There must be a lot of anti-bond sentiment circulating these days, as my inbox has been lighting up lately with questions about whether bonds still make sense to investors. It started last year when Ray Dalio got on a roll and made a series of rather provocative comments about how he thinks you’d be crazy to hold government bonds and how cash is trash, too. It accelerated as interest rates continued to drop to new lows. And it has reached a bit of an apex as bond returns have taken a pretty decent hit in the last few months. Was he right? Should you sell all your bonds now before it’s too late?
I’ve wanted to write a long reply for a while now, but I’ve struggled with finding the right approach. One option is to recap how capital appreciation and bond convexity work to drive bond returns even at very low or even negative rates. I could also talk about how, despite the miniscule top-line nominal numbers, interest rates today are still nowhere near historical lows in inflation-adjusted terms. Or I could politely point out how Dalio speaks about bonds in terms of safety where volatility is a bad thing (“one day’s price change is greater than one year’s yield”) but that stocks are just as unpredictable and some portfolios actually use that volatility to their advantage.
While all of those arguments are worthy of discussion, I also think that at some point they start to feel a little too in the weeds. Beyond the immediate question, I can’t help but feel that engaging the details solely on their own tactical terms not only feeds the wrong mindset but also misses a more profound truth.
For starters, none of these fears are unique or new. If bonds are the boogeyman of 2021, I got just as many questions about small cap value in 2020 as large growth stocks dominated. Before that it was stocks as a whole, with everyone fretting that the market was wildly overvalued and destined to crash. And on, and on… you get the idea. No matter what’s going on in the world, there is always at least one deadly financial fear lurking around every corner just waiting to take you down the first chance it gets.
But regardless of whether you’re talking about high stock valuations, a disappearing value premium, bonds at crazy low rates, or the next macroeconomic emergency that will surely arise from the ashes of the one before, you may be surprised to learn that none of it really worries me all that much. Because from my perspective there’s a deeper investing reality that most people don’t see.
This is admittedly a hard pill to swallow, and not everyone ultimately gets it. So to explain what I’m talking about, let’s try something a little different and talk about one of my favorite movies of all time — The Matrix.
We all have a part in the Matrix
I think one of the things that makes the Matrix so special is that the story is timeless. The theme of an average guy awakening into a dangerous world and slowly learning that he’s the One who transcends the system touches on a lot of things that we can all relate to. I imagine a lot of you are just like me and have felt like Neo at some point slaving away in an office cubicle, living a second life online, and having a deep but indescribable sense that there’s something happening just beneath the surface that you don’t understand.
Eventually Neo runs across a few enlightened individuals who open his eyes to the inner workings of a world that most people are blissfully unaware of. Not only is the reality they take for granted not real, but there are also incredibly deadly inhuman agents whose sole purpose is to kill anyone who questions the status quo.
In order to survive, the group trains relentlessly to hone their skills and even challenge the limits of physics that constrain the world around them. From kung fu mastery to crazy firearm skills and leaping between buildings in a single bound, they become the superheroes of lore even as most travel unnoticed in the shadows. To the new initiates, the masters seem unstoppable.
But for all of their power and training, even the strongest people are still just pawns compared to the computerized agents. The calm and collected black-tied killers are faster than any human, anywhere and everywhere at once, and uniquely skilled at taking down the very best. Nobody has ever faced an agent head-to-head and survived. So they stay on constant alert, stage small battles where they can, and in the end they run to live and fight another day.
The Matrix resonates because it taps into a lot of deeply embedded cultural archetypes that we can all relate to. Naiveté, awakening, and fighting the system are themes that can apply to lots of things in life. Even investing.
The agents that can end everything in an instant if you’re not paying attention are a lot like markets. Those super low interest rates in bonds really do pose a serious risk to your life savings if you’re not careful and try to pick the wrong fight with too much money on the line. And there are similarly deadly agents for small cap value, large cap growth, commodities, and any other number of volatile markets that can turn on you in a moment’s notice. Markets don’t mess around.
