more understandable investment, or an attitude adjustment, or both. (Hopefully, this book will fix both problems!)