Being wealthy doesn't mean having all the money in the world, just not having to worry about it.

Lesson 15 – How to Slowly and Safely Go Broke

Everybody knows that stocks are risky. Everybody is right. Even a typical globally diversified stock portfolio, the S & P Global 100 Index ETF, lost 56% of its value between that Halloween date in 2007 that I mentioned in the last lesson and March 9, 2009, which by a strange coincidence is National Panic Day. (I’m not kidding!) Similar drops occurred in 2000-2002, 1972-1974, and, of course, 1929-1932. While the drop that began in 1929 was the worst in nominal dollar terms, because of deflation, a decline in the cost of living, the real loss was around the same as in the most recent disaster, around 60%.

We all agree that having your dollar turn into 40 cents, even temporarily, makes for a miserable few years. Well, if you can’t handle that, how would you feel about losing 67%? That’s what would have happened with an investment made on New Year’s Eve in 1940 and held until September 30, 1981 (which is National What-Holiday-Can-I-Make-Up-Now Day) — an investment in United States Treasury bonds. Of course, since the loss was spread out over 41 years, you would have slept like a baby as 2/3 of your wealth disappeared. Besides, in nominal dollars your money actually multiplied nearly 2 1/2 times. It’s just that the cost of living multiplied seven times — which actually makes things worse because you would have owed federal income taxes each year on the interest income.

Stock-market losses have generally been quick, and the recoveries almost as rapid. If the long-term databases I’ve seen (which go back to 1900) are right, the global stock market has never gone eight years without reaching a new all-time high on a total-real-return basis. By contrast, that 1940 investment in Treasury bonds didn’t recover all of its purchasing power until 1991, more than a half-century later. Of course, circumstances were quite different in 1940. Twenty-year Treasury bonds were only yielding around 2%, while today they’re earning around 2 … er … um … never mind. The point is that it could happen again.

Let’s take a look at bonds from the perspective of our PIG (Preservation, Income, Growth) goals:

P – Bonds, assuming they make their promised payments of interest and principal, preserve and slightly enhance the number of dollars you have but they may not preserve your purchasing power.

I – The income from bonds since the founding of the Federal Reserve System in 1913 has been mostly fictitious, averaging 5.5% in dollar terms but only 2.2% after inflation, and less than 1%, sometimes less than 0%, for a taxpaying investor.

G – Bonds essentially have no growth prospects since they only repay their face value at maturity. Over the long term the pitiful interest income is all you can count on.

Now my case against bonds may be a bit of a straw man, since few people plan on keeping everything in bonds. Don’t bonds offer a diversification benefit in a portfolio that includes stocks as well? Yes. More on that in a later lesson. But first, I’d like to discuss some other ways to diversify a portfolio. And then we can cover combining the different elements. That’s enough for now.