The famous investors you look up to like Dalio and Buffett are like the other freed heroes in the Matrix. Endowed with seemingly superhuman trading skills, they can move faster and jump higher than anyone else and even dodge the occasional agent bullet. Who wouldn’t want to achieve the same level of success? Much of the investing advice you find today thus resembles cool sounding modules on how to wield a katana or fly a helicopter just like the most skilled investors that came before you. The more skills you have the better equipped you are to go to battle, even if the best know not to directly challenge the markets if they want to survive.
There are even good parallels like the investing Oracles who everyone looks to for advice but who never seem to give a straight answer. There are the people like Tank and Dozer who never enter the Matrix at all and depend on living vicariously through skilled advisers who do the work for them. And there are even turncoats like Cypher, such as the heads of certain trading platforms with the power to pull the plug on your trading ability at the absolute worst possible time. I imagine many people on WallStreetBets felt like Switch as Robinhood halted GME purchases. Sure, they knew it would end at some point. But not like this.
But the two most important characters for our purposes are Neo and Morpheus. You and me. And the key wisdom of the entire movie is actually delivered relatively early on before Neo had any idea what it meant.
Of course, it took a while for Neo to internalize Morpheus’s insight. Through a series of events he learned about his abilities and became more and more confident in taking on the agents. But even then, he never seemed to let go of the idea that with enough training and lots of guns he could beat the agents at their own game. In fact, it wasn’t until he took a series of bullets straight to the chest that he finally woke up to what Morpheus was trying to tell him. The bullets and agents were just isolated code in a larger simulation, and Neo had the unique ability to see the big picture.
So when I say that things like interest rates and stock valuations don’t ultimately matter, I’m not at all trying to imply that they’re unimportant or don’t deserve investor attention. But I’m also not saying that I can teach you how to dodge those bullets. Like Morpheus guiding Neo, I’m just exposing you to the underlying truth that eludes most people searching for exciting answers.
With the right portfolio, the individual market agents so feared by most investors have no power over you. The bullets they rain down are but floating curiosities to be studied rather than dodged. Their most aggressive fighting moves are parried on autopilot by an intelligent, well-diversified asset allocation that reacts in real time. And while the most skilled tactical investors hone their advanced fighting skills, you can simply breathe deeply and flex, safely rejecting that exhausting reality and starting a new and empowered way forward without fear.
Tracking historical bullets
Like most people first exposed to the truth of the Matrix, you may think it sounds like a bunch of hogwash that’s too good to be true. I get it. I’ve been there, too. Sometimes you really do have to get shot to understand that the bullets have no bite, so let’s look at some historical examples of how a truly diversified asset allocation handled some particularly dangerous markets that sent many investors to an early grave.
I’m going to focus on the Golden Butterfly, not because it’s unique (there are lots of great options) but because it contains so many assets that really do terrify lots of people. And I’m also going to play the long game and speak in terms of decades, as prolonged bear markets are the real tests for investors who fear significant sea changes in how markets operate.
20% Total Stock Market
20% Small Cap Value
20% Long Term Bonds
20% Short Term Bonds
I think we can all agree that low rates and negative real yields make bonds relatively unattractive compared to when they paid reliable income and had more room for rates to safely drift downward. Are you worried about the potential for rising interest rates that will deeply cut the value of your bonds? I totally understand. So let’s play this out.
Picture rates not just sloping upwards in an orderly fashion but spiking well into double-digits. While that will result in huge capital losses, at least you’ll have the big coupon payments to look forward to, right? Think again. Interest rates aren’t set in a vacuum, so visualize inflation consistently matching or surpassing the rising rates. Now imagine that vicious cycle continuing for a full decade. Your long term bonds continue to pay less than 3% when adjusted for inflation even as rates take off, and your short term bonds experience negative real rates for all but a few lonely months for the next 10 years.
That’s a really tough situation for bond investors that would feel like a complete 180 from the 40-year tailwind of slowly declining rates we’ve been blessed to experience since the early 80’s. One might even call it unprecedented.
