Why Not All Equities? Why Hold Bonds at All in a Portfolio?

Fact: Over a suitably long period, like twenty years, equities have always outperformed bonds/fixed income investments. This is well documented in such books as the Equity Risk Premium by Bradford Cornell, which I will be reviewing soon (e.g. see this Google book extract from page 71). If you are a long term investor such as a person in your twenties starting to save for retirement, why not just forget about bonds, grit your teeth through market downturns and go for a 100% equity portfolio?

Here are some reasons:

1. Danger of selling out at the wrong time - if you went through the 40% decline in equities from 2001 to 2003 and did not sell, then you will be ok but believe me it ain't easy. Could you stick out a ten year period like the 1970s when equities went nowhere? As the famous economist John Maynard Keynes once said, "The market can stay irrational longer than you can stay solvent." (reference in the Wikipedia entry here; go look, there are so many other juicy quotes). This quote raises the other way of bailing out too early - you cannot absolutely know what your holding period will be, despite your initial intentions. Your personal circumstances may cause this to happen; suppose you decide you want to use the money to buy a house or to give it away to an important cause. Suppose you die and your family needs to use the money for living expenses. It would be better to avoid the most severe dips if you can without sacrificing returns, which is exactly what bonds can do in a portfolio with equities, as I explain below.
   
2. A portfolio with bonds and equities will have higher performance and lower volatility than an equity-only portfolio! Yes, Michael, you can have your cake and eat it to. This surprising counter-intuitive result I have previously written about last May in Portfolio Magic ... 3+1=5. The beneficial effect is not confined to bonds - international equities, real estate and commodities have also been shown to do the magic. That's why my portfolio, the structure of which is shown at the bottom of this blog, is built as it is. The effect comes about through the combination of assets with positive returns whose returns are not correlated (i.e. don't move in sync, the best situation being when they are negatively correlated so that one goes up when the other goes down). Two great books which explain and demonstrate this effect with real data are Roger Gibson's Asset Allocation (reviewed here; see Chapter 8 The Rewards of Multiple-Asset Class Investing) and Richard Ferri's All About Asset Allocation (reviewed here; see Ch4. Multi Asset Class Investing). Have a look at my portfolio: I find it interesting and reassuring that the only holding that has actually gone up is DJP the iPath DJ-AIP Commodity Index while all my equities are down. The bond holding AGG is down slightly on the chart because it doesn't include the cash interest payments I have received.

So, I'm suffering through this downturn with everyone else but I have confidence that I will be further ahead in the long run. As Keynes also said, "The long run is a misleading guide to current affairs." Fool that I am, I expect to be here for a long run yet.