Sorry Guys, Stocks Are Not Bonds

Includes: SPY, TLT, VIG
by: Dale Roberts

There have been many articles on Seeking Alpha that suggest investors should simply replace their bonds with stocks. Or that investors should simply ignore risk altogether and sell their bonds. There have been articles that suggest investors should not hold bonds at all. Once again, without any mention to risk or risk tolerance levels. Just who should hold zero bonds?

As you can imagine I spend considerable time imitating a bobble-head doll with my head repeatedly shaking side to side in the typical "NO" gesture.

Stocks are not bonds.

Investors largely hold bonds for two reasons; for income and for portfolio risk management, and generally for their lower risk characteristics.

Bonds are number one on the food chain when a company runs into trouble, or goes bankrupt. If a company goes out of business, bond holders are paid first. They are first in line. Shareholders are standing on their tippy toes trying to get a glimpse of those bondholders at the front of the line. If there's real trouble with the company, those shareholders might as well just go home, cause there won't be anything left after the bond holders take their cut; sometimes that's a full cut.

It's the same story if a company is struggling but not declaring bankruptcy. The bond holders may continue to get their income in full. The dividends can be suspended, reduced or cut. Remember in the Great Recession 37% of all dividend champions froze, reduced or eliminated their dividends. Dividend champions are the best of breed; the companies that have increased their dividends every year for 25 years running.

Bonds are top of the food chain.

Here's a real life example of two investors and what happened with GE (NYSE:GE) in the recession. GE ran into real trouble to say the least. They cut their dividend. By the time they cut their dividend in 2009 the stock price had already fallen by some 70% from its recent top. In June of 2009 GE cut its dividend from .31 to .10., GE had a share price above $41 in late 2007, it fell to $11.95 in June of 2009. A notable SA author got caught in that trap and sold at a loss.

On the bond side, I recently spoke with a friend of mine who is a very savvy investor who largely owns many vacation rental properties in Canada and Europe. He also invests in stocks and bonds and ETFs. In the recession he made a lot of money off of GE. Why? Because bonds are at the top of the food chain, and that reduced the risk. He purchased a bond from GE's financial arm, the source of GE's troubles. He was confident enough that GE would not go out of business, and being first in line on the income and return of capital front, he purchased a GE Capital bond at a discount. ln a very short period of time, he received income, he won in price terms when the bond matured. He had a total return above 150%.

That's an example of why some investors buy bonds. That's one of many examples where on the income front, the bond was much more reliable, and was a lower risk investment than the stock offering. The bond was also a better bet and investment on the total return front.

Perhaps the most common reason for holding bonds is managing risk in a balanced portfolio, that is, using bonds to mitigate or temper the price fluctuations (risk) of stocks. I call bonds shock absorbers. When I use that phrase, clients seem to pick up on the concept and usefulness of bonds, real quick.

And here's another fact, lower beta stocks are not bonds when it comes to price protection or for lowering portfolio volatility. Stocks never work like this.

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Above we see the S&P 500 (NYSEARCA:SPY) charted against 20-year Treasuries (NYSEARCA:TLT) moving into and then out of the recession. It's uncanny to say the least. They are the mirror image of each other in price terms. When the stock market went one way (down), the long term treasury market went the other way (up). Stocks and bonds are not always inversely correlated but when it comes to recessions and severe price drops the bonds are there. In the above chart we can see that TLT was even there during the small hiccups within the equity recovery in 2010 and 2011.

Lower beta stocks can sometimes help cushion the blow of price drops, but in a very severe correction that potential for reduced volatility of 10 or 20% is not going to help a risk averse investor one iota. Many dividend investors on SA write that the safety of their lower beta dividend stocks would have cushioned the blow through the recession.

Here's how the popular dividend growth ETF Vanguard's (NYSEARCA:VIG) held up in price terms during the recession. VIG is a great measuring stick because companies in VIG have a dividend growth history and there are some very effective (proprietary) value metrics applied. Also, VIG is a total return champion.

Here's VIG vs. Mr. Market.

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Certainly the dividend growth history and value metrics helped VIG hold up a little better than the market. Does it look like the TLT chart? OK, case closed.

We don't have much to compare with on SA for those who pick their own companies, but here's SA Author David Fish's Fund DRIPX and how it fared through the recession. As per its name, the fund holds companies that (NYSEARCA:DRIP) or reinvests the dividends. Certainly the chart below is a price chart, but dividends won't help much in a short term price drop, certainly not a price drop of over 50%. That fund fell with the market.

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And even a broad-based bond ETF can help a balanced portfolio hold up. Our Streetwise Portfolios offer a unique and real world snapshot of how bonds helped balanced portfolios hold up during the market meltdown. The portfolios had a launch date of January of 2008, just five months before the markets started to correct big time. The markets corrected by about 60% in price terms from top to bottom.

The Balanced Income Portfolio with 70% bonds to 30% equities was never even down 10% from inception. The Balanced Portfolio with 40% bonds was down some 20% from inception. The Balanced Growth Portfolio with 25% bonds was down about 35% from inception in its worse days and weeks.

Here's a chart with the three equity (Canadian, U.S. and International indices) and the bond component of the portfolios; we can see the "shock absorber" effect of the bonds. In this case they are holding steady, holding down the fort.

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The bonds in the above portfolio are doing their double duty, they're reducing portfolio volatility by a significant amount, and they're delivering income to the portfolio.

Here's how the Balanced Portfolio held up vs. the broader market.

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And do most investors need those shock absorbers? Yes. Dalbar studies show that individual investors lag the market returns available by a very large degree. There's simply too much buying high and selling low.

To suggest that investors should ignore risk is inviting trouble. The unfortunate irony is, that many of the writers suggesting that investors ignore risk, or suggesting that there are no risks in investing in equities such as dividend growth companies, is that many of the writers appear to not have been investing for a longer period, and there's no trace of them investing through the market meltdown. They have no idea if even they themselves will be able to navigate through a severe correction. You don't know you're risk tolerance level until you've been truly tested.

As Warren Buffet writes, if you can't handle a 50% correction in your investments, don't invest in stocks. We might add, if you can't handle a 50% correction, then construct your portfolio so that the complete portfolio may likely only fall 20% or 30%. You may choose to invest in bonds or other fixed income instruments, or simply keep your equities at a manageable percentage of your total holdings.

Taking on too much risk is the root cause of investors collectively losing hundreds of billions of dollars in the equity markets. Risk is not to be taken lightly, dismissed or ignored.

If you need to reduce your risk, remember, stocks are not bonds. If your aim is to reduce portfolio volatility, work in some bonds, or simply hold equities at a total portfolio concentration level that you are comfortable with.

And remember, perhaps the most important determinant for success is patience, and staying the course - staying invested. Take a good hard look at your personal risk tolerance level, and then create the portfolio that you reasonably believe will help you stay invested throughout the years and decades.

Do your research on stocks and bonds and the risks they both hold, and be careful out there.

Disclosure: I am long DIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.