The thing is, it’s not.
That’s exactly the situation in bonds that unfolded in the 10-year period from 1972-1981, the single worst decade to invest in bonds since 1970. Add up massive capital losses due to rapidly rising rates with huge inflation that completely negated the higher interest payments, and long term bonds lost 49% in inflation-adjusted terms while even safe short term bonds lost 15%. There’s no way around it — that’s just brutal.
As much as most investors absolutely love US stocks, there’s always a nagging voice in the back of their heads about valuations. Because as great as stocks have done recently, watching the CAPE ratio soar to over 33 has a lot of people worried. That’s really high historically (nearly double the historical average of 17), and it could very well be a sign that the markets are overpriced and overdue for a sharp correction. And it also doesn’t bode particularly well for value stocks if the “value” the literature is based on historically really isn’t there anymore. That is a big reason why many prominent investors today are a lot more skeptical about the future prospects of popular assets like small cap value.
Now imagine how you might feel if the CAPE ratio was not simply at a lofty 33 but north of 40. On the one hand, that probably means that stocks have been on a historic tear piling up massive profits. But on the other, that’s a huge red flag. What’s your move?
Well, that’s exactly what happened in 1999 at the tail end of the dot-com bubble. But while that indeed marks the start of the worst decade for stocks in the last 50 years, valuation doesn’t even begin to tell the full story. Lead off with the stock bubble bursting, follow it almost immediately with the chaos of the 9/11 attack in 2001, chase it with years of war in the middle east, and close the run at the end of 2008 in the throws of the financial crisis and Great Recession. It’s hard to script it any worse than that if you tried.
Over those 10 years starting in 1999 and ending in 2008, the total stock market lost 28% in inflation-adjusted terms. For the sole source of income in most traditional stock-heavy portfolios, that type of loss for a full decade is all but intolerable. That was also the worst decade since 1970 for small cap value, but believe it or not it gained 46% in that time. While that fact is pretty remarkable and is a testament to the long-term resiliency of small cap value even when times are tough, keep in mind that the gain was only after a fast and deep 49% drawdown in just 2 years. So I imagine a lot of normal people didn’t hang around for those profits and ended up selling at a substantial loss.
Gold has got to be the most polarizing of all the assets, as people tend to either love it or hate it. Its fans like how it is a historically relevant store of value that crosses all eras and cultures, is divorced from many of the market factors that may torment stocks and bonds, and can serve to generate sizable profits when nothing else does. Its haters despise the extreme volatility, think its inflation-fighting characteristics are overrated, and usually describe it as no more inherently valuable than a pet rock collected and traded by increasingly greater fools. I’ve talked about both perspectives in detail, but for the purposes of this post it’s beside the point.
Since it was finally freed from government-mandated price controls in 1971, the gold price has been all over the map with multiple big peaks and valleys. And the absolute worst decade to invest in gold was the 10-years between 1981 and 1990. It started at the peak of a massive price bubble resulting from those negative real rates and massive inflation we discussed earlier. And it involved a huge, long drop that ultimately fell 78% and only recently recovered 40 years later at the end of 2020. Over that particularly bad decade, gold lost 59% in inflation-adjusted terms and still wasn’t done falling. I mean seriously — just look at the drawdowns chart dripping in red.
No matter how you feel about gold, that’s no ordinary agent. We’re talking full god-mode Oracle-devouring psycho Smith.
To recap, real investors that had their life savings on the line before you even knew what investing was all about experienced decade-long losses of 28% for stocks, 49% for bonds, and 59% for gold. Fancy alternatives like small cap value did better, but only if you had diamond hands through some seriously scary drawdowns while everyone else thought you were stupid. Even short term bonds that lots of people depend on for emergency funds lost notable money as well. And if it happened to them it could happen to you, too.
I imagine many of those investors felt like some of you that “this time is different” and that the portfolio rules of thumb they previously took for granted were irreparably broken. So I can see why well-trained investors both then and now might be sorely tempted to run for the nearest exit the first time any of those agents turn the corner.
Check out the Drawdown charts for each of the five assets in the Golden Butterfly. The Matrix takes no prisoners.
There is no spoon
This is the part of the story where most people stop. They receive undeniable proof that certain market conditions can wipe out particular assets. They see evidence that some of those conditions may be ready for an encore. And they make an educated choice to do everything they can to keep it from happening to themselves and others.
Everything, that is, except for looking at the portfolio as a whole.
Scroll up for a moment and look one more time at the series of Drawdown charts for each Golden Butterfly asset. Imagine yourself as a silly buy and hold investor with no trading skills who ignored all of the warning signs and simply bought each of those 5 assets in equal amounts and continued to blindly rebalance into the underperformers every year no matter how bad it got. Picture in your mind what the same chart for the Golden Butterfly looks like. How deep were the drawdowns? And how long did they take to recover?
Does it look like this?
Click to reveal
Since 1970, the single worst decade to invest in the Golden Butterfly was the 10-year period from 1999-2008. Not too surprisingly, that’s the same timeframe that was also the worst for the volatile stocks that make up 40% of the portfolio. But unlike the total stock market, the Golden Butterfly gained 49% in that timeframe. And unlike small cap value, it never experienced that sharp short-term fall, either.
Keep in mind that the Drawdowns chart does not only look at this one timeframe, but at every possible annual start and end date since 1970 simultaneously. During the absolute worst times not only for stocks but also for bonds, cash, and gold, the Golden Butterfly absorbed every single one of those punches and never dropped more than 11% (using year-end data) or stayed underwater for more than 2 years and change. Those are the types of consistent results against hostile markets that even the most skilled trader would have a tough time sustaining.
To look at it another way, here’s the Portfolio Growth chart for the Golden Butterfly. This shows the compound growth for every annual start date since 1970 overlayed on the same chart, and it also assumes a typical situation where an investor continues to save more money over time rather than simply invest in a single lump sum.
Within that remarkably tight collection of outcomes (play with this for comparisons), I took the liberty of marking the three worst-case 10-year start dates we talked about earlier for each asset. Green is the period starting in 1972 that killed bonds, red is the period starting in 1999 that wiped out stocks, and orange is the period starting in 1981 that really did a number on gold. The lesson here is that any one asset alone can indeed be extremely dangerous if that’s all you invest in, but all of the portfolio outcomes starting in those bad asset years were perfectly ordinary. A well-built portfolio is greater than the sum of its parts.
For portfolios like the Golden Butterfly, the secret to success is not in fighting individual assets on their terms but in seeing past the volatile markets to the underlying economic system in which they operate. No asset will always succeed, but they all have certain economic conditions in which they thrive or struggle. And by building a portfolio that effectively balances those conditions, no one market will ever be able to do much harm. In fact, when one shoots to kill another takes the bullet and more than makes up the difference. Like Neo awakening to a world of code to be embraced rather than feared, a truly diversified portfolio plays a different game entirely.
So circling back to the many questions I get about the current economic environment:
- Don’t interest rates have nowhere to go but up?
I think it’s more complicated than that, but it certainly looks like it could happen.
- Is it possible the value premium is fading?
Sure, even its proponents acknowledge that it’s cyclical and can have long dry spells.
- Are stocks hopelessly overvalued and due for a correction?
Yeah, valuations are super high and I could see a bear market on the horizon.
- Is cash with negative real rates a drain on your resources?
It can still be helpful as ballast for risky assets, but I don’t like negative rates either.
- Isn’t gold just a shiny metal that pays no dividend and can flounder for decades?
I mean it has a lot more financial history than just any rock, but that other stuff is all true.
Even assuming those realities are inevitable, in the end none of them really matter. Because after spending many years studying portfolio theory, I’ve come to the conclusion that the major downsides of all of those situations are largely avoidable with the right choices.
- What are you trying to tell me? That I can dodge bullets?
No, Neo. I’m trying to tell you that when you’re ready, you won’t have to.
Help me show others how deep the rabbit hole goes.